Preview of the Week Ahead

Corrective forces are likely to weigh on the US dollar through most of the week. The critical event will the the European summit. There is much anticipation for what has been called "durable" and comprehensive" action to address the European debt crisis.

More broadly speaking, over the last couple of the weeks the capital markets have begun correcting the large moves since in September. Equities and commodities have generally firmed, the dollar has surrendered some of its gains, core bond yields have backed up and money seems to be returning, albeit slowly, to some of the emerging markets, notably in Asia.

In the currencies, the Commitment of Traders still reveals large short euro and sterling positions as of Oct 12, The euro and sterling's rise since then suggests more positions have been covered, but there is scope for additional position adjusting in the days ahead. I still think the euro can test the air a bit above $1.40 and sterling can test $1.60. The Canadian dollar can get closer to parity with the greenback. The Aussie is looking a bit stretched but can move a bit nearer $1.0450.

Of note, the non-commercial (speculative) market has gone net long Swiss francs for the first time in a few weeks and at about 13k is the largest net long since mid-June. It would appear the speculative market is not convinced that the SNB is about to re-peg the franc lower against the euro (talk recently has been CHF1.25 or CHF1.30).

We are skeptical because our understanding is that is was a controversial decision, there are some other concerns, like housing prices, and there is concern about the potential cost. Thus far, the reserve data suggests the SNB has been able to achieve the 20%+ depreciation of the franc at little cost.

Japanese officials may be envious. They had intervened by a record for a single day (~$55 bln) in early August and failed to produce a lasting impact. There is talk in the market that they may try to duplicate the SNB's results. Color us skeptical here too. The yen market is considerably bigger than the market for Swiss francs. The yen is not nearly as over-valued as the the Swiss franc. Japanese officials lack sufficient gravitas, partly as a function of their earlier miscues or poor track record of unilateral intervention.

Before the EU Summit is at hand, there is bound to a be a push back from some banks as already hinted by one of their lobby arms, the Institute for International Finance. It sees no compelling reason to agree to larger haircuts on Greek bonds than already agreed in late July. This is likely to prove a negotiating tactical position rather than the last offer.

China releases a series of economic reports in the days ahead, but none will suggest that it is headed for anything but a soft landing. Although the yuan weakened last week and some see it as a protest against the US Senate bill redressing currency misalignment, it likely to strengthen in line with the anticipated dollar weakness in the days ahead. The bill is unlikely to be approved by the House of Representative. The fact that three separate US free-trade agreements were approved last week suggests that the situation is more complicated than a rising protectionism ahead of next year's national elections.

The US has a full slate of economic data that will help economists hardened their Q3 GDP forecasts for the world's largest economy. Last week's retail sales speaks well to the consumption component of GDP and because of the methodology, the measured strength is likely to carry into Q4.

The economic highlights include September industrial production. Manufacturing output is key and in the first two months of Q3 has risen 1.1%. In Q2 it rose 0.4.%. Capacity utilization rates may have ticked up from the 77.4% reading in August. The utilization rate bottomed in May 2009 at 67.3%. Manufacturing capacity utilization was at 75% in August. Before the crisis, it peaked near 79.7 in April 2007.

Rising capacity utilization rates may be important if they lead to bottlenecks and cost-push inflation. Both the PPI and CPI measures will be reported in the week ahead. The most important piece of the inflation news will be the core CPI reading and in Sept, it likely ticked up above 2% for the first time since Oct 2008. This in turn is important, because the rise in the core rate of inflation is a constraint on Federal Reserve policy for more dramatic action to attempt fulfill its mandate of full employment in a more timely fashion.

The Treasury's International Capital (TIC) report is for the month of August and is too dated to spark a market reaction. In fact, although this report still is analyzed by some participants, the variability on a month to month basis, the lagged release and the significant revisions have seen this report lose some of its previous ability to move markets.

That said, the Fed's custody holdings report is likely to garner more interest. It is more timely and still captures the holdings of more than $3 trillion of US Treasuries (and Agencies). As noted in a prior post, foreign central banks have cut their Treasury holdings of seven weeks running. With money flowing back to East Asia and the currencies stabilizing, it would not be surprising to see this trend reverse.

Lastly, the US earnings season gets more fully underway. Big financials and big tech are featured this week. Large financial firms appear to have guided expectations lower and the market expectations appear to center around 3% increase in earnings. Note that in recent quarters, some earnings growth can be traced to pulling funds back out of loss reserves. Big tech is expected to report around a 9% increase in earnings. The S&P 500 has recovered to the upper end of its 2 1/2 month range. Resistance is seen from about 1230, the late Aug high to1277, the 100-day moving average.