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Main » Articles » Forecast

June, 2009 Monthly Forecast

The ABC’s of Recovery

by TradetheNews Staff

With the doomsday scenario apparently off the table, prospects for recovery have helped fuel the resurgence in stocks and in some commodity prices. The first wave of the Treasury's unprecedented debt sales have been absorbed relatively smoothly, though the US dollar has weakened substantially on concerns about the mounting government debt burden. Still, there are growing hopes that the economic rescue measures implemented by global central banks and governments are beginning to take hold and provide a lush foundation of ‘green shoots’ underfoot that can be nurtured into a blossoming global economic recovery by late 2009 or into 2010. The data in May seemed to have confirmed that things have stopped getting worse but do not suggest a timeframe for when the economic environment will actually improve. Debate is now centering on what the “shape” of the economic recovery will be, with sentiments represented by letters from "V" to "U" to "W," and of course, the dreaded "L". A number of economic and political events in June could help influence the outcome of this economic alphabet soup.

Triple-A, For Now

Peering into June, trading in US Treasuries will likely remain a focal point for financial markets around the world. The action in these markets will hint at the possible shape and timing of any economic recovery. A sustained uptick in rates could severely hinder any rebound in US housing, but also stoke fears the United State’s AAA sovereign debt rating could be jeopardized by driving up the cost of issuing and servicing future debt. US credit markets participants will also continue assess Fed policy with specific attention on the effectiveness of its quantitative easing program.

The benchmark US 10-year yield gained roughly 40 basis points in May to test the psychological level of 3.5%, including a spike towards 3.75% late in the month. The relative ease with which rates were testing their highest levels in months caused some justifiable fears that a subsequent move up in mortgage rates could extinguish any recovery in the housing market. The widening spread between mortgage backed securities and comparable Treasuries over the final two weeks of May only fanned those concerns. The month’s final two trading sessions saw rates retreat as experts and government officials, including some at the Fed, signaled the current environment of rising rates is likely a harbinger of economic improvement down the road. As long as rates stay within a context that is historically viewed as low, and the incoming data continues to decline at a slower rate, a bottoming process for the economy can find traction. Under that scenario the allocation from the relative safety of government backed bonds to riskier assets can continue.

Ultimately rates likely moved higher in May on concerns surrounding rapidly expanding deficits and the ever increasing future Treasury supply needed to fund it. Though the month’s auctions of new supply went off pretty much as well as can be expected, anxiety remains high ahead of the 10 and 30-year paper sales set for the second week of June. Demand has definitely been more fickle at the long end of the curve as evidenced by the US benchmark spread widening out to its highest level on record in the final week of May. A certain level of trepidation has seeped into markets surrounding the US Treasury’s ability to successfully find demand for the oncoming supply.

Treasury demand concerns were initially highlighted through a mid-May coupon purchase by the NY Fed. It garnered special attention after the amount submitted for sale was the largest since the inception of the quantitative easing program, but in response the Fed was unwilling to increase its purchases. This gave the markets a noticeable jolt of disappointment in light of the fact just the day before, the FOMC minutes hinted that the Fed was mulling an increase of its asset purchases going forward. US yields continued to trek higher into month’s end as traders and prognosticators alike suggested the markets were testing the Fed’s resolve. Criticisms abound regarding the size of the Fed’s asset purchasing operation and the ultimate effectiveness of the quantitative easing methodology, with many critics urging the Fed to immediately announce that it will boost its current operations to buy back Treasury and mortgage backed securities, which currently have about $170B and $750B remaining, respectively. Reports suggest that Fed members are studying the recent rise in yields but are still hesitant to make any dramatic changes at this time. With the FOMC not scheduled to meet until June 23rd, it will be interesting to see if rates can continue rise without the Fed stepping up in a more aggressive manner.

The mid-month the move higher in US yields was exacerbated by S&P’s decision to downgrade its outlook for the UK’s AAA sovereign debt rating. Concerns quickly found their way to the US as many speculated a similar action on Uncle Sam’s debt was in the offing. Though both Moody’s and S&P would ultimately come out and affirm their AAA ratings and outlooks, comments from widely followed experts like PIMCO’s Bill Gross and Mohamed El Erian kept the notion in the forefronts of traders' minds. Both pointed to the conflict of interests between the government’s aggressive short term actions to stimulate growth and the long term imperative to significantly cut the deficit and future borrowing needs.

All the "T" in China

These sovereign debt rating whispers were intensified by an environment of a declining US dollar and rising prices for hard assets. Speculation is growing that foreign nations are looking to diversify away from dollar denominated assets, and the mid-June meeting of BRIC nations in Moscow promises to see ministers discussing the dollar. Also of note, on June 1st and 2nd Treasury Secretary Geithner will travel to China to meet with his counterparts there. Geithner, whose first political gaffe came during his confirmation hearings when he seemed to suggest China was a currency manipulator, will likely tread very carefully as he meets the USA's biggest creditor. Any policy missteps at this critical juncture could cause the dollar to slide and Treasury yields to rise further.

China's PM Wen recently cautioned about "blind optimism" for economic recovery, warning governments should not underestimate the possible duration of the crisis. Abundant caution is warranted as unemployment and bankruptcies continue to mount, and the housing market continues to seek a bottom. In light of this, EUR/USD enters June just above the 1.40 level with the USD clearly on the defensive, despite US officials assuring that a strong dollar policy remains intact. The direction the US dollar will take in coming months will be largely determined by the “shape” of things to come, both in terms of the shape of the economic recovery and the shape of the global yield curve.

Major central banks may be caught in a US dollar trap as large holders of US Treasuries (particularly China) have little choice but to keep pouring the bulk of their growing reserves into the U.S. debt instruments. China has expressed its discontent with the Fed freely printing money under for its quantitative easing activities, but the Treasury remains the only market big enough and liquid enough to absorb China’s huge purchases.

Should the USD continue to exhibit weakness, the question of currency intervention could become one of the key buzzwords in June. Last year, prior to the global economic slowdown taking hold, the German Export association called the 1.50 level in the EUR/USD a ‘line in the sand.' Should the greenback reach this boundary, economic headwinds and the need for US to keep confidence in the dollar might provoke a rare central bank coordinated effort to hold that line.

Preparing for an “L”-Shaped Future?

June 4th will see the ECB policy meeting, which is expected to hold interest rates at 1.00%. The meeting will generate intense interest as the ECB is expected to provide the technical details of its €60B covered bond purchase plan. At the ECB's press conference, the media may raise the question of whether the program can be expanded beyond €60B, which is less than half the size of the equivalent Fed asset purchasing operation. Market participants will also look for more hints on whether the ECB has definitively decided if interest rates are at their lowest possible level. The BOE meet the same day and is expected to remain hold its base rate at the historically low 0.50%.

The FOMC's rate announcement comes on June 24 as speculating grows that the Fed will up the ante on quantitative easing. To their credit, the Fed and other central banks have started jawboning about the eventual withdrawal of the extraordinary stimulus they have been providing. But this summer central bank speakers may start feeling pressure to be more forthcoming about the details of what will clearly be a very tricky disengagement process to forestall murmurs that and exit strategy might not exist. This even as the Fed may judge it needs to go even bigger on its asset buying plans.

In its latest economic forecast, the Fed revised its outlook to reflect a deeper recession in 2009 and slower recovery in 2010. Several data points this month will help inform the central bank's evolving economic assessment. Unemployment, though deemed a lagging indicator, is particularly sensitive in this time of the government essentially nationalizing auto makers and financial firms and forcing massive layoffs as part of restructuring efforts. The US May Nonfarm Payrolls and Unemployment data will be released on June 5, and are expectations are the jobless rate will continuing to stampede toward 10%, while over half a million jobs will be lost for the 7th month in a row. Inflation data represented by the PPI (6/16) and CPI (6/17) will also be increasingly eyed as commodity prices continue to press higher.

“A” is for Ana

Commodities had a remarkable rally in May, with the CRB commodities index posting its biggest monthly percentage gain since 1974, on bets that the world economy is starting to stabilize. Crude oil led the way, rebounding significantly off of recent lows thanks in part to strong compliance by OPEC members and a weakening US dollar. In fact, crude had its biggest one month move in about 10 years, rising over 30% in May. Notably, $66/barrel oil has not been followed by natural gas, which continues to linger near multi-year lows, a sign that the crude rebound could be based more on speculation of economic recovery than on any fundamentals. Ironically, the bets on an economic rebound that have helped drive commodities higher could put a damper on recovery as higher material and energy prices could restrain the still fragile economy.

Hurricane season officially starts June 1, and weather experts at NOAA are forecasting a moderately active season with 9 to 14 named storms expected of which 1 to 3 are expected to be major storms. The first named storm will be called Ana, and she and her brethren could throw some new volatility into the energy market after three relatively quiet storm seasons following the upheaval Katrina caused in 2005. A rough hurricane season in the Gulf of Mexico and persistent dollar weakness could boost the entire energy complex and send crude toward OPEC’s nominal $75 target. On the other side of the ledger, as the price of oil rises OPEC members have an increasing incentive to cheat on quotas, though they have shown unprecedented discipline to date.

U-Turn Ahead?

As the pace of decline has slowed, investor appetite has turned back in the direction of China, where expectations of hard commodity demand has helped copper reach 7-month highs. Recently Vale, the biggest miner of iron ore and nickel, announced it was not planning any more output cuts due to recovery of demand from China. That sentiment was then echoed by other large miners Rio Tinto and Fortescue Metals, who saw China demand improving amid the bottoming process in spot metal prices. The timing of the bullish outlook is particularly significant for another reason—Chinese steelmakers are still embroiled with miners on securing this year's pricing commitment and face the prospects of buying iron ore at the steadily rising spot levels, while their Korean and Japanese competitors have already secured a 33% price cut.
Other voices are less optimistic. The CEO of mining giant BHP recently expressed concerns that Chinese buying is not an evidence of real demand but rather an inventory buildup at bargain prices in preparation for the stimulus. Also, according to the Financial Times, implementation of that stimulus is in question because state officials and private sector— responsible for CNY2.8T of the CNY4T package—are having trouble financing their share of the burden. Likewise, a World Bank official suggested that expectations of recovery in China is premature and needs to be validated by improving domestic consumption. The coming weeks should clarify some of this uncertainty over the true economic state of the region, however if the balance does shift back in favor of the skeptics, given the extent of the recent run-up, the perception of the V-shaped bounce is likely to take an abrupt U-Turn.

Spelling it Out

The global economy is still in a fragile state, and despite signs of stabilization and glimmers of recovery the timing of these improvements remains uncertain. Keep in mind that there are plenty of factors that could complicate things, not the least of which is the US Treasury’s plans to borrow $1.8T this year. The Treasury’s ambitious plans can only deepen the coming glut of sovereign debt and might threaten the US and other nation’s sovereign ratings, while ensuing interest rate problems could further weaken the world's reserve currency. And nobody should count on a return to spending by newly cautious consumers, who have been tempered by withering home prices and shrinking 401Ks. Spending will not be roaring back to pre-crisis levels, making it clear that while the worst may be over the road to recovery will be B-U-M-P-Y.

Calendar of Significant Events

June 1-2: Geithner in China

June 4: ECB and BOE rate decisions

June 5: May US Nonfarm Payrolls and Unemployment

June 10: Treasury’s 10-year auction

June 11: Treasury’s 30-year auction

June 24: FOMC rate decision
Category: Forecast | Added by: forex-market (2009-05-31)
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