Forex Market Update

Friday, Jul 31, 2009, 14:00 GMT

By John Hardy Consultant/FX Strategist Saxo Bank

US economy shrinks less than expected in Q2, but initial reaction doesn't celebrate the news. More important data next week.

Bond markets are in rally mode, though reaction in the JPY crosses is so far inconclusive for those looking for a bearish reversal.

MAJOR HEADLINES – PREVIOUS SESSION

• UK Jul. GfK Consumer Confidence out at -25 vs. -23 expected
• Japan Jul. Nomura/JMMA Manufacturing PMI out at 50.4 vs. 48.2 in Jun.
• Japan Jun. Jobless Rate rose to 5.4% vs. 5.3% expected and 5.2% in May
• Japan Jun. Household Spending rose 0.2% YoY vs. 0.5% expected
• Japan Jul. Tokyo CPI fell -1.8% YoY vs. -1.7% expected
• Japan Jun. National CPI out at -1.8% YoY and ex Food and Energy at -0.7% vs. -1.8%/-0.6% expected
• Japan Jun. Housing Starts fell -32.4% YoY vs. -30.6% expected
• Sweden Q2 GDP out at 0.0% QoQ vs. -0.4% expected
• EuroZone Jul. CPI fell -0.6% vs. -0.4% expected
• EuroZone Jun. Unemployment Rate out at 9.4% vs. 9.7% expected vs. 9.3% in May (which revised down from 9.5%)
• Switzerland Jul. KOF Swiss Indicator out at -0.99 vs. -1.45 expected
• Canada May GDP out at -0.5% MoM vs. -0.3% expected
• US Q2 Initial GDP estimate out at -1.0% vs. -1.5% (Q1 was revised down from -6.4% from -5.5%)
• US Jul. Chicago PMI out at 43.4 vs. 43.0 expected

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THEMES TO WATCH – UPCOMING SESSION

(All times GMT)

• Australia Jul. AiG Performance of Manufacturing Index (Sun 2330)
• China Jul. PMI Manufacturing (Mon 0100)
• Japan Jun. Labor Cash Earnings (Mon 0130)
• China Jul. CLSA Manufacturing PMI (Mon 0230)

Market Comments:

The WSJ led with an article this morning (Bond Worry: Will China Keep Buying) analyzing this week's treasury auctions and claiming that the relatively poor showing for the 2-year and 5-year auction this week were due to China's refusal to consider buying US debt of longer than a year in duration on concerns about the value of its reserves and the long term risks of US creditworthiness in light of the US's massive foray into unprecedented deficit spending. Another line in the article may be a key for whether we should worry about the demand for US treasuries: "many are selling in favor of riskier assets such as corporate bonds, stocks or even higher-yielding debt of other countries". If this is true, then treasuries, and the US dollar, may be able to breathe a sigh of relief if this tremendous bear market rally ever fades and reallocation . In fact, taking into consideration the magnitude of the rally in risk, the performance of the treasury market has been remarkably strong. That goes for Europe as well, as Bunds have rallied very strongly off recent lows all week and yet EURJPY has traded above 135.00 in the European session today. What gives?

The markets lost their moxie after the US GDP data for Q2, which, although it looked good on the headline at -1.0% annualized vs. -1.5% expected, looked less rosy in some of its internal numbers. It also marks the first time since 1947 (!) that the US economy has seen four consecutive quarters of negative growth. For year-on-year comparisons, many of the declines were stark: gross private investment is off an astounding 27.4%, personal consumption matched the Q4 low of -1.8%. Exports were down -15.7% and Imports down -21.3%. The annualized quarterly numbers showed goods purchases down -4.1% (compare this with the astounding -16.4% in the Q4 panic) and service growth was actually the most positive since Q2 of last year. The optimists and those looking forward will rightly point out that the GDP report is old news and that looking forward it appears that Q3 will show a positive growth number as the stimulus feeds into the stabilizing economy. The debate then moves to the question of sustainability, where we see the risk of a significant double dip, perhaps arriving as early as later this year.

A lot of attention today on the US "cash for clunkers" program , in which consumers can receive up to $4,500 for their old, gas-guzzling cars if they purchase a new, more fuel efficient model. A token $ 1 billion was allocated to the program, likely as a trial balloon. The program has been so successful that the funds have already disappeared in less than a week. It wouldn't be surprising to see this program expanded in an effort to juice the economy further. If so, it could possibly boost consumption data for a few months, enough to fantasize about an imminent recovery in consumption - until we realize that this consumption is simply borrowing from medium to longer term consumption. The hope being, of course, that by then a rebound will be under way.

After the US growth data today, it appears the market is having a look at going into risk aversion mode. Considering the market's fickle behavior of late and the fact that today must contain some measure of end of month fixing flows, it is impossible as we write this to hang our hat on this move for the rest of the day (and even as we are writing this, the reversal is in danger of reversing - will the market ever make up its mind?), but if the market does close sharply lower in equities and higher in bonds, the USD, and JPY, then we have a good technical reversal that makes next week critical for potential follow through. In any case, next week is a very busy week for data, and now that we are largely through the earnings season, the key will be the market's reaction to these big data releases.

Chart: USDSEK
The Swedish krona has improved very sharply almost across the board on the potent combination of a very weak Euro and strong emerging market currencies and equities this week, not to mention Sweden's positive GDP data for Q2. But the krona may be getting ahead of itself. At the same time, the USD appears to be at an inflection point here as well as risk appetite may be turning at any moment. Any return to USD strength and risk aversion could trigger pronounced volatility in the USDSEK cross, especially now that it has crossed to new lows since last October, and any reversal could generate a huge move on the realization that the break was false. This is all hypothetical, of course. Either way, the pair is likely to remain very volatile in the coming week either way.

More analysis: Saxo Bank Market News & Analysis

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