Ever since March 2009, the relationship between the dollar and U.S. equities has behaved like similar ends of a magnet. When equities rose, the dollar fell and vice versa. Analysts blamed the role of the government’s lenient credit policy for this inconsistency.

Now, other factors have come into play. The dollar and equities seem to be reacting similarly to national and global economic events. On the national scene, there are signs that employment is stable, trending upwards and definitely has the attention of the Obama Administration.

While the necessary spirit of cooperation is at record lows in Washington, there appears a hint of progress.  The $15 billion jobs bill is progress and consumer spending is on the rise. Meanwhile, more small businesses have indicated a willingness to hire. 

The Federal Reserve had such favorable credit terms that the effect was to drive the dollar down and equities up. Basically, investors were using a currency that cost virtually nothing to acquire undervalued equities. It may have been and still may be a false economy, but it stemmed the tide at a critical time.

With recent statements from Fed Chairman, Ben Bernanke, the future of the dollar looks good. Bernanke has outlined a series of actions designed to strengthen the currency. Interest rate hikes, a cessation of purchasing distresses assets and certain progressive credit reforms are all positive steps for the dollar.

Timing is Everything

The Fed’s changes have been timely. As the euro zone tries to untangle the financial chaos in Greece, the euro has suffered a significant downturn. In 2010, the euro has dropped 4.8 percent against the dollar and a whopping 7.6 percent against the yen.

On Monday, French President Nicolas Sarkozy said there are plans to rescue Greece. He added that if the fiscal crisis in Greece worsened the euro would be hurt. Currency trading has been light as investors are waiting and watching Prime Minister Papandreou’s attempts to control the damage.

But, Greece may well be just the first block in the tenable euro zone to tumble. Spain may be next with Italy, Portugal and Ireland in the wings. With talk of more quantitative easing in Great Britain and a fair amount of intense disagreement between the liberal and conservative factions in England, the pound is wavering under the pressure.

Australian and New Zealand dollars rose favorably against the dollar on Monday.

In 2010, the S&P 500 is up 2 percent. The dollar has risen 3 percent. Helping the equities markets are a new infusion of merger and acquisition activity. The Options Exchange Volatility Index (VIX) is a highly regarded index indicating markets attitudes. The VIX has fallen below 18 percent and is trending towards the year’s low.

As the Oracle of Omaha suggested, things are looking up and it is a good time to invest, in the dollar and in equities.

On Thursday, The Federal Reserve offered a generally favorable assessment of the nation’s economy as the Federal Open Market Committee (FOMC) supported holding the central bank’s interest rates steady in a 9-1 vote.  Kansas City Federal Reserve Bank President Thomas Hoeing, who is opposed to the Fed’s sustained exceptionally low interest rate policy, registered the lone vote of dissent.

The FOMC statement lacked assurances about the strength of the recovery, instead offering carefully controlled suggestions of improvement. The pace of the recovery was described as “moderate for a time” and the overall recovery was depicted as “likely to remain weak.”

Addressing the ongoing housing crunch, the body affirmed its commitment to allow the $1.43 trillion program for the purchase of mortgage-backed securities to expire at the end of March.  Analysts have expressed fear about the cessation of the program that has bred some stability into a tenuous marketplace.  The Fed pulled back from its more positive forecast about inflation saying price growth will likely remain subdued.

The Markets Reacts

The U.S. dollar reacted positively to the Federal Reserve statement pushing the euro below $1.40.  Hoenig’s dissenting vote was interpreted as an open door to a tightening of monetary policy.  The majority of primary dealers expressed the view that to combat inflation, the Fed would begin to raise rates this year.

After a sharp downturn last week, the equity markets seem to be stabilizing.  Federal Reserve Chairman Ben Benanke’s nomination is expected to be voted upon in Congress on Thursday.  Equity markets have stumbled as his confirmation has become less certain.

The Federal Reserve issued other definitive statements.

• The economy grew in the 3^rd quarter of 2009 and is presumed to have grown more aggressively in the fourth quarter.
• Consumer spending remains subdued.
• The real estate market is showing signs of renewed weakness.
• Several emergency lending programs will be halted as of February 1, 2010.
• Favorable short-term lending to banks will halt in 2010.
• Dollar swapping with foreign central banks will cease on February 1.

On the Street

Traders supported a position that short-term interest rates will increase in the third quarter of 2010.  U.S. short-term rate futures turned lower after the FOMC policy release.  Expectations are that the Federal Reserve will maintain an “ultra loose” monetary policy into 2011.  Futures on federal funds fell to session lows following the FOMC report.

The benchmark 10-year Treasury yield closed at 3.64% or 2 basis points higher than on Tuesday. The yield on 10-year swaps over Treasuries closed at 12.25 basis points, down from session highs of 13.25, but up from the 12.0o on Tuesday.

George Ball, Chairman and CEO of the Sanders Morris Harris Group, drew the following conclusions about the Fed’s two day meeting;

“The most important part of the Fed’s announcement and perhaps the most unsettling for investor’s over the short-term is that they are giving the March end-date to purchases of mortgage-related securities.  That will give us a true test of the strength of that vital marketplace, to see if it can stand on its own without being propped up by big brother.”

Equity markets are rising.  Crude oil is on a tear.  And the euro has everyone worried.  From European central bankers to the regional exporter, even to the U.S. traveler looking at an even more expensive European getaway, people are paying attention when it comes to the Euro.  And why not?  The currency has skyrocketed higher against the US dollar in recent months, making an impressive 20 percent gain since hitting the 1.2500 support back in February.  The scary thing is, the gains may be more to come as the current momentum seems to be bent on some key factors.

Economic Pessimism

Pure fundamental reasoning for the recent downturn has some in the market convinced that further dollar weakness is sure to come.  Although the European economy is down in the dumps as well, the masses seem to be focusing on the growing twin deficits currently held by the U.S.  The same concerns helped to support a higher Euro valuation just five years ago, when estimates had calculated a fiscal shortfall of $700 billion.  Chump change to what experts are now shuddering at when considering the plethora of programs that have been approved by the current administration.  Participants of the era will also scarcely remember falling employment as well.  All in all, current budget deficits will have to be funded by an increasing number of Treasury debt issuance, adding to an already bloated credit bill that is surely to decrease the confidence in U.S. based debt.

Carry Trade Bandwagon

It used to be the Japanese yen that was the butt of all carry trades in the last two to three years.  However, now it seems that the greenback is the funding currency of choice.  It makes perfect sense as the Federal Reserve has made significant cuts to the benchmark interest rates over the last 20 months in order to accommodate the underlying credit markets.  But at what cost?  With benchmark rates at the record low of 0.25 percent, traders will continue to sell the U.S. dollar short, helping out the Euro.  Making it even worse is the fact that U.S. rates aren’t expected to be raised until after all of the other G7 central banks have their turn.  Although expectations were hovering around a 40 percent chance of a 25 basis point increase by the Fed in the fourth quarter, those estimates have dwindled and placed a higher likelihood of that happening at the tailend of the first half 2010.

Dollar Doldrums: Central Banks Want Out

Additionally, central banks have played their part in rumors and threats as entities in all parts of the world have begun to talk the dollar down.  Earlier this summer, BRIC nations complained about their exposure to the dollar with Russia leading the way for a supranational currency or preferential trading of special drawing rights backed by the World Bank.  All of this talk of currency conversion has done nothing but increase already nascent speculation that a massive Euro conversion may happen as nations attempt to diversify out of U.S. dollar based assets.  This is of particular interest as three of the five aforementioned nations have risen up the currency reserve ladder (#1 China, #3 Russia, #5 India), with the fourth (#8 Brazil) not too far behind.  As long as there remains the underlying discomfort between the greenback and these nations, there will be a supported preference for anything other than U.S. currency.

The Monkey Wrench

Given the recent facts and trends, Euro strength looks to be here to stay.  Even if European Central Bank President Jean Claude Trichet begins his dutiful jawboning of the detrimental effects of a stronger currency, speculators are likely to keep pressing the currency higher.  The only caveat seems to be in the form of an earlier economic assessment of the Euro region.  Given the fact that interest rates remained relatively high in the area, economic growth may be slow to come.  The slower growth will likely keep European nations behind the current recovery and force policy makers to drag heels when it comes to raising rates in the near future.  Should this economic stalling actually take place, the current euro momentum may be placed in jeopardy.

Britain’s newspaper, The Independent, reported on Tuesday that Gulf Arab states, Japan, Russia, China and France were negotiating behind the scenes to replace the U.S. dollar with a basket of currencies in future oil trades.  Citing unnamed Gulf Arab and Chinese banking sources, reporter Robert Fisk’s articles caused a sharp upturn for the Euro, which edged as high as $1.4749 in European trading before the report was discredited.

The tenuous dollar still gave way to the Euro, which settling at $1.4701 against the dollar.  The weaker dollar and anticipation about Wednesday’s U.S. earnings reports sparked another strong rally in U.S. equity markets.  By Tuesday afternoon, Gold cleared the $140.00 barrier and hit an all-time high as U.S. equities rose another 131 points.

Fisk’s story set off a firestorm of public and private reaction.  The report was quickly denied by Algeria, Russia, Saudi Arabia and the United Arab Emirates.  Muhammad al-Jasser, Saudi Arabia’s head of the Central Bank labeled the report, “absolutely incorrect.”

Russian finance minister Dmitry Pankin added; “We did not discuss this at all.”  While the story seems baseless, there is a general uneasiness about the reeling dollar.  Stretched by abundant forms of quantitative easing and with overwhelming trade and budget deficits, the American dollar remains under pressure.

Meanwhile, other economies appear to be forging their way out of the recession.  The concern is that the U.S. is headed for another downturn before the recovery gains a foothold.

Fisk’s report mapped out a strategy that crude oil trading would convert to a basket of currencies including the Japanese yen, the euro, the Chinese yuan and a new, unified currency of the Gulf Cooperation Council within nine years.

IMF in Istanbul

On several occasions, Russia and France have publicly encouraged a shift away from the dollar for oil trading.  The currency’s volatility has also caused China, the holder of the largest foreign exchange reserves, to support a change.

While the talks among IMF members have been addressing global trade imbalances, the key to sustained balance may well be the further devaluing of the dollar.  David Moore, a commodities expert with the Commonwealth Bank of Australia explained; “I don’t think we will see much concrete action out of such discussions because even when the dollar is weak, it doesn’t mean that commodities are undervalued.  In fact, when the dollar weakens, commodity prices tend to increase by a higher ratio.”

Such a conversion presents many practical issues.  Many financial ministers agreed that it is already difficult to convert to a single currency much less a handful of options and conversion rates.

Several analysts countered by pointing to Iran as an example of a country that has been able to make a fairly seamless transition away from the dollar.  However, most analysts thought the process more laborious than worthwhile.

Strong Message From Australia

The Reserve Bank of Australian (RBA) sent a clear message that the country has emerged from the recession by increasing its cash rate by 25 basis points to 3.25 percent.  The Bank indicated more increases were in the offing.

The Australian dollar immediately jumped to a 14-month high.  Asian currency banks seemed to be ready for strong moves as several economies moved to pull back from quantitative easing. 

The surprising move by the RBA made Australia first Group of 20 bank to hike rates.  The bank indicated a desire to increase rates to 4 percent over the next few quarters and hopes that rate would reach 5 percent by 2011.

The Australian economic recovery and real estate markets have been bolstered by the country’s strong banking presence.  Treasurer Wayne Swan said: “The Australian economy is outperforming other advanced economies and I guess many economists will see the decision today as a consequence of economic recovery.”

By now, the notion that the nascent global economic recovery is being and will continue to be led by China has become cliche. The NY Times summarized: “In past global slowdowns, the United States invariably led the way out, followed by Europe and the rest of the world. But for the first time, the catalyst is coming from China and the rest of Asia, where resurgent economies are helping the still-shaky West recover from the deepest recession since World War II.”

The statistics are certainly compelling. After a brief dip in the first quarter, GDP grew by an impressive 7.9% in the second quarter. In hindsight, the downturn in Chinese economic output was so slight as to hardly warrant use of the term recession to describe it; any other country would have rejoiced after achieving 6.1% (2009 Q1) growth, especially in the context of the current economic climate.

While stock market investors are evidently optimistic that the economy will continue to gather momentum, China-watchers and policymakers are more cautious. Wen Jiabao, premier of China, insisted that, “We must clearly see that the foundations of the recovery are not stable, not solidified and not balanced. We cannot be blindly optimistic.”

Wen’s downbeat prognosis should be seen in the context of China’s massive stimulus plan, which delivered an immediate jolt to the economy, but is already winding down. “The flood of bank lending in the first half of this year — equivalent to more than half of gross domestic product in the period…is ebbing. Net new lending in July was 355.9 billion yuan ($52.13 billion), the lowest figure so far this year and well below the first half’s monthly average of 1.2 trillion yuan.” Some analysts believe that this sudden decrease is due to seasonal factors, but others argue that it is a sign that the boost in lending (and spending) from the stimulus may have already exhausted itself.

In addition, the stimulus itself was not necessarily geared towards sustainable growth (in the economic, not the environmental sense). Over the last two decades, China embraced an economic model focused around exports and capital investments, at the expense of domestic consumption. While it will certainly be years before economists can determine whether the recession changed the structure of China’s economy, the earliest indications point to business as usual. “This year the bulk of the government’s stimulus is going into infrastructure, further swelling investment’s share. Chinese capital spending could exceed that in America for the first time, while its consumer spending will be only one-sixth as large.”

To be sure, the government has rolled out incentives and subsidies designed to reduce savings and increase consumption. However, Chinese cultural mores and the government’s lack of social services represent a formidable obstacle to any opening-up of the mentality of Chinese consumers- and their wallets. In fact, while China’s government is still nominally Communist, spending on public services is among the lowest in the developed world. Despite doubling to 6% of GDP, such spending is still well below the OECD average of 25%. The widening rich-poor gap, meanwhile, suggests that most of the windfall from China’s economic boon has been bestowed upon a relative handful of businesses and people, such that the majority of China’s 1.3 Billion populace simply doesn’t have the means to increase consumption.

For better or worse, the global economic downturn has severely crimped demand for Chinese exports, and this component of GDP could remain depressed for quite some time. After a record $400 Billion in 2008, the trade surplus plummeted in 2009, “to $35 billion in the same [second] quarter, 40% down on a year earlier…the decline is even more impressive in real terms (adjusting for changes in export and import prices), with the surplus shrinking to less than one-third of its level a year ago.” In fact, some analysts project that China could soon experience a trade deficit, if current trends continue.

All of this suggests that the Chinese RMB is not likely to return to its path of rapid appreciation (28% in real terms), observed from 2005-2008. (The currency has essentially been fixed at 6.83 RMB/USD since December 2008, leading to an 8% decline in real terms to match the decline of the Dollar.) China’s foreign exchange reserves, which have come to mirror the appreciation of its currency, are once again expanding. ($2.13 Trillion at last count). Given the decline in the trade balance and the explosion in the budget deficit, however, much of this increase must be attributed to the inflow of speculative capital, which will not necessarily translate into currency appreciation.

Some economists insist that the Yuan is still undervalued by as much as 25%, but investors don’t believe that it will bridge this gap anytime soon. While the spot exchange rate has risen to the strongest level since May, futures prices indicate a modest 1.5% appreciation against the Dollar over the next twelve months. This is an improvement from expectations of a flat exchange rate, but still a long way away from what some economists think is reasonable.

For all those who believed the tireless American consumer would lead the country and the globe from the depths of the recession, guess again.  In the face of a conservatively stated 9.7% unemployment rate, the American consumer is not buying the recovery.  Instead, they are closing their pocketbooks and putting the recovery in the hands of those that caused the recession.

This is bad news for an American economy that relies on consumer spending to fuel 70% of the Gross Domestic Product.  Were it not for the government sponsored Cash For Clunkers program, the downturn in consumer spending would be even worse.

On Tuesday, the Federal Reserve released their consumer credit report card.  The results gave good reason for immediate and short-term concern.  With unprecedented force, the American consumer has stopped spending and is saving money.  In July, consumer credit fell by $21.6 billion, well below the $15.5 billion plunge in June.

The figure caught many analysts by surprise and fueled speculation that the recovery would be slower and take longer than originally anticipated.  The continued debate regarding health insurance and the ever-rising unemployment rate has taken the spotlight away from a possible recovery.

As Bernard Baumohl, a chief global economist with the Economic Outlook Group in Princeton, New Jersey, said; “It is one important sign that consumers are not going to be contributing very much to the economy for the balance of this year and probably for a good part of next year.  Consumers will be in the background.”

Consumer Credit Down 6 Straight Months

Only once before has consumer credit dipped for six consecutive months.  That was in 1991.  With unemployment at the highest rate in 26 years, incomes are tumbling and household spending is falling right alongside. 

Signs of a recovery appear now to be not the result of consumer confidence but rather re-supply as inventories have finally been sufficiently depleted since the recession began in December 2007.  Baumohl added; “There is no way that this recovery can be sustained unless we see a pickup in household spending.  The big question out there is will we see Americans spend again to keep this recovery alive.” 

Every aspect of consumer credit shrunk in July.  Non-revolving credit, which includes closed-end loans fro big ticket items like cars, boats, college education and holidays plunged to a record $15.4 billion.  Revolving credit made up of credit cards and charge cards dropped $6.1 billion.

As credit shrinks, consumption also falls.  Americans are feeling better with reduced debt and less goods.   The emphasis now is on finding new jobs and reducing expenditures, not exactly the mindset that ignites a recovery.

The Federal Reserve governors appear divided about the meaning of certain economic trends.  The Fed’s August 11-12 policy session was optimistic but tempered with caution.  The minutes of the meeting indicated that Reserve members felt the risks to the economy had eased, but the trajectory of the recovery, inflation and deflation worries and effective interest rate changes remain tenuous factors that will determine the eventual “exit strategy.”

The minutes included the following analysis; “Meeting participants agreed that the incoming data and anecdotal evidence had strengthened their confidence that the downturn in economic activity was ending and that growth was likely to resume in the second half of the year.”

The consensus is that the current recovery will be modest and the chance that the recession will resemble a “W” rather than a “V’ is strong.  As a result, the Federal Reserve has determined to stay the course on certain stimulus spending despite inflationary risks.

Al Dales of Capital Economics in Toronto offered the following observations; “The Fed is in no hurry to alter its current policy stance.  The Fed will complete its asset-purchasing program and remains reluctant to withdraw its policy support soon.”

As of September 2, 2009, the Federal Reserve has bought $792 billion in mortgage-backed securities and $118.6 billion in mortgage agency debt in 2009 alone.  Since the recession began in 2007, the Fed has total purchases of $1.25 trillion in mortgage-backed securities and $200 billion in mortgage agency debt.  These programs are set to expire at the end of 2009.  The central bank did take steps to wind down a $300 billion long term Treasury purchasing program.

Inflation Woes

The bottom line is that there is no quick fix for the economy, which entered the country’s deepest recession in December of 2007.  In fact, the fed seems resolved that the recovery will be slow and prolonged.  The central bank does not rule out the possibility of another downward spike and thus is hesitant to commit to an exit strategy preferring instead to extend certain stimulus investment.

Citing high unemployment and low manufacturing, the Fed does not fear inflation.  However, in speaking with CNBC on Wednesday, Charles Plosser, the Chairman of the Philadelphia Federal Reserve, warned against a potential spike in inflation.  Plosser believes that the Fed may have to raise its favorable interest rates sooner than anticipated. 

Plosser provided evidence of a stronger than expected recovery at the end of 2009 and predicted bigger gains in 2010.  At the August meeting, the Federal Reserve voted to keep benchmark overnight interest rates steady at near zero.

A new American phenomenon, household savings, has combined with the high unemployment and lack of consumer confidence to contain spending. The economy needs a loosening of the consumer’s pocketbooks to stabilize the recovery.

The OECD Weighs In

Early Thursday, the Organization of Economic Co-Operation and Development (OECD) predicted a stronger than expected recovery.  OECD chief economist Jorgen Elmeskov said; “Compared with expectations a few months ago, we now have a recovery which may be coming a little earlier and it may be slightly stronger because financial conditions have improved more rapidly than we assumed a few months ago.”

The OECD predicted a 1.6% expansion of the U.S. economy in the third quarter and 2.4% in the fourth.  These are substantial reversals of the OECD’s June projections.

The OECD also predicted third and fourth quarter improvements in the G-7 economies of 1.2% and 1.4% in the third and fourth quarters of 2009.  Europe’s big winners appear to be Germany and France.  Japan is expected to grow 1.1% in the third quarter.

Elmeskov cited a significant global reduction in unsold homes as a major contributing factor in the recovery.  “In some countries, including the United States, it also looks as if the bottom of the housing market might have been hit a little earlier than assumed.”

The OECD urged economies to continue monitoring quantitative easing policies but to begin developing exit strategies that would include normalization of interest rates.  These rates should begin to rise in the third quarter of 2010.

According to the most recent report on Japanese growth, expansion is well on its way for the world’s second largest economy. The tip has helped the yen currency this week, trading up to as high as 94.00 against the US dollar from last week’s low of 97.78. However, is this wave of new growth sustainable? Or are the statistics overshadowing a still weakened economy? Taking a look at the report, it seems that the recent and rather large economic cash handout (along with broader economic stimulus) may be contributing heavily to the recent strength. This point alone could have greater implications for the Japanese yen.

Rapid Recovery

For the second quarter, the Japanese economy has beaten the world’s largest economy to the punch. In the three months of the quarter, Japan has added an annualized equivalent of 3.7 percent on a preliminary basis. The figure has outpaced economic expansion in the US, now pitted at a mild 1 percent contraction and is an improvement from the downturn seen earlier this year. For the record, the Japanese economy was actually anticipated to shrink by a whopping 15.2 percent. But where did this growth come from? Several key sectors looked to have contributed.

Exports – With a recovery hiccup, global consumption of Japanese made goods actually rose during the three month period, improving to over 6 percent for the quarter on quarter. Incidentally, improvements were largely linked to Chinese demand for Japanese goods. The development added heavily to the overall figure as the country continues to remain export growth dependant.

Public and Private Consumption – With credit a bit eased in the country, businesses have increased their short term consumption of capital, although not increasing their longer term investment options. Additionally, cash handouts by the current administration have helped spur some public improvements as policy heads set aside $21 billion in stimulus over the last couple of months.

Limited Exposure – Comparatively speaking, Japanese banks seemed to have been somewhat sheltered by the current crisis as financiers saw the damaging initial effects of leveraged balance sheets a few years ago. As a result, since then banks have cleaned up their holdings while minimizing their exposure.

A Deeper Look

However, given all the good vibes, the underlying Japanese strength may not be as sustainable as one would hope for. Specifically, sector data continues to show a slowdown, if not a complete stalling, of corporate investment for the country. Businesses that don’t expand, won’t spend the money or effort to spend on new factories, labor or equipment. The sentiment is reflected in the fact that corporate owners continue to remain weary of a V shaped recovery, believing more in the L shaped counter. Moreover, consumption is still trickling in. According to the most recent retail sales report, domestic spending has declined for the 10^th straight month – falling by 3 percent. The figure was increasingly disappointing when considering the government has implemented $277 billion in economic stimulus over the last 12 months. Ultimately, things aren’t expected to improve with estimates still pointing to a post war record match of 5.5 percent in unemployment for the land of the rising sun.

A Single Caveat

The only shimmer of hope is expected to surface from the upcoming elections. Currently, the nation is being ruled by the reigning LDP (Liberal Democratic Party) through Prime Minister Taro Aso. As a result, under the recently passed recovery packages, cash injections are expected to wind down by next year. However, given the disapproval ratings of Aso, focus is turning to the policy platform of competitor and DPJ (Democratic Party of Japan) leader Yukio Hatoyama. Should the candidate be newly elected, expectations remain that the current program will continue along with further aid being provided in the form of generous individual allowances and tax cuts.

Shimmer of Hope: Is This The End?

Yen Implications

So what does this all mean for the Japanese currency? Given the underlying weakness in the economy, it is safe to say that continued economic softness is expected to contribute to broader yen selling. Incidentally, throughout the last decade, traders have sold off the currency in comparison to the US economy and not solely on one region’s results. If Japanese data remained weak, the US dollar would strengthen and vice versa. As a result, additionally taking into consideration the global market’s current run up, yen bulls may be in for a bumpy ride heading into the fourth quarter. However, should US economic data take a turn for the worse, the notion that Japanese economic weakness may be overshadowed will likely take a back seat.

Switzerland’s seasonally adjusted Unemployment Rate is set to rise to 3.9% in July, the highest in close to five years, pointing to mounting headwinds for consumer spending and thereby overall economic growth. In fact, the jobless rate may actually be understating the total impact of the current downturn on consumers’ spending power as many firms looked to cut costs by switching a portion of the workforce to a “short-time” schedule, which amounts to fewer hours and thereby smaller paychecks. Naturally, this trims disposable incomes and adds to already formidable disincentives to consume. Although exports are heavily represented as a component of Swiss economic growth, domestic demand is still by far the most important driver of activity, contributing about 60% to total output. The State Secretariat for Economic Affairs (SECO) has forecast that the jobless rate will register at 3.8% through 2009, an expectation that has been echoed in a survey of economists conducted by Bloomberg. Job losses have grown at an average pace of 3.35% in the six months through June and so would be expected to rise by an average of 4.25% in the second half of the year.

Germany’s Current Account surplus is expected to print at 8 billion euro in June from 3.7 billion in the previous month as exports grow 0.9%, outpacing a 0.7% increase in imports. Although this would mark a bit of an improvement on a monthly basis, the outcome still falls firmly within the downward trajectory that has been in place since the surplus peaked in the third quarter of 2007. Indeed, economists polled by Bloomberg predict that net exports will contribute an average of 3.72% to overall economic growth this year and in 2010, the smallest in 6 years. While Germany’s current account has been eroding for the better part of the past two years, its US counterpart has been narrowing. Indeed, the US external deficit peaked in the three months to September 2006 and has narrowed by a whopping $113.3 billion to date. Germany has a deep trade relationship with the US, so a continuation of this trajectory implies long-term downward pressure on EURUSD as capital outflows overwhelm inflows into the Euro Zone’s largest economy and top exporter.

Separately, the annual pace of decline in German Industrial Production is expected to moderate for the third consecutive month, with output shrinking -17.5%. As with similar improvements noted in recent months across developed countries, the reading is unlikely to prove particularly market-moving considering traders have likely already priced in the stabilizing effects of the ample global fiscal boost and inventory restocking into the exchange rate. Indeed, the question to be answered from here is what will happen after the flow of government cash dries up and the inventory cycle runs its course.

Finally, the UK Producer Price Index report is expected to show that wholesale inflation shrank at an annual pace of -1.7% in June, the largest drop on since records began in 1979. The metric points to continued downward pressure on consumer prices, the headline inflation gauge, as lower wholesale costs filter into the final price tag. Indeed, the Bank of England said that while “some recovery in output growth is in prospect,” aggregate supply is likely to continue to outstrip demand “for some while yet, bearing down on inflation in the medium term.” CPI fell below the 2% target level for the first time in 2 years in June and is expected to average at 1.15% for the remainder of the year.

On balance, the European data docket is likely to prove secondary as currency markets focus their attention on the upcoming Non Farm Payrolls report out of United States to be released late into the session.

Asia Session Highlights

Australia’s AiG Performance of Construction Index fell for the second consecutive month to register at 39.5 in July, showing the building industry contracted at the fastest pace since April. The metric was led lower by drops in sector-wide employment, apartment construction, and engineering demand. The government introduced A$34 billion in fiscal stimulus this year, distributing A$12 billion as cash handouts to households and setting aside A$22 billion for infrastructure projects. We noted signs that the consumer-focused portion of the plan was losing steam earlier this week, and today’s report may be the first clue to confirming that the building component is heading in the same direction. Indeed, it is hard to imagine that any infrastructure project can meaningfully get off the ground without engineers to design it and new builders to execute it.

Related Article: Reserve Bank of Australia Hints at Rate Hikes, Traders Not Convinced