NEWS / Foreign Exchange

The USD resuming its downtrend or not?

Our Proprietary Index of Weekly Indicators for the US economy is showing a weakening WoW, but it remains on an elevated level. It is actually higher than in Q4 of last year, which was positively surprising a lot of analysts, when we began to see data from this quarter. On the other hand, the housing figures are still really weak and the level of Leading Indicators is pointing to an increasing likelihood of a recession down the road.

This week??™s most important event was the change in the FOMC statement at the Fed meeting. The Fed is finding itself between a rock and a hard place with a weakening housing market and elevated core inflation. It did the only right thing and changed the policy stance to neutral in the statement.

Another development on the central bank scene deserves a comment too: The spread of the sub-prime mortgage problems is now becoming a political issue with congress now talking about the need to increase the bureaucratic control over mortgage issuance and the risk that is taken on by mortgage financials, the appraisal standards etc. Fed officials are no doubt feeling the heat on this issue and they can be expected to pass on the problem to the mortgage financials. Although we are already seeing clear signs of tighter credit conditions in the sector, the political intervention or threat of such might lead banks to tighten conditions even more. In other words, the cycle is about to turn to one of fear instead of greed.

So far, the increase in credit spreads is modest. In our opinion, the risk of defaults in mortgages is not adequately priced in yet. We would not be surprised by the Moody??™s rates BAA corporate bonds to yield more than 2 percent over government 20-year bond yield by the end of the year.

Japanese 6-month rates are apparently refusing to go much lower from present levels. We are also seeing an increasing focus on the fact that Japanese land prices ??“ both urban and non-urban have increased for the first time since 1991.

That might be an additional reason to expect liquidity to be tighter in the months to come. What kind of impact would that have? Risky trades across the board should be hurt by rising credit spreads. Emerging Markets are especially vulnerable. Stocks are also likely to get hurt as consumption growth slows. A rough estimate is that a fall in the housing market of 3 percent translates into a 1.5 percentage point draw on real GDP growth. The latest housing market data indicates that the housing market has fallen by exactly 3 percent YoY, but we believe that it will continue even lower as the speculative housing demand from the past is being dumped on the market in a long covering frenzy.

Moving on to the European economy, the ECB is still hawkish but not in a hurry to normalize rates. Our Index of Monthly Indicators for the Euro-Zone still indicates that we are back to 2000 levels in the economic activity. Still not red-hot, but moving in the right direction.

Overall, stocks are in danger of a continued sell-off. Emerging Markets are not offering a sufficient return at the moment to justify a long position. Fixed Income is looking a bit weak, but we would rather buy it than sell it, if the Credit Spreads are continuing to widen from here.

US10Y??™s should outperform Bunds in the mid-term.

The USD is a sell on rallies. The current rally does not make much sense. The currency might have a higher yield than other majors, but the risks are increasing and AUD and EUR are about to test new highs vs. USD. See more on this below.