Don't Blink; You Could Miss Something

Sentiment regarding the weak euro and chances of new rate hikes is shifting in the wake of economic data indicating a slowdown.
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One could get whiplash by trying to keep up with market sentiment.

Two weeks ago, conventional wisdom held that thus far the rate hikes by the

Federal Reserve

weren't proving effective and that

Greenspan & Co.

would have to get more aggressive. Talk even surfaced that as many as another 75 basis points of tightening were needed before the November election. Conventional wisdom also held that the euro's weakness was structural in nature, reflecting an unattractive investment climate.

Now it's all different. A string of economic data has come in weaker than expected over the past week or so, culminating in Friday's soft employment report. The private sector as a whole cut jobs for the first time in four years. Manufacturers cut 17,000 jobs in May, after increasing payrolls by 10,000 in April. The construction sector shed 29,000 jobs on top of the 34,000 lost in April. The 64,000 jobs lost in retail is the largest decline since January 1991 and represents about a third of the jobs created in April.

The jobs data are especially important because they are the first significant comprehensive economic data of the month, and based on them we can glean insight into the various other reports that will be released in the coming weeks. For example, the decline of jobs in the manufacturing and construction sectors, coupled with the small decline in the work week, suggests soft output and

construction spending reports. The inconsequential penny-an-hour increase in hourly earnings warns that personal income may post only a small rise. This, in turn, is consistent with a further pullback in consumption that has been seen in a number of recent reports.

The labor market is also important because Greenspan has flagged the shrinking pool of available workers as a potential inflationary threat. The weak jobs report prompted a sharp reassessment of the likely trajectory of Fed policy. Through May 31, the July

feds funds futures contract had reflected 100% confidence that the Fed would raise rates by 25 basis points at its June 28 meeting. The weak data in the

National Association of Purchasing Managers

report left the market about 80% confident.

The jobs data was a big blow to the market's confidence of a rate hike. In fact, the market now suspects the odds are greater that the Fed stands pat. Rather than a sign of new aggressiveness on the part of the Fed, last month's 50 basis-point hike is beginning to take the appearance of a signal that it may pause to monitor the impact of its policy to date. However, to be clear, the market is not concluding the Fed is done, but there does seem to be a light at the end of the tunnel. The September fed funds futures contract is still reflecting high confidence of one more quarter-point hike before the election.

No More Euro Trashing?

Belief that the U.S. economy is slowing is helping fuel a swing in sentiment toward the euro. Increasingly, the market appears to be taking a more constructive view of the euro. I have long argued (since last June) that the euro's fundamentals had shifted, growth was accelerating, important capital market reforms were indeed taking place, corporate and tax reforms were being implemented. Arguments that the euro was weak for structural reasons seemed unconvincing to me. The one piece of the fundamental jigsaw puzzle that had been elusive, the slowing of the U.S. economy, might be at hand.

Arguments about left-of-center governments running Europe, the lack of credibility of the

European Central Bank

and direct investment outflows will all quiet down as the euro strengthens. Sentiment tends to follow the price action, rather than the other way around. With its recent gains, the euro has barely begun to recover. The medium-term outlook would be enhanced if the euro can push above the $0.9500-$0.9600 area, where a number of technical indicators converge.

When the dollar is weakening, market observers often trot out stories about the U.S. current account deficit. However, as always, the key is in the financing of that deficit. The impressive showing of both U.S. stocks and bonds while the euro has been recovering suggests foreign investors are still prepared to give us money (through portfolio and direct investment) to buy their goods (our trade deficit). This means that the dollar is unlikely to fall precipitously.

Then again, talk of a hard landing in the U.S. economy also seems more than a touch premature. The Federal Reserve and most market participants have been forecasting a slowdown in the economy for quite some time. Many players are likely to see what they are looking for, but keep in mind that quarterly growth numbers are fairly volatile. Recall that the U.S. economy only expanded by 1.9% (at an annualized pace) in the second quarter of 1999, and that was no harbinger of a slowdown. Similarly, the 2% growth in the second quarter of 1998 was the weakest of that year after a 7% expansion in the first quarter.

Marc Chandler is the chief currency strategist for Mellon Bank. At the time of publication, he held no positions in the currencies or instruments discussed in this column, although holdings can change at any time. While he cannot provide investment advice or recommendations, he invites you to comment on his column at

chandler.m@mellon.com.