Don’t Catch A Falling Knife!

The US leading indicators have now been negative for nine out of the last twelve months due to the beleaguered housing market and sputtering stock market. The acceleration in the downtrend in leading indicators suggests an even greater risk to the global economy in the months ahead. Question about the viability of Fannie Mae and Freddie Mac are keeping mortgage rates higher than they should be, hence putting additional strain on home sales.

The first tidbits from the Fed’s annual retreat last weekend in Jackson Hole, Wyoming suggests that the financial storm has not yet subsided and its effects on the broader economy are becoming apparent in the form of softening economic activity and rising unemployment.

The Ifo index of business sentiment, which is fairly correlated with industrial production growth, has dropped sharply in recent months. The Ifo index for August, which goes print on Tuesday, will give investors some insights into the current state of the German economy. Despite signs of slower growth in the Euro-zone, the ECB has been reluctant cut rates due to sharp rise in CPI inflation this year.

The Japanese economy contracted at an annualized rate of 2.4% in the 2Q due in part of the 3.3% drop that occurred in industrial production during the quarter. In my view, the Japanese economy has slipped into a mild recession already. The BoJ has confirmed no easing bias, but the economic slump should keep alive market speculation of a rate cut.

In my view, the USD is overbought, with the 15-day RSI jumping above the 80 threshold for the first time since the Asian currency crisis in August 1997. Risk reduction played a major role at that time, but the risk was emanating from Asia, not from the US as it is today. In this context, recent USD gains continue to appear at risk, perhaps increasingly so. the Russia-Georgia dispute, which appeared to be winding down a week ago, has lingered longer than initially anticipated. The uncertainty the dispute has brought to the geopolitical arena could be partly responsible for extending USD gains in recent weeks, also reflected in the out-performance of the JPY versus most European currencies in recent weeks. In this context, EUR/USD and EUR/JPY are likely to continue to reflect the political uncertainties in that region which is crucial for European energy supplies.