Market Directions Sunday September 9, 2007


*       US job growth plummets, the Fed dusts off its white hat
*       The ECB quick steps to a new economic tune, but promises to
remain true to the old standards
*       China raises the banking system reserve requirement for the
seventh time this year


The Week in Review September 4 -September 7


United States


The Non Farm Payrolls (NFP) on Friday gave the Federal Reserve its
economic rational to cut the US Fed Funds rate. The loss of four
thousand jobs in August shocked all markets; most observers had looked
for the creation of 100,000 new jobs. The reaction against the Dollar,
the Dow Jones Industrial Average and the Yen crosses was swift and
permanent.

The markets are now presented with a new economic scenario and a new set
of Fed and ECB assumptions; neither development has been fully priced.
The Dollar fell more than two figures against the Yen, a figure against
the Euro and 200 points versus the Sterling. The ECB  has been forced to
act against its better instincts, the Fed will soon be. This is an
unusual situation for the world's central bankers who have been
practicing a new brand of transparent communication with the financial
and currency markets. Until now the inflation targeting by both banks
has been viewed as a success. Inflation rates have responded as
predicted and the communication skills of the bankers have produced very
few surprising moments. But inflation targeting is a poor policy guide
for disruptions of the type the credit markets have witnessed since
early August. And by acting under duress and only after other remedies
were tried, both central banks have created an additional non
transparent source of worry and a heightened sense of unease. Former Fed
Chairman Alan Greenspan must have had a satisfied afternoon on Friday;
his view of the close and important connections between the financial
markets and the economy is looking correct right now.

The Fed Chairman, Ben Bernanke, can now reduce interest rates with
reference strictly to the economic fallout from the credit markets and
without the appearance of bailing out Wall Street institutional
investors and investment banks. In the two months of the third quarter
to date, payrolls have averaged only 32,500 per month, barely one fourth
of the monthly average in the second quarter. It is likely that the
employment fallout from the financial sector layoffs, let alone from the
worsening construction industry, has barely begun to hit the payroll
numbers. Things will get worse before they get better. The potential
cycle of job losses, falling wages, shrinking consumer spending and
rising mortgage foreclosures could easily propel the economy into
recession. With such a large overhang of poor quality mortgages the
downdraft on the economy could be powerful.

Over the next few weeks almost $1 trillion in commercial debt,
specifically asset backed commercial paper (ABCP), will enter the credit
markets needing refinancing. This is more than five times the amount of
debt that has come due since the credit market problems began one month
ago. A good portion of this debt has little to do with sub-prime
mortgages and much has nothing to do with mortgage securitization at
all. If the issuers of the debt cannot find buyers in the market then
some of this paper could end up on the books of the banks that
structured the original debt instruments and provided contractual back
up credit lines for the issuers. In many cases the banks are obligated
to buy back the debt if it cannot be sold on the open market. More than
anything else it is this unknown addition to their balance sheets that
is making the banks very wary about lending and it is why they are
keeping their cash close to home instead of lending it out to the credit
markets--they cannot now tell how much of this asset backed commercial
paper will be on their books at the end of the quarter September 30th or
the end of October. A cut in the Fed Funds rate will do very little to
alleviate this worry.


Eurozone


Despite the deliberate implication of a 0.25% rate increase at the
August second meeting of the ECB, financial events have supplanted
intentions. The ECB did not raise the refinancing rate at their Thursday
policy meeting. It remains at 4.00%; the vote to stay was unanimous.
Jean Claude Trichet, the central bank president, avoided using the code
"strong vigilance' and then, as he had done at the August 2nd meeting
where he did utter the phrase, he pointed out to all the reporters at
the press conference, that he did not say 'strong vigilance'. "I did not
pronounce the word 'strong vigilance' and I don't want to comment any
more than that", he said. OK, one is bound to think, we get it. He also
stressed that the bank 'compass' remained fixed on "price stability"
but
that, "We have to care for an appropriate functioning...of the money
markets at whatever price, at whatever interest rate".

The ECB analysis is very similar to that of the US Federal Reserve, Mr.
Trichet is just more oblique in his statements. EMU economic growth is
strong though recently signs have crept out that the expansion peak has
passed. And though inflation is subdued, is not absent. But it not
enough for 'main street' to feel secure, financial markets must function
smoothly. To borrow a line from the novel Dune 'the credit must flow'.
The ECB does not have to comment on the wisdom of the wholesale creation
of asset backed instruments in the past few years nor on the habit of
funding many of these long term instruments with short term credit. They
know that a severe credit market contraction will damage
indiscriminately, good credit worthy firms will be shut out of funding
as well as poor substandard ones. In the current situation the weight of
the risk has changed dramatically since early August and ECB clearly
feels compelled to support the economy as opposed to targeting
inflation.

On Friday ECB governors were at pains to tell the markets and the
financial press that the central bank remained very concerned about
inflation. No doubt they are, but their worry for the economy is far
greater. "As we say in German delaying something does not mean that it
has been ruled out.....The process of adjusting [interest rates higher]
has not ended', said Alex Weber. While Jurgen Stark commented that the
link between trend inflation and money growth is intact and leads to
inflation within two or three years. And that every surge in money
growth is followed by inflation. ECB Money supply growth (M3) was 11.7%
in July far beyond the 8.0% target.  

It is quite possible that in two months time the credit markets will
have resumed normal functioning and the ECB will again take up its
inflation quest. Unfortunately it is just as possible that the credit
market  contraction will seriously damage the 'real economy' and that
ECB rate hikes are over for this cycle.


United Kingdom


The Bank of England (BOE) left if main interest rate unchanged at 5.75%.
But, in what was an unusual move for the bank, it also issued a
statement explaining its action. Most BOE policy decisions are
unaccompanied by justification. The Thursday statement cited financial
market disruptions and concerns over asset backed securities as part of
the background that led to the MPC decision.


China


The People's Banks of China (PBOC) raised the reserve requirement for
Chinese banks another 0.5% to 12.5%, effective September 25th; it was
the seventh increase this year. The PBOC also promised to let the
markets have more said in determining the Yuan exchange rate. What that
promise might mean for the appreciation of the Yuan was not elaborated.
Premiere Wen Jiabao said that growth was a bit fast and credit a bit
loose. The Beijing government has been less than successful at reining
in speculation and inflation in the Chinese economy. There is no reason
to think that this latest move will suffice. But there may be help on
the horizon in the form of slower economic growth in China's Western
export markets.


Economic Releases September 4 - September 7


United States


Monday: The August Institute for Supply Management (ISM) Index came in
on point for August; the headline figure was 52.9 against the prediction
of 53.0 and 53.8 in July. Prices moderated to 63.0 as predicted, down
from 65.0 in July and employment improved to 51.3 from 50.2 in July. The
ISM has not, in the past, been swayed by market events, and the
continued moderate expansion does not, and should not be expected to
reflect the recent financial market turmoil. Construction Spending
slipped 0.4% in July, worse than the flat reading that had been
forecast, but as the June number was revised higher the identical amount
to +0.1% from -0.3%, the overall effect was moot.

Wednesday: the National Association of Realtors (NAR) Pending Home Sales
record dropped 12.2% in July to 89.9; June was 102.4. It was the largest
decline in the history of the series and leaves the sales figures down
16.1% year to year. This statistic tracks home sales that are "in
contract", that is a price has been agreed between the parties but the
deal has not closed. NAR suggested that disruptions in the mortgage
markets are causing mortgage commitments by lenders to be withdrawn. The
Federal Reserve 'Beige Book' became the latest official acknowledgement
of the financial market turmoil, saying that recent problems have
"deepened" the housing slump. But the overall tone of the economy as
reported in the 12 reserve districts was still positive, "reports...
indicate that economic activity has continued to expand" at a moderate
or modest rate though the pace of activity has slowed in some districts.
While noting that the declines in the housing and construction sectors
were continuing, "Outside of real estate, reports that the turmoil in
financial markets had affected economic activity during the survey
period were limited".

Thursday: Unit Labor Costs for the second quarter were revised down to
1.4% from 2.1% in the prior release. However, the total increase
remained brisk at 4.9% over the last four quarters. Productivity in the
second quarter was adjusted to a +2.6% annual rate from +1.8%. One of
the major gauges of the service based US economy the Institute of Supply
Management (ISM) Non Manufacturing Report showed consistent strength in
August measuring 55.8, the same as in July and substantially better than
the median forecast of 54.5. New Orders scored 57.0 well ahead of the
July reading of 52.8. The Employment number fell to 47.9 in July, much
weaker than June's 51.7, which was the lowest score since December 2003.
The report was a mixed bag with the headline number depicting moderate
growth and a robust new orders component but a weakening employment
picture. According to ISM Survey Chief Anthony Nieves, "A steep drop in
the...non-manufacturing employment index reflects caution and not an
actual decline in business conditions".

Friday: Non Farm Payrolls registered a fall of -4,000 jobs in August;
the median prediction had been for a gain of 100,000. Payrolls for June
and July were also revised down a total of 81,000. The Dollar suffered
an immediate penalty, in the first five minutes after the release at
8:30 am it dropped 70 points against the Euro, 90 against the Yen and 85
versus the Sterling. The Euro/Yen dropped more than 50 points. The
carnage in job creation was universal: the construction industry shed
46,000 jobs, retail trade 27,000, and even government payrolls sank by
28,000. The unemployment rate stayed at 4.6%, despite the job losses,
due to the end of temporary summer employment for many thousands of
students.


Eurozone


Tuesday: Real GDP for the second quarter was unrevised at +0.3%
quarterly and +2.5% yearly. The yearly figure for the first quarter was
adjusted slightly higher to +3.2% from +3.1%. Annual EMU GDP peaked in
the third quarter 2006 at 3.3% and was 3.2% in the fourth. Several
reasons are postulated for the decline: a delayed effect from the
increase in the German value added tax (VAT) that took place in January,
the drag of the high Euro on exports to the United States and the high
price of imported oil. Except for the North Sea production, EMU nations
import virtually all their crude oil. The Produce Price Index (PPI)
gained 0.3% in July a +1.8% annual clip; +0.2% and +1.7% had been
forecast. The annual rate for June was revised to +2.2% from +2.3%.

Wednesday: Retail Sales for July gained less than anticipated at 0.1%,
median expectation had been +0.3%. The June results were adjusted up to
+0.6% from +0.4 and the year to year result was moved up to +1.0% from
+0.9%. May was revised down 0.1%.


Germany


Thursday: Total Manufacturing Orders fell 7.1% in July, much more than
the 3.2% decline predicted. The June version of this volatile series was
revised up to +5.1% from +4.9%.

Friday: July Industrial Output rose only 0.1%, forecasts had been for a
gain of 0.7%. The June number was revised up to +0.2% from -0.4%. The
Manufacturing Output for July moved ahead 0.2%; the June result was
revised up to -0.3% from-0.5%.


United Kingdom


Monday: British Retail Consortium (BRC) Retail Sales rose 1.8% year on
year in Aug, one third better than the July figure +1.2%. July had been
the lowest gain since last November. Total Sales rose 3.7% annually in
August compared with 3.1% in July a gain of 3.0% had been forecast.

Tuesday: the Chartered Institute of Purchasing and Supply (CIPS)
Manufacturing PMI for August scored a three year high at 56.3, up from
55.7 in July. It is the 20th month in a row that it has been above the
50 dividing line between contraction and expansion.

Wednesday: the CIPS Services PMI for August rated 57.6, well over the
median expectation of 56.5; July was 57.0. Input Price Inflation was
57.5 in August the same as in July and the lowest level since October of
last year. Prices Charged were stronger in August 53.1 from 52.2 in
July, indicating that firms are more sanguine about being able to raise
prices in the future. Services are 75% of the UK economy and the
Monetary Policy Committee (MPC) of the Bank of England said the
relatively low level of current price inflation contributed to the MPC
decision not to raise rates.

Thursday: Manufacturing Output for July fell 0.3% leaving the elapsed
year at +0.8%. Both numbers were well below the median prediction of
+0.2% monthly and +1.2% yearly. Industrial Production for July fell 0.1%
monthly, the yearly result was +0.9%; +0.2% and +1.0% had been forecast.
The May and June monthly figures were each adjusted down 0.1%.


Japan


Tuesday: The monetary base for August rose 0.7% over a year ago. It was
the first expansion in 18 months, and far ahead of the July when it
contracted 2.3%.


The Week Ahead September 10 -September 14


United States


Tuesday: International Trade Balance for July at 8:30 am; expected
-$59.5 billion, June -$58.1 Billion.

Friday: Retail Sales for August at 8:30 am; expected +0.6%, July +0.3%.
Retail Sales ex food and Autos at 8:30 am; expected +0.2%, July +0.4%.
Industrial Production for August at 9:15 am: expected +0.3%, July +0.3%.
Capacity Utilization for August at 9:15 am; expected 82%, July 81.9%.
University of Michigan Consumer Sentiment for September at 10:00 am;
expected 83.5, August 83.4.


Eurozone


Wednesday: Industrial Production for July at 9:00 GMT, m/m and y/y; June
-0.1% m/m, +2.3% y/y.

Friday: Final HICP for August at 9:00 GMT m/m and y/y; expected -0.2%
m/m, 1.8% y/y.


Germany


Friday: Final CPI for August at 6:00 GMT m/m and y/y; expected 0.4% m/m,
1.9% y/y. Final HICP for August at 6:00 GMT m/m and y/y; expected 0.5%


United Kingdom


Monday: Output Produce Prices for August at 8:30 am GMT m/m and y/y;
expected +0.1% m/m, +2.4% y/y. Input Produce Prices for August at 8:30
am GMT m/m and y/y; expected -1.0% m/m, +0.6% y/y.

Wednesday: ILO Unemployment Rate for July at 8:30 am GMT; June 5.4%,
Average Earnings including Bonus for July at 8:30 am GMT three month
average y/y; expected +3.4%, June +3.3%. RICS House Price Survey for
August at 23:01 GMT; expected +10.0%, July +12.6%.


China


Monday: Producer Price Index for August, release time unannounced ytd;
July +2.4%.

Tuesday: Consumer Price Index for August, release time unannounced ytd
and, y/y; July +5.6% ytd, +3.5% y/y.

Wednesday: Retail Sales for August, release time unannounced, ytd and
y/y; July +16.4% ytd, +15.5% y/y.

Thursday: Industrial Output for August, release time unannounced, ytd,
y/y; July +18.0% ytd, +18.5% y/y%.

Friday: Fixed Asset Investment for August, release time unannounced,
y/y; July +26.6%.


Japan


Monday: Second quarter revised GDP at 23:50 GMT (prior day): first
release +0.1%. Money Supply for August at 23:50 GMT (prior day): July
+2.0%.

Tuesday: Machinery Orders for July at 23:50 GMT (prior day): June
-10.4%.

Wednesday: Consumer Confidence for August at 5:00 GMT; July 44.4.

Friday: Revised Industrial Output for July at 4:30 GMT; June +1.3%.

Joseph Trevisani
FX Solutions
Chief Market Analyst