Sterling Shocked

The UK surprised the markets by reporting that Q4 10 GDP did not expand slowly as the consensus expected, but actually contracted by 0.5%. The economy last contracted in Q3 09. A full breakdown of the report is not made available until the next report in late February. However, the preliminary numbers suggest that the service sector contracted 0.5% and construction fell 3.3%, while industrial output rose a little less than 1%. This is largely consistent with the PMI readings. The market's reaction to the disappointing data was clear. UK interest rates fell sharply. The market had priced in aggressive BOE tightening over the next several quarters, encouraged by the 3.7% CPI reading for December and with the view that the VAT hike would further boost CPI in the coming months.

The unexpected contraction in UK GDP has triggered the beginning of the unwinding of these expectations, with the short-sterling futures strip taking back 15-20 bp of tightening. The operative word is beginning. There will likely be further unwinding, even though the poor weather no doubt impacted. Today's report makes BOE King's speech late today even more important, but it may steal any thunder potential of tomorrow's release of the Jan MPC minutes. Sterling itself is posting an outside down day--having trading on both sides of Monday's range and will most likely finish below Monday's low near $1.5920. The risk now is that a break of $1.5720 signals additional near-term losses $1.5650 and then $1.5400 over the slightly longer-term. For its part the euro looks likely to retest the end of last year's high near GBP0.8650 and then GBP0.8700.

Today will also be remembered for the initial bonds sale of the European Financial Stability Facility (EFSF). The 5 bln euro 5-year bond was over-subscribed nearly by a factor of nine. Yet the successful auction has not seen peripheral spreads over Germany narrow; to the contrary, all but Ireland are wider today. First, as we have suggested, comments by a number of sovereigns had suggested that the triple-A EFSF (and EFSM) bonds were seen as more attractive paper to invest, rather than an additive. Second, comments from Spanish officials have seemed to heighten concerns. Economics Minister Salgado was quoted suggesting that additional government injection of funds into the financial system would be limited to 20 bln euros.

This is considerably less than the markets had anticipated is necessary. Indeed, the amount the cajas will need to recapitalize will not be known until at least late next month when the cajas must report 2010 results. The government has indicated that it will seek to liberalize the ownership of the cajas to attract private capital, but this may prove easier said than done given the lack of transparency. The market's disappointment with what its sees as the lack of sufficient resolve has been taken out not only on Spanish government bonds, but the shares of the banks are off more than 3% near midday in Madrid, more than twice the overall market.

The Bank of Japan met today. It left rates on hold of course as widely expected. The upward revision to growth in FY10 is not all that surprising (3.3% from 2.1%) as it largely reflects history. However, what was unexpected was increased forecast for Japanese inflation from 0.1% to 0.3% for the FY11 that begins April 1. While higher commodity prices may help bolster measured inflation, there is likely to be an offset this year as the inflation gauge is re-jigged and preliminary reports suggest it will increase the weight of electronic goods, which have a deflation of their own.

The dollar has spent the past eight sessions largely confined to a JPY82-handle. It is hard to get inspired by it and the performance on the crosses reflect the other leg more than the yen. Of note, over the last few sessions, the euro has been flirting with its 200-day moving average against the yen, which comes in today near JPY112.20. It looks like the market is rejecting it and a break of JPY111/60 would lend credence to that view.

The FOMC's two-day meeting begins today. It is the first meeting of the year and it could turn out to be one of the dullest. Little has taken place since it met last in mid-December that would materially affect their FOMC assessment. Five new regional Fed presidents rotate on to the FOMC as voting members and the new members overall appear somewhat more hawkish than the last year's, especially Philadelphia and Dallas Fed presidents (Plosser and Fisher). Recent public comments suggests that neither is inclined to dissent presently from a decision to continue the Fed's Treasury purchases or the guidance to keep rates low for an extended period of time. That said, if there were to be a surprise, Fisher seems the more likely of the two to dissent.

Recognizing the recent string of data, the Fed may marginally upgrade its assessment of growth, especially in terms of consumer spending. The fact that the unemployment rate fell 0.4% in December is unlikely to impress Fed officials as it reflected people leaving the labor market, arguably giving up looking for work. Data continues to point to little price pressure, including the Fed's preferred measure of the core PCE deflator, continues to decelerate. The recent rise in energy and food prices may be acknowledged, but the FOMC is more likely to see this as a retardant on growth rather than an accelerant of inflation. Indeed there is some speculation that the higher energy prices will blunt whatever marginal fiscal stimulus that was provided by the recent bipartisan agreement.

There is no reason to expect the FOMC to backtrack from its plan to purchase $600 bln of Treasuries. The next two meetings (mid-March and late-April) will likely be more interesting as attention turns toward guidance of expectations for the completion of its long-term asset purchases. This may hinge not just on the economic performance, but also by what the Fed expects to happen. In this context, the new growth and inflation forecasts that will be presented at the FOMC meeting will be important.

Unfortunately, these will not be made public until the minutes are released on Fed 16. Recall that in mid-Nov, the central tendency was for the economy to grow 3.3% in 2011 and 4.0% in 2012. Ironically, the central tendency for 2010 was 2.4%-2.5% and this looks to be too low. Note that in nominal terms, the US economy surpassed its old GDP peak in Q2 10. In real terms, we may learn at the end of the week, that in Q4 10, the US economy surpassed the Q2 08 peak of $13.359 trillion. In Q3 real GDP stood at $13.278 trillion.