US Data Beats Estimates... Economic Outlook Still Bad

Judgment day has arrived for Euro banks

I will start off this morning’s Pfennig with a note from Chuck who is wrapping up his presentations at the Agora Financial Investment Symposium in Vancouver. Chuck will be flying home later this morning, but sent me the following last night before turning in:

“Well… I just finished my ‘Guide to the EverBank Global Toolkit’ presentation…

“There were more than 150 people in the room, and I had a coffee break following my presentation, which meant… I stayed there until every last question had been answered!

“The buzz around the conference today was the HUGE run-up of the currencies and metals yesterday… That was fun to watch, especially when I was up in front of 900 people for the General Session, telling them that they needed to be diversified!

“The data was mixed, with Existing Home Sales falling by less than forecast, but the number of people filing Initial Jobless Claims rose to 464,000 last week. The fears of bad stress tests in Europe faded, and risk was put back on the table…

“With risk back on the table, for the day, The Aussie dollar (AUD) took the pole position, for as I’ve said many times, the Aussie dolalr is a proxy for global growth…

“So… By the time I get to Phoenix, she’ll be rising… And, the Eurozone bank stress tests will probably be leaking to the public… I’ll go out on a limb here, and say that we’ll probably see a small bank or two (or three) show stress; this way, the media, being dumb as a box of rocks, will think, “Wow! That test was for real!” and Armageddon will have been averted… That should underpin the euro, for the trade the last couple weeks has been to sell the rumor and buy the fact… They sold euros waiting for the results, they’ll probably buy them when the results print… Or maybe this all gets thrown in the trash! You just never know!

“Well, we’re winding down the day here… I hope you have a great weekend!”

Chuck mentioned the stress tests in Europe, which have been dominating the news wires this morning. These tests are supposed to assure investors that the European banks that survived the recent financial crisis are strong enough to continue to operate. Thus far only one bank, Hypo Real Estate in Germany, is known to have failed the tests, but since it has already been taken over by the government, its capital levels aren’t an issue. The tests will cover 91 banks in 20 European Union countries and are really nothing more than a PR campaign for these banks; trying to give the public enough comfort to trust these institutions with their deposits.

The key to these tests will be their transparency. If the report simply states which banks failed and which passed they will be largely useless for analysts and investors. These results need to give specifics on the assets of the banks and the valuations of these assets in addition to the levels of capital. Many of the economic ministers of the different European countries involved have come out and assured everyone that their major banks passed the tests, so it would really be a shock if any of the major banks failed the tests. I am siding with Chuck’s thoughts that a few of the banks will fail, and those will be taken over by their country’s government or enter into agreements to merge with or sell to stronger rivals.

A story in The Wall Street Journal this morning raised the possibility that in Spain, many regional savings banks recently agreed to enter into mergers that are designed to fortify their balance sheets. But that wasn’t accounted for in the stress tests, which were based on data from the end of 2009, and heading into the tests, several of these banks were among the short list of banks that might have trouble passing.

The results of the tests will be published around lunchtime here in the states, so we could get some volatility in the last few hours of trading.

Yesterday the dollar moved lower versus most of the major currencies after data released in the US dimmed the outlook for a strong US economic recovery. Initial jobless claims came in above expectations, but continuing claims were slightly below. Existing home sales were also not as bad as expected, falling just 5.1% compared to expectations of a 9.9% slide. And finally, the leading indicators fell 0.2% compared to expectations of a 0.3% decline.

While most of the data beat expectations, the numbers don’t paint a rosy picture for our future economic prospects. The data shows why Chairman Bernanke continues to keep the possibility of additional stimulus if the US economy doesn’t continue to improve. But not all central bank heads believe additional stimulus is what is needed.

In an article written for The Financial Times, ECB head Jean-Claude Trichet is pounding the drum for belt tightening by the developed world. Trichet was never a fan of the ‘quantitative easing’ techniques used by the UK, US, and Japan and most recently the ECB itself. And now he is urging these central banks to quickly remove all of the excess capital that they have injected into their economies. “With the benefit of hindsight, we see how unfortunate was the oversimplified message of fiscal stimulus given to all industrial economies under the motto: “stimulate”, “activate”, “spend”! A large number fortunately had room for manoeuvre; others had little room; and some had no room at all and should have already started to consolidate.” Trichet warns in the article.

The best performer versus the US dollar overnight was the British pound (GBP), which shot up almost 1.2% in the past 24 hours. The pound moved higher after a report showed that June retail sales in the UK rose more than economists predicted and another that reported the UK economy grew at the fastest pace in four years during the second quarter. GDP in the UK rose 1.1% during the second quarter, almost twice the 0.6% rate predicted by economists.

Oil moved higher, further helping the pound sterling and also pushing the Mexican peso (MXN) and Norwegian kroner (NOK) higher. Mexico’s peso was the second best performer versus the US dollar for the day and the week. Investors looking for higher yields have begun moving funds down into the Mexican markets where they can get large interest rate differentials to the US.

Both the Brazilian real (BRL) and Canadian dollar (CAD) moved higher throughout Thursday’s trading day, but then retreated in overnight trading. The loonie is still poised for a nice weekly gain versus the US dollar, as are all of the commodity-based currencies.

South Africa’s central bank left rates unchanged for a second meeting in a row as consumer spending showed a recovery and wage costs surged. South Africa has cut interest rates seven times since December 2008, and some investors felt we would see another cut. But the World Cup, which ended July 11th, fueled wage demands and pushed up prices in many of the major cities, pumping up risks of inflation.

President Obama signed an extension of the unemployment benefits, but an article which appeared in this week’s Economist magazine raises the question of one of the major issues still facing this administration: What to do with Fannie Mae and Freddie Mac?

In 2008, Fannie and Freddie were placed into ‘conservatorship’ by the US government. This move was meant to be temporary, and meant to stabilize the housing sector without an outright nationalization of the institutions. But the two mortgage companies continue to lose money, which is being taken from the Treasury ($145 billion so far), and no one from the administration seems to know what to do with them. Treasury Secretary Tim Geithner has promised to address the matter by early next year, but has yet to suggest just what he will do.

These two firms guaranteed 96.5% of all newly originated mortgages, so no private mortgage insurer seems able to step in and fill the huge void that would be left by the exit of either firm. The companies have guaranteed $5 trillion in mortgages, and continued weakness of the housing market will undoubtedly increase the losses on this portfolio. It will be interesting to see what solution eventually occurs, but as The Economist article suggests, I don’t see the government getting out of the housing business anytime soon.

The additional losses will need to be financed, adding to the national debt. So for the currency markets the continuing losses will equate to a higher debt load for the US, and eventually a weaker US dollar.

To recap… The stress tests will finally be unveiled, and will probably be a non-event for the euro. US data beat estimates, but still show the economy is in trouble; Trichet urges central banks to start pulling in the liquidity; South Africa kept rates unchanged, and Fannie and Freddie continue to rack up losses for the US taxpayer.

Chris Gaffney
forThe Daily Reckoning

The Daily Reckoning