Oct. 15 Beige Book Report

Oct. 15 Beige Book Report

Summary Outlook:
The Beige Book is most likely to highlight the downside trajectory of the US economic outlook and reinforce widespread views that the US economy is headed for a recession. But that is mostly 'old news' for markets, so the subsequent market reaction is more difficult than usual to gauge. However, we think FX will take the lead from stocks and look for JPY-crosses to dominate afternoon trading in FX. For the reaction to the Beige Book, we think that market sentiment remains exceptionally fragile and that the risks are skewed toward another slide in US stocks, which will drag down JPY-crosses (e.g. EUR/JPY and AUD/JPY) in the process. But there is likely to be significant two-way price action, as those who think further declines in shares are needed battle it out with those who think prices have already overshot the downside relative to the future outlook.

In terms of a trading strategy, recent volatility precludes our assigning concrete price levels, but we will take a crack at presenting a strategy based on our most likely scenario. We would look to get short JPY-crosses going into the Beige Book release and look to partially cover those shorts on the initial negative reaction to the headlines, probably within the first 5-10 minutes post-release. If prices continue to move lower, we will have only a partial short remaining open. If prices recover, though, we would then look to re-sell JPY-crosses on any rebounds (which could be substantial, i.e. 100-150 pips) as bargain hunting materializes. But we expect such buying to be short-lived. We would look for the ultimate reaction to then return to weakness. We would be actively taking profit on such further weakness, gradually reducing the position and lowering stops to protect profits, given the extreme volatility seen lately.

Research Analysis:
Here is how we expect the characterizations of consumer spending, inflation, real estate and lending to have evolved.

• Consumer spending will probably be characterized as worsening given that US consumers grappled with the biggest financial crises since the Great Depression and likely continued to buckle down as a result. The previous Beige Book noted a "retrenchment in discretionary spending" and we look for this pattern to continue. Retail sales for August declined -0.3% and are expected to drop another -0.7% in September. Meanwhile, consumer confidence measures have not been pretty. The IBD/TIPP economic optimism index for October fell to a paltry 41.1 from 45.8 in the fifth weakest reading ever. This coupled with a -20% drop in stock prices since the end of the period covered by the last Beige Book suggests a pretty negative assessment of consumer spending is in store.
  
  
• Inflation is expected to be toned down quite a bit from the previous Beige Book. Most of this will come from the recent plunge in oil and other commodity prices. Oil prices have collapsed more than -30% since the last Beige Book period to just under $80/bbl. Meanwhile, the CRB commodity price index has come off more than -24% in that same period. So while the last Beige Book noted "continued price pressures" we expect this latest one to show a marked downturn in inflationary forces. The Fed has acknowledged very recently that inflation continues to wane and has hinted that it is no longer an impediment for cutting rates further if the current financial crisis warrants it.
  
  
• Real estate is likely to have remained in the dumps while lending looks to have tightened further across the board. Existing home sales plunged -2.2% in August and are expected to have slipped another -0.2% on top of that last month. New home sales got decimated -11.5% in August and are expected to have remained week in September as well. Credit measures meanwhile were extremely tight over the last month. Indicators of interbank lending such as Libor and SWAP spreads blew out to all time highs, in an indication of heightened counterparty risk. This likely trickled down to consumers and firms in the form of less credit extension. We expect credit to remain tight until the latest measures by the US government - buying toxic mortgages from banks and outright capitalization of bank balance sheets via preferred stock purchases - take effect.