Significance of EC Shuffle

Over shadowed by the emergence of Dubai's financial crisis, the European Commission was re-shuffled. France and Finland were given the highly coveted portfolios of internal markets (which is to include financial services regulation) and the economic and financial affairs respectively Michel Barnier and Olli Rehn. Spain's Joaquin Almunia was given the competition portfolio and Belgium's Karel De Gucht has the trade portfolio.

The Implications of Dubai's Financial Crisis

A storm broke out last week, emanating from the part of the world that is widely seen as a major beneficiary of the rise in oil prices. Yet Dubai’s story is not about oil. Indeed it is precisely the absence of oil and natural gas (less than 6% of GDP) that prompted this emirate go down the path of tourism, hospitality, and commercial real estate development, that lies at the heart of the matter now.

Check-in Brazil ADRS vs Local Shares

One of the noteworthy developments here in Q4 has been the renewed interest in capital controls by countries trying to manage the flood of portfolio capital. Brazil's 2% tax on purchases of Brazilian stocks and bonds is among the most significant examples.

ECB and BOE Continue to Provide Dollar Liquidity

The dollar has been sold off today and ECB and BOE have added fuel to the fire. They continue to provide dollars to their member banks, who then appear to turn around and sell them.

Why The Dollar is Broadly Lower

The combination of the apparent resolution of the West LB situation and the FOMC minutes have conspired to send the US dollar broadly lower today. The FOMC minutes in particular have been seized upon. On one hand, it is unusual for the FOMC to give so much space to a discussion about the dollar. This is, however consistent with what appears to be a stepped up campaign by both Treasury and Fed officials to cite the dollar in an unsolicited way. The ostensible purpose is likely to demonstrate that there is no "malign neglect".

Banking Center Updates

Developments in the banking sector have somewhat overshadowed German economic news today. Yet German GDP data may stand in contrast to US GDP due this morning. It’s not that German Q3 GDP was stellar. Q3 GDP was unchanged from the preliminary data at 0.7% q/q (and -4.8% y/y) and a breakdown of the data showed consumption continued to fall (down 0.9%q/q), offset by investment spending (up 1.3% q/q) as companies invested in machinery and equipment while exports gained 3.4% though that was offset by a 5.0% gain in imports with next exports detracting 0.5% from GDP. Still US GDP is expected to be revised lower to 2.8%. Other euro zone data were mixed in line with today’s other US data (confidence, housing data and the Richmond Fed index). Germany’s Nov Ifo survey was stronger than expected at 93.9 vs. 92.5 exp while expectations rose from 96.8 to 98.9 (97.3 exp) but the Ifo’s Nerb warned it was still too early to consider removing stimulus. French business confidence was disappointing, remaining unchanged at 89 in Nov vs 91 expected. The euro remains inside yesterday’s range, recovering some of its early losses. Still the currency has been unable to rise back above the $1.4960 area and an unexpectedly large downward GDP revision could see the single currency pull back toward $14890.

Greece Tensions Growing More Acute

Currency in Crisis

The pressures on Greece continue to increase and this is reflected in the credit default swaps and the interest rate spread over Germany. Indeed, that is a key development in the euro zone over the past month, Greece yields have risen above Ireland, which had been the highest yield in EMU this year. Ten year Greek yields are just below 5%, while Ireland is near 4.75%.

ZAR Best Performing Currency

The South African rand is the strongest currency today, gaining 1.87% against the sagging greenback. Several factors are helping lift the rand.

Many are linking the rally in gold to new record highs with the rand's strength. Year to date the correlation between dollar-rand and gold is -18.8%. The euro has been more correlated with gold year to date (26.5%). However, in the last three months, the rand has shown a 60% correlation, eclipsing the euro's 50% correlation.

T-Bills

With U.S. T-bill yields hovering near zero, today's weekly bill auctions may attract more general market attention than usual. Here is what is going on: due to the approaching debt ceiling, the US debt managers have reduced T-bill sales. At the same time, the demand for short-term paper is great.

Speculative Positioning

The latest commitment of traders, reported late Friday for the week through Nov 17th showed that speculators (non-commercials) had pared back their bets. Given that interest rate differentials remain decidedly dollar negative, sentiment poor and some ideas that the U.S. may be forced to extend either its credit easing or its fiscal stimulus longer than Europe, the pared back positions may clear decks sufficiently to fuel a year end dollar slump short-term players re-establish positions.

Watch $1.4880 in the Euro for Dollar Direction

There is much talk in the markets about a double-no-touch structure between $1.48 and $1.51. However, more immediately we think the $1.4880 area is a key pivot. A move above $1.4880 would take neutralize the downside pressure on the euro and point to a retest on the $1.4960-$1.5000 that has capped upticks over the past few sessions.

Bernanke's Comments...What it All Means

Leaving aside the market's immediate reaction, Fed Chairman Bernanke's comments about the dollar are very revealing, not just for his thinking, but it likely reflected senior officials in the Obama Administration as well. In the last FOMC statement that the Fed highlighted three considerations behind its view that its Fed funds target can remain exceptionally low for an extended period of time: capacity utilization, price pressures and inflation expectations. In his speech Bernanke outlined the conditions under which the dollar's movement would become more salient for the conduct of monetary policy. The dollar becomes a more important policy consideration if the change of its value jeopardized the ability achieve the dual mandate of full employment and price stability.

Another Push on The Dollar

In the post-Bernanke market, the dollar has fallen to new lows for the session against all of the majors. what did Bernanke say that was so dollar negative? Nothing. The market was not convinced that he will make his concern or monitoring of the dollar with action. Indeed, Bernanke played this down the inflationary significance of the dollar's decline by putting the decline in the context of the big run up in H2 08 and Q1 09. Moreover, by noting that he did not see bubbles in the US presently also provided dollar bears with fresh fodder.

More on Bernanke

If officials do not like foreign exchange volatility, Fed Chairman Bernanke may not be pleased with the market response. The mention of the dollar, which traditionally is a topic the Fed defers to the Treasury Dept, prompted interbank and option dealers to cover short dollar positions, even though no new ground was covered or specifics cited. However cooler heads quickly prevailed and the dollar returned to pre-Bernanke levels. It is clear from the Chairman's remarks that the dollar's decline is not of sufficient proportions to prompt a change in the US monetary policy. Bernanke continues to envision that the economic conditions are such that will allow rates to remain low for an extended period. Like other officials we have spoken with, Bernanke frames the recent dollar decline in the context of the dollar's rally in H2 08 and Q1 09.

Bernanke Sends Dollar Higher

We have noted that in recent weeks, the Fed officials have not been shy about commenting about the dollar, even when unsolicited by reporters. The first comments from Bernanke point to this as well. Bernanke says that the Fed is keeping an eye on the dollar--though apparently not sufficiently to mention it in the recent FOMC statement. He also says that the Fed's policy will help ensure that the "dollar is strong". It is not clear what exactly that means. Still the dollar has jumped on the news after the euro ran out steam earlier in front of the $1.50 level. On other issues Bernanke has not broken any new ground. At the end of last week, the euro found a base near $1.4825. That support is key. A break would suggest a move back toward $1.4625.

Credibility Issues Weigh on Greek Bonds

Currency in Crisis

Greek bonds continue to be worst performer among European bonds. The 10-year bond yield is up another 10 bp today after a move of roughly the same magnitude at the end of last week.

When the new government under PM Papandreou (elected early Oct) claimed that the deficit it was inheriting was twice what the previous government had projected, there was much hand wringing and disbelief. This weighed on Greek bonds and drew some derisive comments from the rating agencies.

What to Expect from Bernanke Today

Federal Reserve Chairman Bernanke will speak about the economy in NYC at lunch today. There are a few points that the market will be closely watching.

1. He is likely to reiterate the general thrust of the recent FOMC statements. The economy is recovering, but it remains fragile and price pressures remain well contained. The Fed is in no hurry to raise rates.

Japan Stock Market

Next month will be the 20th anniversary of the peak in the Japanese stock market. Chinese officials attribute Japanese capitulation to the relentless US demands for currency appreciation as a contributing factor to the poor performance over the past two decades and do not want to be caught in the same trap. Consider that in early 2005, notable economists were claiming that the yuan was 20-25% under-valued and that such a currency adjustment would be necessary to bring the bilateral trade into balance. Beginning in July of that year, China allowed its currency to appreciate 20-25% over the next three years and by the end of the period the Chinese trade surplus had doubled. At the start of this year, some of the same economists were calling for another 20-25% appreciation.

APEC

There was no important break through at the weekend APEC meeting. The ministers promised to resist protectionism and adopt structural reforms as necessary to unwind the global imbalances, but without detailing specific changes or making new commitments, one must assume little has changed. If anything the reluctance of officials to seek yuan appreciation kept the dollar bearish sentiment intact. If the yuan is not going to share in the adjustment process, some reasoned, then the euro and other "adjustable" currencies will have to. At the same time, some participants were disappointed having expected some move by the Chinese ahead of the US and then European visits. The implied appreciation imbedded in the non-deliverable forward market for yuan narrowed (0.2%), breaking a three day advance. China's trade with ASEAN members has increased 20-fold since 1993 to almost $180 bln. China's stimulus efforts and general economic well being has become increasingly critical for many countries in the region. Although the yuan has effectively been repegged to the dollar since July 2008, the dollar's weakness seemed a greater cause of concern. Officials from several countries expressed concern that the low Fed funds rate and excess liquidity is fueling a huge wave of speculation that is inflating asset prices and overwhelming many developing countries. Meanwhile, Chinese people themselves are happy to borrow dollars as a way to "bet" on yuan appreciation. Foreign currency borrowings by Chinese businesses and individuals has risen for eight months through Oct and stand 40% above year ago levels at a record $360 bln. Demand for dollar loans and the corresponding drop in dollar deposits has lifted the cost of borrowing dollars on-shore in China.

Data Favoring Another Israel Rate Hike

The central bank of Israel hiked rates in August to become the first to begin to normalize monetary policy during the recovery. It held rates steady in Sept and Oct, but speculation is increasing that it will hike rates again when it meets on Nov 23.

IPOs may Steal Limelight from Fixed Income Next Week

The US Treasury successfully completed its record quarterly refunding this week and Corporate America, not deterred by the mid-week holiday, appear to have raised $20 bln in new bond offerings. Nearly $10 bln of corporate bonds was sold on Monday Nov 9th, the busiest day in about a month. Typically, the post-Thanksgiving period sees a significant slow down of corporate bond issuance.

Reviewing the Dollar’s Outlook

The U.S. dollar appears to be stabilizing. We continue to believe that the main forces that have undermined it are largely cyclical rather than structural in nature. Several months ago we identified three indicators that would help investors time the dollar’s bottom: short-term interest rate differentials, the status of the general risk-on/risk off trades, and technical factors. We review these indicators here.

Import Prices Trend Higer

US import prices rose 0.7% in October. The market was expecting an increase closer to 1%. However, the underlying trend is clear. Import prices have risen in all but two months thus far in 2009. The fact that imported prices are still off 5.7% from a year ago is reflecting the base effect of the collapse of import prices in the Aug-Dec period. Imported fuel costs are an important culprit. Excluding fuel (not just oil), imported prices rose 0.4% after a 0.5% rise in Sept.

Developing Europe Still Contracting

Of the major industrialized, only Japan and Canada have not reported Q3 GDP estimates. Japan reports on Monday is expected to have expanded at almost the same pace as the US. On the quarter the US expanded by almost 0.9%, while the Japanese economy may have expanded by around 0.7%. With the Big Three in the euro zone reporting, the preliminary estimate is that the euro zone expanded by 0.4% after a 0.2% contraction in Q2. The UK's 0.4% contraction represents the outlier. Canada reports at the end of the month and the economy probably was fairly stagnant.

China

Speculation that China may move on its currency this weekend will likely prove for naught. Nevertheless yuan non-delivered forwards continue to rise today and indicative pricing for the 12-month NDF is for a 3.6% appreciation, the most in several weeks. Many observers, including the media risk exaggerating that Nov 11 report by the central bank that said that global capital flows and changes in major currencies would be taken into account in setting foreign exchange policy and did not repeat the standard mantra emphasizing stability. However, this might not be the signal of a change in policy. Two days before the report was posted, PBOC Governor Zhou said the yuan was not under much pressure to appreciate. And the day after the report was released, Premier Wen did not mention currency policy in a speech and the last time he seemed to address it he called for stability (at a reasonable and balanced level). The economic reports this week showed deflationary pressures easing, though not quite as fast as economists expected, and exports improved, though not as fast as expected. It does also not seem part of China's modus operandi--to appear to capitulate to US, European and IMF pressure. With Obama's visit at hand and European officials next in line to visit, now does not seem to be a particularly likely time to expect a shift on the currency. At the same time, China has indicated it will expand the trials of liberalizing fx rules for individuals and allowing non-financial institutions to offer the service. This in turn has driven the Chinese dollar-denominated B shares sharply higher.

Red Letter Day: Repeal of Glass-Steagall 10-years Old

Ten years ago today US President Clinton delivered the coup de grace to the Glass Steagall Act, which had in any event been diminished by 1000 cuts by officials in the prior couple of decades.

Many observers attribute a good part of the US financial crisis to the repeal of the Glass-Steagall prohibitions preventing a cross fertilization of investment and commercial banking functions.

Changes in MSCI Emerging Market Indices-Effective Month End

As part of its semi-annual review, MSCI has announced changes in global emerging market benchmark indices, with China and Brazil stocks among the main beneficiaries. MSCI estimates that more than $3 trillion are benchmarked against indices globally. The changes will be be effective at the end of the month.

Asian FX Rates

There may be much back-slapping over the fact that Asian-Pacific finance ministers have endorsed market-oriented exchange rates, consistent with the op-ed piece in today's Wall Street Journal by the US Treasury Secretary and the finance ministers from Indonesia and Singapore. But actions will speak louder than words and there is much precedent for lofty platitudes to be followed up with little action. Mostly thunder, little rain. A survey of the currency regimes in a number of East Asian countries reflect a reluctance to embrace market driven foreign exchange rates. Managed regimes are the rule not the exception. Although APEC seemed to largely sidestep the issue about the Chinese yuan peg, there is speculation that China is signaling a change in its stance.

What Euro Options are Telling Us about Spot

The options market can often shed light on spot market activity. Indicative pricing in the options market suggests that while the euro is nearing the highs for the year, many participants seem unusually nervous. Often the options market moves in tandem with spot. So in a rising market, the demand for calls is greater. However, this is not the case presently.

Global Recovery Lifts Poland and Israel

While the Asian recovery story is front and center today, with the slew of Chinese data, including the nearly doubling of its monthly trade surplus, and Japanese machinery orders showing more than twice the expected rise, following favorable trade news on Tuesday, trade data from Poland and Israel provides additional evidence of the synchronized global recovery.

Taiwan News

Taiwan's decision to ban foreign investors from parking funds in time deposits is having little market effect. There did not seem to be unusual movement. While the stock market was up 1%, it seemed largely in line with most of the regional equity markets and not a flight from the time deposits. Bonds were firm as well, but again, nothing unusual. Some local contacts suspect that as the time deposits mature, that it will put a bid tone under Taiwanese asset prices. However, there are also some money market alternative as well. According to yesterday's statement by the Financial Supervisory Commission, foreign investors may still invest up to 30% of thicker remitted funds in short-term (maturity of less than 1 year) financial products. Brazil, who had imposed the 2% IOF (tax on BRL purchases for bonds and shares) is also not finding much success with its foray back into capital controls. The currency itself is essentially unchanged since the tax was announced on Oct 19th. However, the local press is fanning speculation that more measures are in the work and this may be deterring short-term players from push the dollar much below the BRL1.70 level. There are reports that measures under consideration including stepped up intervention with the Treasury joining the central bank, encouraging capital outflows, and schemes that would insulate the economy from the demand for Brazilian financial assets. Lastly there is also talk of raising the tax to 4% but exempting equities. There seems to be serious drawbacks and issues of effectiveness of all these measures to be sure, but the underlying point in both Taiwan and Brazil is that some developing countries are wresting with the flood of portfolio capital inflows.

The Bearish Case for Sterling

Sterling has been resilient today in the face of the Fitch warnings of the UK's rating vulnerability and the deterioration on the trade front. Supporting it has been reports suggesting that Norway's petroleum fund is looking favorable at some UK property investments and M&A related activity. There are of course some large investment houses that have identified sterling as a beneficiary of the generalized recovery.

Taiwan Takes A Step in Brazil's Direction

Taiwan's Financial Supervisory Commission announced that effective immediately foreign investors were banned from parking funds in time deposits. Moreover foreign investors cannot extend their existing time deposits when they mature. The ostensible reason for the ban is to curb currency speculation, according to officials. As of the end of October, there was an estimated NT$500 bln of foreign investment in time deposits, something on the magnitude of five times more than officials would be comfortable with.

US Refunding

It is difficult to envision today's $25 bln 10-year Treasury note sale to be as well received as yesterday's 3-year offering. Indirect bidders, which includes but is not limited to foreign central banks took down 68.5% compared with an average of 45.3% over the past ten auctions. The bid-cover, which is a metric of demand, was 3.33. Demand for this record sized issue was the strongest since 1993. The average for the past ten auctions was 2.63. Even if the reception at today's 10-year auction is not as spectacular, the point is that demand for US Treasuries, even at these low yields, remains strong. It also illustrates why the foreign exchange market is not the center of concern for most policy makers. Clearly the G20 and IMF are not so concerned and if anything see it as part of an ongoing adjustment. For US policy makers the weak dollar comes at a relatively low price, at least presently. Typically currency depreciation costs are seen in terms of inflation and a risk premium. Although inflation expectations are dynamic, it does not seem as if the dollar's weakness is spurring much in the way of price pressures. US rates remain low and foreign demand for US Treasuries remains robust (buying a greater proportion of this year's significantly larger offerings compared to a year ago). Moreover, over the past month as the euro flirts with the $1.50 level and the dollar index makes new lows for the year, the US S&P 500 is the best performing G7 equity market and US 10-year Treasuries have outpeformed the UK, Germany and Japan.

Inflation Expectations or What?

There is much talk today about what appears to be rising inflation expectations in the U.S. There are several market indicators that are capturing people's attention today.

First the yield curve, measured by the difference between the 2 year yield and the 10-year yields stands near 262 bp, having risen now 21 bp over the past month. Second, the five-year/five year forward, which some Fed officials have cited in the past, is at 288 bp today, the highest in over a year. This is also reflected in the 10-year breakevens (10-year TIPS vs the conventional note yield). Third, some observers are also emphasizing the new record high price of gold. Fourth, the dollar remains offered with the much watched dollar index making a new low for the year.

Look To Buy Euro Vs. CZK

The euro has slumped around 4% against the Czech koruna since November 2nd. The news stream from Czech Republic has not been that supportive, giving the impression that koruna is being lifted by generalized factors.

China Data on Tap

A flurry of Chinese data will be reported in the next 12-24 hours. The general picture that will be depicted by the data is of an economy that continues to recover from the global financial and economic shock of last year. There are three elements that will command the market's attention: inflation data, exports and new yuan loans.

Japanese Foreign Reserves Rise

Japan's foreign reserves stood above $1 trillion in October for the 12th consecutive month. Reserves rose a little more than $4 bln over the course of the month. This largely reflected valuation adjustments. The euro rose roughly a cent against the dollar, and this is partially offset by the decline in asset (bonds) prices. Also in terms of valuation, the price of gold appreciated from $995.75 to $1040. This increase was worth about $1 bln to Japan's reserves. These was also a modest increase in Japan's SDR holdings.

Breaking Up is Hard To Do

The financial crisis is usually dated as of mid 2007, but officials did not appear to coordinate an international response until Lehman’s failure sent shock waves through the global financial system a little more than a year later. And even then it seemed like officials acted in concert, like slashing interest rates rather than pursuing a coordinated path. In fact, the failure of the UK government to support Barclay’s attempt to purchase Lehman appears to have estranged the Anglo-American relationship.

Liquidity Ample--Music Playing, Risk On

This week's rash of central bank meetings have concluded. And the take away message is that the major central banks have not begun to remove the extraordinary liquidity provisions. And even in Australia, which hiked rates for the second time, seem to be signalling a gradual approach.

New Initiative from Brazil?

Media reports are playing up local press stories that Brazil officials are evaluating additional measures to slow capital inflows which are driving the Brazilian real higher. The 2% tax may have led to some greater volatility in the currency, but net-net the currency remains firm. Other ideas being considered include the government selling a BRL denominated bond issue overseas. Perhaps most important for foreign investors though is the talk that officials may change the rules and allow investors to deposit guarantees overseas.

More Thoughts on Brazil's 2% Transaction Tax

Investors continue to grapple with the 2% front-end tax BRL purchases for bond and equity investments. One might expect that the efficiency of the market is such that arbitrage will keep the ADR in line with what one would pay for the local shares. This does not seem to be the case, making the ADR a potentially viable alternative to the local shares. Here is our work using Petrobras as an example.

European Bond Update

There are three main stories to be aware of in the European bond market today.

First, Fitch cut its Irish bond rating of AA+ to AA-, citing widening fiscal shortfall and the rising cost of the financial support programs. S&P and Moody's had reduced Ireland's sovereign rating earlier this year, but the Fitch move puts its rating one notch below S&P and 2 below Moodys. Our sovereign rating model had Ireland at the bottom of the developed country universe and although Fitch say the outlook is stable, our work warns that Ireland's macro situation could yet justify another downgrade. Irish bonds weakened on the news but net-net on the day the spread over bunds is 1 bp narrower. At the 2-year sector, the spread has widened a couple of basis points.

New EC Forecasts--a bit more optimistic than the IMF

The European Commission released new forecasts earlier today that generally upgrade its outlook, the first time in two years. On Thursday the ECB staff will provide updated forecasts as well.

The EC now expects the euro zone economy to expand by 0.7% next year. Previously it though the region's economy would contract by 0.1%. The IMF is less sanguine and forecasts a 0.3% expansion next year, half of what the EC envisions. The EC places this year's contraction at 4%, while the IMF see it a tad deeper at -4.2%. The EC sees unemployment rising to 10.7% in 2010 and the 10.9% in 2011. Here too the IMF is less confident and has forecast unemployment to rise toward 11.7% in 2011.

Q4 US Borrowing Slashed

Late yesterday the US Treasury announced a dramatic cut in its anticipated borrowing requirements for this quarter. The net borrowing is expected to now be near $276 bln. This is down by almost half (43%) from the previous estimate of $486 bln.

RBA Kicks Off Central Bank Meetings

The Reserve Bank of Australia is widely expected to hike rates early Tuesday. This would be the second move in the cycle. A Bloomberg survey found 18 of 22 expect a 25 bp hike while the remaining four expect a 50 bp move. We are inclined to be part of the majority here, believing that fragility of the global recovery and strength of the Australian dollar favor an incremental approach. The swaps market looks for another 200 bp of tightening over the next 12-months.

Iceland Scales Back Capital Controls

Effective today, Iceland lifted restrictions on capital outflows. New investors can now exchange their holdings for foreign currencies, provided the transactions are duly registered.