Positive News for the US Labor Market

The dollar moved a bit higher yesterday as data released here in the US finally contained some positive news for US workers. The ISM’s index of non-manufacturing businesses rose to 54.3 in July from last month’s 53.8 figure. And more importantly for market psyche, it was well above expectations that had predicted a drop to 53. About 90% of the US economy is service related, so this number is more closely watched than the manufacturing reports.

Today we will get some additional jobs data with the release of the weekly initial jobless claims. If these numbers surprise on the upside, the dollar could get some additional love from the currency markets. This may seem counter to what had been happening in the markets, as the dollar always seemed to rally when the US data was bad, and got sold off if the US data surprised on the upside. So why the shift? What’s up?

The currency markets of late have changed from focusing on the global economic recovery/dollar safe haven trade to looking at expected interest rate moves by the FOMC. With the European sovereign debt crisis behind us (for now), and Asia firmly entrenched in recovery, the global economic prospects have brightened a bit. So currency traders have shifted back to looking at where interest rates may be moving.

Many of the research reports coming out of the big banks have been about the possibility of deflation in the US, and what the FOMC is prepared to do if/when prices fall. Pimco’s CEO Mohamed A. El-Erian has been all over the news wires talking about the possibility of a deflationary period here in the US. And while he only puts the risk of deflation and a double-dip recession at 25%, his concerns align with those expressed by St. Louis Fed Reserve President Bullard last weekend. In order to counter this risk of deflation, El-Erian believes the Fed may have to lower rates, or begin another round of quantitative easing to stimulate the US economy.

So while most of the rest of the world is looking to raise rates in order to drain some of the excess liquidity they pumped into their economies, there is a real debate going on here in the US on whether the FOMC will be lowering them. There is a real possibility that the global recovery will leave the US behind, forcing the US Fed to keep rates low while the rest of the globe raises them. This interest rate differential would be bad news for the US dollar and boost the prospects of those currencies whose countries are raising rates.

That is why the negative data being released in the US as of late has caused the dollar to sell off, and a positive jobs report could boost it back up. But the US dollar is going to have to fight against the tide in order to move higher. The strong downward move by the US dollar over the past two months is starting to trigger momentum trades by technical traders. Citigroup technical analysts released a note yesterday suggesting the dollar index will extend its downward trend due to a breach of the 200-day moving average. This move below 80.713 was important, according to Tom Fitzpatrick and Shyam Devani. “Further losses are still likely,” they wrote. “A breach of the 80.40-79.92 area, especially on a weekly close basis would be a significant development suggesting further losses for the US dollar over an extended period down to below 75.” Neither Chuck nor I are big technical guys, but we do try to keep abreast of what the techies are saying, as many computerized programs are based on these technical factors; so they definitely have an impact on the markets.

As I mentioned earlier, the US FOMC is considering another round of stimulus, while the ECB is starting to look at a second run at an exit strategy. The ECB had previously begun to exit the stimulus programs last year, but the Greeks handed them a bit of a problem early on in 2010. So the ECB was forced to do a 180-degree turn and introduced bond purchases in early May. Now that the euro-area is again showing some strength and the debt crisis has calmed, the ECB will likely be looking to exit these stimulus programs. The ECB will announce a non-move in interest rates after their meeting later today, and Trichet could start talking about the exit during his press conference.

The Euro-bank stress tests combined with the positive economic data have given the ECB some room to start to withdraw money, as investor’s sentiment has turned back positive. A report this morning showed German factory orders jumped more than twice as much as forecast in June. This continues the pattern of European data topping economists’ estimates. This trend has restored confidence in the European recovery and in the ability of banks to survive. While many criticized the stress tests as too easy, and overly optimistic, they accomplished exactly what they were supposed to do, boosting confidence in the European banking system.

The successful bank stress tests in the US and Europe have encouraged the Chinese to conduct some of their own. China’s banking regulator told lenders last month to conduct a new round of stress tests to gauge what could happen to Chinese banks if property prices fall as much as 60%. The real estate bubble in China has been an ongoing concern for economists, with many predicting a dramatic US-like fall in these markets and a repeat of the global financial crisis of 2009.

But I think these worries are misplaced. Even if we have a major fall in Chinese property prices, I don’t know of a large global secondary market for Chinese mortgage backed bonds. The US mortgage industry encouraged investors across the globe, with many of the securities backed by US properties purchased by foreign banks and investors. In addition, Wall Street repackaged these US loans into sophisticated investment vehicles using leverage, which caused the ultimate losses on the drop in US home prices to be dramatically increased, causing the global financial crises.

Contrary to the US mortgage market, the Chinese property loans are not widely held so losses would be limited to investors within China. While a 60% drop would certainly hurt these investors, the impact on the global markets would be limited.

The UK will also meet today and is expected to leave rates unchanged. BOE Governor Mervyn King has repeatedly stated the need to leave the key rates in the UK at near zero for a ‘considerable’ time. King does not want to risk upsetting the nascent recovery in the UK, and is willing to risk higher inflation, which has exceeded the target rate of 2% all year.

A dovish press release following the rate announcement could put some pressure on the pound (GBP) which has been one of the best performing currencies over the past couple months.

Canada’s dollar (CAD) was among the best performing currencies overnight as it moved to the highest level versus the US dollar since May. Higher oil prices and the positive data out of the US combined to move the loonie higher. These same factors also helped the Mexican peso (MXN) rise for a fourth day. The peso has had a ‘stealth like’ move higher and is now the second best performing currency versus the US dollar for 2010. Mexico has benefited from higher oil prices and the higher interest rates, which are attracting US investors.

To recap: We finally got some positive news here in the US, which boosted the dollar, signaling a move away from the ‘safe haven’ trades; both the ECB and BOE are expected to leave rates unchanged today; China is performing some stress tests of their own; and our neighbors to the north and south are enjoying some stronger currencies.

Chris Gaffney
for The Daily Reckoning

The Daily Reckoning