Tuesday, December 05, 2006

If You are Waiting for Cracks: Watch Japan

EUR/USD 1.3330 Hi 1.3365 Low 1.3296
USD/JPY 114.73 Hi 115.46 Low 114.43
AUD/USD 0.7858 Hi 0.7900 Low 0.7854
EUR/JPY 153.00 Hi 153.92 Low 152.61

This week is a big week. What everyone is waiting for is the answer to the question of the year: hard landing or soft landing? Last week pretty much all the data released in the United States, with the exception of the upward revision to Q3 GDP, came out well below market expectations and in line with the Hard Landing scenario. This week we have November NFP which will be examined remorselessly for clues about where the U.S. economy is heading. This is interesting because Non Farm Payrolls are, in fact, a lagging indicator of economic activity and don’t really give an accurate indication of where the economy is heading. For now the market is looking for an increase of 105,000. What everyone is waiting for is the slow-down in the Housing Market to show up in the employment data. So far it hasn’t, but it will.

We also have the ECB meeting on Thursday. Another 0.25% hike is expected. Trichet is reportedly not worried about the Euro appreciation or a possible U.S. recession. Indeed, in a recent press briefing Trichet airily dismissed the impact of a possible U.S. recession on growth in the EuroZone. The U.K. he assures us is a more important trading partner for the EuroZone than is the United States. According to ECB calculations a 1% fall in U.S. GDP should only translate into a 0.2% reduction in GDP growth in Europe. Despite the holistic nature of, well, everything, the man obviously still believes in straight-line correlations, econometric models and the existence of the "independent variable". So "Old Europe".

The EuroZone will get its rate hike Thursday but the real focus will be on the press conference for signs that more are coming, or not. Extreme vigilance or wait and see? An inordinate amount of energy is expended interpreting the "Trichet code". However there are growing concerns in Europe about the international economic environment and, despite his airiness, Trichet is unlikely to indicate anything more than a vigilant monitoring of the economic trends both internationally and within the EuroZone. According to some commentators, notably the super-bear at Morgan Stanley, there is more airy nonchalance about economic risks in Asia at the moment than there is in Europe. Europe is only just emerging from a fairly difficult decade and nowhere is there more awareness of the risks of overplaying the Monetary Policy card than in "Old Europe". So, potentially, the post-hike conference could be bullish for Stock Markets. Or, at least, could lead to some short covering after the recent correction. If Trichet goes with "Extreme Vigilance", however, all bets are off.

While all eyes are on the U.S. and the USD, which indeed is in very bad shape, in Asia, as Stephen Roach has correctly pointed out, the risks of a hard landing are starting to build. And the weakest link at the moment is Japan.

The Japanese track record in economic management, despite the miracle economy and their capacity for producing sellable goods, is somewhat spotty and the median age of the people in charge at the BoJ is something like 120. Whizz kids they are not. Economic policy in Japan has produced poor results for more than a decade and yet, strangely for a country that came up with the Meiji Revolution, all that is on offer is more of the same. The Japanese try to prevent an appreciation of the YEN by buying USDs and they keep parking the proceeds in U.S. Treasuries, which sends all sorts of weird signals to the U.S. Government. The main one being: keep spending on anything you want we’ll keep providing the cash. The distortions this creates on both sides of the Pacific are vast and are likely to prove ultimately unsustainable.

This year the Nikkei has racked up a gain of just under 1% YTD, and is still something like 50% below the peak it reached in the early 1990s. The YEN has begun to strengthen and more appreciation is likely as the stops are triggered on the YEN Carry Trade.

Despite all the talk of a demand-led recovery taking hold in Japan, Japan is still an export-orientated economy. A stronger Yen and a weaker U.S. economy will make exporting more difficult. In addition, Japan looks likely to take a financial loss on its USD denominated assets, of which it currently holds A LOT, in the case of a sustained, substantial depreciation of the USD/JPY. So far this year we have not seen a major USD/JPY correction but all the indicators suggest that is where we are heading. A test of 110.00 doesn’t look unlikely for the USD/JPY by year end.

The ECB move this week is unlikely to provide impetus for more EUR/USD gains. Buy the rumour, sell the fact. Longer term players should note that the USD downtrend is not over yet. Not by a long shot.

OIL 63.11
GOLD 650.70

OIL and GOLD remain supported as the USD struggles. The USD is likely to continue struggling. Indeed, an acceleration of the trend is likely as EUR/USD strength bleeds into USD/JPY weakness.

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