HIGHLIGHTS OF THE WEEK

United States

• Foreign currency policy captured headlines this week as Japan intervened to devalue the Yen, and pressures mounted on China to accelerate its appreciation of the RMB.
• Currency interventions are limiting the potential impact of U.S. export growth during the recovery. This is a challenge for America, because a rapid improvement in the terms of trade would go along way to aiding the recovery, as indebtedness impedes consumer spending.
• The prospects for quantitative easing (QE) could create an interesting dynamic in currency markets, as foreign countries react to a possible decline in the USD.
• In the end, not every economy can rely on exports to support growth.

Canada

• The robust pace of Canadian economic growth recorded since the third quarter of 2009 is likely to moderate, reflecting a slow recovery in global demand and a combination of domestic risks.
• Most notably, record levels of household indebtedness, which drove high levels of consumer spending in the past nine months, will now put downward pressure on spending as households become more cautious.
• This will have a particularly adverse impact on the housing market, which recorded massive gains over the course of 2009, driven largely by this debt-fuelled spending spree.
• We expect the cooling in consumer spending to feed into the downturn in the housing market, which has already begun and will persist throughout the remainder of 2010 and a large part of 2011.

UNITED STATES – CURRENCY MATTERS

Foreign currency policy captured headlines this week as Japan intervened to devalue the yen, and pressures mounted on China to accelerate its appreciation of the RMB. Both issues highlight a desire among many foreign governments to fuel domestic production through export growth. However, this is problematic for a struggling U.S. economy that itself could benefit from improving terms of trade.

After selling an undisclosed amount of yen during Tuesday’s overnight session, Japan managed to depreciate its nominal trade-weighted exchange rate, which had surged in recent months. Following this move, the yen lost between 3 to 4 percent of its value relative to major currencies including the USD, EUR, TWD and GBP. Of course, economists recognize that the nominal exchange rate does not paint an accurate picture of Japan’s trade competitiveness. Instead, economists prefer to look at the real exchange rate, which adjusts for differences in the domestic purchasing power of a currency. Since Japan has been plagued by in falling prices for much of the last decade, one yen can purchase more today than it could ten years ago, whereas one dollar or euro purchases less. After taking this price effect into account, the yen is actually a weaker currency than it was during much of the 1990s. Still, perceptions matter, and many Japanese exporters have grown used to historical valuations above the 100Y per USD threshold. The current stated target is for 90Y.

The intervention comes at a time when lawmakers and the Obama administration are getting increasingly worked up over the lack of a meaningful appreciation in the Chinese yuan. Prior to the meeting of G-20 leaders in June, China announced that it would resume a policy of controlled RMB appreciation against the USD. While this news was well received, patience has clearly started to wear thin as the revaluation proceeds at a glacial pace. This week the U.S. filed two complaints with the WTO in relation to the RMB. In a testimony to the Senate banking committee this past Thursday, Treasury Secretary Timothy Geithner used some unusually strong language to express his growing impatience with China’s currency policies.

All of this action in the world of foreign exchange is an ongoing challenge for the U.S. recovery. Internal pressures have prompted the Chinese and Japanese monetary authorities to intervene in the foreign exchange markets, and hold down their currencies. As a result, U.S. consumers are again being asked to act as the world’s demander of last resort. This presents a problem, because households remain entrenched in an extended period of deleveraging that will continue to impede spending growth.

Data emphasized this trend. While retail sales surpassed expectations in August – and keep in mind that markets are not all too rosy these days – this release comes on the heels of some pretty disappointing reports that had sparked concerns of a double-dip recession. Also, the apparent "strength" in goods spending masks the true state of the American consumer. Data on personal consumption expenditures show that spending in the much larger services category has been especially slow during the recovery. Friday’s release of the University Michigan Consumer Confidence Index also showed that households remain very pessimistic.

Ideally, export growth would be doing more to support the U.S. recovery, by offering an alternative source of demand to producers. While we believe trade will contribute positively to GDP in the near term, ongoing drollery among the world’s major currencies means that there is less support from improving terms of trade than would otherwise be the case.

We still might see the U.S. step into the global parade of currency devaluation. Suppose the Federal Reserve were to opt for another round of quantitative easing (QE), which ironically becomes more likely if subdued U.S. export growth does not pickup the slack of a sluggish consumer. On face value, QE would expand the supply of USDs and could cause a depreciation in the currency. Of course, such a move would not be designed to target the exchange rate, but it would certainly be a side-effect. Yet a depreciating dollar driven by QE would be an awkward development. Would Japan respond in kind with further currency intervention? And how would China respond? In the end, not every economy can rely on exports to support growth, and policies designed to devalue currencies through printing money are bound to have unintended consequences.

CANADA – THE MATURING ECONOMIC RECOVERY: A HOUSING PERSPECTIVE

The Canadian economy has reached yet another inflection point along its recovery, that of moderation. This follows one of the most atypical economic recoveries in Canadian history in which the domestic economy acted as the primary engine of growth. The Canadian recovery was led by robust domestic demand, particular in consumer spending and in the housing market, which fuelled enough growth to recover both employment and real output losses that accrued over the course of the Great Recession in just four quarters. No other G8 nation can make an equivalent claim.

However, achieving such outsized gains in the early months of the recovery was the result of heavy dependence on debt-fuelled private consumption which led to Canadian household debt levels reaching their highest level on record. As a result, TD Economics expects a cooling in consumer spending in the coming quarters as households correct this debt imbalance. This, coupled with a downturn in the housing market, the waning impact of prior fiscal and monetary stimulus efforts, and a downgrade to U.S. economic growth prospects has led TD Economics to similarly revise down its entire outlook for the Canadian economy (Please see our September QEF at www.td.com/economics/qef/ qefsep10_can.pdf). The revision now calls for average real GDP growth of just 1.5%-2.0% on an average annualized basis in the coming four quarters, down from 2.0%-3.0% in the previous forecast.

In fact, the domestic risks outlined above have already begun to play out in the housing market. In 2009, households had clambered to get into the market as early as possible so that they could take full advantage of near zero short-term interest rates, beat out regulation changes and, for those in B.C. and Ontario, two of Canada’s largest housing markets, act before the implementation of the HST. Demand was, thus, extremely frontloaded to 2009. In the 11 months between January and December 2009, existing home sales skyrocketed by almost 66% and prices by more than 21%. Since the start of 2010, we have been seeing that strength unwind; sales have corrected and have declined by more than 20%, while prices a more muted 3% as of this past August. Although the August figures, reported this week, actually revealed improvements in both sales (+4.1% M/M) and prices (+0.4% M/M), this was likely a temporary bounce back from July’s big declines in the B.C. and Ontario markets caused by the HST. On a trend basis, the joyride now appears to be over, but the question is where the housing market is headed next. This truly is dependent on the outlook for households.

On that front, we expect that households are likely to approach overall spending with considerably more caution. Income growth is likely to slow given the impact of the weaker GDP growth profile on employment and, in fact, we are already seeing this spending caution. Second quarter GDP data already indicated a slowdown in consumer spending growth to 2.6% at an annualized pace from 4.3% in the first quarter, while the debt-to-income ratio in the second quarter, data for which was also released this week, fell from its high of 148% in the first quarter to 146%. Moreover, the details in the national balance sheet accounts are truly telling: residential assets actually rose in value in the second quarter reflecting the fact that home prices hit a high in April, or the beginning of the second quarter. But we know that prices have only begun to fall and that the price declines are very likely to continue given how far sales have declined, so the wealth effect has even yet to play into overall spending patterns. In sum, we expect the slowdown in consumer spending to lead to a continued contraction in the housing market throughout the remainder of 2010 and most of 2011, with home sales declining by about 15%, by the second quarter of 2011 and prices declining by about 8% by the end of 2011.

U.S.: UPCOMING KEY ECONOMIC RELEASES

U.S. Housing Starts – August

• Release Date: September 21/10
• July Result: 546K
• TD Forecast: 580K
• Consensus: 554K

After the burst of new life from the lows reached in April of last year, homebuilding activity has again drifted lower in recent months, as the combination of weak demand (following the expiration of the First-time Homebuyers’ Tax Credit Program) and high inventories has compelled homebuilders to moderate new residential construction activity. This pattern is forecast to remain intact in August, though the pace of building activity is expected to rise to 580K units from the 546K units observed in the month before. Most of this upward momentum is expected to come from the bounce-back in single-family unit construction, after three consecutive monthly declines. Multi-family construction, however, should moderate slightly after the 32.6% M/M bounce the month before. In the coming months, we expect the pace of building activity to remain weak on account of the weak economic backdrop.

FOMC Interest Rate Decision

• Release Date: September 21/10
• Current Rate: 0.00% to 0.25%
• TD Forecast: 0.00% to 0.25%
• Consensus: 0.00% to 0.25%

The FOMC meeting next week has some expecting the Fed to announce or lay out the contours of what has now been termed QE2. This may be more a sign of hope than reality, and we would assign a probability no greater than 5% of this happening. That is not to say we are not sympathetic to the logic of QE, we are, but policy makers have no clear consensus among their inner circle of whether it is yet required, and if so, what would be the required triggers. Bernanke admitted at the Humphrey-Hawkins testimony that the FOMC had thought more about the creative ways needed to tighten policy rather than how they would engineer a new round of stimulus. That debate has changed, but has not come full circle.

Bernanke highlighted that the "cost/benefit" analysis of QE would shift decisively should the US flirt with deflation, but that easy choice will remain elusive as the inflation data will not support that conclusion any time soon, if at all. The Fed correctly perceives deflation and a double-dip in the economy as a "tail risk." The harder choice, and the central point of QE, is about growth and the longer term implications for the dual mandate on employment and inflation. These trends tend to develop glacially, not discretely. Consequently, with the downdraft in yields already providing some easing implicit in QE and with the most recent data more rather than less consistent with the soft patch theorists, the Fed has no urgency to act prematurely.

U.S. Existing Home Sales – August

• Release Date: September 23/10
• July Result: 3.8 Million
• TD Forecast: 3.9 Million
• Consensus: 4.1 Million

With the favourable support from the homebuyers’ tax credit program now a distant memory the soft underbelly of the U.S. housing market has become exposed. As a result, existing home sales have declined for three consecutive months, underscoring the point that the main impact of the program was to bring forward sales from the second half of this year. In August, we expect sales to stabilise, and are looking for a modest 2% M/M jump in the number of homes changing hands. Both single-family and condo sales are expected to rise marginally on the month, after their double-digit plunge the month before. Given the stiff headwinds that the housing sector is expected to face in the coming months, we expect the pace of existing home sales to stabilise at close to the current low levels, despite the favourable buying conditions and low mortgage rates.

CANADA: UPCOMING KEY ECONOMIC RELEASES

Canadian CPI – August

• Release Date: September 21/10
• July Result: core 0.1% M/M, 1.6% Y/Y; all-items 0.6% M/M, 1.8% Y/Y
• TD Forecast: core 0.1% M/M, 1.6% Y/Y; all-items -0.1% M/M, 1.8% Y/Y
• Consensus: core 0.2% M/M, 1.7% Y/Y; all-items 0.0% M/M, 1.9% Y/Y

With the impact of the introduction of the Harmonized Sales Tax (HST) now firmly in the rear-view mirror, the true trend in Canadian consumer prices will once again emerge. On a month-over-month basis, energy prices were virtually unchanged, which will eliminate a potential distortion to the all-items price index. Absent the impact of the HST, the all-items price level has slowed markedly in recent months and is forecast to remain weak in August, falling by 0.1%. However, when seasonal variations are taken into account, the all-items price index is expected to rise by 0.1%. On a year-ago basis, all-items CPI is forecast to rise by 1.8% which will match the rate of increase observed in July. Note that this rate of inflation will remain elevated for another 10 months, reflecting the boost in the price level caused by the HST. Core consumer prices (which specifically exclude the impact of the HST) are expected to advance by just 0.1%, reversing the similarly sized decline recorded in the previous month. When seasonal factors are taken into account, core prices are expected to remain flat in August, which represents a further deceleration from the string of 0.1% increases observed in each of the previous three months. Core inflation expected to rise by 1.6% which matches the rate observed in July. With two months of the third quarter now in the history books, it appears that while headline inflation is unfolding as the Bank expects (1.9% on a year-ago basis in Q3), core inflation is just a touch softer (1.6% compared to the Bank’s forecast for 1.8%). While this forecast miss may be corrected in the updated forecast due in October, it does on the margin, support the case for a slower pace of stimulus withdrawal.

Canadian Retail Sales – July

• Release Date: September 22/10
• June Result: total 0.1% M/M; ex-autos -0.5% M/M
• TD Forecast: total +0.8% M/M ; ex-autos +0.3% M/M
• Consensus: total 0.5% M/M; ex-autos 0.3% M/M

The forecast for retail sales in July pits an increase in auto sales and higher gasoline prices against the headwind imposed by the introduction of the Harmonized Sales Tax (HST). It is expected that the former force will prevail and allow total retail sales to increase by 0.8%, which would represent the largest monthly increase since March. The impact of the HST, however, will more readily be observed in the ex-autos forecast for a more timid advance of 0.3%. The exautos component is also expected to be adversely impacted by weaker home sales in the month. From the perspective of its contribution to real GDP growth, rising consumer prices are expected to weigh on the inflation-adjusted measure of retail sales. When paired with the unexpected decline in manufacturing shipments, it is shaping up to be a soft start to the second half of the year.

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Market Outlook

= USD: relief bounce on FOMC?

Intervention by the BoJ and a surprisingly brutal reaction to SNB forecast revisions caused trends to shift in G10 currency markets over the past week and threaten to compound volatility over the coming days as the FOMC meets to discuss monetary policy and in the UK the Sep MPC meeting minutes are published. The USD may be in a win/win position going into the FOMC. If the Fed are downbeat, the USD may benefit from a risk sell off, while if they are more positive, it may benefit from a back up in US yields as QE2 fears are put on the back burner. With the EUR suddenly back in favour and central bank intervention forcing investors to trim long JPY and CHF strategies, predicting flows under a ‘risk off’ scenario is not straightforward. Even though correlations with risk have rebounded, we are alert to retracements in EUR crosses as talk of debt restructuring flares up in the periphery and risk reversals signal a possible counter trend move.

Recap

The BoJ intervened to weaken the yen through alleged unsterilised sales of JPY (tbc next week). The yen jumped in response from a low of 82.88 to the end-of-week highs in the region of 85.80 to the dollar. Despite strengthening against JPY, USD weakened against GBP and EUR as speculation persisted regarding QE2 amidst a slew of weak macro UK numbers. It was a strong week for GBP as it strengthened vs all G10 currencies from oversold levels. The EUR too rallied against G10 currencies except GBP, with concerns over Ireland causing a wobble on Friday. The SNB kept the policy rate unchanged but downward revisions for 2011/12 CPI sparked aggressive unwinding of long CHF positions causing EUR/CHF to spike 300pips before eventually settling below 1.32.

It was another week of soft indicators for the UK economy with a weak RICS survey and a surprise decline in August retail sales. CPI inflation surprised on the upside as it stayed unchanged at 3.1%. Amidst elevated inflation levels, MPC minutes next week are much anticipated but may not bring much clarity on the outlook for monetary policy. On the other hand, data in the US somewhat alleviated double-dip fears with rising retail sales and inventories, surveys showing stable confidence (though Michigan survey down) and declining initial claims to 450k. Core annual CPI fell below 1% in August to 0.9%, causing disinflationary worries to resurface. Euro zone industrial production was flat on the month and the ZEW survey showed declining economic sentiment.

A turbulent week for government bonds dominated by mixed 2020 and 2030 gilt auctions ended with yields closing at the lower end of the range. The front end and belly of the curve outperformed the long end, resulting in a steeper 2y/10y curve (through 240bp for gilts) and 10y/30y (103bp). The 2y/10y swap curve held steady in a range around 182bp pivot. 5y swaps climbed 7bp to 2.24%, retracing from an earlier 2.31% high. A busier than usual week of late for corporates brought sterling issuance from Bank Nederlandse Gemeenten (£200 mln 2015), EDF (£1.0bln 2050) and Co-op Bank (£400mln 2017).

NOK a good alternative safe haven to the JPY and CHF

With the BoJ stepping into the market for the first time since 2004, the yen’s attraction as a safe haven has diminished. This may lead to a search for alternatives. The obvious alternative of the CHF is not particularly attractive, as it has had a similar rise to the yen in recent months, and the SNB downgraded their growth outlook in the latest report in part because of the strength of the CHF. But there is a limited universe of currencies that can be safe havens. The prime requirement is a current account and international investment position surplus, which rules out the majority of the G10 currencies. Other than Japan and Switzerland only Norway and Sweden among the G10 have significant current account surpluses (see chart a). Norway is the least vulnerable to a downturn in the global economy, as much of the surplus is now due to investment income on the government pension fund, and while there is still a dependence on oil and gas prices, it is hard to see a long term decline in the oil price, given peaking ex-OPEC output, and gas prices are already near multi-year lows. Norway also offers a yield pick up over JPY and CHF, and CHFNOK in particular looks very cheap compared to short term rate spread movements (see chart b). Norway also has no requirement to buy foreign currency this year as the significant decline in their budget surplus below their current account surplus means that the government already has enough foreign exchange to fund pension fund contributions this year. Previously they have had to sell NOK in the market to fund contributions to the (foreign currency denominated) government pension fund. The main negative on the NOK as a safe haven is its tendency to be treated as a risk positive currency because of its relatively high yields, but this tendency has diminished of late and it is starting to be treated more as a safe haven, particularly in terms of internal Euro-zone risk.

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Market Movers ahead

• In the US, the FOMC meeting is expected to largely maintain the status quo. The economy has not worsened enough for additional quantitative easing (QE).
• In Europe, PMIs and the German Ifo are poised to disappoint, suggesting growth is now easing.
• In Asia, attention will be on possible further intervention from Japan. Japan could face criticism when global leaders gather for the UN meeting in New York.
• We expect Norges Bank to keep interest rates unchanged at this week’s meeting, but suspect the statement will be a bit more hawkish.

Global Update

• Japan intervened for the first time since 2004 and has so far been successful in stemming the appreciation of the yen.
• The Basel III proposal has eased fears that it forced banks to rush to raise capital and weigh on the global recovery.
• Encouraging data in the US and China ease fears of a double dip.
• However, data from Europe have been disappointing suggesting that growth is now slowing.

Focus

• In the first Focus article, we look at leading indicators ability to predict G10 exchange rate movements. Our conclusion is that to some degree they can.
• In the second Focus article, we look closer at the sustainability of public finances in the US. Our conclusion is that fiscal tightening is needed but at this stage it is not urgent.

Market movers ahead

Global

In the US the main focus next week will be on the FOMC meeting on Tuesday. We expect the assessment of the economic situation to remain unchanged after last meeting’s downgrade. Moreover, we do not believe the state of the economy has worsened enough for the Fed to introduce new quantitative easing measures. Further, the committee continues to be divided on the issue. If will be interesting to see if Hoenig continues to vote against the statement and the extended period language. If not, it will be a sign that the balance in the committee has shifted more in favour of the doves.

Next week will be heavy on data for the US housing market. Housing data continue to be difficult to predict, as the effects of the extended first-time home buyers credit continues to create volatility in the figures. Monday we expect the NAHB index for September to improve modestly. On Tuesday we expect both housing starts and building permits for August to decrease, thereby continuing to move further into historical lows. Later on in the week new home sales and existing home sales are expected to rebound with growth of 3.2% m/m and 8.8% m/m, as last month’s rise in pending home sales indicated more activity on the horizon.

Moreover, we will receive data for durable goods orders for August. After last month’s steep drop in Business CAPEX fear is beginning to spread that domestic demand growth is losing pace. We think it is likely that much of the past month’s setback will be recovered – if not it will be a big disappointment.

In Euroland markets will focus on the important confidence indicators PMI and Ifo. Our models signal that we will see a notable decline in both Ifo expectations and PMIs reflecting the ongoing economic slowdown. The declines are likely to be bigger than consensus expectations and this could spark renewed fears of a double dip in the euro area and thus we could see sovereign spread widening and a EUR/USD decline. We will in particular look at the PMI new orders indices for an indication of how sharp the slowdown will be. We are likely to see further declines in the coming months, but we do not expect that the indicators will dip into contractionary territory before they begin to rise again late this year or early next year. Manufacturing PMIs are set to decline more than service PMIs. Ifo current conditions still have a positive momentum and here we see an upside risk to our almost flat forecast as it might not have peaked yet. Euro area industrial new orders are set to decline 1.4% m/m in July following a 2.5% m/m strong increase in June. The 2.2% decline already seen in German data was partly the result of a correction in export orders, which were pulled up temporarily by very large capital goods orders in July.

In a rather eventless calendar, the BoE minutes will take centre stage in the UK next week even though we do not expect the referendum to contain explosive news on future monetary policy. Voting has probably been 8-1 for keeping rates unchanged, with über-hawk Sentence as lone dissenter. Expanding bond purchases has probably been discussed and we generally expect a dovish tone from the BoE throughout the year.

Things will be a little quieter in Switzerland in the wake of the Q3 monetary policy meeting. On Friday the SNB will be publishing its quarterly monetary policy report, but this tends not to have anything much to add to the information presented at the monetary policy meeting. Tuesday brings figures for M3 money supply growth in August, but while these are interesting in terms of monetary policy, they are unlikely to have any major financial impact so soon after the SNB’s Q3 meeting. Finally, it is worth keeping an eye on the KOF economic forecast on Monday and export data for August on Tuesday.

With no important economic releases scheduled next week, focus in Asia next week will continue to be on Japan’s attempt to prevent further appreciation of the yen. So far no one has dared to test Japan’s resolve following the intervention last week. It is important that the intervention is followed by strong quantitative easing from Bank of Japan (BoJ) and we cannot rule out that BoJ at some stage will call for an emergency meeting to maximize the impact from intervention. However, most likely we will have to wait for the October 4-5 scheduled meeting to get a response from BoJ. Other central banks in Asia should also be watched closely – not least Peoples Bank of China (PBoC). The important question is whether Japan’s intervention will be used as an excuse by other Asian countries to stem the appreciation of their own currencies.

Global Update

Regulation and intervention

This week started with the announcement of the Basel III agreement. The new minimum capital requirements demand that banks hold top-quality capital totalling 7% of their riskbearing assets. However, this will not be fully phased in before 2019. Markets reacted with relief as the long lead-in time eased fears of a rush to raise capital. The next big thing was Bank of Japan’s intervention in the FX market for the first time since 2004. The intervention came after USD/JPY overnight broke decisively below 83. We do not believe Japan is intervening against fundamentals, even though USD/JPY at current levels in our view is not far from fair value and the intervention policy could be successful – at least in the short term.

Data from the US – including retail sales and jobless claims – surprised to the upside this week while euro area data – including ZEW and trade data – disappointed. This pattern may well continue for some time as the US slowdown is beginning to bottom out while the European economy has only just entered this "mid-cycle" slowdown phase. In line with this European stocks fell during the week while US stocks increased. EUR/USD strengthened and oil prices increased slightly. Strong Chinese data released last weekend suggest that Chinese growth will begin to pick up in Q4.

US: More signs of stabilisation in data

In the US we saw healthy gains in retail sales. Both headline and core retail sales increased nicely in spite of weaker car sales, which dropped 0.7% m/m. Following the last few months’ weakening in retail sales growth, which was already very moderate, the positive August figures were a very welcome change. Overall private consumption seems sturdy, tracking at 2.3% q/q AR for Q3, thus reducing fears that domestic demand will cave in.

The regional PMI surveys received so far from the New York and Philadelphia areas have been mixed. While the general impression is of stabilization, both surveys suggest that the level of the national ISM index remains too high. Hence, the takeaway from this week’s business data is that the ISM is set to continue its descent toward the low 50s over the coming months. The industrial production data from August confirmed that the pace of growth in the manufacturing sector is gradually cooling. Production rose 0.2% m/m in August. Since the spring the growth rate has slowed from around 8% AR to about 5% AR.

The recent flow of data from the US has been better than expected and points to some stabilization in growth. While fears over a hard landing have eased somewhat, we think that evidence could continue to be mixed in the coming months.

Euro area data disappointed

The German ZEW expectations disappointed badly by declining to -4.3 in September from 14 in August. Although it is a survey of financial analysts, it has historically been a good lead for indicators like Ifo and PMI, so it is concerning that the index fell so sharply. On a positive note, the ZEW current conditions index surprised to the upside rising to 59.9 in September up from 44.3 in August reflecting the recent strong performance of German growth. There may be an effect that the better things are today the more likely it is to get worse – and thus more analysts expect growth to slow when looking ahead.

Industrial production in the euro area was unchanged in July after it fell 0.2% in June. Prior to that industrial production rose sharply. This sudden stop in industrial production growth is somewhat alarming. In addition, trade figures showed that euro area exports fell by 0.6% m/m and imports by 1.5% m/m in July. Looking forward, we do expect slowing production and trade growth, but the economy should remain on a positive trend. Exports to the US continued to increase in July while exports to Asia – and in particular China and Japan – declined. Exports to Asia are likely to remain in a soft spot for some months, but we do expect that China will begin to pick up again in Q4. Exports to the US may continue to grow, albeit at a slowing pace.

Japan intervenes for the first time since 2004

Following the re-election of Prime Minister Naoto Kan as leader of the ruling Democratic Party of Japan (DPJ), Japan finally decided to intervene in the FX Market to stem the appreciation of yen, see Flash Comment – Japan: Will intervention work this time? We do believe that Japan’s intervention will be able to stabilise the yen in the short term. Most importantly Japan is not intervening against fundamentals, as yen is slightly overvalued. However, it is important that the intervention is supported by further aggressive quantitative easing from Bank of Japan (BoJ). Not sterilizing intervention is the first step. Expanding the BoJ’s new credit facilities or increase its government bond purchase will have to be the next step.

Despite Kan’s re-election as DPJ party leader the political situation remains uncertain and Kan’s premiership could prove short lived, see Flash Comment – Japan: PM Kan wins leadership election. Kan’s first challenge will be to keep the DPJ together and without a majority in the Upper House it will be difficult for Kan to push through his political agenda.

In China the economic data for August exceeded expectations across the board and suggest the Chinese economy is currently bottoming out, see Research: China appears to be regaining strength. GDP growth in our view is still poised to slow below 7% q/q AR in Q3, but growth should start to improve again in Q4. The increase in inflation in August from 3.3% y/y to 3.5% y/y is not alarming. With GDP growth currently below trend inflation in China should peak in coming months. China’s exchange rate policy is again in focus. In the past two weeks the yuan appears to have resumed its appreciation against USD. This probably reflects that the Chinese leadership again has become more confident about growth and renewed political pressure from the US.

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HIGHLIGHTS OF THE WEEK

• This week provided fairly positive economic data, as U.S. Personal income and consumption rose in July, the ISM manufacturing index surprised on the upside, and non-farm private payrolls were also stronger than expected.
• These data support our view that the U.S. recovery will remain on track, and that growth will continue at a relatively slow pace.
• In order to experience a relapse in economic growth, U.S. aggregate demand components would have to register contractions of a magnitude difficult to justify outside of a scenario characterized by a renewed severe shock.
• Drama has been growing ahead of next week’s BOC meeting. Investors are split on the likelihood of a follow-up 25 basis point rate hike.
• Regardless of whether the Bank hikes rates, this is likely to be the last for a while, as economic growth is falling short of the central bank’s expectations.
• Real GDP for Q2 came in at 2%, below the 2.5% consensus estimate and falling short of the Bank’s 3% forecast.
• Q2 data reinforced some of the growing vulnerabilities to the Canadian expansion, including slowing consumer spending, housing activity and export growth.
• We expect real GDP growth to come in closer to the 2% mark than the Bank’s 3% forecast in the second half of 2010 and first half of 2011.

UNITED STATES – FURTHER AWAY FROM THE CLIFF

We had some fairly positive data this week, starting with expansions in both personal income and consumption for the month of July. Then the Conference Board’s consumer confidence index surprised market expectations on the upside and the ISM manufacturing index also fared better than expected underpinned by a surprisingly strong reading in its employment sub-component, and to a lesser extent in prices paid. The latter should help to temper some of the recent talk on the possibility of the U.S. economy slipping into deflation.

This morning’s much anticipated August non-farm payroll report also showed a larger than consensus gain in private sector employment. While none of these indicators are at a level that would support an exuberant response, they do support our baseline view that the U.S. economic recovery remains on track, and will continue to gain ground at a relatively slow speed. By this we mean an annualized pace of GDP growth in the order of 1.8% in the second half of this year and moving to 2.3% next year.

For those who prefer to remain ardent believers that a double dip recession is in the offing, just take a pen and paper and write down the fundamental macroeconomic equation GDP = PC + GC + I + (X-M), namely gross domestic product equals the sum of private and government consumption, plus gross fixed investment plus net exports. Then run a very rudimentary arithmetic exercise: plug in very modest assumptions for each component and see what it would take for GDP to actually record another contraction for a couple of quarters. Say, for example, you assume government consumption declines at a 1% annual rate during Q3:2010 – Q3:2011; private consumption expands at a quarter of the speed it did on average during 1971 – 2009 (keep in mind this period includes three severe recessions), and do the same for net exports. In order to drive headline GDP into a double dip it would require a contraction in gross investments over this period. The problem with this view is that investment registered an average annual contraction of close to 11% during Q4:2006-Q4:2009, and to keep sinking it would imply an unprecedented destruction of the U.S. stock of private physical capital. If on the other hand you think that it’s more likely for consumption to lead the US economy into a double-dip, then it would take a sharp worsening of labor market conditions with an outright largescale loss in jobs. But, given the skeletal job market that currently exists and without identifying a trigger event to force renewed firing, it is difficult to argue for this outcome.

In other words, there are a continuum of outcomes in between a slow recovery and a double dip, and under reasonable trajectories – just reasonable, not even strong trajectories – of the main demand aggregates, growth in the domestic economy remains in positive territory. On the other hand, to get another leg down in economic activity, it would require a negative catalyst, marked by another major shock to drive economic expectations even lower than they are today to effect consumption and investments. Yes, there is still the threat of European sovereign debt running into financial troubles and the more remote possibility of a burst of China’s alleged real estate bubble, but those remain only risks and not the baseline scenario. Every time an economic indicator undershoots a little bit with respect to market expectations, doomsayers come out of the woodwork arguing for a double dip. However, the data continue to move us increasingly away from this possibility.

The key to this recovery will be patience, as it will proceed at a slower pace than any other in recent U.S. history, but this does not argue for a relapse in economic growth. (please see our recent publication: U.S. Recovery Is Tracking Traditional Experience After Financial Crisis Induced Recessions)

CANADA – ONE MORE PLAY THEN IT’S OFF TO THE SIDELINES

What better way to ring in the fall session of trading than a Bank of Canada (BOC) interest-rate decision replete with drama. Ahead of this Wednesday’s fixed announcement date, investors are deeply divided on whether the central bank will bump up its overnight rate by an additional 25 basis points, to 1.00%. Over the past few weeks, financial market expectations have oscillated with each twist and turn in the economic data. Despite being served up a disappointing Canadian GDP report for the second quarter, a barrage of stronger-than-anticipated U.S. figures – notably the ISM and jobs numbers for August – helped to propel the likelihood of a hike from 30% to just above 50% by week’s end. On the other hand, Bay Street analysts – including ourselves – have been near-unanimous in predicting an increase.

Even if the BOC ultimately pulls the trigger on Wednesday, it is likely to be the last rate hike for a while. For one, the recent string of positive U.S. data is more telling of an economy not slipping back into recession than one gaining significant traction. But more importantly, Canada’s weaker-than-expected 2.00% (annualized) reading on real GDP in Q2 – while certainly containing some bright spots – provided some strong signals of the growing vulnerabilities to growth at home.

On the plus side, a major contributor to Canadian secondquarter growth was business capital spending, which had been lagging behind so far in the recovery. On the flip side, a full 2 percentage points of growth alone was attributable to a sharp accumulation in inventories, which tend to provide only a temporary kick. Elsewhere, exports gains slowed, reflecting the ongoing U.S. challenges. And as a testament to the absence of pent-up demand of households, particularly for big-ticket items, personal consumption expenditure and homebuilding activity softened in Q2.

Surprisingly strength in job creation has helped to keep consumer spending well supported in recent months. However, this Friday’s employment report for August should provide some evidence that hiring is beginning to slow down in tandem with the broad economy. The headline number is expected to receive a boost from a rebound in educational services employment, which fell sharply in the prior month, partly due to a statistical quirk. However, excluding education, there was probably little net addition to jobs in August on the heels of a solid run in the spring and early summer.

The data indicate that Canada’s economy is gearing down more quickly than the BOC had envisaged in its July Monetary Policy Report (MPR). In that document, the Bank had not only projected real GDP growth of 3% in Q2, but it had expected that pace to be continued in the second half of 2010 and in 2011. Based on our estimates, it now appears that the profile is likely to be closer to 2%, increasing the downside risk to their core inflation forecast.

Accordingly, rather than continuing to embark on a string of rate hikes, the path ahead is likely to be drawn out. TD Economics is forecasting only four quarter-point hikes throughout 2011 beginning in Q1, taking the rate up to 2%, which is still effectively zero in real terms. Look for the communiqué accompanying Wednesday’s rate decision to signal a pause going forward.

U.S.: UPCOMING KEY ECONOMIC RELEASES

International Trade – July

• Release Date: September 9/10
• June Result: -$49.9B
• TD Forecast: $-47.0B
• Consensus: -47.3B

After three consecutive months of widening, the U.S. trade balance is set for a modest improvement in July. During the month, we expect the combination of a modest 0.7% M/M drop in the pace of imports along with a 1.1% M/M increase in exports to result in the trade deficit narrowing to $47.0B. The decline in imports will be a function of the diminished appetite for foreign goods resulting from the weakening pace of economic recovery along with the lagged impact of softer energy prices. On the other side of the ledger, the weak US dollar is expected to improve the competitiveness of US products globally, thereby providing a boost to exports during the month. Real trade is also expected to improve, suggesting that net trade will be a favourable source of support for economic activity during the month. In the months ahead, we expect the level of the deficit to return to its upward trajectory, as weakening global demand pushes exports lower.

CANADA: UPCOMING KEY ECONOMIC RELEASES

Bank of Canada Interest Rate Decision

• Release Date: September 8/10
• Current Rate: 0.75%
• TD Forecast: 1.00%
• Consensus: 1.00%

It has become an exceptionally close call, but we expect that the Bank of Canada will proceed with a 25 basis hike and take its overnight rate to an even 1.00% next week. While Q2 real GDP growth did fall short of the Bank’s forecast, the underlying details suggest that there is sufficient momentum in the domestic economy to warrant a further reduction in stimulus. Furthermore, real GDP growth continues to exceed the growth rate of potential output, which implies that what remains of the spare capacity created during the recession continues to be absorbed. While the international outlook has certainly darkened, our current tracking for 2010 US real GDP growth of 2.6% remains in the ballpark of the Bank’s 2.9% forecast. Looking beyond next week’s meeting, we feel that the balance of risk is tilted towards an extended pause through the first quarter of 2011. This will allow the Bank to gauge the response of the Fed to recent US weakness as well as to evaluate the various sources of domestic momentum within the Canadian economy.

Canadian Housing Starts – August

• Release Date: September 9/10
• July Result: 189.2K
• TD Forecast: 185.0K
• Consensus: 185.0K

The progressively smaller rate of decline in housing starts over the last three months is expected to continue in August, as starts are forecast to ease just modestly to 185K annualized units. Despite the recent fall in resale activity, building permits have held up reasonably well and the weather across the country was generally supportive of building activity in August. In terms of the composition of starts, single unit dwellings are forecast to stabilize following several months of sharp declines. Meanwhile, the evervolatile multiples component is forecast to remain flat following a sharp 13% increase in July. Taking a longer-term perspective, the housing market is expected to remain on the weak side over the second half of the year. The emergence of a better balance between buyers and sellers is anticipated to reduce the incentive of builders, which will allow starts to return to their demographically supported level.

Canadian International Trade – July

• Release Date: September 9/10
• June Result: -$1.1B
• TD Forecast: $-1.3B
• Consensus: -0.8B

Canada’s merchandise trade deficit is expected to widen further to $1.3B in July. While both exports and imports are likely to rebound from the decline observed in June, the forecasted 1.6% M/M increase in exports will lag the 2.0% increase in imports. While exports will benefit from a weaker trade-weighted Canadian dollar and a rebound in US imports of autos, lower commodity prices and a decline in US shipments of non-transportation goods will limit the magnitude of the increase. The forecasted strength in imports can be attributed to the momentum in business investment and an expected rise in retail sales. Once the impact of changing prices is taken into account, both real exports and imports are expected to increase, but on balance net exports will remain a drag on real GDP growth.

Canadian Employment – August

• Release Date: September 10/10
• July Result: -9.3K; unemployment rate 8.0%
• TD Forecast: 40K; unemployment rate 7.9%
• Consensus: 30K; unemployment rate 8.0%

After posting an unexpected decline in July, the Canadian labour market is forecast to rebound strongly in July, adding 40K new jobs. When paired with the modest expansion in the labour force, the jump in hiring is expected to pull the unemployment rate down by a tenth of a percent to 7.9%. A large part of the forecasted increase in employment is attributed to the partial unwinding of the 65K plunge in educational services employment. In recent years, this phenomenon has provided a lift to employment in either August or September. For the purpose of the forecast, we have split the difference but acknowledge that its impact will provide a significant boost to employment in one of the next two reports. Abstracting away from this temporary influence, a slower pace of overall job growth in the months ahead will reflect the moderation in economic growth over the second half of the year. Nevertheless, robust hiring intentions from both the Bank of Canada’s Business Outlook Survey and the IVEY PMI will limit the downside risk to the labour market.

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Today’s US session was one for those who enjoy watching paint dry. But tomorrow is NFP day and may be yet another day for a USD inflection point.

Today’s session was hardly one for the history books, though we did see fairly strong moves in NOK (in support of the interest rate spreads favoring the currency as we have noted in recent days) and in SEK off the back of the Riksbank interest rate hike and guidance. EURUSD and the other major USD pairs failed to follow up on yesterday’s exuberant move higher in respect of the upcoming US employment report and ISM non-manufacturing report tomorrow.

Nonfarm payroll expectations and reactions

Some have lowered expectations for US nonfarm payrolls due to the weak ADP release (soon we’ll be dropping the "private payrolls" figure, which remains the focus, once the rest of these pesky census workers are fired). The Saxo call (see a great report on the release here: is for a virtually unchanged figure versus a slightly more positive consensus. The market is already very short the USD, but risk is made a sharp comeback yesterday, which pushed the dollar lower. It feels like we’re in need of direction here after so many days of aimless trading in EURUSD and whippy trading in the more risk-correlated AUDUSD, but will we get any kind of resolution in tomorrow’s trading? It’s tough to build any conviction in this environment. For now, risk appetite measures are generally very complacent.

It is perhaps worth noting the reactions to the last three US employment reports.

July Report: the market sold the greenback very lightly after the July employment report on August 6 (in which private payrolls were out at +71k vs. +90k expected and the Jun. data was revised -50k lower). But that was at the tail-end of a weak move in the USD and that very day marked the low of the greenback against the Euro, the Aussie and other currencies. (EURUSD slid from 1.33+ to 1.25 in the subsequent two weeks.).

June Report: in the case of the June US employment report released on July 2, in which payrolls also fell short of expectations, though the unemployment rate improved to 9.5% instead of leaping to the 9.8% expected, the initial reaction was very modest, but the USD sold off heavily in a virtually straight line some days later as risk appetite continued to recover.

May Report: by far the most disappointing of the three reports (payrolls rose +41k vs. 180k expected) on , the release came in an environment of weak risk appetite and was released on June 4. It kicked off a brutal two day slide in the risk, which boosted the USD, but June 7 was the top for the greenback for the year.

Let’s not forget that the important ISM non-manufacturing survey is also up tomorrow. It has been largely stable since peaking out in March of this year despite other ugly data coming out of the US. An ugly deceleration is needed in this index if we are to believe that the US economy is really gathering downside momentum rather than simply flattish at the moment. Also – the biggest mover off the report tomorrow could be the treasury market and therefore the Japanese yen, which remains the highest beta currency out there.

Chart: AUDUSD

Here we simply market the three dates of the last nonfarm payroll reports on the AUDUSD chart. They have certainly come close to interesting inflection points on all three occasions and that may be the case yet again this time around despite the cynicism the market often heaps on this monthly number due to to the way it is calculated.

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Euro 1.3460

Initial support at 1.3385 (March 31 low) followed by 1.3268 (Mar 26 low). Initial resistance is now located at 1.3591 (April 1 high) followed by 1.3627 (Mar 19 high)

Yen 94.25

Initial support is located at 93.68 (Apr 2 low) followed by 93.28 (Apr 1 low). Initial resistance is now at 95.06 (Aug 24 high) followed by 95.29 (Aug 18 High).

Pound 1.5265

Initial support at 1.5173 (Apr 1 low) followed by 1.5044 (Mar 31 low). Initial resistance is now at 1.5299 (Apr 1 high) followed by 1.5382 (Mar 17 high).

Australian Dollar 0.9190

Initial support at 0.9183 (Apr 2 low) followed by the 0.9150 (Apr 1 low). Initial resistance is now at 0.9225 (Apr 5 high) followed by 0.9250 (March 17 high).

Gold 1130

Initial support at 1111 (Apr 1 low) followed by 1101 (Mar 30 low). Initial resistance is now at 1133 (Mar 17 high) followed by 1145 (Mar 3 high).

Oil 86.40

Initial support at 86.00 (Intraday Support) followed by 85.00 (Intraday Support). Initial resistance is now at 88.00 (March high) followed by 90.00 (Intraday Resistance).

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Daily Technical Analysis

EURUSD Outlook

The EURUSD made another indecisive movement yesterday, trapped in a range area of 1.4450 – 1.4600 as you can see on my h4 below, indicating consolidation but the scenario is more to the upside unless we have a break below 1.4450. The bias is neutral in nearest term. We will have some important news from the Euro zone and US today. While ECB likely to keep rate at 1%, traders focus will be more on the ECB press conference. An optimistic tone should support the Euro further while a negative tone may diminish Euro rally. US retail sales data is expected to be weak. Unless we have a significant positive surprise on retail sales numbers, the Dollar should remains under pressure. Break above 1.4600 should continue the bullish scenario targeting 1.4800 area.

GBPUSD Outlook

As I had expected, the GBPUSD continued its bullish momentum yesterday, topped at 1.6302 and closed at 1.6278. The bias should remains bullish testing the major trendline resistance (aqua), which is a potential strong resistance are at this phase. Break above the trendline resistance should trigger further bullish momentum towards 1.6430 in nearest term and 1.6700 in longer term. Immediate support at 1.6250. Break below that level should diminish the bullish momentum and lead us into no trading zone with potential further bearish momentum testing 1.6040 – 1.6113 support area.

USDJPY Outlook

The USDJPY was corrected higher yesterday. My bearish scenario is in serious threat, but it’s too early for a bullish scenario. The bias is neutral in nearest term but as long as price stay below 91.85 area the bearish scenario targeting 90.15 area should remains intact. Break above 91.85 should be seen as bearish failure. Immediate support at 91.00 area. Break below that area should trigger further bearish momentum and keep the bearish scenario intact.

USDCHF Outlook

The USDCHF made indecisive movement yesterday. On h4 chart below we can see that price still trapped in range area of 1.0143 – 1.0213. The bias remains neutral in nearest term but I still prefer a bearish scenario at this phase. Clear break below 1.0143/30 area should trigger further bearish momentum targeting 0.9917 area. On the other hand, break above 1.0213 area should diminish the bearish scenario testing 1.0280 area.

EURJPY Outlook

The EURJPY was corrected higher yesterday. On h4 chart below we can see that after break below the trendline support (red) price retreated higher near the trendline, which is often happen technically. The bias is neutral in nearest term but if price move back above the trendline, the bearish scenario is in serious threat, testing 133.77 resistance area. Break above that area should trigger further bullish scenario at least testing 134.36 area. Immediate support at 132.00 area. Break below that area should keep the bearish scenario intact.

GBPJPY Outlook

The GBPJPY had a bullish momentum yesterday. On daily chart below we can see that price rejected to move below the trendline support (blue) indicating the bullish scenario remains intact targeting 150.69 area. Immediate support at 148.50 area. Break below that area should lead us into no trading zone as direction would become unclear for me

AUDUSD Outlook

The AUDUSD had a bullish momentum yesterday. On h4 chart below ( I have made some adjustment to the bullish channel) we can see that price still move inside the bullish channel indicating the bullish scenario remains intact. However we seem to have a good resistance around 0.9325 area. We need a valid break above that area to continue the bullish scenario targeting 0.9404. Immediate support at 0.9200 area. Break below that area should be seen as serious threat to the bullish outlook.

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Daily Technical Analysis

EURUSD Outlook

The EURUSD made indecisive movement yesterday. The bullish momentum after breakout from the previous range of 1.4250 – 1.4450 seems limited so far and looks like price is trying to make another choppy market. However, as long as price stay above 1.4450 area, the bullish scenario targeting 1.4600 should remains intact. Break below 1.4450 should be seen as potential bullish failure re-testing 1.4250 area once again.

GBPUSD Outlook

The GBPUSD had a bullish momentum yesterday. On daily chart below we can see that price has convincingly move above the bearish channel indicating potential bullish targeting 1.6250 area. Immediate support at 1.6113 area. Break below that area should lead us into no trading zone but only a movement below 1.6040 area could be seen as bullish failure and trigger further bearish scenario back towards 1.5900 – 1.5832 area

USDJPY Outlook

As I had expected, the USDJPY had a bearish momentum yesterday, bottomed at 90.73 and closed at 90.97. The bias remains bearish targeting 90.15 area. Immediate resistance at 91.50 – 91.85 area. Break above that area should lead us into no trading zone as direction would become unclear for me

USDCHF Outlook

The USDCHF didn’t make significant movement yesterday. On h4 chart below we can see that price trapped in a small range area of 1.0213 – 1.0143 area. As long as the bearish channel valid, I still prefer a bearish scenario at this phase and expecting a break below 1.0143/30 area to continue the bearish momentum targeting 0.9917 area. Until that happen, I think I will stand aside for now. A break above 1.0213 area should trigger further upside correction towards 1.0280 area.

EURJPY Outlook

The EURJPY had a significant bearish momentum yesterday, break below the trendline support area after made a false breakout, as you can see on my h4 chart below. This fact should be seen as bullish failure and potentially trigger further bearish pressure testing 131.30 area. Break below that area should trigger further bearish momentum targeting 130.00 area. Immediate resistance at 132.30 area. Break above that area should lead us into no trading zone in nearest term but I still prefer a bearish scenario at this phase

GBPJPY Outlook

The GBPJPY had a bearish momentum, bottomed at 146.65 and closed at 147.06. On daily chart below we can see that we are in critical technical phase as price is now struggling around the trendline support area. Consistent move below that trendline support should be seen as bullish failure and trigger further bearish momentum targeting 145.20 area. Immediate resistance at 147.70 area. Break above that area should keep the bullish scenario intact.

AUDUSD Outlook

The AUDUSD had a bearish momentum yesterday, bottomed at 0.9169 and closed at 0.9198. I think we are in critical technical phase now. On h4 chart below we can see that price slipped below the bullish channel indicating serious threat to the bullish scenario but price still move around 0.9228 – 0.9190 support area. We need consistent move below that area to confirm the bearish scenario towards 0.9100 – 0.9000 area. Immediate resistance at 0.9250. Break above that area should keep the bullish scenario targeting 0.9404 intact.

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The information has been prepared for information purposes only. The document is not intended as personalized investment advice and does not constitute a recommendation to buy, sell or hold investments described herein. This information contained herein is derived from sources we believe to be reliable, but of which we have not independently verified. FXInstructor LLC assumes no responsibilities for errors, inaccuracies or omissions in these materials, nor shall it be liable for damages arising out of any person’s reliance upon this information. FXInstructor LLC does not warrant the accuracy or completeness of the information, text, graphics, links or other items contained within these materials. FXInstructor LLC shall not be liable for any indirect, incidental, or consequential damages including without limitation losses, lost revenues or lost profits that may result from these materials. Opinions and estimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results