U.S. Economic Outlook

The US economy expanded by an eye-popping 5.7% pace in Q4 09, according to the government's initial estimate, the fastest in six years. The slower pace of de stocking, contributed about 3.4 percentage points to GDP. Consumer spending rose at a 2% clip, a bit better than expected, but off the 2.8% pace seen in Q3 09 that was boosted by the cash-for-clunker program.

Another highlight was business purchases of equipment and software, which rose at a 13% annual pace in Q4, the most in three years. However, this was largely offset by a 15% drop in commercial construction. That leaves total business investment up just shy of 3%. Residential construction fared better, rising at a 5.7% annualized pace, though slower than the 19% pace in Q3. Elsewhere note that net exports added 0.5% to GDP, while government spending shaved 0.2%.

January in Retrospect, February in Prospect

One of the forces that we expected to emerge in January was an unwinding of some of the trends seen in December. This force was evident in parts of the foreign exchange market. The poorest performing currency against the dollar in December was the Japanese yen. It lost a little more than 7% in December. In January it was the best performing currency, recouping almost half of what it had lost in last month of 2009.

The worst performing G10 currency in January was the best performer in December. The New Zealand dollar managed to eke out an almost 1% rise against the greenback in December and is off more than 2.25% in January. The Canadian dollar was the only other G10 currency to have gained against the US dollar in December (+0.80%) and in January it retreated by around 1%.

Policy Dilemma Crystalizes in Spain

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Greece has drawn investors' ire, but it is in Spain today where the policy dilemma is most stark.

Today Spain reported that its unemployment rate in Q4 rose to 18.8% from 17.9% in Q3. The consensus was for a rise toward 18.5%. The unemployment rate has doubled in the past two years. As seems to be typical in Europe, the unemployment challenge is especially pronounced for young people. In Spain, that the unemployment rate for young people is reportedly in excess of 40%.

Japan Data and Flows

In recent weeks several investment houses and observers have suggested the attractiveness of Japanese shares. It is difficult as is often the case that what came first the upgraded assessments or the flows. The fact of the matter is, drawing from MOF data, foreign investors have been net buyers of Japanese shares for nine consecutive weeks through last week. Moreover, the buying in January, through then was more than 60% greater than the whole of December (based on weekly data).

As counter-intuitive as it may seem, foreign purchases of Japanese shares is not a reflection of a bullish yen view. Given that foreign exchange component is the key to total return on fixed income investment, a fund managers bullish the yen is more likely to be Japanese bonds than equity. Many observers attributed the Nikkei's relative performance during the last nine months of 2009 to the relative strength of the yen. The yen, it will be recalled, weakened around 10% from late Nov through early Jan and the Japanese stock market tended to out perform the other G7 markets.

We suspect many observers are exaggerating the hawkishness of the FOMC statement

They emphasize Kansas City Fed President Hoenig's dissent. But to even call it a dissent is to attribute too much gravitas to it. In the past, as far as we can tell, dissents were an expression of disagreement over the course of action that the majority endorsed. There was no such thing here. Hoenig disagreed with the characterization of the guidance--he favored dropping the "extended period" for which rates may remain low. In addition, if it weren't that Chairman Bernanke confirmation had been questioned, given his public comments, a dissent by Hoenig seemed likely. In fact, this is likely to only be the first of several dissents we should expect to see from Hoenig. It should reinforce perceptions that Hoenig's views are not the majorities. He reflects a small faction of views. He is an outlier. In terms of the Fed's economic assessment, those with a more hawkish spin are playing up the characterization that growth is moderate instead of weak. But look the consensus is expecting around 4.5% Q4 GDP to be released Friday and a healthy Q1 10 GDP (3%-4%). The Fed has to recognize this and by acknowledging it and still sticking to its essential message it enhances its credibility.

More Thoughts on the Fed

In my first take I said nothing about Hoenig's dissent and that is what many in the market are talking about. I did not think it was all that important primarily because it was not the typical kind of dissent when the FOMC would vote to keep rates on hold and a member would disagree, wanting to say cut rates. Hoenig's dissent was over future guidance. He wanted to drop the guidance about conditions allowing rates to be on hold for an extended period. I also did not think it was significant because Hoenig's views are well known and the role that had been played by Lacker is now Hoenig's. The two-year note did sell-ff sharply, with yields rising 5 bp on the day. This puts the yield up 3 bp over the past five sessions and down 24 bp this month. Fed funds futures leaned a wee bit more toward and Aug rate hike. It appears that others see the dissent as casting a largely unchanged statement with a less dovish tint. Complimenting this is the characterization of the growth outlook as moderate instead of weak.

Fed Stays the Course

The FOMC left rates on hold and in general stayed the course. The long-term asset program was not extended and conditions were such that the FOMC expected rates to remain low for an extended period of time. Surprisingly, there was one dissent on this phrase from new voting member and known hawk, Hoenig. Hoenig argued the phrase "extended period" was no longer warranted. The dissent is surprising because the market had expected FOMC members to rally around the challenged Chairman. (We had highlighted Hoenig's hawkish stance in our Q110 quarterly section, Central Bank Hawk/Dove Barometers but had also noted that two doves, together with Hoenig, became voting members this year.)

Greek Woes Push European Currencies Lower, Yen Higher

Sharp pressure on Greek debt instruments and, to a lesser extent, the other weak credits in the region,is pressuring the European currencies lower, with the euro stopped cold in its tracks before $1.4100 was reached and is now headed toward the lows. Optionality struck near $1.40 may try to contain the down ticks for the next hour, but a break of this psychological threshold is looking increasing likely. Last week's negative dollar news in the form of the new banking regulation proposals and the uncertainty over Bernanke's confirmation have eased allowing the negative news from Europe (and anxiety over Chinese tightening of bank lending) re-assert themselves as the dominant force. While momentum players already appear to be participating in the move, the medium term investors may wait for a break of the $1.3970-80 to ensure that the $1.40 has really broken.

Although Japan's rating outlook was cut yesterday by a rating agency, the yen's recovery from the nearly 10% decline from late Nov through early Jan continues. The JPY89.30 area corresponds with a 50% retacement and the next retracement objective is closer to JPY88.20.

Pressure on Portugal Increases, What Will Socrates Do ?

The reprieve on Greek bonds after the successful placement of 5-year bonds (at a hefty premium to existing 5-year bonds) was short-lived. Benchmark 10-year yields are up 23 bp today, while 2-year yields are up 32 bp, bring the total increase over the past five sessions to 71 bp and 62 bp respectively.

In contrast, the pressure on Portugal is considerably more modest but rising. Today Portugal's 10-year yield is up 6 bp (to 4.17% compared with 6.48% in Greece) and the 2-year yield is up 0 bp (to 1.49% compared with 4.93% in Greece). Over the past five days, the 10-year yield has fallen 6 bp, while the 2-year yield has risen 14 bp. Yesterday Portugal reported a larger budget deficit of 9.3% of GDP last year (the EC had expected something closer to 8%), but promises to reduce the deficit to 8.3% this year and back to the mandated 3% level in 2013. Judging from the developments in the debt market today, including the sovereign CDS markets, many doubt measures are sufficient.

Outlook FOMC

The FOMC will conclude its two-day meeting on Wednesday and we do not expect a substantive change in its economic or inflation assessments. Nor do we think its guidance that conditions will likely "warrant exceptionally low interest rates for an extended period of time."

Even though the December non-farm payrolls report disappointed, it is still fair to say, as the FOMC did in mid-Dec that "deterioration in the labor market was abating." It may have to drop its assessment that the housing sector is showing some signs of improvement, after a recent string of poor news. The very cautious optimism can be retained and the assessment will likely receive quick confirmation in the way of Q4 GDP that will contrast marked with news from Europe--where the UK just reported 0.1% Q/Q).

Peru Tax Part of Trend ?

Last year Brazil imposed a 2% tax on BRL purchases related to fixed income and equity purchases. Taiwan took steps to discourage foreign investors from parking funds in short-term instruments, which it saw as speculation in currency appreciation. Starting this week Peru's 30% tax on foreign investors profits from short-term (up to 60 days) currency forwards (including NDFs). Anecdotal information suggests that the NDF positions are concentrated in one month tenors. In some ways this is simply an extension of legislation from the end of last year that included a capital gains tax on equity.

China Reserves

Local press reports have emphasized the Chinese sliding reserve requirement. The explosion of new bank lending (reports suggest CNY1.45 trillion or ~$212 bln) in the first three weeks of the year appears to have slowed considerably under the administrative measures. There is some speculation that Chinese officials seek to tighten their control by providing monthly quotas instead of the current practice of quarterly quotas. The PBOC left the 1-year bill rate steady today allowing a small increase over the past two weeks. Concern about the impact of China's course has weighed on the equity markets. China's Shanghai Index is off more than 10% from its Nov peak, most of which has been lost since Jan 19th. Hong Kong's Hang Seng is off 13.5% since its Nov peak and 11.8% since Jan 11th. Taiwan's Taiex Index was lifted to new cyclical highs at the start of the year but since the Jan 19th peak, it has lost 9.7%. Through today, the Taiex fell for the 7the consecutive session, the longest such streak in 4 1/2 years.

Key Drivers in Foreign Exchange Market

 With fresh developments light on the ground today, it may be worthwhile to take a step back and re-examine the key drivers of the foreign exchange market.

Last week saw the emergence of a new factor that seemed to eclipse or at least mitigate the impact of the other drivers. Previously problems in deficit issues in Europe and efforts by China to tighten lending conditions were the dominant issues, but last week, the combination of President Obama’s new proposal regarding banking activity coupled with the heightened doubts over Bernanke’s re-confirmation sent shock waves through the capital markets in general and seemed to stop a dollar rally cold. Obama’s new proposals are still regarded as a bit vague (e.g. what kind of proprietary trading, outside of owning of hedge funds and private equity firms, does the Volcker Rule seek to ban) and appears to break from the coordinated international approach that seemed to emphasis the capital requirement tools. The proposed new tax on large banks may encourage some like the UK and France to push again for some kind of financial transaction tax (like the Tobin Tax).

Bonds Today

The better appetite for risk today and supply concerns are weighing on sovereign bond markets. Japanese and European 10-year yields are 1-2 bp higher today. The US Treasury will sell $118 bln of coupons this week. While 10-year yield spreads within the euro zone today are largely steady, pressure on Greece remains evident in the 2-year sector, where its yield has risen another 37 bp to 5.13%. It is trying to place, through syndication, 5-year paper today. Some pressure is also evident on Portugal’s 2-year bon, which is up 4 bp.

Equities Today

Asian equities took the lead from Friday’s sharp losses in North America, with the MSCI Asia Pacific Index falling 0.7%. Its losing streak has extended to the sixth session, during which time it has lost about 4.3%, leaving it up less than 1% on the year. Telecoms, financials and basic materials offered the downside leadership. Ongoing concerns about the tightening of monetary conditions and new fund raising by Chinese banks pushed the Shanghai Composite down a little more than 1%, the largest loss in the region. European bourses are trying to recover from early losses; helped by a recovery in US share prices. Financials, basic materials and industrials are leading the recovery. US shares are set to recover nearly half of what was lost before the weekend.

Currencies Today

The US dollar is mixed with a downside bias today. It is losing ground against the euro and sterling, but is trading higher against the Japanese yen. With new assurances over the weekend, the fear of the politicization of the Federal Reserve and Chairman Bernanke’s re-confirmation has eased and risk averseness is waning. The yen may also be pressured by speculation that the BOJ may extend either its emergency lending (amount and/or duration) to banks or purchase more JGBs as early as tomorrow at the conclusion of its policy meeting. Ideas that the RBA is poised to hike rates next week has helped the Australian dollar recoup some of its recent losses, though a local holiday tomorrow could see interest wane.

Bernanke Confirmation Vote Update

The media is noting that procedural maneuvering is frustrating attempts to hold the Senate vote on the confirmation of Bernanke's appointment for a second term as Fed Chairman. Some reports claim that the Republicans are considering a filibuster. Even though Bernanke is a self-identified Republican and was initially appointed by a Republican president, there is talk that the vote could be along party lines, with the Republicans generally opposed. Bernanke's term expires at the end of the month. It is possible that the parliamentary moves may postpone the vote into Feb. However, on balance it continues to appear most likely that Bernanke's appointment is confirmed. We note that the policy market at www.intrade.com still shows the odds as around 80% chance he is confirmed. This is down from the peak around 96%, but is still seems relatively confident.

What Ails Greece Ails Europe

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Greece lies at the center of Europe’s maelstrom. The proximate trigger was the election of a new government last October that had the audacity to reveal a deep dark secret—Greece’s deficit was three times larger than previously acknowledged.

Currency in Crisis



Prime Minister George Papandreou was contrite and has cobbled together a general plan, effectively reversing many of his campaign promises; claiming to reduce the deficit from 12.7% in 2009 to 3% in 2012. A Herculean labor if there ever was one.

Swiss Intervention

A more modest theme in the FX market has been the strength of the Swiss franc against the euro (~3% since mid-Dec). Recall the quantitative easing strategy the SNB pursued included blocking CHF appreciation through intervention and the purchase of foreign (dollar and euro) bonds. The franc has appreciated through the top end of the range the SNB was perceived to be defending. Indeed, today the franc is trading at its best level against the euro since the first intervention back in March 2009.

Earlier today the SNB published its foreign currency holdings and both dollars and euro holdings increased, suggested QE has continued. Specifically, the SNB's euro holdings rose 5.3 bln euros to 37 bln and the dollar holdings rose by $7 bln to $27.6 bln. While it is possible that the intervention was concentrated in the earlier part of Q4, it is also possible that the demand for Swiss francs, ostensibly coming from eastern and central Europe, where mortgages and other loans were taken out in francs and from the Swiss themselves who may be selling foreign assets to bolster domestic positions. Little in the way of the euro to return toward last year's low near CHF1.46, without a stronger protest from Swiss officials.

Aussie Losses Exaggerated

The Australian dollar has been hit by the broad dollar recovery and weakness in commodities, which may be partly linked to the risk of further tightening of monetary conditions in China. There is another factor that may be taking a toll. Local papers report that Ken Henry, the Secretary to the Treasury, is recommending a tax reform in Australia that aims at replacing a royalty tax on mining projects to a national resource rent tax, like the one on petroleum and related products.

Unlike some of the state-based royalties, the proposed resource tax would be applicable only on profits (not revenue) after exploration and development costs have been absorbed. At some times the new tax would have raised less money than the royalty tax, especially during years that miners were struggling. Australia's Treasury estimates that the new tax would have raised about A$14 bln more than the royalty tax raised over the past three years.

Price Action Indicates Dollar Advance is not Over

The relatively shallow pullback in the dollar was greeted with renewed buying and this would suggest the dollar's recovery is not over. At the moment the foreign exchange market does not appear to be driven by economic data. The Greek crisis is not simply about Greece but uncovers a fissure at the very heart of EMU. Is monetary union really sustainable without political union, without which there is no mechanism to coordinate and enforce fiscal rules. In addition to the fundamental story, whose saliency has increased in the fx and debt markets, there is a technical component as well--with model driven accounts and trend followers jumping aboard the dollar express.

Euro Slide not Sufficient for French Prime Minister

Earlier today, French Prime Minister Fillon reiterated recent remarks by other French officials bemoaning the euro's strength against the dollar. The euro has slid almost 6.75% against the US dollar since late November. The euro's setback means that over the past six months it is essentially flat (-0.71% according to Bloomberg data).

Fillon's remarks were reportedly made in the context of a broader discussion of French competitiveness. France wants to attribute the sharp widening of its trade deficit to the euro's strength. France's trade surplus has deteriorated sharply in recent months. The Nov trade deficit was well above expectations at 5.3 bln euros, nearly a 20% worsening on the month. Barring a dramatic improvement in December figures, which will be reported on Feb 5, trade will be a drag on Q4 GDP.

Greek: Tragedy or Farce?

Currency in Crisis

Moody's may have called the Greek fiscal proposals "relatively well designed" (though it did keep its negative outlook), but the market is voting with its feet and in a big way today with the Greek 2-year note yield jumping 62 bp and the 10-year yield rising 18 bp. The Greek bond market had begun the year on a firmer note after the sell-off into year-end, but in recent days those gains have completely been unwound plus some. Capital is striking after concluding that the present course and the one that Greece has proposed, which means running a huge primary budget surplus, is not very likely to be delivered upon. Some officials have argued that any bailout of Greece would undermine the credibility of the EMU and the euro itself. This seems to be fair for as far it goes. The problem is that it does not go far enough and may reflect the lack of appreciation for what is at stake.

Be Prepared for Softening of US Housing Data

Tertiary reports are warning of renewed weakness in the US housing sector. Today the NAHB Housing Market Index was reported. This little watched survey of home builders tracks present sales, 6-month sales expectations and traffic of prospective buyers (of single family homes). The index ranges from 1 to 100. It most recently peaked in Sept 09 at 19. NAHB reported today that its index slipped to 15 from 16 in December. It has not risen since Sept and is back to where it was in June.

On January 5, the US reported as 16% drop in Nov pending home sales, which pushed the year-over-year rate to 19.3% from 28.7% in Oct. It portends weakness in existing home sales.

Greece Update

Currency in Crisis

Greek 2-year and 10-year bonds are holding in fine today, with the spread against Germany narrowing around 5 bp today. Pressure has intensified in recent days as European support seems half-hearted. Some officials have criticized Greece for relying on one-off measures to cut 10 bln euros from this year's budget, and suggesting that Greece may need to take additional steps.

Greece appears to be making a subtle but important concession today. It will invite a Eurostat member to serve on its statistics agency. While the lack of fiscal prudence in good economic times is the underlying problem, Greece's faulty and compromised data collection is an obstacle to policy and undermines its credibility. It is possible that greater auditing power is given to Eurostat.

Korea Won Vulnerable Near-Term

The underlying economic fundamentals in Korea remain constructive, but the near-term outlook for the currency is less favorable. The dollar is trading to carve out a base near KWR1120 and near-term potential extends toward KRW1140-KRW1150. Contacts report that the central bank intervention is likely to have greater sway as foreign investor demand for won for equity purchases subsides.

Two new features early today initially saw the won strengthen, about those gains have been surrendered in full. First, helped by the unusually cold weather that boosted clothing sales, spending at the country's three largest department stores rose 12.5% in December year-over-year. Recovering domestic demand is joining better foreign demand to help lift the South Korean economy and pave the ground for a rate hike as early as next quarter (currently 2.5%).

China

China's central bank has raised the benchmark 1-year bill rate for the second consecutive week. The 8 bp increase to 1.926% matches last week's increase. Between August 2009 and last week, the 1-year bill rate was steady. This coupled with last week's reserve ratio increase and anticipation that China will report double digit growth in Q4 09 GDP later this week has fanned concerns that China is trying to slow it economy. On the contrary, we think the main objective of these nuanced steps is to manage the pace of loan growth. With December figures reported last week, new loans in China increased CNY9.59 trillion in 2009 and there have been some reports suggesting that this year is off to a strong start. The strong loan growth has exacerbated excess investment in some industries and has helped boost property prices, though there seems to be some debate over whether it is sufficient to count as a "bubble". The risk is that, barring a sudden drop in the Chinese stock market, the PBOC will allow the 1-year bill rate to increase a bit more in the weeks ahead, but officials do not seem prepared to increase the key 1-year lending rate, which is at 5.31%. Separately, a few European officials have been raising concern about the euro's exchange rate and it seems that they have ratcheted up their complaints about the Chinese yuan. In that context, we note that the euro has depreciated about 6% against the yuan since early December.

Yen Likely Won't be Moved by Funding Scandal

News that a second aide to DPJ's Secretary General and king maker Ichiro Ozawa has been arrested in a political funding scandal is not likely to weaken the yen, which is little changed on the day in the NY morning.

Ozawa does not have a public office, but is seen as the power behind the throne. It is possible that Ozawa is called before parliament, but the situation has to escalate, it would appear, for Ozawa to be forced out of the party he was so instrumental in creating.

Thoughts on How the ECB and US Data may Impact the Dollar

Currency in Crisis

The ECB meeting and press conference are unlikely to provide fresh incentives to the market. The ECB is clearly on hold for a few more quarters ate least. The Q&A will be the more interesting, but even here Trichet is unlikely to make any revelations. The ECB is notably reluctant to promise any support to the weaker members. But none of those members appear poised to ask for help any time soon. Greece is to submit its plan to the EU tomorrow, while Greece and Portugal bonds are under strong downside pressure today.

US retail sales and inventory data is likely to be firm and the risk of both reports are on the upside. Neither continued lay offs two quarters into the recovery nor continued household deleveraging is preventing a pickup in consumption. Retail sales, excluding autos, have fallen only once since May 09. November's 1.2% rise, the strongest since January's 1.4% gain is unlikely to be replicated, a positive number is likely, and if so, Q4 09 will be the first quarter that there was not a monthly negative print since Q2 08.

Thoughts on an (unlikely) exit for EMU

There have been more talk in recent days that a current member of EMU will look for an exit. Greece is serving as the lightening rod, with 10-year bond yields soaring 23 bp today. Many observers have referring to the risk as being in the PIIGS countries-- (Portugal, Italy, Ireland and Greece).

Some of the market talk focuses on the near-term--this year. We think those arguments are largely spurious. Thomas Schelling, the Nobel prize winning economist, talked about different negotiating positions in the context of game theory. He called one set "burning bridges". Under this tactic, one would demonstrate one's resolve by denying alternative course. For example, in the game of chicken where two people drive their cars at each other and the first one to turn loses; if one wants to convince one's adversary that one will not turn, Schelling suggests throwing one's sterling wheel out the window.

New Lows in 3m Euro Vol; Spring Coiling for Big Spot Move?

Three month implied euro volatility, which is the benchmark in the options market, has fallen today to reach its lowest level since Sept 2008. At 10.59% it has dropped about 2 percentage points this year.

Even if one does not trade currency options, the option market may help in the price discovery process in the spot market. On one hand the decline in implied volatility could suggest that the market is anticipating a range trading environment to persist. Implied volatility eased in the first half of December, as the euro initially pulled back from the highs for the year, but then rose in the second half of December as the pace of the euro's decline threatened break key support around $1.4200. As the euro has recovered more than 3 cents off that pre-Xmas low, implied volatility has fallen like a rock.

Greek Woes Underscore Risk Aversion Theme Today

Currency in Crisis

Three separate developments underscore the risk aversion theme today: Disappointing Alcoa earnings to kick off the US earnings season, the continued snugging of Chinese rates, including a 50 bp hike in reserve requirements (for large banks), and new worries about the outlook for Greece.

The EU has raised questions over the credibility of Greek macro-economic statistics after having revised its budget deficit estimates sharply in both April and October last year. It found several irregularities, leaving the accuracy of the government's economic reports in doubt. Meanwhile, an IMF team has arrived in Greece, ostensibly as part its regular surveillance efforts.

Strength of Krone and Prospects Higher Norwegian Rates

Norway is the only major European country to hike rates last year and did so twice in H2 09. The central bank indicated after the Dec rate hike that if the krone appreciates more than expected, it could delay or limit further rate hikes. The krone has rallied about 3.25% on a trade-weighted basis over the past few weeks, during which time the euro has fallen 4.3% against the NOK. With real money interest and higher oil prices exciting the speculative community, the krone is off to a strong start this year, second only to the Australian dollar.

Australia Outlook Updated

Neutral sounding Reserve Bank Australia comments after an unprecedented three rate hikes in consecutive meetings had helped encourage a wave of profit-taking that saw the Australian dollar lose about 6.4% against the US dollar in the first 3 weeks of December. However, over the past couple of weeks Australia has reported a series of stronger than expected economic reports, including building approvals, retail sales and a smaller than expected trade deficit. On Thursday, Australia reports Dec employment data. The consensus appears to around 10k, but the Street consistently under-estimated Australian job growth last year and the risk would be on a stronger number.

The Dollar

In terms of market positioning We have argued that the dollar’s rally in December largely reflected short-covering ahead of year end, upon which momentum traders jumped aboard and that it would come off again early in the New Year. The IMM Commitment of Traders positioning is not comprehensive and in others ways flawed, but it does seem somewhat representative of short-term speculative forces. The shorts appear to have overplayed their hand or overstayed their welcome. Consider that as of last Tuesday, the net euro position was short 37.8k contracts. There was only one time (Sept 08) that the net short euro position was that large since at least the early 1990s. As of early last week, the speculative camp was net short all the major currencies. There seems to be scope for additional position adjusting and this will likely weigh on the US dollar. We note that the 5 day moving average is crossing above the 20-day in the euro. A similar bullish cross over took place last week on the Swiss franc. On the other hand, the speculative market is long Canadian and Australian dollars and at the upper end of the recent historical market positioning. However, momentum is still a tail wind. Australia has reported a series of stronger than expected data in recent days and this has renewed speculation of further rate hikes after the RBA took on a more neutral tone last month. Higher commodity prices underpin sentiment.

China

At the end of last year, China reported that its CPI had turned positive from a year over-over-basis. Deflation had ended. Last week, the PBOC allowed the three month bill yield to rise for the first time. This small nuanced move, that will likely be reaffirmed with the 1-year bill sale this week, is a small token move and of greater symbolism than substance. Coupled with today’s news that exports also returned to growth on a year-over-year basis (first time in 14 months), you get speculation of yuan appreciation. This is evident in the 12-month forwards. Chinese officials appreciate the base effect that will flatter the data and is unlikely to act in the near-term to engineer a stronger yuan. The real importance of the strength of the Chinese economy is not so much its exports, but the import side. Imports surged almost 56% year-over-year. Imports from Australia and Malaysia, for example, have doubled. The strength of Chinese imports will help support numerous economies in the region and commodity producers including South Africa and Brazil.

Germany

The German economy, and by extension, the euro zone economy as well, appears to have lost momentum in Q4 09. Last week’s data for Germany included news of a 1.1% fall in Nov retail sales. The market had expected a 0.3% rise. Factory orders for that month fell 0.2%. The consensus had been for a 1.5% increase. The wider trade surplus was a small reflection of exports (+1.3%), but really do more to a slide in imports (-5.9%), which would also suggest poor domestic demand. The euro zone manufacturing PMI did rise to 51.6 from 5.1, but consider that it rose 2.3 point since Q4 after 6.7 points in Q3 and 8.7 points in Q2. The service sector PMI also shows a loss of momentum in Q4. The region’s industrial orders fell 2.2% in Oct, offsetting in full the Aug and Sept increase.

Japan Finance Minister

A new finance minister in Japan has jettisoned the DPJ’s strong yen policy. The move back to the LDP’s position reflects the deflationary concerns and the more pro-business arm of the DPJ getting an upper hand within the party. The dollar had already appreciated nearly 10% from the late Nov lows against the yen before Kan spoke about how businesses would prefer the dollar to be near JPY95. We suspect that Finance Minister Kan will have no more success than his LDP predecessors and that the yen will likely recover from its recent drubbing.

US Labor Markets

The US labor market recovery continues to be slow, but it is taking place. In H1 2009, the US lost an average of 559k jobs a month and in H2 the average job loss was 134k. The average job loss in Q4 was 69k vs 199k in Q3. Looking ahead, weather-induced job losses should help boost numbers, even here in January. The bulk of the 1.15 mln Census Dept workers still need to be hired. On the other hand, the 650k who left the labor market, which allowed the unemployment rate to remain steady will also have to be absorbed at some point. Meanwhile, the American household continues to de-leverage. Consumer credit fell a record $17.5 bln in November, the 10th consecutive monthly decline. This was three times greater than the consensus had forecast. However, the paying did not stand in the way of the strong Nov retail sales (1.2%). Nor will it prevent a robust Dec retail sales report later this week (Jan 14th). Lastly, we note that various measures of US inflation expectations continue to rise. At 2.82% the 5yr/5yr forward, for example, is up 35 bp since late November.

Re-Orientation: Russia Looks East

In 1869 the U.S. completed the transcontinental railroad. With shipping interest in the Atlantic and Pacific Oceans, the partners of Brown Brothers, one of the key investment banks of the period, understood the golden spike as linking Europe and Asia. A little more than a century later, the center of gravity in the world economy has shifted. Since the early 1980s, trade over the Pacific has exceeded that over the Atlantic.

Now a new and profound re-orientation appears to be taking place. Traditionally, Russia looks westward to Europe for its energy exports, but now it is making important strides toward diversifying to the energy-thirsty Northeast Asia (China, Japan, South Korea, and Taiwan), which consumes as much, if not more, energy than the United States and Europe. In contrast to Northeast Asia, the traditional European market is sclerotic and officials are debating significant cuts in fossil fuel consumption over the next decade.

Post Job Thoughts

No doubt the jobs data disappointed and the market positioning was clearly leaning the wrong way. That the dollar has dropped is not that surprising--we thought that was the risk regardless of the data--but rather the greenback's resiliency the far. The euro has not risen above yesterday's high $1.4450 and this is an important level that needs to be taken out to boost confidence that a low is in place. Sterling, for its part, has risen through yesterday's high, but stopped dead in its tracks at the 200 day moving average ~$1.6113. The yen is moving to a different beat, given the stepped up jawboning. A break of JPY92.00 would warned that the yen's sell-off that began in late November may be over.

China

The People's Bank of China snugged policy today by selling 3-month T-bills yielding 4 bp more (1.3684%) than has prevailed since mid-Aug 2009. Nuances are often important. This is not regarded as an equivalent of a rate hike, though next week's sales of benchmark 1-year bills will also likely reflect today's move. In a report out yesterday the PBOC signaled that policy will aim at moderate loan growth while managing inflation expectations. Recall that in late December Chinese Premier Wen expressed concern that the doubling of new loans was causing a rapid increase in property prices. Consumer prices in China rose on a year-over-year basis for the first time in 10-months in November. The little snug on monetary policy helped underpin the yuan.

Canadian Reserves and the Diversification Dilemma

Canada reports its international reserves on a weekly basis and today it reported the figures for the week ending Dec 31. The US absorbs a little more than 80% of Canada's exports. While this would seem to offer a prima facia case for not diversifying reserves, Canada has long diversified its reserves.

Canada's reserve assets include dollar, euro, yen, gold, SDRs and its IMF reserve position. Taking these all into account, about 44% of Canada's reserves were in US dollars at the end of 2009. At the end of June, the dollar accounted for about 52% of Canada's reserves.

Outlook for BoE and Sterling

The two day meeting of the BOE's Monetary Policy Committee has begun. There is practically no chance of a change in rates or in its asset purchase program. Nevertheless the meeting provides a timely opportunity to review the outlook for UK monetary policy.

The last MPC meeting was December 9th-10th. With no dissent, it left the bank rate at 50 bp and maintained its asset purchase program cap of GBP200 bln. It will take the BOE the better part of the next month to complete these purchases, making the Feb MPC meeting potentially more interesting.

Euro Movers: Correlations Reviewed

There has been much talk in recent weeks that risk-on/risk-off trades, in which many instruments seemed to be highly correlated, may be breaking down. We have taken a fresh look at our correlation matrix. At a proxy we look at the correlations with the euro. We run our correlations on percentage change as we believe it is a more robust approach.

We find that there has been no breakdown in the correlation of the euro and the S&P 500. In fact, it has tighten in the recent period. Consider that for all of 2009, the correlation was about 50%. Over the past three months, it has risen to 59% and in the past month, it stands at almost 63%.

Taiwan Officials Getting Serious about FX Speculation

Taiwan officials have tried to discourage speculation on its currency, but to little avail. The Taiwanese dollar rose to its best level against the US dollar since Q3 2008 yesterday before pulling back a bit, amid some scattered talk of possible central bank intervention.

Today the central bank announced that foreign investors have a week to use funds in Taiwanese dollar accounts that have been allocated for stocks to purchases shares. Local banks were reportedly instructed to execute currency trades as soon as clients place orders.

Thinking About Fed Funds

The weighted (by volume) average of Fed funds on New Year's eve was 5 bp. The range that day briefly touched the lower end of the 0-25 bp target for the first time since the end of Q3. Throughout Q4 09, the effective Fed funds rate was very stable between 11 and 13 bp--the middle of the target range.

Recall that the Fed funds futures settle at the average effective rate not the target rate for the given month. The FOMC meeting this month concludes on the 27th. No one expects the Fed to change rates at that meeting and it makes sense then that the Jan Fed funds futures is implying a 12.5 bp average Fed funds rate. The Feb-April contracts implied yields rise 2-3 bp a month. The May contract jumps 6.5 bp to 27 bp. Ironically though there is no meeting in May and the April meeting is late in the month (27th-28th), so the May contract is a better guide to expectations in April. The May contract then implies about an 8% chance of a Fed hike at the April FOMC meeting.

Latest Reserve Composition Data

The most authoritative source for data on the currency allocation of central bank reserves comes from the IMF and it is reported at the end of a quarter for the preceeding quarter. At the end of last week the IMF published Q3 reserve data.

Central banks held $7.5 trillion in reserves at the end of Q3 a $334 bln rise over the quarter and a $446 bln increase from Q3 08. Of this amount, the currency allocation of $4.43 trillion is know, leaving $3.08 trillion unallocated. There are two entities that appear to account for the bulk of the unallocated reserves. China is widely believed not to report the allocation of its reserves. At the end of Q3, China reported that its reserves stood at $2.27 trillion. Only countries are members of the IMF (unlike other international organizations like the WTO, for example) and Taiwan is not country. At the end of Q3, Taiwan reported reserves of $332 bln. These two then can account for a little more than 85% of the unallocated reserves.