And Now What? Q4 and Beyond

The closing of a couple of European bank managed funds and the failure to secure financing for two large acquisitions in August marked the beginning of the credit crisis in earnest. The rally in US share prices that lifted the Dow Jones Industrials and S&P 500 to new record highs and the September US jobs data, coupled with the sharp upward revision to the August series, revising away the contraction initially reported, marks the end of the crisis, even if the money markets have not entirely normalized.

In recent weeks, the capital markets, which had been paralyzed by the liquidity crunch and de-leveraging process, have begun re-opening. The commercial paper market is stabilizing and arguably even expanding again on a seasonally adjusted basis. Admittedly, term LIBOR rates remain elevated but are moving albeit gradually in the right direction. Many of the large investment banks have reported quarterly earnings figures and while there are some casualties, it is clear that the financial crisis is unlikely to turn into a full-fledged banking crisis.

There has been much debate over the impact of the tightening of credit conditions on the real economies. There has been much talk about how the end of housing market expansions in the US has often been followed by economic contractions. For the better part of the past two months, the Federal Reserve has formally recognized the increased downside risks to the US economy. At the same time, European officials, including some in the UK, are scaling back their growth forecasts.

The US Economy is not Falling off a Cliff

Remember 2001. Then the US economy was initially thought to have contracted for three successive quarters. However, the revisions indicated that the economy did not contract in Q2 01. And recall that after 9/11 when many thought the US was headed for a deep recession, it actually was pulling out of one.

Similarly, the 4k loss of jobs in August 07, which heightened concerns about the ability of the US economy to withstand the credit shock, has been revised away. Indeed, rather than lose 4k jobs, the US economy added 89k and to drive the point home, the July series was revised higher by 25k to 93k. The revisions will encourage talk that the Federal Reserve need not have cut rates by 50 bp, which surprised most of the market in the middle of September.

The jobs data drove home the point that several regional Federal Reserve Presidents have made in recent days suggesting a cautious optimism about the economic outlook. The market responded by downgrading the likelihood of another rate cut later this month. The market had been expecting another 25 bp rate cut, but after the employment data, the odds had been reduced to about a 50% chance, rather than a 75-80% chance that had previously been discounted.

With growth fears easing, the market will likely be more sensitive to the price data due for release in the coming days. These include import prices on Oct 11 (Sept consensus 1.0% after -0.3% in Aug), producer prices Oct 12 (Sept consensus 0.4% after-1.4% in Aug) and consumer prices Oct 17 (Sept consensus 0.3% after -0.1% in Aug). Somewhat firmer inflation readings coupled with less of a fear of an imminent recession will encourage the pendulum of sentiment to continue to shift away from an Oct rate cut. A back of the envelop calculation still puts Q3 GDP tracking 2.5%-3.0%, with the outlook for Q4 GDP coming in better than 2%, something that is enviable by most of the G7.

Dollar Outlook May Not Improve Much

Nevertheless the US jobs market has lost some momentum. Consider that the average monthly job gain over the past year has been almost 136k and the pace has slowed to 112k averaged over the past 6-months and 97k over the the past three months. The unemployment rate itself has crept up from 4.4% as recently as March to 4.7%. The continued gradual easing of US labor market conditions will allow the Federal Reserve to cut interest rates before the end of the year.

In Europe growth momentum also appears to be slowing, but the European Central Bank appears to be in no hurry to follow the Fed’s lead in cutting key rates. Firm oil prices, and elevated readings from German consumer prices and French producer prices underscore the upside risks identified by ECB President Trichet. The ECB should be regarded as on hold for the remainder of the year. If there is a change in key rates, it will more likely be in the direction of higher rather than lower rates.

On the other hand, even though the Bank of England has not been as generous in providing the financial system the kind of assistance that the Fed and ECB have provided, it is likely to come under pressure to cut rates sooner. The risks of a rate cut as early as next month appear to be growing.

However, in a weak US dollar environment, the weakness in the UK fundamentals may be most evident on a cross rate basis than against the greenback. And the pressure on the dollar is likely to persist over Q4 07. In fact, given the difficulties faced this year by financial institutions, we wonder if players have sufficient incentives to fight existing trends until next year.

The dollar’s downtrend is well entrenched. It is based on the anticipated trajectory of interest rate and growth differentials. The three-month deposit rates which we often use as a proxy for short-term interest rate differentials are being skewed by distortions in the money markets. But on a trend basis, the premium the US pays over the euro-zone is narrowing. The yield on the US 2-year note had previously dipped below the 2-year German yield, but is now back above by a few basis points.

Our cyclical work finds that the US dollar’s downtrend is the most pronounced when it is happening as interest rate differentials move against it. The last phase of the dollar’s cyclical downtrend takes place as interest rate differentials begin widening. Although in the very near-term some differentials have widened slightly, it has not been sufficient to suggest the dollar’s decline is in its last stage.

Therefore the risk remains on the dollar’s downside. This means that the euro is likely to return toward the old Deutschmark high from 1995 that comes in near the equivalent of $1.4570 for the euro. In a weak US dollar environment, many speculative operators may minimize short-yen exposure, preferring dollar-carry trades. The high yielding Australian and New Zealand dollars, as well as several emerging market currencies, like Brazil, Turkey and South Africa should also continue to outperform.