The Trend is Your Friend

The US dollar appears to be shining as a safe haven.  The Swiss remain committed to their peg and the weakness of consumer confidence and new threats of deflation can only harden the SNB's resolve.  Comments form one SNB member that it will diversify reserves into sterling and yen does not appear to be helping those currencies.  Surely Japanese officials who have boosted the intervention war chest by JPY15 trillion cannot be pleased that the SNB not only deflected speculative flows toward the yen, but will buy yen itself, aggravating Japan's challenges.

Japanese economic data was disappointing and this increases the risk of a disappointing Tankan report early Monday in Japan.  The key highlights of the data include the Sept PMI down to 49.3 from 51.9 and is the first sub-50 reading in five months and a 0.8% rise in August industrial o, half as much as the consensus expected and a decline in household spending much more dramatic than expected.  As noted here yesterday, the Japanese recovery from the March tragedy appears to have lost momentum. 

Owing to tick up in German, Italian and Spanish CPI figures the preliminary Sept CPI for the euro zone is 3.0%, up from 2.5% in August.  This further casts doubt on the ability of the ECB to deliver a significant rate cut next week.   Even a 25 bp rate cut would look odd at Trichet's last meeting.  The November meeting will be the first with Draghi at the helm and it will be awkward for him to cut rates at his first meeting.  He is the first ECB president from a large debtor and it comes as the ECB is already under criticism in some quarters for diluting its hard money stance by buying foreign bonds and easing collateral requirements to the point that some critics say it is becoming a "bad bank"--holding directly or indirectly distressed assets.

Yet the unexpectedly weak German retail sales(-2.9% ) and next week's PMI reports (recall the flash composite was below 50) underscores the policy dilemma.  Inflation is too high, by the ECB's own rules, but growth prospects are poor and the debt crisis is set to intensify. 

The 0.2% rise in US personal consumption still points to a fairly robust, in a relative sense, Q3 US GDP.  The combination of yesterday's upward revision to Q2 GDP and past year employment data, coupled with the relative strong PCE figures and trade balance still suggest US economy expanded more in Q3 than it did in H1 (revised now to almost 0.9%).   The unexpected strength in the Chicago PMI to 60.4 from 56.5, and consensus of 55 may bode well for the national reading next week.  

To be sure, it is not that the US economy is posting dramatic growth.  My point has been and continues to be that H1 was a bit a of fluke and the US economy is not about to contract again and that the survey data in the summer was much poorer than the real sector data.  When it comes to inflation, the track record is clear, headline converges to core.  When there is a discrepancy between sentiment and real sector data is not clear which is the "truther".  

One aspect of the the recent capital outflows from the emerging markets is that some countries have felt compelled to intervene to smooth out their currencies' depreciation.  To intervene in such a way requires them to buy their own currencies and sell dollars. To sell the dollars they need to go into reserves.  The Federal Reserve acts as a custodian for foreign central banks.  The Fed releases its custody holdings every Thursday. In the most recent week, custody holdings at the Fed fell a whopping $32 bln and brings the decline for the month to about $50 bln.  This is the largest decline in at least a few years.  That the dollar remains firm throughout the central bank sales indicates private sector demand is greater and that central banks do not always dictate the direction of the market.  

In term of price action, the euro appears poised to test the $1.3365 area next week. Sterling's 50 day moving average fell below the 200 day average yesterday and the same averages will cross for the euro next week.  This is the my ideal case.  Sterling leads the euro and the Swiss franc confirms.  The franc's moving averages are no where near crossing.  However, parallel to my sense that the euro debt crisis and a positive relative and absolute positive growth shock from the US, technical considerations also bode well for the dollar.  The one caveat is that market positioning at the IMM is stretched and the next Commitment of Traders Report--due late today--may point to an even more stretched condition of short-term momentum and trend followers.  This warns to keep some powder dry and selling into foreign currency rallies rather than downside breakouts.