The economic calendar looks tame in European hours, with the July edition of Switzerland’s ZEW Survey of analyst sentiment the only notably item on the docket. The metric rebounded sharply in June, registering the first positive reading in close to three years. The forward-looking bias of the survey’s respondents tends to see it lead actual trend changes in the exchange rate, however, so a meaningful near-term impact is unlikely barring a wild deviation from recent figures once the data crosses the wires.

On balance, forex price action is likely to fall in with risk trends once again as earnings season continues, with notable reports due from: Carrefour SA, Europe’s largest retailer; Novartis AG, Europe’s second-largest pharmaceutical firm; Accor SA, Europe’s top hotel company; and SAP AG, the world’s biggest computer services provider.

Asia Session Recap:

New Zealand’s Consumer Price Index declined less than economists expected in the second quarter, with the annual inflation rate falling to 1.9%, the lowest since the three months ending September 2007. Forecasts were pointing to a 1.8% result ahead of the release. Transportation and transport supply costs led the drop, -6.6% and -9.5% from a year before. Lower fuel prices and cheaper airfares were likely behind the drop-off: gasoline prices fell 17% from a year before while the average cost of air travel tumbled 21% in the same period as companies slashed prices to entice consumers amid the global recession. The Reserve Bank of New Zealand has said that they expect inflation to fall below the 1-3% target range this year but return to desirable levels by early 2010. RBNZ Governor Alan Bollard added this week that New Zealand is likely to recover faster than its main trading partners from the current downturn, boosting expectations that the central bank will begin raising interest rates sooner rather than later. Indeed, overnight index swaps now show the market is pricing in 79 basis points in tightening over the next 12 months, second only to the Federal Reserve that is seen hiking rates by 82bps over the same time frame.

Separately, the Business NZ Performance of Manufacturing measure rose to 46.2 in June from 43.1 in the previous month. The result suggests the sector continues to shrink, albeit at the slowest pace in 9 months. New Orders led the metric higher, expanding for the first time since April 2008. In annual percentage terms, new orders and output saw positive growth for the first time in at least 7 months. Manufacturing figures have been stabilizing in most industrial countries in recent months as producers adjust inventories to current demand levels; it remains to be seen if this process will translate into a sustainable recovery going forward.

Japan’s Tertiary Index surprised to the downside, showing service demand shrank -0.1% in May versus expectations for a 0.4% gain. It seems job losses are starting to catch up with the world’s second largest economy even as the effects of the government’s massive 25 trillion yen fiscal package continue to be digested. Consumption is likely to remain lackluster as the unemployment rate continues to climb, weighing on overall economic growth and holding back recovery from the worst Japanese recession since World War II. Yesterday, the Bank of Japan slashed its GDP growth forecast for the 2009 fiscal year and said consumer demand “remains generally weak.”

The New Zealand Dollar tumbled 50 pips in a mere 15 minutes late into Asian trading as Fitch cut its long-term credit outlook for the smaller antipodean nation to “negative” from “stable”. The ratings agency expressed concern over New Zealand’s medium-term growth outlook given its “persistently large current account deficit and rising foreign indebtedness”. Fitch warned that the government may need to implement a “stronger fiscal adjustment” after Prime Minister John Key cancelled tax cut plans on fears of the ballooning public deficit. Fitch Asia Pacific Director Ai Ling Ngiam said New Zealand could “fall into a low growth trap”, an allusion to Japan’s infamous “lost decade” of stagnant economic performance. Fitch added that the volatility of the New Zealand Dollar complicates the necessary adjustments, with the currency “more responsive to global financial conditions than to domestic economic fundamentals.”

On three previous occasions, government has run deficits 11 consecutive months.  As the Treasury extends efforts to boost the economy, pressure from automakers and banking continues to pressure the government.  

Historically, June is a productive month for the economy.  In June 2008, the budget benefited from a $33.65 billion surplus.  According to the Treasury Department, the largest single monthly deficit on record was the $194 billion accrued in February 2008.

June concludes the first nine months of the government’s fiscal 2009.  The deficit for this period now stands at $1.086 trillion.  The budget deficit through June 2008 was $285.85 billion. 

Economists now project the Federal deficit will surpass the 11-month streak and continue on deep into the third quarter 2009.  Citing the breadth and depth of the unemployment crises, economists now expect a deficit of $1.5 trillion in fiscal 2009. 

John Silva of Wells Fargo Securities explained; “The Federal Deficit is now at a post World War II high and is likely to continue to rise in the near term as deficits rise and the economy remains weak.  These deficits will influence the allocation of global savings for the foreseeable future.  No doubt where this train is going.”

Treasury Operations Soar

In May 2009, The White House predicted the deficit for fiscal 2009 would top the $1.84 trillion mark.  The 2008 deficit was $459 billion.  The government has extended $700 billion in Rescue Funds through its Troubled Asset Relief Program and has launched its $787 billion stimulus package.

While only 10% of the stimulus package has gone out the door, the government is under pressure to start spending.  Obama’s stimulus package may be the wild card in the employment and housing deck.  Until that card is played, unemployment, housing and health care remain big-ticket items confronting the Obama Administration and prolonging the longest and deepest recession in history while creating the escalating deficits.

The government income and expense sheet shows income of $215.36 billion, down from $259.91 billion in June 2008.  The decline is the 14^th consecutive month that year over year income has declined.

Government spent $309.68 billion in June compared to $226.37 in June 2008.  $5.4 billion was spent on mortgage-backed securities from Fannie Mae and Freddie Mac.   

Geithner Paints a Better Picture

The equity markets appeared unbothered by the magnitude of the government deficits as investors held optimistic views of Goldman Sachs and other anticipated earnings reports.  Treasury Secretary Geithner, speaking in London, suggested that the U.S. and Britain were headed for a period of growth rather than the originally expected period of double-dip recession.

“We have a very powerful set of policies in place, coming on stream.  I think there is a very good chance we will see the U.S. economy and the world economy get back to recovery, get growing again, over the next few quarters,” said Geithner.

Geithner acknowledged that risks and unexpected challenges lay ahead but that; “policies have been very effective in arresting, in mitigating the forces of the storm and we’re starting to see a better basis for recovery starting to be made in the U.S.” 

Geithner’s suggestion that several economies, specifically Asian economies, would lead the charge away from the recession gained credibility as Japan reported industrial output rose 5.7% in May. 

Meanwhile, Li Dongrong, an assistant governor of the People’s Bank of China, said that China’s banks issued 1.53 trillion yuan ($223.9 billion) in new loans in June.

US Inflationary and Retail Sales Report

Consumer prices in the US economy are likely to remain muted, helping the Federal Reserve in keeping to the currently low interest rate of 0.25 percent. As long as prices continue to remain steady, 0.1 percent in the last month over month comparison, sentiment will continue to side with monetary policy that is set to be accommodative through till year end.   This simply means that it remains less likely that policymakers will vote for an interest rate hike till 2010. On the other hand, traders will be looking for a positive up tick in consumer spending through the US retail sales report on Tuesday morning. Although hopes are high for another positive rise in sales for the month of June, speculation is showing some pessimism of a sub par posting. Support for the theory comes from the recently released monthly retail industry report that showed a double digit decline in year over year sales figures.

US Federal Reserve Meeting Minutes

With the decision already being released, traders and analysts will be looking at the meeting minutes report to find further clues and insight into potential future decisions that will be taken by policymakers. Although it is quite clear that rates will stay low for some time, the thin possibility of a mention on inflation could spark the curiosity of the most dovish of interest rate speculators. As a result, eyes will be targeting anything that could stray from what central bankers have noted in the past - particularly low interest rates, long period of time.  The sentiment has been reflected in the short term fixed income markets as the front end of the curve has rallied over the last 48 hours.

Bank of Canada Consumer Price Index

Although not as popular a trade as the US counterpart, the Canadian CPI report for the month could spark some noteworthy action as production has shown signs of life in recent months. Residential construction, for the third straight month, advanced even as employment prospects continued to dim.  According to the most recent Statistics Canada report, unemployment in the economy rose by 0.4 percent to 8.4 percent, the highest in 11 years. As a result, the recent spate of economic activity could spur some inflationary pressures, turning the currently overwhelming dovish sentiment. However, market participants are likely not ready to jump into a hawkish mindset yet. The fact that the CAD has appreciated by an impressive 11.4 percent since the beginning of year can do a lot to quell nascent inflationary pressures and make central bankers rethink raising interest rates any time soon.

Will construction push central bankers to raise?

Retail Sales Weakness Continues

With the US economy down in the dumps, plenty of consumers have turned to saving their hard earned cash rather than feeding their desires for the latest fads.  This has caused a reversal of sorts in lifestyle, visibly seen through a savings rate that has soared above zero percent in the past two years.  Hitting a 15 year high, US personal savings is now at 6.9 percent according to the Bureau of Economic Analysis, compared to negative figures as late as 2007.  As a result, retailers have been hit hard, reverting to massive deductions in prices for existing inventory in order to maintain market share.  The strategy hasn’t been working.  According to the most recent monthly report on the health of the industry, sales at stores open at least a year in major retailers have seen an average 14.7 percent decline compared to last year’s numbers.

Retailers Seeing Red

Although some have seen the recent slump as a result of poor weather and even worse economic news, the fact remains that there were no rebate checks to boost demand.  Last year’s tax rebate checks helped to boost spending slightly as this year’s stimulus payments went straight to the savings account. As a result, the back-to-school season, widely watched by industry analysts, is looking to be a lot like last Christmas with further discounting by department stores anticipated for the upcoming school year.

What Does This Mean For The Euro?

A return to risk aversion, due to further concerns over economic weakness, may spell disaster once again for the euro as similar conditions and bearish expectations helped to lead the single currency lower this time last year.  As retail sales figures began their precipitous drop in the month of July 2008, corresponding with the market meltdown, the US dollar appreciated by as much as 23 percent against the euro before bottoming out at 1.2328 in October.  The same conditions apply here as macro traders will likely be forced to buyback the greenback, exiting out of their positions in other riskier assets (Euro, Aussie, Sterling) with the rest of the market looking for safe haven currencies on doubt of a sustained global recovery.

Subsequently, during the last 5 months of 2008, US policymakers continued their rate cutting scheme in earnest, hoping to alleviate a tightened credit market and a massive market exodus.  Should retail sales figures be to the low side of estimates, the same sentiment will likely keep Fed Chief Bernanke on the side lines, reinforcing earlier statements that monetary policy will be “very accommodative” due to a continually deteriorating economic environment in the near term.

Turning to the continent, Germany’s ZEW Survey of investor confidence is expected to see the headline figure rise to 47.8 in July from 44.8 in the previous month, the ninth consecutive improvement and the highest reading since May 2006. The broader Euro Zone ZEW result is set to follow a similar trajectory, rising to 44.0 in July. Still, improvements in the metric are unlikely to offer much near-term support to the Euro: the ZEW reflects the forward-looking perspective of the poll’s respondents, meaning the reading tends to lead the single currency by a significant margin such that the trend in the closely watched Expectations component of the report has corresponded inversely with major tops and bottoms in the exchange rate. Indeed, the ZEW began to trend lower in the beginning of 2006 and bottomed out in July of last year; the same end-points mark the boundaries of the last major uptrend in EURUSD that saw the pair test record highs above 1.60. If the same dynamic continues to hold, traders can expect the European unit to set a bottom as the ZEW tops out, a scenario that seems unlikely for the time being considering how much ground remains to be covered before the economy regains firm footing. In fact, according to the International Monetary Fund (IMF), the Euro Zone as a whole and Germany in particular stand apart from most industrialized countries in being expected to see GDP contract in 2010.

Overall, risk sentiment is likely to usurp the limelight once again in European trading hours. Second quarter earnings announcements from Goldman Sachs and Johnson & Johnson late into the session are likely to be of particular significance, with traders looking to Wall St to set the pace for where risky assets go in the days ahead. Indeed, forex markets largely oscillated in overnight trading despite hefty gains across Asian stock exchanges with the upswing in confidence already priced in during US hours.

On balance, price action is likely to fall in with trends in risk sentiment. US Dollar saw buying interest overnight as Asian stock exchanges tumbled close to 2% on average, boosting demand for the safety-linked currency. The same dynamic is set to continue in European hours with equity index futures slipping deeper into negative territory.

However, the British Chamber of Commerce has urged policymakers to expand their asset-buying scheme by 25 billion pounds, saying a recovery is “not guaranteed”; the call for further easing has been echoed by the Shadow Monetary Policy Committee, a group of independent economists that meet at the Institute of Economic Affairs. The disparity in growth forecasts is also notable: the IMF expects the UK economy will grow 0.2%, a survey of economists conducted by Bloomberg points to a 0.9% result, while the OECD says growth will be flat in 2010. If reality proves to side with the pessimists in the days ahead, slower output growth could well translate into a steeper than expected decline in inflation, calling for the BOE to step up easing efforts.

The final revision of Germany’s Consumer Price Index is expected to show that the annual inflation rate came to a standstill in June. Leading indicators point to continued weakness ahead: producer prices have fallen to the lowest in over two decades, foreshadowing lower consumer prices ahead as lower wholesale costs are reflected in the final price tag. This suggests inflation is set to dip into negative territory in coming months, threatening the Euro Zone’s largest economy with the onset of deflation. Such a development is all but certain to take the currency bloc as a whole along the same trajectory, threatening to commit the region to long-term stagnation as consumers and businesses are encouraged to wait for the best possible bargain and perpetually delay spending and investment.

Separately, Germany’s Trade Balance surplus is set to shrink 9.0 billion euro from 9.4 billion in the previous month. The broader Current Account surplus which includes cross-border capital flows as well trade in goods and services is set to narrow to 3.7 billion euro, the lowest in fourth months. A survey of economists conducted by Bloomberg calls for the external sector to contribute just 3.1% to overall economic growth this year, the lowest in five years, as lackluster global demand continues to weigh on overseas sales of German products. Indeed, exports are expected to add just 1.5% in May after falling by a whopping -5.0% in the previous month, putting overall outbound volumes at the lowest level since May 2005.

German Industrial Production is expected to see the annual rate of decline ease to -20.0%, rebounding from a record low at -21.6% recorded in the previous month. As with other industrial economies, smaller negative numbers in the headline figure are to be expected in the months ahead as firms adjust inventories to lower levels of global demand. That said, overall output growth is likely to remain weak as overseas sales remain lackluster with most of the world still mired in deep recession. Indeed, the International Monetary Fund reckons world trade volumes will shrink -11% this year and rebound by a meager 0.6% in 2010.

In Switzerland, the seasonally adjusted Unemployment Rate is set to rise to 3.6%, the highest in over three years. Job losses will weigh on disposable incomes and discourage spending, weighing on overall economic growth. Indeed, the UBS Swiss Consumption Indicator fell to the lowest level in 5 years in May. The onset of deflation may further complicate matters: CPI shrank -1.0% in June, the most since 1959; the economy may slip into a long-term period of stagnation if expectations of lower prices are to become entrenched, encouraging consumers and businesses to perpetually wait for the best possible bargain and hold off on spending and investment.

With consumer agencies and reporting services under pressure to tell it like it is, Standard & Poor’s released a report on Monday that puts the recent National Association of Realtors (NAR) monthly housing report in proper perspective.  Standard & Poor’s raised its projections regarding losses expected to result from risky loans backing U.S. mortgage securities.  The new S & P report indicates that as many of 40% of these loans will fail.

The increased projection for subprime and Alt-A Residential mortgages arrives at a time when the real estate market is reeling from more than 30% value losses and when the market is oversupplied with short sale and distressed inventory.  S & P expects their report to have a significant impact on bonds originally carrying AAA ratings.  Many bonds are now valued based only upon the remaining interest payments and are trading for cents on the dollar.

For investors who are already feeling the pinch from 30-40% investment portfolio losses, the biggest decline in the housing market since the 1930’s has pointed out the fragile composition of the recovery.

The S & P report included the following projections for subprime and Alt-A mortgages: 

• Subprimes originated in 2005 - 14% from 10.5%
• Subprimes originated in 2006 - 32% from 25%
• Subprimes originated in 2007 - 40% from 31%
• Alt - A originated in 2005 - 10% from 7.75%
• Alt - A originated in 2006 - 22.5% from 17.3%
• Alt - A originated in 2007 - 27% from 21%

Loss severities include foreclosure costs, liquidation costs, carrying costs and declines in property values.  Standard & Poor’s projects loss severities for subprime mortgages originated in 2006 and 2007 will be 70%.  For Alt - A bonds issued in the same years, loss severities are projected to be 60%.  S & P reported that loss severities have exceeded 100% in many cases.

The report included a summary that highlights the depth of the housing decline.  “We have observed increases in loss severities and we expect them to continue to rise until we reach the trough of the market value decline, which we believe will be in the first half of 2010.” 

Seven Crippling Factors

The Standard & Poor’s July 6^th release includes forecasts that subprime defaults for loans originated in 2005 will top 11%, as 2006 subprime defaults are expected at a 30% rate while 2007 subprime defaults will exceed 49%. 

The startling report comes at a time when homeowner’s balance sheets have been devastated.  The subprime lending policies are a leading cause of the recession and have come under fire by the Obama Administration.  The Standard and Poor’s report seems to underscore the Administration’s initiative for the creation of a new Consumer Protection Agency.  While the new agency may prevent similar lending practices in the future, the housing market’s recovery will need support from seven key components.  

• Unemployment - Last week’s unexpected rise in unemployment put a lid on the recovery. With unemployment rates expected to exceed 10.6% by 2010 and with real unemployment projected at more than 15% in certain U.S. urban areas, the full depth of the housing crunch may yet be felt. Predictions are that employment will be the last economic component to recover.

• Tight Credit - Under close scrutiny and unsure of true housing values, banks are playing it close to the vest on mortgage lending policies. With the recent increase in defaults from prime borrowers, caution continues to be the word in mortgage lending.

• Consumer Confidence - While overall consumer confidence suffered in the wake of the newest unemployment report, Standard & Poor’s indicates that consumers see the current market as one with opportunity. However, the prevailing mood is that the market has yet to bottom.

• Price Pressure - “Move up buyers” are critical to the housing recovery. Burdened with homes that are undervalued and in some cases underwater, meaning that the value is below the financing level, “move up buyers” are out of the market. A current bill before Congress offering all homebuyers, not merely first homebuyers, a $15,000 tax credit may help offset equity losses and bring this necessary element back to the market.

• Short & Foreclosure Sales - The NAR reports increases in Pending Sales and Closed transactions but the majority of transactions are short and foreclosed properties. Additionally, many pending short sales do not actually close. Most of these transactions are from investors, not homeowners. As investors are “buy and sell” opportunists, these transactions are likely to negatively impact housing prices until inventories are recycled.

• Appraisal Revisions - The National Association of Realtors has asked the New York State Attorney General to investigate new changes in the Home Valuation Code of Ethics (HVCC). On May 1^st, Freddie Mac has insisted on strict compliance with these new policies that are negatively impacting home valuations and driving the market to new lows. The NAR reports that the automated appraisal process is causing many appraisals to fall below agreed purchase prices and causing contractual failures.

• Interest Rates - While rates remain favorable, they are rising. In a market filled with negatives, the new interest increase is just one more draining component. If rates go higher, sale will decline further.

A housing recovery will not occur until all these components show positive trends.  In the meantime, there are no quick fixes on the horizon.  The housing adds fuel to the Obama Administration’s push for an increased stimulus package.