Dollar Hangs Tight on GM Risk, Recession Trades Still On

Signs of stability in the US manufacturing sector has failed to turn around the market’s risk appetite. Although the US dollar has weakened marginally against all of the major currencies, if US stocks continue to sell off, we could see the dollar regain strength.

Will the US government allow GM to fail?

The fate of General Motors will be the biggest event risk until the end of the month. In my opinion, the US government will not allow GM to fail. President elect Barack Obama has already pledged on numerous occasions to support the auto and retooling industry. To back off his promises so early in the game would be a reputation killer and not something the world expects from Obama. House Speaker Nancy Pelosi has also called on Congress to pass an emergency rescue package for the industry. Given that 1 in 10 jobs in America deals with the auto industry (from dealerships, auto parts etc), there is no question that the US government will extend life support to General Motors.

Nonetheless the longer the US government stalls, the more strain it puts on the financial markets, because investors don’t like uncertainty.

G20 Holding Out for Obama

The G20 meeting this weekend was also a big disappointment. With slightly more than 2 months to go before the US Administration changes, this was hardly a surprise because President Bush was not expected to commit his successor Barack Obama to any initiatives that he does not support. Since the group set an action plan for March 31 and another meeting for April 30, the G20 is clearly waiting for directions from Obama’s new Administration before putting the pedal to the mdeal. . The only problem is, the global economy may not be able to wait that long.

Recession Trades Still On
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EUR/USD Slips as Oil and Stocks Head Lower

Even though the lack of meaningful US economic data has kept the US dollar in flux, there is one commodity that is continuing to grind lower. Oil prices fell to the lowest level in 20 months as exporters wake up to reality that crude prices may stay at current levels for some time.

For the currency market, the decline in oil prices is bullish for the US Dollar, and Japanese Yen but bearish for the Euro and Canadian dollar. The weakness of US stocks will also add pressure on high yielding currencies Since the beginning of the year, there has been a 70 percent positive correlation between the EUR/USD and the price of oil.

With the fear of weakening global demand keeping oil prices under pressure, OPEC nations are starting to realize that production cuts may not be the answer. The strong rise in commodity prices that we have seen throughout 2006 and into the summer of 2008 was driven by the frothy expectations that the global economy will continue to expand at a healthy pace. That of course has been proved to be false.

Now that oil prices have dropped more than 50% since the summer and have refused to recover, oil exporters have resorted to hedging their oil exports at sub-$100 levels. The front page story in the Financial Times today talks about how Mexico, the world’s sixth largest oil producer is hedging nearly all of next year’s oil exports. This is a clear sign that they fear oil prices will remain below $70 a barrel in 2009. Even though the report only talks about Mexico, we doubt that they are the only oil producing country to start hedging.

In order to hedge against a drop in oil prices, oil producers need to enter into derivative contracts that basically involve selling oil prices forward.

Source: GFT Dealbook

Source: GFT Dealbook

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Don’t Pin Hopes on China, Recession Trades Still On

US equities turned as traders realize that everyone is pinning too much hope on China. The reality is that China’s stimulus plan will not save the global financial and economic crisis. Instead, the only thing that is assured is that at one fifth of 2007 GDP, China will have less money to spend on financing the US’ current account deficit.

China: Not the Answer to Everyone’s Problems

Every country is doing their best at stimulating domestic growth and that is exactly what China is focused on right now. Their priorities are at home and not abroad and their plans to invest in low-rent housing, infrastructure, rebuilding programs and tax breaks on capital spending are aimed at helping their economy cool at a more manageable pace. However it is not a bailout for the financial market and will not be enough to stimulate global growth. Some foreign manufacturing and construction companies will benefit from China’s investment in infrastructure, but the bottom line is that like the rest of the plans announced by developed governments, it shifts and not creates wealth. We also don’t think that it is a coincidence that China made its announcement ahead of a busy data week that will surely confirm the continued weakness in the Chinese economy. With a need to focus domestically, Chinese demand for dollar denominated investments will decrease, especially after some particularly nasty losses incurred at the Sovereign Wealth Fund.

Will there be Fireworks at the November 15 Meeting?

World leaders will be headed to Washington for the Economic Summit on November 14 and 15. The hope is that we will see more detailed proposals on dealing with the economic crisis. Unfortunately as the date nears, investors are starting to realize that no substantial changes may come out of the meeting. With a little more than 2 months before the leadership changes in the US, the current administration may not want to commit to any major policy changes. But if they do, that is exactly what can turn the financial markets around (US President-elect Barack Obama has announced that he will not be attending the financial Summit). Although G20 finance ministers and central bankers pledged to jointly tackle the global financial crisis at this weekend’s G20 meeting, the disagreement between more or less state controls are becoming increasingly clear. It remains to be seen whether there will be fireworks at this weekend’s emergency summit.

Recession Trades Still On
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Why October Non-Farm Payrolls Could Fall by -300K

Even though the US economy has not officially entered a recession, the US labor market has.

October will mark the tenth consecutive month of net job losses. The market currently projects a loss of 200k jobs last month, but given the trend of job losses in past recessions, there is a growing chance that we may finally see job losses top 300k.

There is every reason to believe that the US labor market deteriorated significantly in the month of October. The credit crisis hit a peak, forcing companies to cut back. No one can argue that the US economy is in the worst shape since the Great Depression. Since we have seen a single month job loss of more than 300k in every recession over the past 30 years, there is no reason to believe that this time, it will be different.

However a weak job number may not necessarily be negative for the US dollar if it triggers another wave of risk aversion, forcing investors into the safety of the low yielders.

Impact of Weak NFPs on Currencies

If non-farm payrolls fall more than 250k, it would be initially negative for the US dollar, but when the US stock market opens, we could see the dollar rally. Traders need to remember that the dollar is appreciating not because of the strength of the US economy, but because money flocks into low yielding currencies during a global recession. In a very short period of time, the US dollar has become the second lowest yielding G7 currency.

A weak labor market number will mean two things – more weakness for US equities and another 50bp rate cut from the Federal Reserve next month. By extension, it will lead to weakness in USD/JPY, EUR/USD, GBP/USD and all of the Japanese Yen Crosses. The only way to avoid another round of selling would be if non-farm payrolls dropped by less than 150k.

Arguments for More than 200K Drop in Non-Farm Payrolls

Every month, we take a look at 9 leading indicators for non-farm payrolls and this month, every single one of them points to large job losses. Consumer confidence has hit a record low, layoff announcements and continuing claims hit a 5 year high while the employment components of service and manufacturing both point to continued job losses. Not only are more Americans being laid off, but those who have already lost their jobs are having a very tough time finding new ones. It is rare that we get such a strong signal about the state of the labor market, but the layoff announcements coming from all different sectors of the US economy confirm that we will see large scale job losses.

This is the main reason why US equities have sold off aggressively over the past 48 hours, sending investors into the US dollar and Japanese Yen, the 2 lowest yielding currencies.

Here’s how the 9 leading indicators stack up:

1. Employment Component of Service Sector ISM Dropped to Lowest Level since 1997
2. Employment Component of Manufacturing Sector ISM fell 7.2 Points to 34.6, Index Fall to 26 Year Lows
3. ADP Report Private Sector Job Losses of -157K
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Bailout Plan Fails to Impress, Traders Worried More About Dominoes Effect

The Congressional agreement of the $700 Billion bailout plan has proved to be anti-climatic for the stock and currency markets. There was a relief rally in the US dollar Sunday evening, but it lasted for no more than a blink of an eye as more problems came knocking on the door for financial institutions. Investors quickly moved onto the latest problems with a string of bank bailouts announced in Europe and the practical failure of Wachovia. Being sold at $1 a share is almost the same as filing for bankruptcy.


The US dollar has weakened against the Japanese Yen, but its strength against the Euro and British pound indicate that the concerns for those currency pairs now shift to the prospect of further bank failures in Europe. In the Eurozone, Fortis was bailed out by Belgium, the Netherlands and the Luxembourg governments while the Hypo Real Estate group was bailed out by the German government. In the UK, Bradford and Bingley was nationalized by the UK government. If the US banking sector is a good model, then we know that this is just the beginning of bank failures as the dominoes effect triggers more losses. With the ECB interest rate decision scheduled for Thursday, the problems in the banking sector could pressure the European Central Bank to consider easing monetary policy.

On the heels of the bailout plan, the Federal Reserve has injected a tremendous amount liquidity into the global money markets by increasing their swap lines. This is driving gold prices through the roof as inflation fears soar and money flocks out of US dollars and into gold as the safe haven play. Nonetheless, the Fed is trying to tell the market that they are serious about providing liquidity with the size of today’s liquidity injection – they more than doubled their swap limits from $290B to $620B.

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