Gain Capital

The dollar is finishing the week lower against other major currencies, after a nervous and choppy week of trading. Throughout the week, the USD (in US Dollar index terms) was mostly steady amid the turmoil, and the weakness all came on Friday in the aftermath of weaker than expected July NFP jobs gains and ISM non-manufacturing readings. But the dollar was mostly a sideshow to the on-going uncertainty and disarray in the credit markets, which kept equity markets nervous and off balance. The DJIA looks set to close on new lows for this move down, while the broader S&P looks set to go out on four month lows.

The unfolding mortgage-backed security meltdown continues to infect the broader credit markets, spreading as it has from low-grade debt issues into higher-graded corporate bonds. Each day it seems, a new story (or stories) comes out suggesting there is more rotting fish in the closet. On Friday alone, S&P revised Bear Stearns ratings outlook to negative and the banks underwriting the KKR/Boots takeover failed to sell a second tranche of debt due to lack of buying interest. (That was the second time in as many weeks the banks had to cancel the debt sale due to lack of investors, even after they discounted the bonds and raised its interest rate.) It seems likely that the fallout will continue for many weeks to come and financial markets will remain jittery and generally unable to sustain attempts to rebound.

The overall phenomenon of credit risk reduction that is taking place has significant, broader implications for financial markets in the months ahead. The withdrawal of easy credit has reduced the liquidity available to leveraged funds (CTA’s and hedge funds), resulting in margin calls and position reductions, which precipitated last week’s equity market decline and carry-trade unwinding (JPY-cross selling). The freeze in lending has also up-ended the steady stream of M&A and LBO deals and potentially threatens to de-rail deals already announced. This credit-squeeze will continue to keep equity markets on edge, and while it does, the carry trade will remain under pressure.

To be sure, there are many in the market that are looking at the current swoon in stocks and declines in JPY-crosses as buying opportunities, with solid fundamental arguments to back those views (e.g. corporate earnings are solid; interest rate differentials favor short JPY positions). We saw this in the middle of the week as US stocks rallied and JPY-crosses recovered higher. But the market conditions that made the ‘buy-on-dips’ strategies work so well for the first half of the year (and longer) have essentially evaporated. The fundamentals have not really changed, but the market environment certainly has.

The opportunistic buyers will not give up easily, and this will lead to repeated false starts higher, punctuated by even more dramatic set-backs. The set-backs are likely to be triggered by fresh news of distress in the credit markets and overall higher volatility conditions. For currencies, I think this means that JPY-crosses have become a sell-on-rallies, rather than a buy on dips. I’ll hold this view while EUR/JPY (as a proxy for other JPY-crosses) remains below the 164.00 level on a daily closing basis. We started the week with a rebound in the JPY-crosses that retraced exactly 38.2% of last week’s wipeout, and we’ve not been able to those levels again. While opportunistic buyers wait below, nervous and trapped longs wait above looking for an opportunity to exit.

In USD terms, the buck is heading out under pressure, having tested back down to within a few points of the critical 80.00 level in the US dollar index. My outlook for the USD remains favorable against European currencies and negative against the JPY. Strangely enough, during periods of extreme market upheaval, the USD tends to do well as a safe haven destination, despite much of the upheaval originating out of the US. You wouldn’t believe this from late Friday trading action, but European currencies have as much to lose from the credit-squeeze induced volatility as the USD, as European firms and financial institutions also face exposure to the debt market meltdown. European equities have given back more of their gains than US shares so far, and a bank failure in Germany was avoided after a government organized bailout. The same goes for financial markets in the other G-10 economies, with a few Australian hedge funds having suffered major losses. In this regard, I favor buying USD on dips, selling EUR, GBP, AUD and NZD on rallies.

USD/JPY remains a tricky one, but overall I expect USD/JPY to remain a sell on rallies while we remain below the 119.50/120.00 area on a daily closing basis. Japan’s government is expected to upgrade its assessment of the export sector and the labor market, the first upgrades to those sectors in one and two years, respectively. The government is also projecting a real GDP rate of 2.2% in 2008, and a CPI rate of 0.4%, suggesting the government now sees the end of deflation. The MOF continues to seek to restrain JPY weakness, and the risk is that retail investors are forced to capitulate and buy back JPY-shorts on further strength, effectively removing one of the main forces supporting the carry trade. I would expect the retail segment to throw in the towel on a USD/JPY drop below 116.00. When in doubt, trade USD/JPY off the equities as that short-term correlation remains in full force.

Looking ahead to next week’s data out of Japan, the June preliminary leading economic index is out on Monday afternoon, and it is (usually reliably) forecast to rise from 40.9 to 80.0, the highest since February 2006. The Cabinet office will release the August monthly economic report referenced above on Tuesday. Data releases on Wednesday morning include June machine orders and July money supply and bank lending reports, followed by the July Economy Watchers survey in the afternoon. Thursday morning sees weekly net stock and bond investment flow data. Friday morning sees July domestic CGPI (corporate goods price index) and final June industrial production and July consumer confidence in the afternoon.
Eurozone data is light and begins on Monday with June German factory orders. Tuesday sees June German industrial production. Wednesday sees June French and German trade balance reports. Thursday sees June Dutch industrial production and CPI. Friday finishes up with June French industrial/manufacturing production, July Italian CPI and June Eurozone OECD leading indicators.

US data is similarly light, starting with preliminary 2Q non-farm productivity on Tuesday morning, followed by the FOMC’s expected steady rate decision in the afternoon. All eyes will be focused on what the Fed has to say regarding current market turmoil and the prospect of any remedial Fed rate cut. I look for the Fed to maintain a brave face, acknowledge market conditions, and stay the course with inflation as the primary risk going forward, with rates on hold for the foreseeable future. Wednesday sees June wholesale inventories and weekly mortgage applications. Thursday sees initial weekly jobless claims and July ICSC chain store sales. Friday has only the July import price index report scheduled. The only speaker of note is US Treasury Sec. Paulson, who will speak on the global economy on Tuesday.

The RBA is expected to raise rates to 6.25% when it announces its decision on Tuesday evening EDT/Wed. morning local time. I would expect a reaction similar to what happened after the last RBNZ rate hike two weeks ago, as this hike is probably the last in the RBA’s tightening cycle, whether or not they explicitly state that, as the RBNZ did.

The Bank of England will issue its quarterly inflation report on Wednesday, and this will be the pivotal news for the outlook for UK interest rates going forward. I expect them to remain concerned, but express confidence that actions to date are likely to result in inflation returning to below target levels in an acceptable timeframe, with a subsequent likely sharp GBP negative reaction. If the BOE has to keep hiking, it’s going to make the US housing/mortgage market meltdown look like an ice cream party. More on that next week.