Good Is Bad, and Bad Is Good
By John R. Taylor, Jr.
Don’t ever forget that Main Street is not the market and the market does not reflect Main Street either. In fact, looking back through history, the positive correlation between the two is not very strong. Today, despite sequestration, or perhaps because of it, the US economy is doing very well, and the government – or at least the Federal Reserve – has forecast a strong second half of the year, with growth above 3%. However, the US bond and equity markets just finished a miserable month. At first glance, the next quarter might seem very positive for US equities, but the specter of tapering is giving the world nightmares. How much of the global tremors will hurt the US markets? Looking ahead, we believe that the decline in the US government deficit as a result of sequestration, tax increases, and economic growth means that Washington’s quarterly need for funds is dropping so sharply that even reduced Fed purchases will not mean higher US rates. Furthermore, most US corporations are in a very strong cash position, with low interest rates locked in for any future cash need. As far as American consumers are concerned, their short term debt position has dropped from a high of around 140% to 105% of their income, and with lending rates down sharply in the past few years, their annual debt burden is lower than it has been for the past 20 years. Except in the mortgage area where rates have jumped from a historic low late last year to around 4.35%,100bps higher, the US looks well set. Even if everyone seems to be running scared, there is no reason for the US economy to be constrained by interest rates. From where we stand now, 10-yr rates should be steady or even decline over the next half-year. Because of this, tapering will not have a negative impact on real economic activity.
For risk markets, the picture has been different and will probably continue to be different, with the problem focused in the emerging markets. The world is addicted to cheap and very plentiful US dollars and several of the larger emerging markets need a fix every day. Liquidity is disappearing. What we are seeing seems to be a parallel of the 1996 period, about a year before the start of the Southeast Asia crisis. Western Europe and North America had gone through the US savings bank crisis from 1988 to 1992, which undermined all US banks and caused Greenspan to drop rates from 9% to 2%. As a result, money flowed from the US to emerging Asia and elsewhere setting off a boom. By 1994, growth was embedded and all seemed perfect, except Asian equity markets which began to look toppish. Within a few years, global equities were lower, US outflows had ceased, the dollar was struggling up, and many Asian countries were running current account deficits. It is not a perfect fit, but tapering today means that the US dollar drip-feed will end soon. The threat of inflation, the deteriorating trade picture, and the living conditions pay squeeze in many of these countries, means that the political choices are very difficult. As foreign investors sense these problems, they exit their investments and demand higher interest rates for future ones. Governments respond by liquidating some of their reserves and allowing their currencies to decline. The liquidation of reserves means that global liquidity declines and the countries with the weakest outlooks will be the biggest losers. The winner is most likely the United States and possibly other well-rounded economies, but a drop in liquidity will hit asset prices everywhere.
European Currencies Headed Lower into August
By Jonathan Clark
Our outlook has turned more negative on the European currencies – instead of forming a significant low around the middle of July, as we previously predicted, it now appears that the weakness will persist into August. This change has very significant implications since the euro is sitting on the uptrend support currently at 1.2920 (green ellipse) from the low in July. A close below this level would increase the odds that this is the start of as aggressive decline, although the downmove could possibly stall at the (blue) neckline of a head-andshoulders formation at 1.2800. This lower level must give way to provide final confirmation the single currency is headed strongly lower, and the objective for this technical formation is the 1.1825 area.
Recent Eurozone data provides evidence that the economy is stabilizing after six consecutive quarters of contraction, thereby justifying the ECB leaving its monetary policy on hold. Austerity programs are meeting increased resistance even in Portugal, which was previously considered an austere role model in the Eurozone debt crisis for its adherence to creditor demands. CDS and sovereign debt yields, however, are not flashing particularly dangerous signs yet. If the Eurozone isn’t in crisis, then euro weakness will most likely be related to Federal Reserve policy and US macroeconomic data. Chairman Bernanke has set numerical benchmarks at which the Fed will consider hiking rates, and these same benchmarks are seen as valuable to determining when the central bank will taper asset purchases. This renders inflation and (even more significantly) employment data as important variables for determining asset prices. Strong employment data means weak European currencies and this appears likely as US corporate layoffs are close to their lows seen in the boom time of the 1990s and both Wednesday’s ADP employment report and BLS jobless claims show an improving employment situation. EUR/USD fell to its lowest level in five weeks on Wednesday and this reinforces our negative outlook. We are expecting it to continue lower into the week of July 15 before an intermediate low is due. It should test the strong support between 1.2750 and 1.2800 before recovering for a week. It should then attempt a further decline and a close below this support area will confirm it is headed lower into the week of August 5 or the following week. Our target for this downmove will then become the 1.2400 area, but we cannot rule out a further decline to the S-H-S objective of 1.1825. This should be a significant low and then the euro should turn higher and begin an uptrend lasting a minimum of several months. It will take a close above the resistance between 1.3150 to 1.3165 to signal that our negative forecast is getting into trouble, but this is unlikely.
By John R. Taylor, Jr.
Don’t ever forget that Main Street is not the market and the market does not reflect Main Street either. In fact, looking back through history, the positive correlation between the two is not very strong. Today, despite sequestration, or perhaps because of it, the US economy is doing very well, and the government – or at least the Federal Reserve – has forecast a strong second half of the year, with growth above 3%. However, the US bond and equity markets just finished a miserable month. At first glance, the next quarter might seem very positive for US equities, but the specter of tapering is giving the world nightmares. How much of the global tremors will hurt the US markets? Looking ahead, we believe that the decline in the US government deficit as a result of sequestration, tax increases, and economic growth means that Washington’s quarterly need for funds is dropping so sharply that even reduced Fed purchases will not mean higher US rates. Furthermore, most US corporations are in a very strong cash position, with low interest rates locked in for any future cash need. As far as American consumers are concerned, their short term debt position has dropped from a high of around 140% to 105% of their income, and with lending rates down sharply in the past few years, their annual debt burden is lower than it has been for the past 20 years. Except in the mortgage area where rates have jumped from a historic low late last year to around 4.35%,100bps higher, the US looks well set. Even if everyone seems to be running scared, there is no reason for the US economy to be constrained by interest rates. From where we stand now, 10-yr rates should be steady or even decline over the next half-year. Because of this, tapering will not have a negative impact on real economic activity.
For risk markets, the picture has been different and will probably continue to be different, with the problem focused in the emerging markets. The world is addicted to cheap and very plentiful US dollars and several of the larger emerging markets need a fix every day. Liquidity is disappearing. What we are seeing seems to be a parallel of the 1996 period, about a year before the start of the Southeast Asia crisis. Western Europe and North America had gone through the US savings bank crisis from 1988 to 1992, which undermined all US banks and caused Greenspan to drop rates from 9% to 2%. As a result, money flowed from the US to emerging Asia and elsewhere setting off a boom. By 1994, growth was embedded and all seemed perfect, except Asian equity markets which began to look toppish. Within a few years, global equities were lower, US outflows had ceased, the dollar was struggling up, and many Asian countries were running current account deficits. It is not a perfect fit, but tapering today means that the US dollar drip-feed will end soon. The threat of inflation, the deteriorating trade picture, and the living conditions pay squeeze in many of these countries, means that the political choices are very difficult. As foreign investors sense these problems, they exit their investments and demand higher interest rates for future ones. Governments respond by liquidating some of their reserves and allowing their currencies to decline. The liquidation of reserves means that global liquidity declines and the countries with the weakest outlooks will be the biggest losers. The winner is most likely the United States and possibly other well-rounded economies, but a drop in liquidity will hit asset prices everywhere.
European Currencies Headed Lower into August
By Jonathan Clark
Our outlook has turned more negative on the European currencies – instead of forming a significant low around the middle of July, as we previously predicted, it now appears that the weakness will persist into August. This change has very significant implications since the euro is sitting on the uptrend support currently at 1.2920 (green ellipse) from the low in July. A close below this level would increase the odds that this is the start of as aggressive decline, although the downmove could possibly stall at the (blue) neckline of a head-andshoulders formation at 1.2800. This lower level must give way to provide final confirmation the single currency is headed strongly lower, and the objective for this technical formation is the 1.1825 area.
Recent Eurozone data provides evidence that the economy is stabilizing after six consecutive quarters of contraction, thereby justifying the ECB leaving its monetary policy on hold. Austerity programs are meeting increased resistance even in Portugal, which was previously considered an austere role model in the Eurozone debt crisis for its adherence to creditor demands. CDS and sovereign debt yields, however, are not flashing particularly dangerous signs yet. If the Eurozone isn’t in crisis, then euro weakness will most likely be related to Federal Reserve policy and US macroeconomic data. Chairman Bernanke has set numerical benchmarks at which the Fed will consider hiking rates, and these same benchmarks are seen as valuable to determining when the central bank will taper asset purchases. This renders inflation and (even more significantly) employment data as important variables for determining asset prices. Strong employment data means weak European currencies and this appears likely as US corporate layoffs are close to their lows seen in the boom time of the 1990s and both Wednesday’s ADP employment report and BLS jobless claims show an improving employment situation. EUR/USD fell to its lowest level in five weeks on Wednesday and this reinforces our negative outlook. We are expecting it to continue lower into the week of July 15 before an intermediate low is due. It should test the strong support between 1.2750 and 1.2800 before recovering for a week. It should then attempt a further decline and a close below this support area will confirm it is headed lower into the week of August 5 or the following week. Our target for this downmove will then become the 1.2400 area, but we cannot rule out a further decline to the S-H-S objective of 1.1825. This should be a significant low and then the euro should turn higher and begin an uptrend lasting a minimum of several months. It will take a close above the resistance between 1.3150 to 1.3165 to signal that our negative forecast is getting into trouble, but this is unlikely.
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