Fast lane China, slow lane US

With global equity markets having rallied over recent weeks, announcements from the central banks in both the US and the UK removed the wind from the sails of economic recovery.

On Tuesday, the US Federal reserve downgraded its outlook for the US recovery as the FOMC agreed to begin reinvesting proceeds from expiring mortgage backed securities into Treasury bonds, a move which will ensure that the bloated US balance sheet will remain at current levels as opposed to naturally decline. This was followed by the Bank of England cutting its growth outlook for the UK economy, pointing to vulnerable business and consumer confidence, as well as tight bank lending and the government's spending cuts.

Nobody has stated that the rehabilitation of the global economy was going to be a straightforward process… events this week are a perfect illustration of the sort of announcement which will continue to periodically check the progress of equity markets. The Fed’s actions are not in themselves a major U-turn however the quick shift from talk of tightening monetary policy to what is being termed as QE Lite, has clearly spooked investors.

As we have stated on numerous occasions, this is no ordinary recovery and we expect the global equity markets to remain torn between bouts of investor confidence and the issuance of downbeat economic data. Indeed, it is the latter in the driver’s seat at present with the US reporting that jobless claims had ticked up to a four-month high. Unemployment in the UK is also providing policymakers with plenty to think about as official data showed a sharp rise in long-term unemployment and a smaller than expected fall in the number of people claiming jobless benefits.

As both the US and UK economies struggle to get back on their feet, the Chinese economy is hurtling along at breakneck speed. The contrast between the established and new economies is fascinating as one digs into its tool kit to repair a flat tyre while the other is hoping red hot brake pads don’t give out.

The two problems are not unrelated, as any US economic envoy to Beijing will attest. The key link between the two is the value of the Chinese currency. The US simply says the yuan is undervalued and artificially restrained from rising. The Chinese say, that’s our business, not yours.

The low value of the Chinese currency propels huge volumes of exports of its goods, especially to the US. The import prices of Chinese goods in America are therefore very cheap creating a double whammy problem for the US. Consumers get to buy lots of cheap goods, and they buy the Chinese goods in place of American made goods, therefore displacing American jobs. That’s the US version.

China has been under relentless pressure from the US to let the value of its currency rise to a more realistic level. The Chinese have, of course, politely listened but not hurried into action.

Beijing announced a de-pegging of its currency value to the US dollar on June 19 this year, but its US critics say this has been too tightly managed to be of any consequence. The yuan has appreciated by 0.9% against the US dollar. In another step towards appeasing the Americans (and others), China changed its rules allowing the sale of yuan-denominated financial products in Hong Kong giving companies greater access to yuan funds.

China’s currency policy is still dictated, to a large extent, by the rapid growth of its economy. Full year growth for 2010 is still expected to be in the range of 10-11%. This is the view of a government think-tank, and is above the level other forecasters have been expecting. The huge demand for housing has been at the epicentre of the hot growth so the government has focused heavily on this aspect, particularly on property speculation.

The US is fighting its own battle on the value of its currency. The latest piece of dreary news on the economy was the disappointing payroll data last week that showed 131,000 jobs were lost in July, way more than forecasters had hoped. The data has many observers thinking that the Federal Reserve will have to take action again to stimulate the economy. The mantra for two years now has been “near zero rates” for “an extended period of time” and that won’t change. It also pumped US$1.7 trillion into the economy by buying longer term Treasury securities and mortgage-related debt.

Some observers in the US are calling for a “Hail Mary” pass – a football term describing a desperate, long, hopeful last pass before the end of a game – in order to stimulate an economy that has thus far not responded to the more traditional methods. There seems to be no shortage of advice for the government and the Federal Reserve, but the decision will not be simple.

It begs the question, if the US is still struggling to ignite its economy nearly two years after the GFC began, will Europe and the UK follow a similar pattern?

The G20 meeting in November, then, should be a fascinating confabulation of ideas that worked and those that didn’t. Remember, the Europeans are favouring the fiscal restraint path to reduce government debt, while the US has favoured a growth path for the economy ahead of pulling back on spending.

The FTSE 100 has recently broken back below its 200 day moving average but looks to have found support at the confluence of the 50 day moving average and the blue inverse head and shoulders neckline support. There are currently two potential scenarios; the first being a bullish inverse head and shoulder reversal pattern that suggests a retest of the 2010 highs. However, given the recent sell off we also look to have completed a bearish rising wedge pattern that would give us a downside target that suggests a retest of the 5,000 level.

Both scenarios look equally valid at present which may explain the tight trading range that the market has been in for the past few weeks. A break above the 200 day MA or below the 50 day MA could determine the direction of the market for the next few weeks. 

The Dow Jones Industrial Average has now pulled back below its 200 day moving average but has managed to find support at the 50 day moving average. However, of some concern is the recent bearish MACD crossover which suggests that the trend may be changing from up to down. It is still too early to tell if this is a shake out of weak longs before a surge higher or the beginning of something more ominous. A break of the 50 day MA could result in a retest of the psychologically significant 10,000 level.

Gold found strong support at the US$1,157 level, which led to an almost vertical run to reach a recent high of US$1,214.25 on August 12. The 50 period moving average (green line) also sat at this level which offered firm resistance, capping the recent advance.

A sustained break above the US$1219 resistance level could potentially mark the end of the short term weakness seen during mid June to the end of July. Should this scenario play out, the potential upside is back towards the June 21 high of US$1,265.

On the flipside, should Gold retrace from current levels, downside support is located at the 200 period moving average (red line) at US$1,154.