FOREX TRADING

Highlights

• Dark clouds gathering on the horizon
• Looking for another slide in risk assets
• Sterling reacts well to budget
• Banking sector fears set to keep the EUR nervous

Dark clouds gathering on the horizon

US housing data in the past week revealed the extent of the artificial and temporary support provided to the US housing market by the home buyer tax credits. The data had been expected to show decent gains on a final flurry of home closings before the end of June deadline to close, but the sharp declines showed that many home buyers were unable to secure financing. Housing data is only expected to deteriorate from here out as an extension of the tax incentive program seems highly unlikely in the current deficit reduction environment. Given the still high levels of foreclosures and underwater mortgages, as well as a large ‘shadow inventory’ (homes that would be on the market if conditions were better), it appears US housing is about to see a ‘double dip’ decline. The implications for household spending are quite ominous, as the wealth effect of deflated home values and still depressed stock market portfolios generate a negative feedback loop to consumption. Add in still high unemployment levels (and the failure to extend unemployment benefits due to deficit concerns), and we have another negative feedback loop undermining US consumption. Together, these threaten to see the US recovery falter sooner than we expected, which has also altered our view on the broader global recovery. (more…)

There have been further signs of improvement in financial markets over the past week and volatility continues to decline. That said, many markets continue to trade with pretty high risk premiums, elevated volatility and reduced liquidity.

Yesterday, BNP Paribas’ long-term issuer default rating was downgraded to AAfrom AA by Fitch. Standard & Poor’s yesterday published a review of the asset quality of the Spanish financial system, which included an upward revision of expected losses for the real estate sector.

Conditions in covered bond markets in Portugal, Ireland and Spain have been worsening lately, and the problems in the Spanish and Portuguese banking sectors remain an important theme. It is notable that there has been some stabilisation in the covered bank spreads in the past two days.

Over the past few week, most sovereign spreads have been relatively flat in PIIGS. Spanish spreads have narrowed substantially following a couple of strong Spanish bond auctions last Thursday. In core countries such as France, the Netherlands and Belgium, spreads have narrowed a little over the past week.

Money market tensions have eased further. In particular, the FRA/EOINIA spreads have tightened. The improvement is also evident in swap and credit markets, but corporate issuance remains very low.

The euro has advanced a little versus the dollar, but it is questionable how sustainable this move is. Implied volatility in majors FX crosses has declined sharply from recent weeks, but is still at elevated levels.

Global stock markets have had a good run during June. (more…)

• People’s Bank of China (PBoC) this weekend announced that it will abandon the defacto USD peg that has been in place since mid 2008 when the global financial crisis accelerated. Instead China will return to a managed float targeting a basket of currencies. This will largely be a return to the exchange rate system from before the financial crisis.
• PBoC has tried to tone down expectations of a major appreciation. It ruled out a major one-off revaluation and left the daily trading band against USD unchanged at 0.5%. In addition, PBoC this morning left its reference rate against the USD unchanged, but has allowed CNY to appreciate in the spot market and on balance it now appears PBoC is allowing CNY to appreciate.
• There are two reasons for China’s move this weekend. First, with signs of a solid recovery PBoC is increasingly turning its focus from supporting growth to containing inflation and preventing asset bubbles. Second, there will probably be a significant political payoff from just a minor appreciation. The announcement just ahead of the G20 summit next week is no coincidence.
• We have left our CNY forecast unchanged. We only expect a modest 4% appreciation against USD over the next year. Although this is now only slightly more than the market expects, we maintain our recommendation to hedge longer-term CNY expenditures because we expect USD/CNY volatility to increase.
• The market reaction this morning has been positive with a marked improvement in risk sentiment as markets focus on a possible positive impact on global growth

China returns to managed float targeting a basket of currencies

People’s Bank of China (PBoC) Saturday announced that it will abandon the de-facto peg of the renminbi (RMB) that has been in place since mid 2008, when the global financial crisis started to escalate, see Statement on RMB exchange rate policy. On Sunday PBoC clarified its position further in a Q&A statement. So far it appears that China will basically return to a managed float with a reference to a basket of currencies started in July 2005 and prevailing until the global financial crisis accelerated in mid 2008. However, the statements from PBoC leave two important questions unanswered. First, will China allow RMB to appreciate and if so by how much and second to what degree will it allow more flexibility and volatility in the RMB exchange rate.

In our view we are unlikely to see major changes in the short run. China will allow RMB to appreciate slightly against USD and volatility in USD/RMB exchange rate will increase substantially compared to the past two years. It is important to note what China did not do this weekend. First, it did not announce a minor one-off revaluation of RMB as it did in 2005 when it kicked off the managed float exchange rate regime. Second, China did not widen the current 0.5% daily trading band against USD. There has been some speculation in the market that both a minor one-off revaluation and a widening of the daily trading band would be part of China’s initial move away from the USD peg. Hence, what China did this weekend was the minimum that could be expected. That said, the announcement was a surprise, as the consensus view was that the European debt crisis had postponed a RMB appreciation against USD well into Q3.

Why does China move on the exchange rate now?

The first reason is that the Chinese government’s concern about Chinese and global growth is receding. Instead the government is increasingly focusing on containing inflation and preventing asset bubbles. The return to a de-facto USD peg has always been regarded as a temporary response to the global financial crisis and not a permanent state for China’s exchange rate policy. In its policy statement PBoC says that it has now become desirable to move ahead with reform of the RMB exchange rate regime, because of the solid upturn in the Chinese economy and a gradual recovery in the global economy. Not least has it been important for the Chinese government that the latest Chinese data for May showed very strong exports and an increase in the surplus on the trade balance.

The Chinese government is increasingly focusing on preventing the economy from overheating. In May inflation exceeded the government’s 3% target for 2010 as a whole and in our view it could be close to 4% by year-end. In its Q&A statement PBoC says that RMB reform will benefit China, because it will help curb inflation and asset bubbles and strengthen effectiveness of macroeconomic tools. In other words, a return to the “old” exchange rate policy will give China greater flexibility to use its exchange rate policy actively to cool down the economy if needed and greater autonomy in its monetary policy.

The second argument is political and is particularly important for the timing of the announcement. As we have argued earlier there will probably be a substantial political and economic payoff for China from just a minor appreciation of its currency. This explains why China chose to announce the end of the USD peg just ahead of the G20 meeting in Toronto next weekend. China hopes that the announcement will be enough to prevent its exchange rate policy from becoming a major issue at the G20-summit. In addition, it hopes that this will be enough to prevent China from being designated “currency manipulator” in the Treasury report that US Treasury Secretary, Timothy Geithner, has delayed to give China room to move on its exchange rate policy. Finally, there is increasing risk that punitive legislation targeting China’s exports might be approved by the US Congress later this year.

How much will China allow RMB to appreciate?

The big question is if China will allow RMB to appreciate against USD and if it does, by how much? In our view China will allow a modest appreciation. In its statements PBoC effectively rules out a major one-off revaluation by saying that the adjustment of the RMB policy will follow the principle of gradualism. In addition, PBoC does everything to tone down any expectations of a major appreciation by saying that the current RMB exchange rate is not far from equilibrium and for that reason there is no argument for a major appreciation.

This morning PBoC left its reference exchange rate against USD unchanged at 8.8275 compared to Friday. The reference exchange rate is used to fix the daily +/- 0.5% trading band. The unchanged reference rate was a disappointment. However, PBoC has since allowed CNY to appreciate further in the spot market (see chart) and overall CNY has appreciated by 0.4% against USD since Thursday. Thus on balance it appears that PBoC is allowing CNY to appreciate slightly.

We expect CNY to continue to appreciate slightly this week ahead of next weekend’s G20- summit. In our view it would be an own goal by China if it does not allow some appreciation following this weekend’s statement from PBoC. This would certainly bring China’s exchange rate policy on the agenda at the G20-summit. However, to get a clear view of how much China will allow CNY to appreciate, we will have to see how much China allows the exchange rate to appreciate after the G20-summit.

We have left our exchange rate forecast unchanged (see table on next page) even though China has decided to resume appreciation slightly faster than we expected. However, we acknowledge that the main risk now is that CNY appreciates more than we expected particularly on a 3M and 6M horizon. CNY forwards have appreciated significantly overnight. The 12M USD/CNY NDF now discounts a 3% appreciation, which is slightly less than our expectation of a 4% appreciation on a 12M horizon.

With the appreciation in CNY forwards its has become less favourable to hedge CNY expenditures. However, we maintain our recommendation to hedge CNY expenditures on a 12M horizon (or longer). This recommendation is based on our expectation that CNY will appreciate slightly more than is currently expected in the forwards but also on our expectation that volatility in USD/CNY will increase.

Market implications

The expectation that China will now allow its currency to appreciate has improved risk sentiment in the market substantially this morning. Financial markets have chosen to regard a Chinese appreciation as positive for global growth because it increases the likelihood of trade tensions between the US and China, will boost real income and domestic demand in China and let other markets increasingly benefit from China’s strong demand. We feared that the shortterm impact might be dominated by concerns about slower growth in China, because CNY appreciation would be regarded as part of monetary tightening. This has so far not been the case.

Most Asian stock markets are substantially higher this morning including Shanghai. Stock market futures suggest a positive opening for stock markets in both Europe and the US today.

As expected Asian currencies besides JPY appreciated markedly overnight with particularly KRW and MYR benefitting from China’s decision to resume appreciation. Commodity currencies have benefitted from higher commodity prices. USD in general has weakened.

For a our view on the longer term impact of China resuming appreciation for financial markets see Research – Asia: Recovery still looks strong.

Sunrise Market Commentary

• Core bonds profit from surprise drop in US retail sales
  On Friday, markets started the session in a positive mood, but a disappointing US retail sales release spoiled the game. Investors picked up core bonds again going into the weekend. This week, we look out whether the cautious easing of tensions on the intra-EMU government bond market can be maintained.
• Euro enters calmer waters
  On Friday, EUR/USD basically tracked the swings in global investor sentiment. As was the case for the stock markets, the damage from a poor US retail sales release was only temporary in nature. EUR/USD regained even the 1.2150 resistance area. This suggests that the single currency might be entering calmer waters. EUR/GBP tested also the lows, but the test was rejected and a nice rebound occurred.

The Sunrise Headlines

• On Friday, US Equities opened lower after a weak retail sales report, but reversed their losses in the last hour of trading. This morning, Asian shares start the week in a positive mood.
• Herman Van Rompuy, president of the European Union, has blamed the strength of the euro in recent years for blinding the eurozone to its underlying fiscal problems.
• New Zealand’s central bank chief warned this morning that the country needed to cut its high debt or face punishment by markets with higher lending rates and the risk that its debt servicing costs may become intolerable. (more…)

U.S. Review

Decision-making in a Time of Economic Uncertainty

• Well, they never said decision-making would be easy. Recent data on employment, GDP, and personal income highlight the complexity of information, which is sometime contradictory and adds to the difficulty of decision-making now.
• Currently, the impact of short-run stimulus programs is ending while we remain uncertain about the sustainable path of growth going forward. One leading indicator, jobless claims, suggests that the sustainable pace of economic growth will be disappointing to many public officials hoping for a jump in public revenues and jobs.

Decision-making in a Time of Economic Uncertainty

Recent data on employment, GDP, and personal income highlight the complexity of information, which is sometimes contradictory and adds to the difficulty of decision-making. Employment rose just 41,000 ex-Census with gains across sectors. The pace of gains satisfies very few. Hiring is just barely enough to technically sustain the recovery but not fast enough to catch up with what a more typical recovery would see. Moreover, the pace of job gains is not sufficient enough to generate the income and tax receipts household and policymakers need or have come to expect.

First quarter GDP came in at 3.0 percent, a trend-like number, but real final sales came in only at 1.4 percent. The underlying demand in the economy remains subpar relative to the typical recovery. Therefore, the crunch for decision-makers is that there is a recovery but it remains disappointing relative to expectations and, therefore, disappointing relative to financial market expectations that were discounted in equity and bond market prices. Within the GDP accounts, personal consumption spending and equipment spending appear to be holding their own. The problems appear in the residential and commercial real estate sectors as well as state & local government spending. Hence, the recovery is both below average and different in character relative to earlier recoveries. These aspects add to the challenge of decision-making for the second half of the year, when we expect growth to remain subpar.

(more…)

Risk-aversion dominated the headlines at the end of the week with the euro tumbling beneath the 1.20-level against the dollar to a fresh 4-year low at 1.1974. The major US equity bourses were sharply lower as the much-anticipated May labor report missed estimates, dragging the Dow Jones, S&P 500 and Nasdaq all lower by around than 3%. Sparking market jitters and ultimately triggering a renewed bout of risk-aversion was the morning announcement from the Hungarian Prime Minister’s spokesperson – in which he identified the Hungarian economy as being in a "grave" state in which the previous government "lied" about economic figures and that "it would not be an exaggeration" for talk of default. The revelation hit the global markets and prompted a spike higher in the VIX index, which climbed higher by more than 14% from Thursday’s close to above 33.6.

The highly-anticipated May labor report largely disappointed as markets had been factoring in a blockbuster report. Consensus forecasts had been looking for a surge in non-farm payrolls to 536k for May, instead adding 431k jobs versus 290k from April. The private payrolls figure sharply missed estimates at 41k, falling short of calls for an increase to 180k from a downwardly revised 218k in April. The inflated non-farm payrolls are largely attributed to temporary government census workers and will not be sustainable over the coming months. The unemployment rate dipped to 9.7%, better than expected versus 9.9% from April.

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Ahead of a very important day of macro-economic releases from the U.S., and ahead of the Non-farm Payroll numbers on Friday, major forex pairs have struggled to break through Swing Point R1 and S1 areas in European trade. The long side of global equities allowed a short-Usd move to be put in place overnight, but the cash markets were not able to easily hold the positive momentum built up in the futures market, after a move higher from Wall Street.

Forex price action is revealing an obvious reluctance from speculative interest encamped on the long side of the Usd to give up ground too easily. It is also clear to see that the momentum unleashed as each global trading region opens and closes is just not backed with enough volume to break new ground on stocks, and is allowing only tentative move in forex to test dollar index support areas.

Ahead of the 08:15 ET ADP and 08:30 ET Weekly Jobless Claim numbers the markets may just consolidate recent moves. The 10:00 ET ISM numbers will then trigger equity direction, just in time to affect the European market close. The impact of a potentially large NFP number on Friday, because of the farcical way that the survey is completed, in what is obviously a jobless U.S. recovery, will weigh heavily on equity and forex sentiment.

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Wakeup Call: Fitch Cuts Spain’s AAA Rating, May Weaken European Financials Further Today

Short-term outlook for stocks is set to ‘sell on rallies’.

What’s going on?

Fitch cuts Spain’s AAA rating (to AA+). That could continue to weaken European financials today.

Some of our long-term trend indicators are turning around (bearish) and money markets indicators still signal increasing tension due to the PIIGS sovereign debt crisis and the interbank market. We change our short-term outlook for stocks to ‘sell on rallies’.

Stories now beginning on how yields on Chinese property bonds are rising. Investors are increasingly nervous on China. Commodities still weak due to this, but Oil and Gold doing well.

Watch out for Canadian figures today.

Calendar (more…)

Daily Technical Analysis

EURUSD Outlook

The EURUSD attempted to push higher on Friday, topped at 1.2452 but whipsawed to the downside, bottomed at 1.2268 and closed at 1.2306. This fact keep the major bearish scenario testing 1.2000 intact but as you can see on mt h1 chart below price still move inside the minor bullish channel indicating the bullish correction is still alive and kicking. Immediate support at 1.2260 area. Consistent move below that area could trigger further bearish pressure testing 1.2140/50 area which is a key support area that must be broken before testing 1.2000. On the upside, initial resistance is seen around 1.2450/70 area. Break above that area could trigger further upside pressure testing 1.2671 region. It is still a difficult and volatile market out there so don’t rush jump into the market and stay discipline with your own trading criteria. Plan your trade and trade your plan.

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HIGHLIGHTS OF THE WEEK

• First quarter U.S. real GDP growth came in at 3.0% Q/Q (annualized), slightly below expectations.
• U.S. consumer confidence in April shot up to the highest level seen since March 2008, marking the sixth increase in seven months.
• Personal income advanced 0.4% M/M in April, while personal spending was flat on the month.
• New home sales surged 15% in April, sending inventories down to 5 months supply; existing home sales jumped 7.6% on the month, but inventories managed to rise to 8.4 months supply.
• S&P Case-Shiller Home Price Index was flat in March, though prices are sitting at 2.3% above year ago levels.
• Concerns over European sovereign debt subsided somewhat this week, assisted in part by China’s denial on Thursday that it will reconsider its investments in European government bonds.
• After having shed close to 5% so far in May, the S&P TSX gained 2% during the week.
• The uptick in risk appetite led to a retreat from government issued bonds and a rise in bond yields.
• At the margin, the likelihood that the policy rate renormalization would begin on June 1st in Canada may have risen following the easing of concerns over Europe’s debt turmoil as we head into the weekend.
• Risks surrounding the specific future path of the overnight rate will persist as long as external risks stemming from European sovereign debt concerns linger.

UNITED STATES – ECONOMY QUIETLY CHUGGING ALONG

As markets remain focused on the situation in Europe, the U.S. economy continues to quietly chug along. The BEA’s second estimate of first quarter real GDP growth was released this week, and despite falling below expectations, the economy still advanced at a decent 3% Q/Q annualized clip. And looking ahead to the current quarter, it appears as though the recovery continues to gain traction.

Consumers are beginning to feel the benefits of the recovery, as evidenced by the surge in consumer confidence in April to the highest level seen since March 2008. While it is unclear as to whether the current financial market turbulence is reflected in these results – and should it persist, confidence may reverse course next month – the fact that both present circumstances and future expectations increased in April is a good sign for the economy. Indeed, rising consumer confidence and, in particular, an improvement in employment prospects, tends to lead to increased household demand, suggesting that consumer spending will be a supportive factor to economic growth in the coming months.

The personal income and spending data that were released this morning, although mixed, offered some support to this view. Personal income advanced by 0.4% in April, and this came despite a decline in government benefits during the month. Meanwhile, real personal consumption expenditures were flat on the month. However, this slowdown in spending growth follows two months of strong gains. And with income growth on the rise, and job creation expected to continue going forward, the recent uptrend in personal spending is likely to remain intact, growing by about 3.0% in the second quarter.

On the housing front, the momentum from the first quarter of the year continued into April, both in the new and existing home markets. New home sales shot up by nearly 15% on the month, extending the 30% jump seen in the month prior. This pushed the level of new homes sold over the 500,000 mark for the first time since May 2008. As a result, inventories slid to only 5 months supply – a rate that hasn’t been seen since the end of 2005. Existing home sales were also impressive in April, rising by a better-than-expected 7.6%. But despite this increase, inventories also managed to rise, hitting 8.4 months supply. Going forward, the housing environment is likely to become more challenging in the near term. Much of the strength in home sales in recent months has been driven by the homebuyer tax credit that expired at the end of April. Hence, we are likely to see some payback in the coming months. Moreover, foreclosures remain a big issue in the U.S., and alongside the slowdown in sales, will lead to even higher inventory levels in the existing home market. This doesn’t bode well for home prices, which, according to the S&P Case-Shiller Home Price Index, are sitting at only 2.3% above the depressed levels seen last year. Still, any near term price declines will likely be limited, as home values have moved roughly in line with income and rent fundamentals, which appear to be gradually improving.

While the U.S economy is clearly still facing several headwinds, including a slow grind up in the housing market, all signs point to a continued recovery. Indeed, the strong hand off from the first quarter, and the first wave of April data, suggest that second quarter real GDP growth will likely match, or even outpace, the rate seen during the first three months of the year. The problems in Europe and the rise in the U.S. dollar do present some downside risks to economic growth down the road. However, we believe that only a slight trimming in growth forecasts will be necessary

CANADA – STRENGTHENED SUPPORT FOR MONETARY POLICY TIGHTENING

Concerns over European sovereign debt subsided somewhat this week, assisted in part by China’s denial on Thursday that it will reconsider its investments in European government bonds. After having shed close to 5% so far in May, the S&P TSX gained 2% during the week. Spurred by some reversal in flight-to-safety flows from U.S. Treasuries, the Canadian dollar joined other major currencies, including the Euro, in strengthening. By week’s end, the loonie was trading at 95 US cents. The uptick in risk appetite led to a retreat from government issued bonds and a rise in bond yields. Yields on Canadian government notes with a 2-year maturity rose by 10 basis points alongside the rally in equity markets.

In order to restore confidence in the euro and try to appease financial markets, Italy, Spain, Portugal and the United Kingdom followed Greece’s footsteps and unveiled their respective fiscal austerity plan. While well-received by investors, doubt still lingers over whether or not these plans, combined with the emergency 750 billion euro facility, can be implemented effectively.

Importantly for Canada, the improvement in risk appetite notably supports commodity prices and equities. Crude oil near futures edged up to reach near US$75 per barrel as of Friday morning alongside the prior day’s equity gains as well as data released in the U.S. showing an increase in oil demand. Oil prices have yet to stabilize on a trend basis, however, after sliding from near US$87 as of April 5th. Lower energy prices present some downside risk to Canadian equities, incomes, and some provincial fiscal balance sheets leveraged to royalties on this resource.

While recent fluctuations in Canadian financial markets have largely reflected international developments, markets should be more in-tune to domestic economic releases next week. Canada’s real GDP figure for the first quarter will be released on Monday, with a consensus forecast calling for a quarterly GDP annualized growth of 5.8%. Our own call is for a slightly better performance of 6.0% growth.

This will be followed by an interest rate announcement by the Bank of Canada (BoC) on Tuesday. Real economic growth will likely be sufficiently high to meet the BoC’s expectations. As such, this should present the BoC with an opportunity to raise the overnight rate off of its emergency level of 0.25%. Futures markets are fully pricing in a rate hike of 25 basis points, which would bring the overnight rate to 0.50%. At the margin, the likelihood that the policy rate renormalization would begin on June 1st may have risen following the easing of concerns over Europe’s debt turmoil as we head into the weekend. At the international level, the OECD also stressed the need for the BoC to begin raising its overnight rate “without delay”.

Accompanying a BoC move could be a dovish statement outlining European sovereign debt concerns as the dominant downside risk to the outlook. Faced with the prospect of a possible pause in the hiking cycle if financial turmoil were to resurface, markets would refrain from pricing in too much near-term tightening. The absence of such dovish overtones in the BoC statement would likely induce a bond selloff and push the Canadian dollar closer to parity.

Risks surrounding the specific future path of the overnight rate will persist as long as external risks stemming from European sovereign debt concerns linger. Even though Canada maintains modest trade with – and financial exposure to – European markets, it will not be sheltered from the expected volatility in the price of its commodities and financial markets. These fluctuations, however, are so far unlikely to yield more than a modest trimming to Canadian growth forecasts for 2011. Nonetheless, those looking for resolution and clarity in the BoC statement may be underwhelmed. The BoC will more likely keep its cards as close to the chest as possible, giving itself the needed flexibility that such volatile times demands.

U.S.: UPCOMING KEY ECONOMIC RELEASES

U.S. ISM Manufacturing Report – May

• Release Date: June 1/10
• April Result: 60.4
• TD Forecast: 58.5
• Consensus: 59.5

The ISM is expected to edge down to 58.5 in May after rising to a six year high of 60.4 the previous month. New orders, employment, and production are all set to decline from the torrid pace the previous month while inventory building should edge higher and deliveries hold steady. The ISM has been exceptionally strong benefitting from strong exports and domestic inventory demand and investment spending. Over coming months, two of those three pillars of support are expected to diminish. Export orders hit a cycle high of 61.0 in April, but recent dollar strength and slowing demand from euro area countries will depress an important source of manufacturing strength going forward. Remember, almost 80% of exports are manufactures of some type, so the effect will be more muted on the services ISM index. Prices paid hit a cycle high of 78.0 in April, but the roll over in commodity prices as well as energy prices over the reference period, combined with plunging unit labor costs, should push this measure to 70.0, or lower.

U.S. Nonfarm Payrolls – May

• Release Date: June 4/10
• April Result: 290K; unemployment rate 9.9%
• TD Forecast: 475K; unemployment rate 9.8%
• Consensus: 500K; unemployment rate 9.8%

The May employment report is expected to show ongoing momentum in job creation remains intact. The headline gain of 475k (500k consensus) will be driven disproportionately by census hiring which has thus far been well below average. May is the big hiring month for census workers and tepid hiring to date may result in an even larger headline gain currently anticipated. Still, the focus will be on the pace of private job creation. Here we expect about 175k which would represent another strong monthly gain though modestly below the 231k pace in April. The deceleration in private job hiring will be concentrated in manufacturing 10k (44k in April) and business services 40k (80k in April). The unemployment rate is forecast to dip to 9.8% from 9.9%, but we admit the balance of risks is skewed to a lower rate given the surge in the labor force last month and the knock on effects from census hiring. Wage growth will remain tepid posting a 0.1% gain leaving the y/y change unchanged at 1.6%.

CANADA: UPCOMING KEY ECONOMIC RELEASES

Canadian Real GDP – Q1 /10

• Release Date: May 31/10
• Q4 Result: 5.0% Q/Q ann.
• TD Forecast: 6.0% Q/Q; Consensus: 5.8% Q/Q

The Canadian economic recovery was in full force in the last six months and it now looks like real Canadian GDP grew close to 6.0% annualized in the first quarter of 2010, following a strong gain of 5.0% in the previous quarter and significantly greater than the 3.8% we were anticipating. That’s as V-shaped as economic recoveries come. Nearly every component of real GDP posted robust gains in that quarter with domestic demand at the top of the list. The pace of retail spending over the first three months of 2010 suggests growth in consumer spending was in the range of 4.5-5.0% led by spending on discretionary durable items. Moreover, residential investment is expected to grow by a second consecutive gain of 30%, bolstered by strength in new homebuilding. Leading indicators suggest that business investment in machinery and equipment was up 10%, following a contraction in the previous quarter. This is a good sign that businesses are finally feeling more optimistic about future economic prospects. The caveat of the report will be household debt. Household debt as a percent of personal income likely grew to a record high 147% as households funded consumption through borrowing. As interest rates begin to rise and households have to devote a greater share of their income to servicing their debt, this may well constrain future consumer spending growth.

Bank of Canada Interest Rate Decision

• Release Date: June 1/10
• Current Rate: 0.25%
• TD Forecast: 0.50%
• Consensus: 0.50%

The Bank of Canada is grappling with a strong domestic economy versus substantial downside risks to the global and financial outlook. We believe the balance of evidence continues to argue for a 25bps rate hike on June 1st, though the probability of this action is not greatly in excess of 50%. The housing market is still extraordinarily strong, consumers continue to spend with conviction, and an overnight rate near zero seems anachronistic in this context. While it might initially appear unseemly for the Bank to hike into a severe stock market correction, it would arguably be even more frightening to the market if a peripheral country like Canada was worried enough to defer rate hiking despite such compelling domestic arguments. In the event that conditions deteriorate further, the Bank can always pause later in its tightening cycle, with minimum damage done.

Canadian Employment – May

• Release Date: June 4/10
• April Result: 108.7K; unemployment rate 8.1%
• TD Forecast: 15.0K; unemployment rate 8.1%
• Consensus: 20.0K; unemployment rate 8.0%

The Canadian labour market has been on fire lately, adding jobs in each of the last 4 months at an average pace of close to 50K per month. This positive momentum in labour market activity should continue in May, though we do not expect an encore performance following the staggering 109K jobs that were added the month before. In fact, with the pace of job gains in April far outpacing levels consistent with the current stage of the economic rebound, we expect the number of jobs added in May to drop markedly, with only 15.0K net new jobs created. Strong construction activity and a rebound in manufacturing sector employment should ensure that the goods-producing sector of the economy will continue to add jobs in May, while the service sector should shed jobs following the blistering 106.6K positions that were added in April. The unemployment rate is expected to remain unchanged at 8.1% as more displaced workers move into the labour force in search of jobs. Over the next few months, we expect the pace of job creation to move back within the 20K to 40K range, as the Canadian economic recovery continues to gain self-sustaining momentum. The unemployment rate should continue its downward trajectory.

PDF Format

Highlights

• Risk sentiment and markets stabilizing; rebound potential
• Spanish downgrade latest threat to EUR
• Easing of tensions bodes well for the EUR
• EUR/GBP still sitting above key support

(N.B.: Monday May 31 is a holiday in the UK and US. Market liquidity is likely to be lower and volatility may be higher as a consequence.)

Risk sentiment and markets stabilizing; rebound potential

Global stock markets appeared to stabilize in the past week on signs that the recent sell-off was extreme and that the global recovery was continuing. The MSCI World index managed to rebound slightly after falling to new lows for the decline, generating a sizeable ‘hammer’ pattern on weekly candlestick charts, a potential bullish reversal indicator. The S&P 500 also saw a sharp rebound from the significant 1040/45 level, potentially putting in a key price low. Other risk assets recovered more convincingly, such as the CRB commodity index, which held the prior week’s lows and closed up about 1.5%. US Treasury yields also gained on the week in another sign that demand for safe haven assets was beginning to ebb. In currencies, the JPY-crosses (e.g. AUD/JPY, CAD/JPY) mostly held above recent lows and posted gains for the week, the exception being EUR/JPY. Gold prices also saw some bounce after a week of vicious liquidations and regained the $1200 level.

We think there is further potential for risk assets to recover in coming weeks, though there are certainly many different headwinds. Overall, the credit crisis in Europe appears to be receding, with some slight declines toward the end of the week in sovereign debt credit default swaps (CDS), a measure of the risk of default. To be sure, concerns over the health of European private sector banks remain, and this is the most likely source of further risk aversion in the near-term. But as long as credit markets continue to calm down, investors desperate for returns are most likely to return and buoy risk assets. We think it’s significant that Chinese officials immediately squelched speculation they were abandoning Europe and suggests intense global coordination to stem the latest financial sector crisis. Also, as a contrarian indicator, investors holding bearish outlooks over the next six months outnumbered bullish views by 21%, the highest split since Nov. 2009. We would also look at the likely capitulation of two weeks ago as significant turning point. In currencies, we would look for opportunities to buy JPY-crosses on weakness and remain diligent in protecting and taking profits on gains in light of the many potential potholes out there. (more…)

Sunrise Market Commentary

• Global bonds hammered, as risk appetite returns pushing equities sharply higher
  Yesterday’s trading was dominated by a return of risk appetite. As usual, the turnaround was much more violent in the US bond markets than in EMU with US yields higher by up to 18 basis points while German yields limited the rise to 6 basis points. The re-steepening of the curve in the US was pronounced, but less so in Germany.
• EUR tries to move away from the lows
  Yesterday, the euro profited from a rebound in global risk appetite, even as the link between EUR/USD and the equity markets was not one-to-one. Nevertheless, a retest of the lows was again rejected, suggesting that there is still room for a technical rebound. Sterling was supported by rumours on the Prudential/AIA deal.

The Sunrise Headlines

• US equities storm ahead, as investors’ concerns about the funding and debt crisis ease, making them again more optimistic on the growth outlook. S&P rose by 3.3%, led by the cyclicals (financials, energy and materials). Asian equities rallied moderately overnight for the third day in a row.
• Japanese consumer prices marked their 14th month of annual declines in April, but if one excludes the effect of the scrapping of school tuition fees the outlook may not be so bad. Strong April retail sales support that assessment.
• Commodities rebound, as waning risk aversion suggests global growth might stay strong. Oil extends gains and reaches two-week high above $75/barrel.
• Spanish parliament approves by one vote the austerity measures, but the razorthin majority raises the prospect of early elections.
• US CP statistics show the decline in outstanding amounts slowed in recent week, but the foreign financial CP continues to decline, suggesting US funds are diminishing exposure on European banks.
• Prudential shares halted in HK trading, as AIA renegotiations on the price tag restarted. Rumours affected sterling trading yesterday.
• In the UK, GfK consumer confidence declined for the third month in a row.
• Today, attention focuses on the release of US Chicago PMI, the Swiss KOF sentiments survey and Swedish GDP. The Italian BTP auction will get a lot of attention in the European debt markets. (more…)

After Japanese inflation data overnight, today’s economic data calendar is primarily focused on the US. April personal income and spending figures are published alongside the latest ‘core’ PCE deflator and the Chicago PMI and Michigan surveys for May. Following yesterday’s slightly weaker-than-expected outturn for the second estimate of Q1 GDP, we look for a +0.3% m/m outturn on US personal spending in April, giving some uplift into Q2. Consumer spending has performed quite well recently, although a still low saving ratio (currently at 2.7%) means that the scope for strong gains looking further ahead could be limited. Meanwhile, our forecast for May’s Chicago PMI index stands at 62.8 compared with 63.8 in April. This survey has continued to trend upwards this year following the significant headway made in 2009. However, we expect a pause for breath on concerns about the durability of the global economic recovery during the current period of financial market volatility.

Chart: US personal consumption is performing well, though additional headway could be difficult to achieve going forward

News and Events:

With no new info coming out this morning, FX markets remain calm and prices in range. After yesterday’s rollercoaster day in equities, driven by strong US data, Asian markets are all in the green giving risky assets a boost. The major problem facing markets will continue to be the lack of liquidity, which especially on the downside, manifests itself rather severely. From the EU, more disagreement among members states and officials continues to plague the Euro – most likely capping any gains the Euro may make. Germany put forward a proposal for an EU levy on banks but it was quickly rejected by France, a motion Britain disagreed with months before. Spain’s parliament will vote today on the 1st round of austerity measures but with the Spanish Socialists just seven seats short of the majority, there is a genuine concern that the vote will fail. A piece from the Financial Times drew attention to the growing inclination among central bankers and large asset managers to diversify of out EUR assets. The article further stated that SAFE, the major Chinese regulatory organization, was discussing the prudency of holding Eurozone bonds although no indication was given that allocations to the Eurozone would be diminished. An unnamed Chinese official additional stated that China’s strategy of FX reserve diversification would not be modified in lieu of current events. Recent US TIC data shows that Chinese appetite for US treasury bills has recovered. Should large players deem the risk of holding EU assets too great, a fundamental shift to other assets would permanently weigh on Euro valuation. A slew of European bond auctions attracted some attention yesterday, but the ECB asset purchasing program possibly distorting the market, it’s hard to derive any useful information from this data. With US data gaining momentum, today’s Q1 GDP release is likely to surprise on the upside. Should the market feel the news is signaling the return of real US growth, combined with the its current safe-haven status, we should expect the see the USD surge on all fronts. (more…)

• With the ongoing deterioration in the US dollar money market, there is growing speculation as to whether the Fed will intervene further any time soon to stabilise the situation.
• We believe that the bar for further Fed intervention is relatively high. The current level of market stress is simply not high enough to make use of the various liquidity programmes under the existing terms.
• Moreover the money market problems are mainly driven by the foreign US dollar squeeze and to a lesser extent domestic US problems. US commercial banks have plenty of liquidity with about USD1,000bn in excess reserves.
• The most likely move by the Fed, if any, is to ease the terms of the US dollar swap lines by cutting the penalty rate to 75 basis points on top of the OIS, although this would break with earlier precedence.
• While it would help little to cap the 3M LIBOR at the current level, it could prevent a further widening of the FRA/OIS spread and thereby keep swap rates in check.

The bar is high for further Fed intervention in money markets

With the ongoing deterioration in the US dollar money market, the debate surrounds what the Fed could do remedy the problem.

Before making these considerations, it is reasonable to emphasise that this time the problem is rooted in foreign markets. This is in sharp contrast to the previous blow out. The fact that this is less of a domestic issue and more of a foreign issue is likely to raise the bar for further intervention – in particular as the Fed is in the process of unwinding and because the central bank is under increased political scrutiny.

This is particularly so as the Fed has already undertaken the obvious by reintroducing the currency swap lines with the ECB, BoE, BoC, SNB and BoJ. However, so far this has been relatively unsuccessful. Even though the LIBOR OIS spread has continued to widen only USD9.20bn has been drawn from the programme so far. (more…)