S&P 500 Futures
From the middle of May prices steadily dropped for two months. Much of this selling pressure was due to much larger than expected losses within the banking industry, including the well publicized problems at Fannie Mae and Freddie Mac. In this period, with the exception of Canada, all of the developed nations in the MSCI World Index experienced declines of 20% or more since September.
After the June 2006 lows were taken out there were some recovery gains, which were attributed to news that profits at Bank of America had declined by less than analysts had expected. Prices continued to move higher due to better than expected earnings from Wells Fargo and Company and on news that JP Morgan reported better than anticipated earnings. There were some additional gains as of a result of the better than expected durable goods report.
During these partial recovery gains the July16th advance in bank stocks was the largest single day rally for the sector in 16 years. More recently, there was some follow through strength due to weaker crude oil prices and there was some additional support when the ADP Employer Services report said employment increased by 9,000 against a guess of down 60,000. Although some traders look at this report as a clue to the following employment number, it has been our experience that the correlation between the ADP report and the actual number for nonfarm payroll has been very low. The nonfarm payrolls portion of the employment report is expected to show a 75,000 decline.
Companies within the S&P 500 are likely to report the largest decline in quarterly earnings since 1998. With more than half of the companies reporting so far in the second quarter, earnings have fallen 24% from the year ago period. Earlier, analysts were expecting a decline of only 11%. In the financial markets sector, industry profits have dropped 87% against earlier guesses of down 60%.
Even though recent earnings reports from some banks have been better than expected, there is a growing feeling that there will be more problems in the industry within the next one to two years. Our analysis suggests that there are more subprime related problems to be revealed later. Recently the U.S. Federal Reserve announced that they are expanding their Primary Dealer Credit Facility, which was established to alleviate subprime banking problems. It will introduce an 84 day Term Auction Facility, which it said will be in addition to its existing 28 day loans. In addition, the Fed said they will increase their swap line with the European Central Bank to $55 billion from the current $50 billion. This news suggests there are more banking write downs yet to be reported.
Some analysts are now saying that the market has made a bottom for the move and 20% returns can be expected over the next 12 months. Our analysis suggests this will not be the case. The studies that we have recently completed suggest major bottoms have not been made and, most likely, the recent lows will be taken out later this year. The main trend is lower which is likely to continue until well into 2009.
U.S. Dollar Index Futures
In the middle of July the U.S. dollar fell to a record low against the euro due to ideas that Federal Reserve Board Chairman Bernanke’s report on the economy to Congress will say credit market pressures will undermine economic growth in the U.S.
At this time the U.S. dollar came under additional pressure as a result of higher crude oil prices and on ideas that credit losses at financial firms in the U.S. will widen, as the U.S. economy continues to weaken.
More recently, however, the U.S. dollar was able to partially recover due to a better tone to the U.S. banking industry. Some of these gains took place after Treasury Secretary Paulson said a strong dollar is in the interests of the country and after the Federal Reserve Bank of Philadelphia president said interest rates should be increased in order to fight inflation.
Lower crude oil prices recently have also helped the U.S. dollar to recover to the middle of the five month trading range. A recent study showed that the U.S. dollar and the price of crude oil have moved in the opposite direction 90% of the time during the past year.
One factor limiting U.S. dollar gains, however, is the possibility that Freddie Mac and Fannie Mae may need to raise as much as $10 billion by selling new shares.
In spite of the better tone to the greenback more recently, the longer term fundamental situation suggests the main trend for the U.S. dollar is lower. Most likely, credit market problems in the U.S. will intensify in the weeks ahead. In addition, the decreasing chances of an interest rate increase from the Federal Reserve will continue to undermine the U.S. dollar.
Before the end of the year expect a test of the July lows of 71.555, followed by another down leg to new historical lows. We are expecting a bear market in the U.S. Dollar Index to continue well into 2009.
Euro Currency Futures
Prices for the euro have been underpinned by ideas that the European Central Bank will increase interest rates one more time before the end of the year, possibly at their September meeting. Underscoring this idea are comments from European Central Bank Council members when they said there is room to increase interest rates another time this year, even though the euro zone economy is weakening. These comments were made after the ECB just raised their benchmark interest rate on July 3rd by 25 basis points.
The euro was also supported by comments from another European Central Bank Council member when he said the ECB’s current interest rate is “not exactly restrictive” with inflation currently running at 4%. These comments were made in early July. Euro zone inflation is now running at 4.1% on an annualized basis. The euro continues to be very attractive versus the U.S. dollar from an interest rate differential point of view. This is because the Federal Reserve has maintained a benchmark interest rate of only 2%, while the European Central Bank has their key lending rate at 4.25%.
More recently, there was some selling pressure in the euro after consumer confidence in Germany fell to its lowest level in more than 5 years.
Additional pressure came into the euro after euro zone industrial orders fell 3.5% in May on a month to month basis. This was the largest decline in over 6 years. More long liquidation came into the euro after German investor confidence fell to a record low.
In spite of the softer euro recently, our long term analysis suggests favorable interest rate differentials will dominate, causing the euro to register new historical high prices against the U.S. dollar before the end of the year.
British Pound Futures
Earlier in the month, the British pound advanced to above the $2.00 level on expectations that increasing inflation levels will keep the Bank of England from lowering interest rates. At this time a government report showed British inflation had increased to an 11 year high. These gains took place in spite of a weakening outlook for the British economy and after the Bank of England governor Mervyn King said there may be “an odd quarter or two of negative growth.”
More recently, the British pound fell after an industry report from Rightmove, Plc showed U.K. house prices dropped 2% in July from a year ago. This was the first annual drop since Britain’s most popular housing web site started monitoring house price data in 2002. The pressure in the housing industry suggests that the next move in U.K. interest rates will be to the downside, which in turn, should continue to pressure the British pound. In fact, Bank of England policy maker David Blanchflower said the central bank must cut interest rates to support the economy, which is headed for a recession that may last more than a year. There was some additional selling on news that the U.K. government will increase its borrowing after Chancellor Darling introduced new spending guidelines. It is thought that these new spending rules will allow the government to break its own regulations on public sector debt limitations.
Further selling pressure developed after a London based research company said U.K. home values declined by 5% from the year ago period, which was the largest decline in 7 years. There was additional selling on news that retail sales in the U.K. in June fell 3.9%, which is the largest decline since 1986.
Expect the pound to lose ground to the euro, while it will likely trade sideways against the U.S. dollar.
Japanese Yen Futures
The Japanese yen has been in a down trend since the 104.50 area from March of this year. Interest rate differentials have gradually been turning more bearish for the yen in this period. Currently there is only a 20% chance that the Bank of Japan will raise their official benchmark interest rate to 75 basis points from the current 50 basis points by the end of this year, while the market continues to believe that there is a greater chance that the Federal Reserve Bank will increase their benchmark interest rate by 25 basis points later this year to 2.25%.
Also hurting the yen was a report that Japanese exports unexpectedly fell 1.7% in June from the year ago period. This was the first drop in over four years. This news caused traders to believe that any potential interest rate increase from the Bank of Japan will be delayed.
More recently the Japanese yen was able to temporarily trade higher due to worries that losses at financial companies in the U.S. will persist. This caused investors to unwind yen “carry trade” positions. In the “carry trade,” investors borrow in countries with low interest rates and invest in higher yielding assets in other countries.
Australian Dollar Futures
The Australian dollar recently made a 25 year high against the U.S. dollar due to firming commodity prices, elevated inflation levels and prospects of higher interest rates from the Reserve Bank of Australia. Some analysts were predicting that the Australian dollar would be able to advance to par with the U.S. dollar.
However, some of this bullish sentiment was recently tempered when the Reserve Bank of Australia said slowing demand will ease inflationary pressures. The Australian currency was also hurt by news that home building proposals unexpectedly dropped in June for the second consecutive month. In addition, there was some further pressure as a result of the recent weakness in commodity prices. Exports of metals and other commodities comprise about 17% of the Australian economy.
Expect the Aussie to find support at the .9250 area. Ultimately, favorable interest rate differentials will take prices higher against the U.S. dollar, and by next year, the Australian dollar could be as high as 1.0000.
Eurodollar Futures
All charts provided by APEX
The long term fundamental influences remain bullish. The Fed’s “Beige Book” on the economy was the weakest ever published. In this report there were 97 references to “weak, weakness, weaker or weakening,” versus the 20 year average of only 35.
Prices remain firm due to ideas that the U.S. housing industry will continue to soften along with prospects of weak corporate earnings. New home sales fell to near their lowest level in 17 years. There was some additional strength in futures when the president of the Federal Reserve Bank of Minneapolis said in an interview that the credit problems in the U.S. markets may get worse.
There was some temporary pressure due to the belief that plans to rescue Fannie Mae and Freddie Mac will result in large increases in Treasury offerings. Another bearish influence is the expanding budget deficit. According to government officials, the U.S. budget deficit will increase to a record $490 billion next year. The Treasury also predicted that they will need to borrow 53% more in the current quarter than previously estimated.
While the Fed is currently talking tough on inflation, we are anticipating they will have a much more accommodative tone later this year, due to further pressures in the economy along with more credit problems. According to our work, the credit crisis is far from over, which will remain supportive for the Eurodollar futures. Our call for lower interest rates from the Fed very much remains a minority view since the vast majority of analysts are expecting the Fed to raise interest rates before the end of the year.
Expect higher prices for Eurodollars as it becomes more obvious that a weakening economy, along with the continuing credit crisis needs more accommodation from the Fed and not higher interest rates.
Continue to trade Eurodollars from the long side as the pressure on the Fed to lower interest rates intensifies. In addition, Eurodollar futures are likely to gain on the 10 year notes and the 30 year bonds. We expect a bull market for Eurodollar futures to continue well into 2009.
For more information about this article, please contact Alan Bush 1.800.243.2649 or email at alan.bush@archerfinancials.com.
Futures and options trading involve significant risk of loss and may not be suitable for everyone. Therefore, carefully consider whether such trading is suitable for you in light of your financial condition. The views and opinions expressed in this letter are those of the author and do not reflect the views of ADM Investor Services, Inc. or its staff. The information provided is designed to assist in your analysis and evaluation of the futures and options markets. However, any decisions you may make to buy, sell or hold a futures or options position on such research are entirely your own and not in any way deemed to be endorsed by or attributed to ADMIS. Copyright © ADM Investor Services, Inc.
