Gain Capital

Banks lose billions more, but ‘the worst is past’; don’t buy it
Despite all indications that the US economy is slowing even further, US stocks and risk appetites in general have rebounded to their best levels for the year. Additional multi-billion dollar write downs and losses at major financial institutions are apparently no match for investors who buy the going wisdom that the ‘worst is behind us.’ The same people who said the sub-prime meltdown was contained 6-9 months ago are now touting the end of the financial crisis even as they announce major 1Q losses and additional job cuts. At the same time, credit rating agencies are still downgrading individual RMBS (residential mortgage-backed securities) issues, which will necessitate ongoing write downs of assets held on financial firms’ balance sheets and continue to erode capital. No doubt, the government-led bailout of a major US investment bank and the opening of the Fed’s discount window to non-bank financial firms instilled confidence in Wall Street that the government would step in again if the situation deteriorated further. But what is happening behind the scenes?

LIBOR rates (London Interbank Offered Rate), the benchmark global lending rate between banks, have continued to edge up over the past several weeks, reaching new highs of between 75-100 bps above central bank rates. LIBOR rates typically average only 10-15 bps above central bank base rates, so the higher cost is symptomatic of banks that are continuing to hoard cash and remain reluctant to lend to each other. The British Bankers Association (BBA), the group that administers the daily LIBOR fixing process, even had to warn participating banks not to submit misleading pricing indications or face being banned from the process. The suspicion was that some banks had been low-balling the LIBOR rates they submitted, which are supposed to reflect rates at which each submitting bank is able to borrow in the inter-bank market. The rationale behind that was that no bank wants to be seen paying significantly more than others banks, out of fear it would be seen as a lack of confidence. In short, banks remain incredibly insecure regarding funding and market perceptions, which should be seen as a sign that the financial turmoil is far from over.

The Big Disconnect: Fundamentals weaken, but risk is back on
On the fundamental side, US economic growth data continues to soften (US Mar. housing starts/building permits fell more than expected; Philadelphia Fed manufacturing index fell to new lows; weekly jobless claims rose again, as did continuing claims, which are just shy of the 3.0 mio mark; and Mar. retail sales ex-gasoline were flat) even as inflation pressures persist. Fed speakers this week mostly belonged to the hawkish camp (Plosser, Fisher, and Lacker) and true to form they cautioned that additional rate cuts may stoke inflation and jeopardize long-term US prospects. Interest rate markets, aided by the higher LIBOR rates, took the bait and began pricing out anything more than a 25 bp rate cut on April 30, and even pricing in a tiny chance of a steady rate. Anecdotal information continues to pour in that US consumers are in deep retrenchment, which is fueling a vicious spiral lower in consumer spending and incomes. The four pillars of a potentially significant US downturn remain in place and show no sign of improving: 1) high and rising energy prices pinching disposable incomes; 2) softening labor markets raising job insecurity and depressing confidence and spending; 3) home prices falling, reducing household wealth and aggravating mortgage insolvencies; and 4) credit conditions remain tight with no sign banks are about to re-open the spigots.

Despite this weak backdrop, stock markets and risky assets have posted sizeable gains for the week, which I view as a serious ‘disconnect’ to reality. A fair amount of this investor enthusiasm appears born of excessive pessimism, along the lines that ‘it’s been so bad, it just has to get better.’ Bank earnings data was sobering, to put it mildly, and I suppose with the worst fears not being realized, there was some cause to celebrate. But I continue to view such rebounds in risk appetites as short-term in nature and as opportunities to sell risky assets on strength. The near term resistance levels, which must hold or a larger rebound is indicated, are 1400 in the S&P 500, 104.60/105.00 in USD/JPY; and 164.80/165.40 in EUR/JPY. Next week’s US data contains a number of housing reports and they should serve as a reminder that we are in the middle of a downturn, not at the end of one.

Market tests G7 resolve on USD weakness/EUR strength
The market has so far largely ignored the G7’s shift in currency language, which implicitly called for a stronger USD and a weaker EUR, with EUR/USD set to close the week at the same level as before the G7 statement. True, EUR/USD is finishing the week well below its highs after a vicious shake-out on Friday, but that appears to be more the result of excessive long EUR/USD positions from very high levels. US dollar sentiment remains weak and I continue to expect another try to take out the 1.6000 level next week. I look to build EUR/USD long positions between 1.5640/1.5740 on remaining weakness, and to take profit on strength between 1.60-1.61. EUR/USD’s upside is in jeopardy if we see a break below trendline support at 1.5620/30. Eurozone officials will continue to complain if the EUR appreciates further and their verbal intervention seems likely to continue to unsettle short-term traders, offering additional opportunities to buy EUR/USD on dips. But I would note US Tsy. Sec. Paulson’s post-G7 press conference comment in which he cited the shift in FX language as an ‘acknowledgement’ of market changes, rather than a threat of intervention. Until the US appears on board for intervention to stem the USD decline, EU officials will be on their own. The risk of unilateral European intervention is not small and increases greatly if EUR/USD breaks above 1.6000, which is why I recommend taking partial profit on EUR/USD longs above 1.6000 at the minimum.

USD/JPY and the JPY-crosses have traded directly higher in line with gains in other risky assets like stocks and are representative of decreased risk aversion. As I’ve suggested above, I don’t expect the rebound in risk appetites to be sustained very much longer, with the likely catalyst weak US housing data next week. Concerning the G7 statement, the gain in EUR/JPY is an even greater ‘in your face’ to EU complaints, with EUR/JPY having gained around 5 yen since before the G7 statement. If the Europeans are concerned about the strength of the EUR against the USD, they’re even more concerned about the strength of the EUR against Asian currencies, of which the JPY is the most obvious. From Japan, exporters are increasingly likely to be selling USD strength into the 105.00-107.00 area, suggesting strength seen this week may be the extent of the recovery in USD/JPY. A daily close back below 103.00 would be a sign of a rejection. EUR/JPY has significant trendline resistance drawn off the highs dating back to last July and a break above 165.50 would be needed to see gains extend further. The whole outlook for a top in USD/JPY, EUR/JPY and other JPY-crosses hinges on risk appetites turning back to risk aversion, which will require a piece of negative real-world news.