This Week's Market Outlook

Highlights

• Risk rally stalls for the moment
• Sterling set to remain on the defensive
• Earnings still show little organic growth
• Treasury auctions again in focus
• Key data and events to watch next week

Risk rally stalls for the moment
Despite the crescendo of USD negativity this past week (e.g. CNBC devoted a full day's worth of programming to the weak dollar theme), the greenback actually held up pretty well, while the JPY struggled further as the biggest loser. On the week, the USD is better against the JPY, GBP, and CAD, and slightly weaker against AUD, EUR, NZD, CHF, gold and silver. Perhaps interestingly, EUR/USD broke above the psychological resistance level of 1.5000, made little progress and looks set to close just below it for the week. Eurozone finance ministers and ECB President Trichet did their best to talk down EUR/USD, but the market paid little attention. Cable experienced a massive rejection from a break above its Ichimoku cloud on strength early this past week and looks quite vulnerable (see below). CAD went on a roller coaster ride, but ultimately fell against the buck on more strident warnings from the Bank of Canada against further strength. BOC Gov. Carney used the "I" word (intervention) and traders reacted for the time being with further short-covering in USD/CAD. We are cautious that markets will continue to heed the BOC threat, but excessive USD-short positioning there may see further gains toward the 1.09-1.10 area, where we would reconsider selling USD/CAD. The 21-day sma at 1.0550 may be the trigger higher, and a daily close above would be bullish in our view.
It's too soon to say the risk rally is reversing, but it certainly feels as if investor euphoria has run its course. Stocks (S&P 500) lost ground on the week despite some better 3Q earnings (see below) and Treasury yields finished out the week at their highest levels since the end of summer. Still, we have no firm technical clues of a broader reversal and instead must reckon with further consolidative price action in the week ahead. However, due to extreme positioning (short USD, record long gold) a reversal could get messy in short order, so we will be on high alert for signs of a larger reversal. In addition to the weak USD and risk on/off themes, it looks like a case of increasing differentiation between economies based on the fundamental outlook. We expect the differentiation theme to continue even if a USD-positive correction should occur. In order of appeal, we would use pullbacks as multi-week buying opportunities in AUD, NZD, and CAD as mentioned above. In order of aversion, we would look to continue to sell JPY and GBP on remaining strength.
Sterling set to remain on the defensive vs. the EUR in the approach to Nov MPC
The plunge in the value of the pound following the release of shockingly poor UK Q3 GDP data (-0.4% m/m) begs the question of whether sterling can stage a turnaround in the coming sessions. Against the EUR, the outlook for the pound has been worsened by the perception that the Eurozone recovery remains on track. Friday?s releases of the German Oct IFO survey and the Eurozone Oct PMI both showed further improvement. Both Germany and France returned to growth in Q2 2009 and these numbers combined with a worse than expected contraction in the UK economy during Q2 played a significant part in depressing the value of the pound vs. the EUR through the summer. Looking ahead, the prospects for UK Q4 GDP will be supported by the VAT hike on Jan 1, 2010 which is likely to lead to some front-loading of expenditure. That said, UK economic potential will be dampened for some time by rising unemployment, higher savings rates and the reining in of fiscal stimulus. With the gap between the recovery in the Eurozone appearing to accelerate away from that in the UK and given the ongoing concerns about the UK?s appalling fiscal position the value of GBP vs the EUR is likely to remain severely weakened for some time. Forthcoming UK house price data is likely to show further stability, while lending data are also expected to confirm that conditions are less bad. The CBI distributive trades data may also show signs of an improvement in the high street activity. However, in the wake of the horrible Q3 GDP release none of these data releases are likely to be strong enough to push the risk of further QE from the BoE off the table. In the approach of the Nov 5 MPC meeting sterling is likely to trade on the defensive. A break above the EUR/GBP 0.9200 level could lead to a jump higher to the 0.9310 area.
We remain cautious with regards to the potential of such a pickup given the dreadful state of the consumer balance sheet and the awful employment landscape. Given that, by our calculations, the consumer still needs to unwind roughly $500 billion in non-real estate credit to get back to sustainable debt/income levels and that unemployment will continue to rise in the first half of 2010 right through 10% makes this sort of organic growth questionable to say the least. This is the main premise behind our view that the current rally in equities is well overdone and a sharp short-term correction is looming.
The next two weeks will paint a better picture of the current earnings landscape as we have 290 companies slated to report. As such, the price action in all markets will be beholden to the outcomes in this space. Given very strong inter-market correlations - with commodities, stocks, and yields all moving opposite to the US dollar - we could be setting up for a significant reversal in the recent trends. In other words, should earnings disappoint on the top-line, we would expect the US dollar to find a solid short-term base and see a significant pick-up in buying interest. Those likely to suffer the most on earnings disappointments are AUD and CAD as much of the near-term strength here (economic fundamental improvement notwithstanding) can be directly attributed to the euphoria in the commodities space. The gold bulls will also undoubtedly head for the exit.
Earnings still show little organic growth
With about 1/3 of S&P 500 companies having reported 3Q earnings, the picture remains eerily similar to the 2Q results. The bottom-line results (EPS) are coming in 16% above expectations while the top-line sales figures have registered marginally below conservative forecasts at -0.1%. This suggests businesses continued to drive the bottom line via cost-cutting, mainly on the employment front. We didn?t get that net -768,000 job loss in the quarter by accident. With the consumer seemingly in deleveraging mode (as per recent trends in consumer credit data) and the unemployment rate likely to be sticky above 10% well into 2010, driving organic earnings growth will be extremely difficult still. If nothing else, these rather lackluster earnings reports suggest a potential short-term top in the equity space as the price action looks to have overshot reality. Indeed the US market is now trading at a 20.5 price-to-earnings ratio ? about 17% above the long-term average valuation. Long-term fundamental difficulties notwithstanding, the USD could be poised to carve out a short-term bottom over the next week or so if this pattern on the earnings front continues to play out. The buck has seen a -95% correlation with equities thus far this year, so any reversal in risky assets should elicit a nice pop in the US dollar.
Treasury auctions again in focus
The US Treasury is scheduled to offer a record $123 billion in notes next week and the outcome of these auctions could have serious implications for the US dollar. Among these are 2-year ($44b), 5-year ($41b) and 7-year ($31b) offerings. The key metrics in terms of gauging the health of the auctions will be the bid/cover ratio, the indirect take and the market tail. The bid/cover ratio measures the amount of interest in the auction relative to the amount being offered. Thus a bid/cover of 2.7 or greater for the 2-year, 2.3 or more for the 5-year and 2.5 or above for the 7-year would be considered healthy participation. The indirect take is used as a proxy for foreign central banks, so a higher percentage suggests more foreign interest for US paper. An indirect take above 50% would be a good sign that foreigners are not shunning USD-denominated debt. Lastly, the market tail measures what yield the auction participants bid at (in other words what return they deem as compensation for their risk) relative to where the market is trading. Should the tail come in above 4 basis points (0.04%) or so, this would suggest investors are demanding more return for holding US paper than what the current market is offering. This means holding US paper is deemed more risky at the margin. So a positive tail above that 4bp threshold would be a USD negative as yields would likely spike. A large positive tail coupled with a weak bid/cover and thin indirect take would be decidedly US dollar negative. For now, however, the demand for US paper remains robust and has shown little signs of waning.
Key data and events to watch next week
The US data week begins with the little-advertised Chicago Fed National Activity Index on Monday. Case-Shiller home prices and consumer confidence are up on Tuesday while Wednesday sees durable goods, new home sales and the usual weekly oil inventory report. The highlight of the week comes Thursday with 3Q advance GDP along with the typical jobless claims data. Personal income/spending, Chicago PMI and the University of Michigan consumer sentiment index round out the week on Friday.
The Eurozone kicks off with German consumer confidence on Monday. French consumer confidence follows on Tuesday while German CPI is up on Wednesday. The Eurozone business climate indicator, Eurozone consumer confidence and German employment are on tap Thursday. Eurozone CPI and German retail sales close things out on Friday.
The UK has a light week on deck and starts with the CBI distributive trades report on Tuesday. Consumer credit and mortgage approvals are up on Thursday while consumer confidence is due Friday. The Bank of England will also release a report on the asset purchase facility on Monday and this could be market moving as well.
Japan is on the busier side for a change. Retail trade kicks off the action on Tuesday. Small business confidence, PMI manufacturing and industrial production are due Wednesday while Thursday has employment, household spending and consumer prices. Housing starts and the Bank of Japan rate meeting are up Friday.
Canada also has an important week ahead. Data is on the light side with industrial product prices on Thursday and monthly GDP on Friday. However, we also have Bank of Canada Governor Carney speaking on Monday and Finance Minister Flaherty on Tuesday. Given the recent musings with regards to concern about the Canadian dollar strength, these speeches could offer up some market moving tidbits.
The calendar down under is more lively than usual. In Australia we have PPI on Monday, CPI on Wednesday, leading indicators and new home sales on Thursday. New Zealand starts with consumer confidence on Tuesday. Business confidence, trade and the RBNZ rate decision are all due Wednesday while building permits round out the week Thursday.
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Weekly Market Wrap

Earnings season hit its stride this week, although the effect on markets has been hardly salutary. Trading in US equities was highly volatile, with the leading indices whipsawing back and forth in the absence of any overall negative or positive theme. The DJIA spent most of the week above 10,000, but closed out on Friday below this key psychological level. Economic data played a minor role, with most attention paid to another brace of mixed housing numbers. September housing starts and building permits fell below August levels, while the September existing home sales data over 9% sequentially. With the holiday season imminent, a National Retail Federation poll showed that US consumers plan to spend 3.2% less on a y/y basis on holiday shopping in 2009, stating that "Americans are not ready to declare an end to the recession." Meanwhile, third quarter GDP reports from China and the UK impacted FX and bond trading. China's GDP growth was stronger than the prior two quarters at +8.9% (though slightly below consensus), while a dismal UK GDP data reading of -0.4% shocked investors and took the wind out of sterling. The Fed confirmed this week that it has been testing reverse repo operations for several months, calling it a critical part of its eventual exit strategy, although it declared that the tests do not signal any imminent policy shift. Note it was just last weekend that Barron's implored Fed Chairman Bernanke to raise the Fed Funds Rate to 2%, and later in the week the FT speculated that Fed governors may soften their commitment to the zero rate policy via wording in the FOMC statement. For the week, the DJIA fell 0.2%, the S&P 500 declined 0.8% and the NASDAQ Comp slipped 0.1%.
Tougher government regulation of telecommunications and the financial industry occupied Washington this week. It was hard to avoid news of moves by the Treasury's "pay czar" Feinberg to slash executive compensation at TARP recipients and examine even wider restrictions on pay at banks. The Fed began its own review of pay in the financial sector, noting that up to 28 large banks would face special "horizontal" compensation reviews. On the Hill, the House Financial Services Committee voted in favor to speed up implementation of elements of the Consumer Financial Protection Agency. The FCC moved closer to adopting "net neutrality" as official policy, with exceptions for "reasonable" network management needs.
On Wednesday Morgan Stanley was the final big banking firm to report earnings. Morgan blew out estimates and returned to profitability after three quarters of losses. Morgan Stanley's CFO insisted that putting losses behind the bank is not a relief but an affirmation of its strategy. Leading regional banking name Wells Fargo also crushed expectations, although many commentators have expressed concern that the bank continues to rack up more non-performing assets and higher provisions for credit losses. Dick Bove spooked markets on Wednesday afternoon with a big reversal on Wells Fargo following the bank's report. Bove, who had initially called Wells Fargo a big winner just after the earnings came out, seemed to change his mind by afternoon and downgraded the name to a sell upon closer examination of loan loss figures. The regional banks appear to be splitting into groups of winners and loosers, with solid results from Bank of New York and US Bancorp, and more losses from Fifth Third, KeyCorp and SunTrust.
Many quarterly earnings reports are apparently repeating the pattern established in the prior earnings season: EPS meets or exceeds consensus expectations while revenue results lack the surge in sales that would indicate a firm economic recovery. A look at the DJIA components which reported results this week illustrates the point. Thanks to a big tax benefit Caterpillar's earnings were nearly an order of magnitude better than the consensus view, while revenue fell short of expectations. DuPont's earnings outperformed while revenue fell somewhat short. Other leading names are in the same boat: Honeywell's EPS was slightly better than expected, while revenue missed the consensus view somewhat. The firm's CFO said top-line performance will remain challenging. Railroad Burlington Northern also had solid earnings but underwhelming revenues, while its forecast for next quarter was weaker than expected. Oil services name Schlumberger was in line with earnings expectations and revenue was a hair below expectations. Boeing's loss was a bit steeper than anticipated and revenue missed expectations. The aerospace giant also took a hammer to its 2009 guidance, citing the continuing problems in its 787 Dreamliner and 747-8 projects.
Tech earnings continued to be an exception to the rule. Apple yet again surprised to the upside, beating top- and bottom-line expectations handily, and even exceeded "whisper" numbers. On the conference call, Apple executives said iPhone supply was short "virtually everywhere," and bragged that the iPhone has been deployed in more than 50%+ of Fortune100. SanDisk and Yahoo blew out consensus estimates across the board. Amazon beat on EPS by a large margin and met revenue expectations. Texas Instruments modestly exceeded expectations. Broadcom and STMicro were tech losers, with both semi manufacturers missing bottom-line goals by wide margins (ironically, both beat on the top line). Microsoft capped off the week in tech, rising over 5% on Friday on the strength of its earnings and revenue results.
The military-industrial complex had a solidly profitable third quarter. Dow component United Technology, Northrop Grumman and Lockheed Martin all beat earnings expectations, although LMT's revenue was a bit behind the Street. Big pharma had a good Q3, as evidenced in reports from Merck, Novartis, Schering-Plough and Bristol-Myers. Earnings at all three firms were more or less in line with expectations, although Bristol-Myers and Novartis were a bit behind on the top line.
With corporate earnings in the spotlight, Treasury yields have quietly moved higher this week as the liquidity driven rally across a broad spectrum of asset classes appears to be taking a breather. Next week the Treasury returns after a two week hiatus with a record $44B in 2-year, $41B in 5-year and $31B 7-year notes up for grabs, alongside $7B in 5-year TIPS. Although higher, yields have broadly speaking remained range-bound. The 2-year yield managed to test the 1% mark for the first time in October after the FT reported that FOMC members were considering altering their commitment to keeping rates at the zero bound for "an extended period" in an effort to manage inflationary expectations. The 10-year Note is only a few basis points away from the 3.50% level (not tested since late September) while the 30-year Bond finished the week above the 4.25% mark.
The UK surprised many by failing to join Germany and France in technically escaping recession on Friday, posting its 6th successive quarter of negative growth. The considerably worse than expected reading meant the deepest downturn for the UK since records began in the mid 1950's and has heightened expectations for an expansion of quantitative easing from the Bank of England next month. US GDP data is due Thursday, and whilst the market is expecting a firmly positive reading (and by extension, an end to the US recession) the potential for both upside and downside surprises will number provide further event risk for bond traders next week.
Strong corporate earnings in the US and rising commodity prices around the world helped drive the euro to fresh highs against the greenback and the Swiss Franc this week. There was also a fair amount of talk regarding shifting away from the USD as a reserve currency following last week's heated debate. Former US Secretary of State Kissinger commented that China's goal was to dislodge the dollar's position at the heart of the global monetary system, noting that any moves to alter the dollar's reserve status would be made over a long period. PBoC Governor Ma noted that dollar weakness would trigger domestic inflation in China, leading to vague reports that China was looking to help curb USD weakness. The EU EcoFin conclave sent a letter to the chairman of the G20 stating that economic recovery was increasingly apparent and fears of a prolonged recession were fading. The unexpected GDP contraction in the UK took the wind out of sterling and sharpened the debate over a potential expansion of the BoE's £175B QE program. By Friday, dealers couldn't help but notice that the interest yield differentials between US and Germany have been trending in favor of the euro, as the benchmark 2-year yield spread moved towards the 50bps, its highest spread since early June.
EUR/USD tested and then broke above the 1.50 level mid week on continued chatter that Eastern European names were buying euros and that Russia was seeking to reduce the USD weighting in its currency basket to 33% from 55%, although Russian Central Banker Ulyukayev said he sees the weak dollar as a correction rather than devaluation. EUR/USD hit a high water mark around 1.55, a level last seen in early August 2008 before consolidating around 1.50. The German Export Assoc (BGA) believes the euro could rise toward $1.60 over the next few months before settling down to a 1.45-1.55 range. French Presidential Advisor Guaino commented that a sustained bout of EUR/USD above 1.50 would be a disaster for European industry. GBP/USD maintained a constructive tone throughout the week into the UK Q3 GDP data, climbing past a 14-month downtrend line of 1.65 before giving up its gains because of the weak GDP figures.
USD/JPY progressively over the course of the week despite BoJ's Hayakwa comments that Japanese companies were not asking the government to do something to weaken the yen. The BoJ released its quarterly regional report, noting that the economy remains severe in some regions but is improving overall. The currency's weakness late in the week was attributed to press reports that the BoJ expects continued deflation in Japan through 2011, when the Core Consumer Price index is projected to decline for the third consecutive year. The carry-trade sentiment rose a bit for the yen as dealers noted that the report was another indication that the central bank would keep interest rates near zero for the time being.
The trading week in Asia centered on economic data out of China mid week, where the Q3 GDP reading was released concurrently with the monthly industrial production, retail sales and inflation metrics. Despite the multi-month highs across these figures, markets expressed mild disappointment, with the Shanghai Composite extending its losses in the wake of the data. The 8.9% GDP reading was a one-year high, but came in just short of expectations of 9.0%. Industrial production hit a 14-month high at 13.9% and topped estimates of 13.2%, but fell short of the earlier press whisper number of 14.1%. Inflation is declining more slowly and retail sales met expectations.
The rhetoric from the Chinese government was barely optimistic: officials stated the economy still faces insufficient external demand and warned that building up domestic demand remains challenging. Moreover, NDRC researcher Wang said the fundamentals of China's economic recovery are still not sufficient, and top central bank advisor Fan Gang urged policy makers to maintain fiscal stimulus through 2010.
On the monetary front, the minutes of the latest Reserve Bank of Australia policy meeting shed some light on the central bank's decision to become the first G20 nation to raise interest rates. The RBA's focus revealed growing concerns over inflation bottoming at much higher level than previously expected and possibly rising again in 2011. In addition, the RBA forecasted economic growth will return to trend in 2010, and could rise to above-trend levels by 2011. Policymakers also did not appear to be fazed by the rally in AUD, suggesting the Aussie dollar rise reflects improving market sentiment and may actually help to contain inflation.
Trade The News Staff
Trade The News, Inc.
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The Weekly Bottom Line

HIGHLIGHTS OF THE WEEK

• U.S. housing starts stall in September at 590 thousand but existing home sales continue to rise, jumping 9.4% in the month and helping to bring inventories of unsold homes down.
• U.S. Beige Book shows a tepid recovery, with improvements in consumer sentiment and the housing market but continued weakness in labor markets and commercial real estate.
• Federal Reserve Governor Benjamin Bernanke spoke on global imbalances and financial regulation this week, making the case for greater savings in the U.S. and greater domestic demand in emerging markets.
• The Bank of England October Minutes reveal more optimistic outlook, but Q3 GDP later in the week was a big disappointment, showing the economy contracted for the sixth straight quarter.
• Chinese economy grows by 8.9% y/y, with engines of growth expanding beyond just government stimulus.
• Brazil places a 2% tax on investment inflows into the country in the hopes of controlling short-term inflows and avoiding an overheating equity market without putting further upward pressure on the currency.
• The Bank of Canada kept rates at their effective lower bound of 0.25% and reiterated its conditional commitment to do so until mid-June 2009, however presented a slightly more pessimistic tone than its July Monetary policy report.
• Canadian real retail sales were up 0.4% in August, making up for a 0.1% decline in July
• Start to Canadian recovery may be slower than expected.

UNITED STATES - RECOVERING & REBALANCING

In a week focused once again on the fate of the U.S. dollar (not only in the U.S. but in global markets), economic indicators were tentative on the state of the U.S. recovery. As Christina Romer laid out in a speech this week, the early stages of economic rebound have been brought about largely thanks to policy actions ranging from the broad based liquidity provision and quantitative easing action of the Federal Reserve to the impact of specific government programs, such as the Car Allowance Rebate System (CARS) and the First-Time Home Buyer Tax Credit, which have been key factors behind the rebound in consumer spending and turnaround in the U.S. housing market.
With next week's release of the advanced estimate of third quarter U.S. real GDP growth, we will get a better picture of just how successful these measures have been in pulling the U.S. economy out of the Great Recession. We expect a greater than consensus result of 3.8% (annualized) growth, driven mainly by rebounding consumer spending, automotive production, and the housing market. Nonetheless, with the initial stages of recovery now in the rear view mirror and both fiscal and monetary stimulus starting to wind down, the key question now is how well is the U.S. economy prepared to stand on its own to feet?
The data flow this week continued to support our call for a gradual pace of economic recovery. While credit conditions have improved, the U.S. financial sector has not fully recovered and even as focus moves away from major systemic risks within the banking sector, the flow of credit will continue to be impaired by rising foreclosures and commercial real estate losses. The U.S. Beige Book, out this week, was similarly mixed in its reading on the recovery. While conditions in the housing market appear to have improved, continued deterioration in commercial real estate markets was noted across the country. Moreover, U.S. housing starts, after improving fairly dramatically earlier in the year, appear to have stalled in the third quarter and have been steady at just under 600 thousand since June. On the brighter side, existing home sales for September jumped a strong 9.4% and inventories of unsold homes fell to 7.8 months supply, from 9.3 in August. While these results are certainly positive, the impact of the first-time homebuyer incentive should not be underestimated, with first-time buyers accounting for 45% of the sales in the month. The success of the current program, which is set to expire at the end of November, has led to talk of prolonging the program beyond its deadline and expanding it to include all homebuyers.
Federal Reserve Chairman Benjamin Bernanke spoke twice this week. Early in the week his comments were of a global nature, focusing on the Asian experience with the current and past financial crises and also touching on global imbalances. In perhaps one of the more direct statements on the role of currency manipulation on the financial crisis, the Fed chief stated, “trade surpluses achieved through policies that artificially enhance incentives for domestic saving and the production of export goods distort the mix of domestic industries and the allocation of resources in an economy that is less able to meet the needs of its own citizens in the longer term.” With 70% of the U.S. economy directed towards consumption and only 35% of the Chinese economy, there is a lot of room for rebalancing.
Late in the week, Bernanke turned his attention once again to the Fed's role in U.S. financial regulation, making reference to one of the hot button topics of the day - compensation - by noting that compensation plans that encouraged excessive risk taking contributed to the financial crisis and efforts going forward should ensure that incentives are aligned with the long-run health of the organization and do not pose a threat to the soundness of the overall financial system.
All in all, it was a week with a lot of information to digest: U.S. growth is on the mend but the recovery still looks to be drawn out. Moreover, beyond the immediate recovery, issues in global rebalancing and financial regulation will continue to make headlines for weeks and likely years to come.

CANADA - Slowly but Surely

It would appear that the Canadian economy has headed down the road of recovery, but the take-off hasn't been as fast as originally hoped. Even the Bank of Canada provided a slightly more pessimistic tone in its monetary policy report than it had presented in July. However, there were no surprises on the direction of monetary policy. The Bank kept rates at their effective lower bound of 0.25% and reiterated its conditional commitment to do so until June 2010. The Bank stated that while the economic backdrop for final domestic demand has improved more “favourably” than expected, over the medium-term, the negative implication of a strong Canadian dollar will outweigh these positive developments. As such, the central bank has slightly downgraded its growth outlook for 2011 down to 3.3% from 3.5%.
It was not all that surprising that the Bank of Canada made the downward revision to the outlook, as many forecasters felt the Bank's outlook in July was much too rosy given what is widely believed to be a mild recovery in the U.S. and the negative implication of a strengthening Canadian dollar. The Bank's forecast of 3.0% growth in 2010 and 3.3% in 2011 is still slightly more optimistic than our own forecast for growth of 2.5% and 3.0% respectively. And in fact, the recent strength in the Canadian dollar, and an upward revision to our outlook on the currency does put some downside risk to our own forecast. As such, we believe that the Bank of Canada will stay put past its conditional commitment of June 2010, and the first rate hike will not come until the fourth quarter of next year.
What was surprising was that the Bank of Canada upgraded its estimate for growth in the second half of 2009, anticipating that the economy grew 2.0% (up from 1.3% in July's MPR) in the third quarter and will grow a further 3.3% in the fourth quarter. This was a bit notable given that this upgrade follows a month of poor economic data suggesting that the Canadian economy likely contracted in August. Following July's lackluster performance, this has led some to question whether the Canadian economy managed to record growth at all in the quarter. However, like the Bank of Canada we do believe that there are more signs pointing to a budding recovery in the Canadian economy in the third quarter. Unlike the Bank of Canada, we see that recovery coming with the risk of a slower pace than 2%.
Let's start with the good news. Both residential and business investment is tracking much stronger than we had originally thought, and is set to contribute significantly in the third quarter. The recent strength in building permits, and imports of machinery and equipment puts both residential investment and business investment on track for a 20% annualized gain. As such, both types of investment will contribute significantly to growth in the third quarter.
However, investment makes up only a small component of economic activity, and the other major components of growth - consumer spending and exports - are tracking weaker than our forecast. While real retail sales were up 0.4% in August, making up for a 0.1% decline in July, forward looking indicators suggest that sales likely fell again in September. This puts consumer spending on track for a 2.0% gain in the third quarter. The Canadian consumer is on the mend, albeit at a slightly slower pace than we had expected. Meanwhile, July strength in exports gave just enough boost to set exports up for their first gain in over two years; however, much of that gain will be wiped out by losses in August and September as an appreciating Canadian dollar put pressure on the export sector. As such, exports are set for a 13% gain in the third quarter. Putting it all together, our current tracking is that the Canadian economy may have grown at closer to the pace of 1.4% annualized, rather than the 2% the Bank of Canada is forecasting.

GLOBAL - THE SORDID LIFE OF MONETARY POLICYMAKERS

Monetary policy has never been easy. Interest rates must be set today based on expectations of how the economy will be doing 18 months in the future. So, decision making in the face of uncertainty is nothing new for central bankers. However, there was generally a belief that given the economic forecast, the choice of the appropriate level for interest rates was much less uncertain. Discretion was bad. Rules were good. That textbook is now in flux, and the sordid life of monetary policymakers has been on display recently in Australia, the U.K., Brazil, and China.
In spite of the volume of discussion over the decision by the Australian central bank to raise interest rates, that did not represent such a regime change. The near-term hit to inflation and the economy was less severe than elsewhere. Headline inflation fell to a positive 1.3% y/y pace as of September and Australian GDP contracted for only one quarter - avoiding a technical recession. So, the amount of spare capacity now bearing down on inflation is much less than elsewhere. But as insurance against the worst, the RBA had cut interest rates by 425 basis points, so textbook central bank policy mandated that interest rates should start to rise to reflect the better realities.
Textbook central bank policy also places inflation expectations on a pedestal, which may prove to be problematic for the Bank of England. The first reading on Q3 GDP came in at -1.6% (SAAR), vastly underperforming the expectations for +0.9%. This caps off a third quarter in which much of the hard data was rather anomalous, deviating fairly significantly from where forward-looking surveys of producers and consumers suggested economic activity would be. Our initial expectation is that we will see the fourth quarter make up some of this discrepancy, and the Bank of England has signaled they are likely to revise up their expectations for the economy in the medium-term, but they may also revise down the near-term (www.td.com/economics/comment/ boe_oct09.pdf).
This is important because the BoE's decision on how much government debt to purchase is based on the cumulative deviation of GDP, not just on expectations for growth. So less growth now and more in the future could actually translate into more government debt purchases now, but interest rates rising a bit more quickly in 2010. This is complicated by growing hawks on the Council. Inflation expectations are actually creeping up in the U.K., with our estimates suggesting that the current level of inflation priced into financial markets would be consistent with a 2.5% y/y headline inflation rate 12 months from now. Central banks take anchored inflation expectations seriously, and faced with rising inflation expectations now and an academic debate over how much slack there is in the economy and how that may or may not impact inflation down the road, persistently high inflation expectations will win every time. That is why the BoE could hike rates in the face of economic slack and why the Fed and Bank of Canada are still much more comfortable where they are.
For emerging markets, the tendency remains “Be like China.” Rather than moving to the more formulaic approach of central banks in the G-7, the idea is it's ok to manage your currency, take on huge currency reserves, and when necessary use the big stick of capital controls as opposed to the invisible hand of incentives. After all, it helped China reach their target of 8% GDP growth (www.td.com/economics/ comment/rk102209_china.pdf). Brazil this week was not ready to raise interest rates. Even though the economy is making quick work of the 4% decline in GDP earlier this year, the currency has gone on a tear as investors piled back into Brazilian equities. Since fears of asset bubbles have taken on an elevated role in the brave new world of central banking, policymakers implemented a 2% tax on capital inflows. Just a few years ago, Brazilian markets would have likely been severely punished for this blunt force trauma, but this Tobin tax to discourage finicky speculative inflows comes right out of discussions from the G-20 in September (www. td.com/economics/special/rk0909_g20.pdf). And, it certainly doesn't hurt that this tax will raise money from outside investors to finance domestic government spending. With the “Be like China” mantra among emerging markets, rather than directly preventing central banks from raising interest rates, this may be the more likely way that fiscal and monetary policy become intertwined in the post-subprime era.

U.S.: UPCOMING KEY ECONOMIC RELEASES

U.S. Durable Goods Orders - September

• Release Date: October 28/09
• August Result: total -2.4% M/M; ex-transportation 0.0% M/M
• TD Forecast: total 1.5% M/M; ex-transportation 1.0% M/M
• Consensus: total 1.0% M/M; ex-transportation 0.7% M/M

With the recovery in the U.S. economy appearing to be gathering further traction, capital expenditures are slowly coming back on track as U.S. businesses prepare for the impending pick-up in demand for their products. Moreover, with the U.S. dollar nearing the cyclical lows of mid-2008, export demand is fast becoming a source of favourable support for U.S. manufacturing goods. As such, we expect U.S. durable goods orders to rise by a respectable 1.5% M/M in September, following the sharp drop the month before. The rebound should be mostly driven by a pick-up in transportation equipment orders, though other sub-components are also expected to post gains. Excluding transportation, orders should also rise, though by a more respectable 1.0% M/M. In the months ahead, we expect durable goods order to remain in positive territory and to perhaps gather further momentum, supported by the improving U.S. and global economies.

U.S. Real GDP - Q3/09

• Release Date: October 29/09
• Q2 Result: -0.7% Q/Q ann.
• TD Forecast: 3.8% Q/Q
• Consensus: 3.0% Q/Q

The third quarter of 2009 will in all likelihood mark the emergence of the U.S. economy from the longest and deepest recession in the post-war period. At 3.8% (annualized), the return to positive growth is expected to be substantial. The main pillars of growth will be a rebound in consumer spending, business inventory investment and residential construction investment. Aided by fiscal stimulus and cash-for-clunkers legislation, spending on automobiles skyrocketed in August, and while spending fell back in September on the expiration of the government program, other areas of consumer spending continued to hold up. The emergence of the U.S. automakers from bankruptcy was also important in returning growth to positive territory, and automobile production likely added close to 1.5 percentage points to growth in the quarter. Finally, the rebound in U.S. housing starts that took place mainly through the second quarter of this year implied more hammers and saws were put to work through the third quarter. On the negative side, fixed business investment (excluding inventories) continued to flounder in the quarter. Non-residential structures investment in particular saw another quarter of deep decline and is unlikely to rebound any time soon.

U.S. Personal Income & Spending - September

• Release Date: October 30/09
• August Result: income 0.2% M/M, spending 1.3% M/M; core PCE deflator 0.1% M/M, 1.3% Y/Y
• TD Forecast: income -0.1% M/M; spending -0.4% M/M; core PCE deflator 0.1% M/M, 1.3% Y/Y
• Consensus: income 0.1% M/M; spending -0.5% M/M; core PCE deflator 0.2% M/M, 1.3% Y/Y

With the support from the cash for clunkers program virtually washed out of the data in September, we expect to see a modest pullback in personal consumption expenditures during the month. The decline in motor vehicle spending, however, is likely to be partially offset by strength in expenditures in other categories as U.S. consumer spending continues to stabilise. As such, we expect personal consumption expenditure to fall by 0.4% M/M, undoing some of the 1.3% M/M surge in August. Income is also expected to be weaker, and after rising for two straight months, personal income should fall by a modest 0.1% M/M, reflecting in part the soft U.S. labour market conditions. On the inflation front, the core PCE deflator is expected to rise by a modest 0.1% M/M. The annual pace of core PCE inflation, however, is expected to remain unchanged at 1.3% Y/Y. In the months ahead, we expect the core PCE deflator to continue to ease as the growing economic slack in the U.S. economy dampens core consumer price pressures.

CANADA: UPCOMING KEY ECONOMIC RELEASES

Canadian Real GDP - August

• Release Date: October 30/09
• July Result: 0.0% M/M
• TD Forecast: -0.1% M/M
• Consensus: 0.1% M/M

Even though the Canadian economic recession is now behind us, the path to economic recovery is likely to be uneven, as the favourable support from domestic demand (driven in large part by supportive fiscal and monetary policies) is partially offset by the drag from the strong currency. In August, we expect GDP to decline by 0.1% M/M, following the flat print in July. During the month, the positive momentum coming from the pick-up in domestic consumer spending and motor vehicle production should be offset by softer wholesale sales activity and the weakness in tourism-dependent sectors of the economy. The performance of the manufacturing sector, however, remains uncertain as even though real shipments were lower, actual production could possibly be positive. Overall, we expect both goodsproducing and service-producing sectors of the economy to be weak - or flat at best. In the coming months, the Canadian economic recovery should remain intact, as the significant monetary and fiscal policy stimulus administered to the Canadian economy gather traction, though the recovery is likely to both slow and fragile.

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Weekly Economic and Financial Commentary

U.S. Review

Public Policy Shapes the Recovery

• September’s 1.0 percent rise in the Leading Economic Index offers insight into next week’s first look at Q3 GDP. The LEI is up at an 11.8 percent annual rate over the past six months, the strongest gain since 1983.
• Hopes that the recovery will rival the rebound from the 1981-2 recession will likely be disappointing—the growth mix is heavily weighted toward one-hit wonders like cash for clunkers and the first-time homebuyer tax credit.
• Hiring plans and hours worked remain depressed as businesses weigh risks of healthcare reform, cap and trade legislation and less friendly business conditions.

After a Strong Start, Momentum will Fade

The Leading Economic Index rose a full percentage point in September, as eight of the ten indicators increased. The largest contributors were a wider interest rate spread, increased consumer expectations, and a decline in weekly unemployment claims. By contrast, the average workweek and building permits both declined. With September’s increase, the LEI has risen for six consecutive months and is up at an 11.8 percent annual rate over that time period. This marks the strongest six-month pace for the LEI since August 1983, when the U.S. economy was in the midst of one of its strongest recoveries ever.

Hopes for another strong recovery appear to us to be considerably overblown. Much of the improvement in the LEI has come from the financial indicators and expectations for future economic conditions. The historic drawdown in inventories is also apparent in the LEI, showing up as a slower pace of deliveries. The closer you get to actual economic conditions, however, the less buoyant the figures look. Orders for consumer goods and nondefense capital goods show relatively little improvement and the average factory workweek’s only real increase was in July, when motor vehicle output was restarted.

The coincident economic index, which measures current economic performance, was unchanged in September, following 0.1 percent gains in July and August. Continued declines in nonfarm payrolls and little to no growth in personal income and business sales are being offset by rising motor vehicle output. Increased motor vehicle output has lifted industrial production solidly over the past three months, benefitting a whole host of other industries ranging from steel to semiconductors. Without the lift from motor vehicle output, the improvement in industrial production would be imperceptible and the coincident economic index would still be negative.

One area where there has been real improvement has been jobless claims. Weekly first-time unemployment claims peaked back in March and are currently down 21 percent from their high. Unfortunately, unemployment claims remain extremely high. Claims rose 11,000 during the latest week to 531,000. First-time unemployment claims averaged 532,250 over the past four weeks, which means that roughly 2,129,000 jobs were lost last month. Hiring remains well below that level, which means nonfarm employment likely posted another hefty decline during October.

Another area of improvement has been housing. Housing starts rose 0.5 percent in September and have now risen for five of the past six months. All of the improvement has been in single-family homes, which have risen in six of the past seven months. Much of that increase is being attributed to the $8,000 tax credit for first-time homebuyers, which expires on November 30. Since home purchases must be closed by November 30, the impact of the tax credit on new home construction has likely passed. We expect home construction to stall out near current levels or even give back some of its recent gains. A sustainable rise in home construction will require tangible improvement in the labor market, which we have yet to see.

U.S. Outlook

Durable Goods • Wednesday

New orders for durable goods fell 2.4 percent in August driven by a significant decline in nondefense aircraft orders. While orders appear to have fallen significantly, the “headline” tends to be extremely volatile on a month-to-month basis. The three month annual rate of nondefense capital goods orders excluding aircraft is a better gauge of manufacturing activity and it jumped to its highest level in over three years. Moreover, recent consecutive gains in industrial production suggest a similar rise in new durable goods orders in September. Hence, we expect “headline” durable goods orders to spike 4.8 percent in September. While motor vehicles and parts have played a key role in boosting the “headline,” orders excluding transportation were flat in August. Further, the continued depletion of inventories and increase in shipments suggest manufacturing activity is poised to pick up in coming months.

Previous: -2.4% Wells Fargo: 4.8%
Consensus: 0.9%

New Home Sales • Wednesday

New home sales rose for the fifth consecutive month in August and are well off of their lows reached earlier this year. With some of the improvement in sales being attributed to the fist-time homebuyer tax credit, which is set to expire on November 30th, some retracement is likely. We are already beginning to see a slow down of the benefits from the program with sales rising only 0.7 percent in August, following a downwardly-revised 6.5 percent gain in July. We expect new home sales will likely rise only 0.2 percent in September to an annual pace of 430,000. While the pace of growth in new home sales is slowing, we do not expect a re-test of this year’s lows. Inventory levels continue to decline and are now at their lowest level since the early 1990s.

Previous: 429K Wells Fargo: 430K
Consensus: 440K

GDP • Thursday

Real GDP is expected to rise at a 3.7 percent annual pace in the third quarter and average a 3.1 percent pace for the second half of this year. The rise in GDP will likely mark the end of the most severe recession in the postwar era, but growth at this robust pace will likely be unsustainable. Much of the improvement will merely reflect stronger economic growth overseas which is boosting demand for exports, federal government spending and a reduction in the rate of inventory liquidations. Residential construction will also likely make a modest positive contribution after contracting from economic growth for 14 consecutive quarters. A sustainable economic recovery, however, will require an improvement in final demand in the private sector which remains exceptionally weak. Real GDP is expected to grow at an annual rate of 2.4 percent in 2010 which will make for a very sluggish recovery.

Previous: -0.7% Wells Fargo: 3.7%
Consensus: 3.0%

Global Review

U.K. Economy Slumps for Sixth Consecutive Quarter

• U.K. GDP data that were released this week, which indicated that the British economy had contracted for the sixth consecutive quarter, were disappointing. Not only did the manufacturing and construction sectors weaken further, the service sector also posted a modest decline.
• The weaker-than-expected outturn raises the probability that the Bank of England will increase the size of its asset purchase program at next month’s policy meeting. If so, sterling could encounter some selling pressure as the money supply rises further.

U.K. Economy Slumps for Sixth Consecutive Quarter

News released this week that real GDP in the United Kingdom slumped 0.4 percent (not annualized) in the third quarter relative to the previous quarter was very disappointing. Not only was the outturn much worse that expected—the consensus forecast had looked for a modest increase—but the data show that the economy is now about 6 percent smaller than it was when it peaked in the first quarter of 2008. The news came as a surprise because the purchasing managers’ indices had suggested that the economy was expanding modestly (top graph). In addition, previously released data on consumer confidence, which rose to its highest level since April 2008, and the volume of retail sales had suggested that real personal consumption expenditures had grown somewhat in the third quarter.

A detailed breakdown of real GDP into its underlying demand components will not be available for a few more weeks. However, preliminary data suggest that construction spending and industrial production were notably weak in the third quarter. British statistical authorities said that the former fell 1.1 percent and the latter was off 0.7 percent. Relative to last year, industrial production is down more than 10 percent (middle chart). Output in the service sector also appears to have contracted modestly.

One way to square the apparent growth in retail spending with the decline in overall GDP is via inventories. That is, British producers may still be slashing production to bring stocks back in line with final sales. If the soon-to-be-released demand-side components indicate that de-stocking did indeed weigh heavily on real GDP in the third quarter, then there may be a silver lining in the data. Namely, inventories may boost GDP over the next few quarters as the pace of de-stocking eases. Moreover, recoveries that appear to be underway in other parts of the world should eventually translate into stronger exports. The recent weakness of sterling, especially against the euro, should also help to bolster British exports (bottom chart).

What are the implications of the weaker-than-expected GDP data for Bank of England monetary policy going forward? The minutes of the Bank’s policy meeting in early October showed that all nine members of the Monetary Policy Committee (MPC) voted to keep the Bank’s main policy rate at 0.50 percent, where it has been maintained since early March. In addition, the MPC decided to keep the size of its unconventional asset purchase program unchanged at £175 billion. However, the minutes also indicate that the MPC would revisit the size of the asset purchase program next month when the quarterly Inflation Report is prepared.

In our view, the disappointing GDP data raises the probability that the MPC will increase the size of its asset purchase program. Until a self-sustaining recovery is underway, the MPC may err on the side of additional monetary stimulus. If the MPC does indeed announce plans next month to step up its purchases of government and corporate bonds, which would have the effect of further increasing the U.K. money supply, the British pound could come under some selling pressure.

Global Outlook

Japanese Industrial Production• Thursday

The usual end-of-the-month barrage of Japanese economic data will hit the wires next week. Industrial production (IP) data for September will be one of the most closely watched releases. Since the bottom in February, IP is up 20 percent, but still remains down 18 percent year-over-year. It seems likely that production rose again in September, but probably at a slower rate. September data on retail sales and housing starts will also print next week.

Over the past year, the unemployment rate has risen from less than 4 percent to nearly 6 percent. The rate ticked down from 5.7 percent in July to 5.5 percent in August, and data that are slated for release on Friday will show whether this new trend continued in September. Due to economic weakness and the negative rate of CPI inflation, the Bank of Japan clearly will refrain from hiking rates at its policy meeting on Friday.

Previous: 1.6% (month-on-month change)
Consensus: 1.0%

German Unemployment Rate • Thursday

Real GDP in Germany plunged nearly 7 percent between the first quarter of 2008 and the first quarter of this year. However, the unemployment rate has risen only ½ percentage point over that time. Not only has the government implemented a program that allows employees to work shorter shifts, but some German businesses may be hoarding labor. If a sustainable recovery in Germany fails to take hold, the unemployment rate could rise significantly once the government program expires and businesses realize they can no longer afford to hoard labor.

Speaking of sustainable recoveries, retail sales in Germany have been weak over the past year or so. Indeed, the value of retail sales was off 2.6 percent in August relative to the same month last year. Data on retail spending in September print on Friday.

Previous: 8.2%
Consensus: 8.3%

Canadian GDP • Friday

Signs of stabilization in the Canadian economy are beginning to emerge. Real GDP increased slightly in June, the first monthly increase since the summer of 2008, and was flat in July. Economic activity will likely strengthen in coming months. The market expects August GDP data to show economic growth remained neutral. The Canadian labor market has exhibited signs of strength in recent months. Payrolls have added more than 50,000 new workers in the past two months—a number commensurate with a gain in the United States of over half a million jobs. As the labor market improves, consumer spending and economic recovery are not far behind. On Thursday September’s price data for industrial products and raw materials will be published. Raw material prices may reflect the recent jump in commodities, while industrial product prices will likely remain benign.

Previous: 0.0% (Month over Month)
Consensus: 0.0%

Point of View

Interest Rate Watch

A “Return to More Normal Levels”

In his editorial last week, Mervyn King, Governor of the Bank of England, offered investors and private/public sector decision-makers some guidance on the direction of long interest rates—they are going up. We agree.

Four forces provide the upward bias for interest rates. First, economic expectations will bias credit demands upward while the supply of credit will increasingly shift towards riskier assets and thereby the demand for Treasury debt will likely diminish on a relative basis.

Second, while interest from both the Fed and the investor class will wane for Treasury debt the supply of debt will continue to increase as Federal deficits expand, reflecting outsized spending relative to revenue gains.

Third, the weaker dollar will increase currency risk in buying U.S. dollar denominated assets. Moreover, the current outlook is for public policy in the U.S. to exercise its “benign neglect” as in an earlier generation. The Treasury Department is responsible for the currency and at this point there appears to be little interest in altering public policy to shore up the dollar.

Finally, the intriguing challenge for financial markets will be the interplay between monetary and fiscal policy as the Federal Reserve attempts to exit the bond market. By the end of October the Fed will discontinue its purchases of Treasury debt and by March, 2010, the Fed will discontinue purchases of MBS and ABS securities. Such an exit strategy will be associated with a rise in interest rates if all else remains the same.

There are three steps in this process that will raise issues. First, how much will rates rise without the Fed’s direct support? Second, how much will any rate increase affect mortgage and consumer lending rates? Third, how much will any change in rates impact the economy and what will be the political response?
Any exit strategy becomes part of a political tug-of-war that will balance the Fed’s independence and the political concerns for reviving hosing and the jobs market.

Consumer Credit Insights

A Peak in Delinquencies?

Historically, consumer credit delinquencies lag the business cycle. Our expectation is that the economy began to turn early summer. Recently we have noticed that selected delinquency series (prime adjustable mortgages and subprime adjustable-rate mortgages) appear to have peaked.

On the one side, household income and employment fundamentals remain weak. Consumer confidence, measured by the University of Michigan survey, has improved modestly but remains far below the levels associated with the last expansion.

So what has changed? Two aspects of the housing market may have supported this change in trends. First, the first-time buyer program coupled with the vast improvement in housing affordability has altered the demand side of the housing market. Buyers have a stronger hand and therefore are better able to purchase homes for which the seller may in some cases be delinquent. Second, foreclosure and delinquency intervention programs have probably led to the restructuring of financing for some delinquent owners and therefore now these efforts are starting to appear as peaks in the delinquency data.

Consumer credit delinquencies are a cyclical phenomenon and while the current rates are high these rates appear to have peaked in some instances and so consumer credit quality is likely to improve ahead.

Topic of the Week

What Is Gold Telling Us?

Some observers have interpreted the record rise in the price of gold recently as a warning that the United States is on the cusp of another inflationary period à la the late 1970s and early 1980s. However, other early warning indicators of inflation, such as yields on U.S. Treasury securities and measures of consumer inflation expectations, do not support the hypothesis that investors are universally concerned about a period of runaway inflation.

Rather, the recent rise in the price of gold appears to be related, at least in part, to attempts by foreign central banks to diversify their reserve holdings on a flow basis. After years of reducing their holdings of gold, foreign central banks bought a record amount of the precious metal in July and anecdotal evidence suggests that their net purchases have continued over the past few months. Speculators appear to be jumping on the pile as well. Since early September open interest has increased by 165,000 contracts, the largest six-week rise in about 10 years. Although it is impossible to determine how much central banks wish to increase their holdings of gold, the big decline in their gold portfolios that has occurred over the past two decades suggests that they have scope to continue buying gold for some time.

Interest by foreign central banks to increase their gold holdings begs a more fundamental question. Have they lost confidence in the dollar? Probably not, at least not yet. Foreign central banks have purchased $53 billion worth of Treasury securities over the past 12 months. Although the pace of purchases has slowed from its rate of a year or so ago, we think foreign central banks would have become outright net sellers of Treasury securities if they had “lost confidence” in the greenback. Foreign central banks are not dumping dollars, but they appear to be diversifying away from the greenback on a flow basis.

For the full report, please see “What Is Gold Telling Us?” (October 20, 2009), which is posted on our website.

Wachovia Corporation
http://www.wachovia.com

Disclaimer: The information and opinions herein are for general information use only. Wachovia Corporation and its affiliates, including Wachovia Bank, N.A., do not guarantee their accuracy or completeness, nor does Wachovia Corporation or any of its affiliates, including Wachovia Bank, N.A., assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or any foreign exchange transaction, or as personalized investment advice. Securities and foreign exchange transactions are not FDIC-insured, are not bank-guaranteed, and may lose value.

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Weekly Focus: Upbeat Earnings Overshadow Mixed Data

Global update

• Q3 earnings in the US continue to surprise on the upside, around 80% have beaten expectations
• In Sweden, the Riksbank held the repo rate path unchanged
• Strong Q3 GDP growth in China and a round of healthy monthly activity indicators for September add further pressure on Chinese authorities to shift focus from supporting growth to controlling inflation risks
• In Euroland, PMI data and the German Ifo index showed further increases, suggesting that economic activity in Euroland continues to recover
• US housing data disappointed compared with expectations, suggesting that housing construction has lost some momentum heading into the current quarter
• An article in FT this week suggested that the Fed is warming up for a change in the 'extended period' phrase. While the Fed's Beige Book indicated a modest improvement in activity, it had a weak undertone
• UK GDP unexpectedly declined in Q3 as the economy continues to struggle under its large dependence on the service industry

Market movers ahead

• In Norway, all focus is on the monetary policy meeting and the new Monetary Policy Report
• Key macro data to watch in Sweden will be the manufacturing confidence figures, and retail sales
• In the US, focus will be on Q3 GDP growth, durable goods orders and regional PMIs
• Euroland inflation data and M3 growth will be worth watching in addition to German unemployment data
• In Asia, the monetary policy meeting at the Bank of Japan will take centre stage

Global update

Upbeat start to earnings season
The earnings season has been awaited with anticipation after the stellar performance of equity markets during the past six months. As expected, earnings are surprising to the upside as corporates have continued to cut costs, while rising top line growth adds to the profits. Roughly a third of the companies in S&P500 have reported so far and around 80% have beaten expectations.
We may be at the height of earnings growth momentum, though. While we expect top line growth to be strong in the coming quarters as well, cost cutting will be less aggressive and in fact we expect US corporates to start adding jobs again already late this year. Earnings growth is likely to continue at a robust pace, but probably not as strong as we have witnessed in the past couple of quarters.
The global rebalancing of growth is coming through in many corporate reports as sales growth is mostly rising in Emerging Markets – not least Asia – whereas markets in Europe and the US are still sluggish. Some of the strong results came from Caterpillar, the industrial bellwether, saying that sales had hit bottom and it saw signs of improving economic conditions. Tech companies have also fared well with for example Apple and Yahoo showing strong results and reporting that brand spending is coming back a bit – a sign that consumer sentiment is improving.
Rebalancing continues
That China has taken over as the most important contributor to world growth was once again confirmed this week. China reported GDP growth of 8.9% y/y, but this mirrors an annualised quarterly growth rate of around 11% following 16% annualised growth in Q2. We expect growth to slow a bit more in coming quarters as the effect from stimulus will fade, but the economic activity is likely to remain robust as external demand improves benefitting exports and private investment. In fact, Chinese export data confirmed a picture of improvement in September. Chinese property investment is also likely to rise in response to the strong rise in home sales. As growth starts to prove sustainable, focus will increasingly shift to inflation and to avoiding asset price bubbles. Policy tightening and scope for appreciation of the Renminbi will gradually receive more attention.
The rebalancing theme got more attention this week as Fed chairman Ben Bernanke said that imbalances might re-emerge as the recovery unfolds. An effort is needed in the US to raise savings through a credible trajectory for reducing fiscal deficits, while Asian countries must work on reducing the high household savings rate through reforms that limit the need for precautionary savings. Such reforms include strengthening pension systems and increasing government spending on education and health care.
Bumps in US housing recovery
US housing data this week revealed that the housing recovery may be losing a bit of steam. Housing starts was slightly softer than expected, although still showing underlying improvement, and NAHB housing index slipped after rising for several months. House prices from FHFA also slipped after rising for several months. Housing data will likely become more bumpy in the short term due to the expiration of the tax credit by end- November (there is some discussion of extending it) but we believe the underlying trend will continue to be one of gradual improvement – most clearly in activity and subsequently also in house prices.

Market movers ahead

Global

• In the US we will receive the last regional PMIs ahead of the ISM release the week after. On balance, the regional indexes released so far point to another increase in ISM in October. Recent data on durable goods orders suggest that CAPEX spending could be recovering and it will be interesting to see if September data will confirm this trend. We expect new home sales to post a robust gain and finally, we estimate that Q3 GDP grew to around 4% q/q AR with domestic demand adding 3pp and inventories 1.5pp.
• In Euroland inflation data and M3 money supply growth will provide new input for the ECB's thinking on exit strategies. German unemployment has been stable for the past four months, which is partly the result of widespread labour sharing. Anecdotal evidence indicates that employers have tried to avoid large-scale firing ahead of the German elections, which were held late September. The stabilisation could thus be somewhat artificial and we might see a renewed increase in German unemployment.
• In Asia focus next week will be on Japan. Bank of Japan (BoJ) is expected to keep the leading interest rate unchanged at its monetary policy meeting. We do not expect a termination of any of the non-conventional easing measures, although we believe it could happen at the next meeting in November. Focus will mainly be on the release of new GDP and inflation forecasts. The GDP forecast is likely to be revised up.

Scandi

• Key macro data to watch in Sweden will be the manufacturing confidence figures, inasmuch as industrial data have been surprisingly poor in Sweden relative Euroland and retail sales. We also suspect that household lending data will see a growing importance going forward, as the Riksbank is becoming increasingly attentive to real estate valuation and credit expansion in Sweden.
• In Norway, all focus is on the monetary policy meeting and the new Monetary Policy Report. A rate hike is widely expected and attention is on the new interest rate path presented in the report.

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READ MORE - Weekly Focus: Upbeat Earnings Overshadow Mixed Data

FX Briefing : Dollar Weakness Persists

Highlights

• EUR-USD climbs over 1.50
• Pound plunges on disappointing Q3 growth
• Intervention pushes up Asian currency reserves

Towards the middle of the week, EUR-USD breached the 1.50 level for the first time since August 2008. The final push came from US equity markets, which reacted very positively to Morgan Stanley's quarterly earnings in particular. All in all, however, the euro only made moderate gains: towards the end of the week, the common European currency was around 1.5040, about 1½ US cents higher than a week ago.
On the macroeconomic side, there was little impetus. Most of the few US data released did not fully come up to expectations. Housing starts and building permits did not improve markedly in September, and the number of initial jobless claims rose slightly in the middle of October. The European indicators were more upbeat. Most surveys for the euro area went up somewhat. According to preliminary figures, the eurozone purchasing managers' index for the manufacturing sector rose over the expansion threshold of 50 again for the first time. The ifo business climate index also improved further in October, from 91.3 to 91.9. The French figures were even better. General business confidence increased from 86 to 89. It is striking that companies are now seeing the outlook for production in their own companies as almost neutral again. Furthermore, consumer spending rose by over 2% in September; the third quarter therefore remained more or less stable.
Sterling's antics
The pound sterling cavorted around again this week. The pound's recovery, which had begun last week after remarks made by BoE deputy governor Paul Fisher, received additional support from the Bank of England's minutes. The minutes of the meeting at the beginning of October revealed no intention of extending the asset purchase programme on the one hand, and on the other, buoyed expectations that the UK economy could revert to positive growth rates in the third quarter. Against this backdrop, the euro dropped to about 90 pence.
The forex market's reaction to the release of the preliminary UK GDP data for the third quarter was correspondingly harsh. The figures published on Friday show a further contraction in real GDP of 0.4% compared to the previous quarter, only marginally better than the -0.6% in Q2. The estimate shows that growth remained negative in nearly all sectors, including the financial services sector. After these figures, EUR-GBP rose to almost 0.92. Cable fell by around 3 cents to below 1.64.
Political resistance to appreciation
The downside to dollar weakness is the appreciation of most major currencies with the exception of the yuan and a few other currencies which are pegged to the dollar. Growth prospects in the Asian growth regions and also in commodity countries are much better than in most industrialised countries. The Asian countries are benefiting from robust growth in China; other countries such as Brazil, South Africa, Australia, Norway and Canada, are relying on commodity prices recovering. This, coupled with international in vestors' growing risk appetite, is leading to high capital inflows into these regions and to a significant appreciation of their currencies. Thus the euro has risen by almost 8% since the beginning of this year; but the real has appreciated by 35%, the Australian dollar by 32%, the South African rand by 27% and the Norwegian krone by 26%. Even the Canadian dollar has gained about 16% against the US currency.
Meanwhile, however, there is increasing resistance to appreciation pressure. This week, the Brazilian government introduced a transaction tax on foreign equity purchases, which could put pressure on the real, at least in the short term. The Canadian central bank president hinted at possible measures to weaken the Canadian dollar. And many Asian monetary authorities are resorting to direct intervention to slow down the appreciation of their currencies.
The chart below, which shows the development of foreign currency reserves in leading Asian countries since the end of 2008, gives some insight into these activities. It is clear that the reserves in most of the countries have soared. South Korea posted the biggest increase - 26%, followed by Hong Kong (24%) and Thailand and Indonesia (about 20% respectively). And China and Taiwan also gained 17 and 14% respectively. In absolute terms, China is the winner with an increase of $327bn; but Korea is doing very well too with over $50bn.

BHF-BANK
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READ MORE - FX Briefing : Dollar Weakness Persists

Weekly Market Commentary

Overview

FX rates pushing boundaries amid generalised US dollar weakness, so much so that Brazil imposed a tax on foreign investment in domestic bonds and equities to stem hot money flows (the tax does not apply to foreign direct investment). This saw the real back up a tiny bit from its strongest this year at 1.697 per greenback, though other major currencies are trading at extremes: Swiss franc 1.0033, Euro $1.5061, Australian dollar $0.9330, Kiwi $0.7635; sterling and yen lagging. This pushed many commodities higher, LME Lead and Zinc the best performers among the metals, +11% this week alone, CBoT Wheat +12%, Nymex Crude Oil to $82.00 per barrel, and ICE Cocoa at $3412 per tonne its most expensive since the 1970's. Most stock indices are up on the week, some to new highs for this year, but others have been rattled - obviously the Bovespa on the tax move and to a greater extent India -6.00% from last week's peak, and Jakarta -5.00% (these three are of course among this year's biggest gainers), also Italy's MIB -3.75% on rumours of budget-minded economy minister Tremonti's possible resignation on PM Berlusconi's decision to cut taxes. Money market rates are unchanged though some are starting to wonder how things will turn out over year-end. Treasury yields backed up a little again but remain well within recent ranges.

Political and Economic Developments

Stock markets defy gravity, propelled by stimulus packages, while the so-called 'real' economy remains mired in debt and doubt. Mervyn King this week said, 'to paraphrase a wartime leader, never in the field of financial endeavour has so much money been owed by so few to so many'. Contrary to expectations UK Q3 GDP shrank by 0.4%, the sixth consecutive quarterly decline (the longest on record) so that annually the drop was 'just' -5.2% from -5.5% in Q2. Great! With VAT set to return to 17.5% in January, the boost from its reduction to 15.0% has been minimal, Retail Sales flat on the month to September as they were in August, though +2.4% Y/Y from May's low of -2.3%. Next: the £400M 'cash for bangers' will run out. Meanwhile Royal Mail is on strike protesting management chaos.

Underlying Themes

Fat cats' pay and banker bonuses castigated in the media and pounced upon by politicians trying to garner public support. Without a hint of irony UK MP's, whose snouts have been in the expenses trough for a decade or more, appoint the unelected to arbitrarily decide on compensation. Ahead of a government-commissioned review of corporate governance the Confederation of British Industry issued a warning on pay and the reputational risk involved because, 'unless they find some way of hitting the reset button over the next year or two, politicians around the world will attempt to do the job for them'. The US is no different with its 'pay tzar' (czar?) Kenneth Feinberg this week slashing top execs cash pay at TARP bailout firms by up to 94% and stopping country club membership fees among other perks. The rules are not retroactive and hadn't some of these chaps already agreed to work for $1? Meanwhile not a peep as to what to do with Fannie Mae and Freddie Mac, the government sponsored agencies that are the rotten core at the very centre of this putrid barrel. The risk and reality is that vast swathes of US business have been nationalised and now there will be no really talented individuals who will want to work at these defunct industries because of political interference and an economic straightjacket. They are doomed to lumber on as inefficiently as any arm of a bureaucratic nightmare, needing regular intravenous top-ups of their drug of choice - taxpayers' money.

What to watch for next week

Monday the 26th holidays in Austria, Hong Kong, Ireland and New Zealand and just UK October Hometrack Housing Survey and German November GfK Consumer Confidence. Tuesday US August CaseShiller Home Prices, EZ16 September M3 Money Supply, UK October CBI Distributive Trades and US Consumer Confidence. Wednesday Japan September Retail Trade and October Small Business Confidence, CPI for the various German states, US September Durable Goods Orders and New Home Sales while the Norges Bank decides on rates (expected +25 basis points to 1.50%). Thursday Japan September Industrial Production, Corporate Services Prices, UK Net Consumer Credit, Mortgage Approvals, Bank Lending and Money Supply, German October Unemployment, Eurozone Consumer Confidence, and US Q3 GDP. Friday Japan September Jobless, Household Spending, Housing Starts, Construction Orders, National CPI, Tokyo October CPI, UK GfK Consumer Confidence. Then German September Retail Sales, EZ16 Unemployment, US Personal Income and Spending, Core PCE, Q3 Employment Cost Index, October Chicago Purchasing Managers and final University of Michigan Confidence. Sunday November 1st All Saints Day with presidential elections in Tunisia and Uruguay; All Souls holidays the day after.

Positioning and Technical Analysis

Jumpy, nervy markets are likely during this last week of October, each instrument working to its own dynamics and liable to bad news coming from offside; US dollar weakness might take a breather but don't bank on it. Treasury yields should hold at current levels with a wary eye on indices where there is no room for complacency.

Mizuho Corporate Bank

Disclaimer

The information contained in this paper is based on or derived from information generally available to the public from sources believed to be reliable. No representation or warranty is made or implied that it is accurate or complete. Any opinions expressed in this paper are subject to change without notice. This paper has been prepared solely for information purposes and if so decided, for private circulation and does not constitute any solicitation to buy or sell any instrument, or to engage in any trading strategy.

READ MORE - Weekly Market Commentary

This Week's Market Outlook : USD still falling, risk still rallying

Highlights

• USD still falling, risk still rallying
• Price action beholden to EPS over next two weeks
• GBP rallies ahead of BOE minutes, 3Q GDP
• EUR strength a topic for Eurozone finance ministers
• Key data and events to watch next week

The greenback lost fresh ground to near 14-month lows, as stocks, commodities and other risk assets continued their ascent, but the JPY emerged as the biggest loser on the week. As suggested in last week's report, JPY-crosses re-connected with risk appetites and saw some of their biggest gains in months after languishing for the last several weeks while the focus was on dollar weakness. With US Treasury yields sustaining recent gains, the JPY is likely to continue to act as the primary funding currency for risk speculators, perhaps giving the USD some breathing room, if only in USD/JPY. Corporate earnings are likely to remain the key driver (see below), however, and any dollar recovery is only likely on disappointing reports or economic data. Sentiment remains extremely USD negative, and dovish FOMC minutes reinforced concerns over the strength of the US recovery. More importantly for the USD, discussion among Fed officials over extending the size of the Fed's asset purchases (quantitative easing) added yet another reason to sell dollars. Markets appeared to be expecting the Fed to wind down its asset purchases, so the FOMC discussion came as a surprise.
In specific pairs, USD/JPY gains over the 90.27 daily Kijun line shift the focus higher while that level holds, and strength over 91.50 is likely to trigger further gains to the 92.50/93.00 area initially. Positioning is still quite long JPY, and despite this past week's squeeze higher in all JPY pairs, we have to reckon with further short-covering in JPY-crosses still to come. EUR/USD has effectively tested the 1.5000 level, though barrier option interest at that level is still a tempting target. Strength above 1.5000 will have the market eying 1.5500 next, but we think the 1.5250/5300 will prove difficult. On the downside, 1.4750/1.4800 looks to be an important near-term support zone and a drop below there may signal that 1.50 has held as a medium-term top. GBP/USD has rallied back to just below the Ichimoku cloud (base at 1.6450/top at 1.6514) which is extremely thin and may be broken relatively easily. Strength above 1.65 is likely to target 1.6750/6800 initially, while a drop below 1.6220/50 likely signals this week's strength was overdone.
Price action beholden to EPS over next two weeks
With only 7% of the S&P 500 having reported thus far, the make-up of 3Q earnings looks eerily similar to 2Q results. Sales have practically been in line with low-ball estimates (+0.1% surprise) while the bottom line continues to outperform expectations (+18.1% better). This points once again to earnings growth via cost cutting and not earnings growth through organic means. Cost cutting, of course, can only last for so long and eventually EPS will have to be driven by a pickup in actual business activity.
We remain cautious with regards to the potential of such a pickup given the dreadful state of the consumer balance sheet and the awful employment landscape. Given that, by our calculations, the consumer still needs to unwind roughly $500 billion in non-real estate credit to get back to sustainable debt/income levels and that unemployment will continue to rise in the first half of 2010 right through 10% makes this sort of organic growth questionable to say the least. This is the main premise behind our view that the current rally in equities is well overdone and a sharp short-term correction is looming.
The next two weeks will paint a better picture of the current earnings landscape as we have 290 companies slated to report. As such, the price action in all markets will be beholden to the outcomes in this space. Given very strong inter-market correlations - with commodities, stocks, and yields all moving opposite to the US dollar - we could be setting up for a significant reversal in the recent trends. In other words, should earnings disappoint on the top-line, we would expect the US dollar to find a solid short-term base and see a significant pick-up in buying interest. Those likely to suffer the most on earnings disappointments are AUD and CAD as much of the near-term strength here (economic fundamental improvement notwithstanding) can be directly attributed to the euphoria in the commodities space. The gold bulls will also undoubtedly head for the exit.
GBP rallies ahead of BOE minutes, 3Q GDP
Sterling has been squeezed higher under a weight of short positions. Better UK labor data has softened the dismal economic backdrop in the UK but the trigger for the move was a report in the FT citing satisfied remarks from the FT's Fisher over the scale and impact of QE. From this the market inferred that QE may be on hold in November. In all probability the MPC is still undecided on the issue and the forthcoming releases of the Oct MPC minutes, Q3 GDP, retail sales and PSNCR are likely to be pivotal in determining whether or not sterling can retain its better tone. Alongside the dismal position of public finances, the release of much worse than expected US Q2 data was arguably responsible for much of the sour mood that has clouded GBP since the middle of the year. Data released during the past few months suggest that the production sector in the UK may be slipping back into recession and this has led to a median expectation for Q3 GDP of just +0.2% q/q (-4.6% y/y). Risk that this number could disappoint coupled with poor PSNCR data and the likelihood that the tone of the MPC minutes will remain cautious on the economic outlook implies that QE may be back on the table by the end of next week and sterling could be struggling to push higher. As a consequence cable is likely to hold a more cautious tone going into the new week. That said, good economic data would support the more constructive technical picture and could lead to another squeeze higher for the pound.
EUR strength a topic for Eurozone finance ministers
On Monday and Tuesday next week, Euro-area finance ministers will gather for a regular monthly meeting and officials' comments suggest EUR strength is likely to be a topic of discussion. Eurozone finance group chief Juncker indicated that he is not concerned about current EUR levels, but that further strength could undermine European recovery prospects. France's Lagarde has been the most vocal in calling for Euro strength/USD weakness to be addressed, but German Economics minister Guttenberg said that USD weakness was not a cause for concern for exporters. However, Eurozone exports fell by 5.8% m/m sa in August. This suggests that the Eurozone could be struggling to shrug off the constraints of its downturn in the face of the strength of the EUR. On balance, expectations are low that the conclave will produce any concrete results to stem the EUR's rise, but traders are likely to tread cautiously until the meetings are done and comments are out of the way. If so, EUR/USD may see some weakness early in the week, but blithe FX comments from finance ministers indicating continued laissez faire attitudes could be taken as a green light to keep buying EUR, leading to fresh gains from late Tuesday onward. More important, we expect risk assets to continue to be the main driver, with stocks setting the tone (see above). On the data front, the week ahead will bring the releases of PMI and the German IFO index. The market is expecting these indices to show that the Eurozone recovery remains on track. While the absence of inflationary pressures in the Eurozone suggest that these data will bring no change in the view that the ECB will not be hiking interest rates until well into 2010, good data should encourage risk appetite and thus support the EUR.
Key data and events to watch next week
The United States has a relatively busy agenda in the week ahead. The homebuilder sentiment (NAHB) index kicks things off on Monday while Tuesday is busy with producer prices and housing starts/permits. The key on Wednesday is the Fed's Beige Book, which provides tons of anecdotal information on the state of the economy. Thursday has the usual weekly jobless claims and the index of leading economic indicators. Existing home sales round out the week on Friday.
There are some top tier reports due out in the Eurozone. Construction output gets the ball rolling on Tuesday while Thursday has the current account and French business confidence on deck. Manufacturing and services PMIs along with French consumer spending are due Friday. Of note as well is a meeting by the EU Finance Ministers next week who are expected to discuss EUR. Should the rhetoric with regards to concern about EUR strength intensify, expect the currency to come under considerable pressure.
The UK also has some important releases. Tuesday starts the action with public sector borrowing data while Wednesday has the all-important BoE meeting minutes and the quarterly CBI industrial trends report. Retail sales highlight Thursday while GDP and home loan activity round out the week on Friday.
Japan is busier than usual. Nationwide department store sales kick things off on Monday while Tuesday has the index of leading economic indicators and machine tool orders lined up. The trade balance is up on Wednesday and a weaker number should cast doubt on the recent JPY strength. Thursday closes out the week with the all industry activity index.
Canada has a characteristically light but important week ahead. International security transactions are due on Monday while Tuesday brings wholesale sales, leading indicators and the Bank of Canada interest rate meeting. In terms of the BoC, we do not expect any change in the current 0.25% target rate but will be on the lookout for any commentary regarding Canadian Dollar strength. In the last go-around they said that "persistent strength in the Canadian dollar remains a risk to growth" so we will need to see something a touch more aggressive in order to see considerable CAD weakness. Friday ends the week with the key retail sales report.
The action is limited down under. New Zealand kicks off the action with the performance of services index on Sunday. The RBA meeting minutes are due Monday while the Australian leading index and motor vehicle sales close things out on Tuesday.
Forex.com
http://www.forex.com
DISCLAIMER: The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase of sale of any currency. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness, nor does author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.

READ MORE - This Week's Market Outlook : USD still falling, risk still rallying