Cool Video: How Tornadoes are Formed

This Cool Video was posted on The Atlantic and originally comes from NASA.  It explains the origins of tornadoes.   In a little less than four minutes you will have a better understanding of complex weather phenomenon.

Two Issues for the Fed: How and When

Federal Reserve Chairman Bernanke testifies before the Joint Economic Committee of Congress tomorrow. The market is anxious for the Chairman to weigh in on the recent comments suggesting that even some like-minded regional presidents like Chicago's Evans seems to be warming to the idea of tapering off purchases.

It is one thing for the more hawkish members, several of whom have never felt comfortable with the latest iteration of quantitative easing, to talk of slowing purchases, but it is another thing for some of the more dovish members to talk in this vein. Yet we suspect there is less than meets the eye. With the stock market extending its advancing streak to near 200 days without a 5% pullback and what Bernanke has called "the reach for yield" has driven the industry index of below investment grade yields below 5% for the first time; it is incumbent on Fed officials to demonstrate their vigilance.

Sterling and Yen Aren't Waiting for Tomorrow

The US dollar remains largely in a consolidative phase, awaiting Federal Reserve Chairman Bernanke's testimony before the Joint Economic Committee of Congress tomorrow. There has been much talk about tapering asset purchases and Bernanke's views are critical. 

However, comments by Japan's Amari, seemingly trying to soften yesterday's comments, after reportedly being criticized by cabinet colleagues helped lift the dollar back toward JPY103. Separately, soft UK inflation figures sent sterling back to the base it build last Friday and yesterday near $1.5165. Against the emerging market currencies, the greenback remains bid.

Emerging Market Highlights for the Week Ahead

(from my colleagues Dr. Win Thin and Ilan Solot)

In the EM space, disinflation and slow growth remain major themes for most of the countries. Certainly, weaker Chinese readings have gotten the headlines but the malaise is spreading well beyond Asia. 

Today, it was Chile that reported Q1 GDP growth at a much weaker than expected at 4.1% y/y, down sharply from 5.7% y/y in Q4. Others in EM are likely to report slower growth and disinflation this week, setting the stage for more stimulus ahead. Brazil is the major exception, and is discussed below. 

South Africa April CPI is due out Wednesday, and is expected to ease to 5.7% y/y from 5.9% y/y in March. On Thursday, the SARB meets and is expected to keep rates steady at 5%. However, if disinflation continues as it is in the rest of the world, we think a rate cut by the SARB will be seen in Q3 in order to help address the slowdown. 

Gold prices continue to fall, down 8 straight days and 10 out of past 11. Falling gold is part of the reason behind the ZAR selloff last week, along with labor unrest. Besides these usual themes hurting the rand, we got a bonus today with bearish bank news.

Spanish Banks: New Look at Restructured Loans

Germany, the tightfisted task master, is encouraging Spain to draw down more than the 40 bln euros it already has of the 100 bln euro line secured from the ESM to recapitalize its banks. Spain's budget minister denies there is a need. Germany does not typically encourage countries to take on more debt needlessly. We suspect by late Q3 or early Q4, Spain will, however reluctantly, take Germany's advice as it will likely need more funds for its banks.

The continued decline in house prices, the contracting economy and high unemployment point to the likely increase in bad loans. While this may be generally appreciated, another problem is emanating from loans to households and businesses that have already been restructured.

The issue is that the loans have been restructured mostly because the borrower cannot service their debt. Banks seem to be hiding the full extent of the damage by classifying the restructured loans as if they are performing normally, in an example of "extend and pretend" or "delay and pray".

Amari and Holidays Spur Consolidation in FX

Most of continental European markets are closed today for Whit Monday and Canadian markets are closed for Victoria Day. With important data and central bank officials speaking later this week, the market is content to keep most of the major currencies within the ranges seen before the weekend.

The yen is an exception. Comments by Economic Minister Amari that the correction to the yen's weakness is nearly complete, and additional yen weakness may be harmful, hit a thin pre-Asia market that saw the dollar spike lower to just below JPY102 before recovering. This was seen as first attempt by the Abe government to slow the yen's descent. The motivation does not come from abroad as much as Japanese officials trying to stabilize the bond market.

Central Banks Dominate Forces of Movement in the Week Ahead

The most important force that has lifted the US dollar across the board is the sense, encouraged by official comments, of the potential divergence in the trajectory of monetary policy between the US and most of the other major high income countries. 

In particular, the pendulum of market psychology has swung back toward speculation of tapering off of QE-related asset purchases by the Federal Reserve.  At the same time, ECB officials continue to indicate they are carefully considering a negative deposit rate. Many still expect the Bank of England to resume its gilt purchases program and new initiatives on its forward guidance in Q3 after Carney takes the helm. 

Meanwhile, Carney and the Bank of Canada continue to push further out when they anticipate full capacity will be reached and when it will remove some accommodation by increasing interest rates. The recent string of economic data, including prices, has been generally softer than expected and the forward guidance the central bank has offered is becoming less credible. Additional easing by the Reserve Bank of Australia is expected, though the recent sharp drop in the Australian dollar appears to be tempering expectations of a rate cut as early as next month.

Cool Video: Time-Lapse of World Trade Center Building

This Cool Video comes from The Guardian.  See the tallest building in the western hemisphere rise in a little less then 2 minutes in the time-lapse video.  The spire was completed at the start of the month.  

Great Graphic: Diverging Growth--Is it the Euro's Fault?

This Great Graphic was found on the Economist's blog Free Exchange in a post titled "What the euro has meant". Under the impression that the charts speak for themselves, with little analysis, the author concludes that most of the euro area would have been better off being the US or Great Britain, even in per capita terms. Seeing how obvious this is the author is stumped by the fact that there is not a bigger push to leave the monetary union. 

While the charts are interesting, the inference is weak.  First, there is an all too common logical fallacy on display here.  Just because the charts begin with monetary union does not mean that the monetary union caused what came afterwards.  Second, surely to make some assessment of what EMU has wrought, a review of the economic performance before EMU is required.  

US growth, for example, generally outstripped European growth in the two decades before monetary union.   Italy and Portugal's competitiveness problem, for example,  was evident before monetary union. To lay the blame  at the feet of EMU seems wrong and disingenuous, though plays into popular prejudices.  Although monetary union was over-determined (Europe's own post-WWII strategy, the problems with the European Exchange Rate Mechanism--ERM-- and political factors related to the reunification of Germany when the Berlin Wall fell), one of the incentives was to boost the competitiveness of Europe to compete with what the French called the hyperpower (the US).  

Any discussion of a country exiting the monetary union needs to come to some understanding of why the country joined in the first place.  That the euro area is not an optimal currency zone was well known before it was launched.  The US itself was clearly not an optimal currency zone for most of its history and some would argue that the continental economy is too diverse and is still not an optimal currency zone.  It cannot be understood abstracted from the political and historical context.   

In summary, we offer three corrective points to the Economist post.  First, it is not clear that Europe's growth problems began with monetary union.  Second, the problem of competitiveness would still bedevil countries if they left monetary union.  Third, the reasons for monetary union cannot be simply reduced to a homo economicus calculation.    This implies that the failure of EMU to resolve the economic challenges countries face is in itself insufficient to spur defection.  

Currency Positioning and Technical Outlook: Dollar Bull Run

The US dollar posted strong across the board gains. It is being driven by the anticipation of favorable developments in the US, in the form of a possible slowing of the Fed's asset purchases, and less favorable developments abroad.

While it is technically poised for additional gains, the biggest risk to the dollar comes from Fed Chairman Bernanke's midweek testimony.  His commitment to QE and readiness to taper purchases, as others have suggested, will be closely scrutinized.  The failure to confirm these growing market ideas, spurred in part by comments from two (non-voting) regional Fed presidents, could prompt some profit-taking on long dollar positions.

While speculation that the Fed may take one of its feet off the accelerator in the next week month helped lift the dollar, other countries are easing policy.  There has been even more talk about the ECB adopting a negative deposit rate.  Continued sub-50 readings in the flash PMI,  due midweek, will heighten the sense that the euro zone continues to contract for the seventh consecutive quarter.