FIRST QUARTILE ECONOMICS |
Against this background, the Yen has crept above the 134 level in recent days and a decisive break of 135 is imminent. The Bank of Japan may indicate its displeasure via some token dollar selling but there is virtually no way the BoJ is prepared to use up another $20 billion plus in foreign exchange reserves, as it did a few weeks ago to no net avail.
Even the DM appears to have peaked out in terms of its recent rally versus the dollar. However, there is still the uncertainty of German rate convergence with other Euro countries so the DM is under no serious threat of significant weakness. Given these factors, from closing week levels of 1.7823 DM and 134.75 Yen, I would anticipate trading ranges of about 1.77 to 1.80 DM and 133 to 137 Yen over the next week or so.
U.S. BONDS: A Reuters survey of thirty-six primary U.S. dealers shows not a single firm looking for a Fed tightening at Tuesday’s upcoming FOMC meeting. Still, the bond market is not taking anything for granted since unanimous street opinions have been wrong plenty of times in the past.
In looking over the development of the past several weeks, bonds have had plenty of chances to break down big time yet the 30-year Treasury remains under a 6 percent yield. The underlying bullish sentiment towards long bonds is actually quite telling. At this stage virtually everybody thinks the next Fed move is a tightening yet there is no overall positioning for such a development or trend in place. And, why should there be with continued good news on inflation and Q2 Industrial production off to another modest start with the April data just released.
Oil prices may be coasting along a bottom and are not pulling the CPI and PPI lower any more but there is no imminent prospect of higher energy prices amidst continued OPEC disarray. The April capacity utilization level now stands at levels of two years ago and at 82 percent gives a meaningful degree of cushion from inflationary pressures. It seems likely that the long end of the curve will continue to respond to the actual level of inflation at hand while the short end will remain somewhat nervous about the eventuality of a higher Fed Funds rate.
My view continues to call for a significant decline in long Treasury yields during the summer with a target around 5.50 percent on 30-years but not much change in short and mid-term bond yields.
INTERNATIONAL EQUITIES: The S+P 500 rose by 0.1 percent on the week while the Dow rose 0.5 percent. The broader Russell 2000 fell by 1.5 percent. The Hong Kong market was a significant loser with a decline of 5.2 percent.
COMMODITY PRICES: Gold prices rose by $2.20/oz last week in apparent reaction to civil unrest and political uncertainty in Indonesia. However, this is nothing more than a transitory support for gold prices and given gold’s recent retreat (from the $314 level just three weeks earlier) it seems likely some more testing of the downside lies ahead.
Oil prices continued to drift lower as WTI fell to $14.51/bl versus $15.15/bl the prior week. Whatever key OPEC members have up their sleeve in terms of production cuts and price supports, the market is unimpressed.
Perhaps the most interesting development on the commodity price front is the further deterioration of the CRB Index towards the recent lows set in the week of January 16 (in the height of the global deflation frenzy). The current downtrend is perhaps more ominous because the markets are trading with “clearer heads” and with a better grasp of the individual commodity fundamentals than was in place in early-January. The chart below, indicates a two-year parallel channel downtrend in the CRB Index with support around the 219 level (about 1.4 percent below Friday’s close).
Accordingly, we are close to seeing a near term bottom and possible upward correction in the CRB Index generally or a breakdown that could open the door to the 1993 lows in the 198 area (a further 10 percent decline in commodity prices). Take your pick. My choice is for further commodity price weakness that will not go un-noticed by fixed income markets.
CANADIAN DOLLAR: The gradual but relentless erosion of the Canadian dollar during the past two months is beginning to make financial market participants nervous about a summer bout of interest rate volatility. In some quarters the Canadian economy’s ongoing strength has made a near-term domestic rate hike a forgone conclusion while other observers have been more neutral or indefinite status quo oriented on the interest rate front.
My reading of the domestic yield curve, of late, has not pointed to any broad or implied consensus of higher rates near-term but evidently Canadian dollar traders have been thinking otherwise. The Bank of Canada’s semi-annual Monetary Policy report, tabled this past week, implied no change in interest rates over the next six months or so and this was apparently responsible for CAD weakness on Wednesday and Thursday (which took the currency from about 1.4350 to 1.4500). While CAD hovered around the 1.4500 level, on Friday, there was no follow-through weakness that often accompanies trading ahead of Canadian long-weekends.
In line with recent commentary here, the currency is now in a precarious technical position. The 1.4500 level represents more than a 62 percent retracement of the rally from late-January to early-March and in all likelihood the stage is being set for a retest of the 1.4700 level that was just barely averted in January. The question then becomes, what does this mean for domestic interest rate volatility and the subsequent outlook for the currency?
In my opinion, the Bank of Canada will do nothing on the interest rate front unless the currency actually hits a new low. Even then there should be no rush to raise the Bank Rate unless it appears the currency is in danger of falling another quick couple of cents. In the past, I have felt an ultimate objective would be the 1.5000 level which translates into 66.66 cents/U.S. At this time, I doubt there is enough bearish conviction in the market to force such a potential development since the trade balance has been improving of late and the negative money market spreads to the U.S. are now relatively minor compared to what prevailed in the first half of 1997.
Another apparent issue of concern to at least some pockets of the market is Bank of Canada credibility. A number of observers think the Bank of Canada has to cool the economy off or risk higher inflation. Well even the Bank of Canada continues to grind its growth outlook for the economy progressively lower while actual inflation, as measured by the CPI, stands at 0.8 percent yr/yr as of April.
The Bank also indicated, this past week, that measurement problems overstate the Canadian CPI by about 0.5 percent and possibly as much as 0.7 percent. This is why an inflation rate below 1.0 percent, the lower target band, is essentially zero inflation and even though the Bank expects a return to the 2 percent area by mid-1999, this is not an overwhelming case for higher interest rates. After six years of being a world leader in getting inflation down and keeping it down, it never ceases to amaze how the Bank of Canada’s credibility continues to come up as an issue in financial market deliberations.
As for the very near term, the Canadian dollar is a bit of a hostage to Tuesday’s FOMC meeting as a Fed tightening would put immediate pressure on the Bank of Canada to raise rates at least by an equal amount. If the FOMC meeting proves to be a non-event, CAD will have some breathing room and will likely firm somewhat. At this stage however, it is difficult to see the currency rally beyond 1.4300 or so. In the event of continued weakness, 1.4600 is the next probable objective.
CANADIAN BONDS: Despite the apparent drama on the currency front, domestic interest rates have posted little reaction. Spreads to the U.S. have moved very little of late while the domestic curve has flattened a moderate amount. Evidently, the domestic long end in particular remains broadly unconcerned about potential negative prospects for the currency over the near term. Canadian bonds will continue to take their basic direction from developments in the U.S.
CANADIAN EQUITIES: The TSE 300 slipped 0.2 percent on the week as Utilities led on the upside with a gain of 3.2 percent and Metals and Minerals led the downside with a decline of 4.1 percent. As it currently appears, commodity oriented stocks remain in some jeopardy. Interestingly, despite the Canadian dollar’s ongoing malaise, Utilities evidently see the interest rate outlook as fairly positive.
May 18, 1998
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