CNBC: The Monday Markets

CNBC: Violence in Egypt, Volatility Everywhere Else

The Internationalization of the Yuan or the Sino-ification of Hong Kong?

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One of the fundamental characteristics of the global financial architecture is that the world’s second largest economy maintains a rigidly controlled currency. The concept of currency wars, as initially articulated last year, seemed to have been a criticism of the easy monetary policy of the Federal Reserve, but is being appropriated and used as a criticism of the lack of flexibility of the Chinese yuan. The reluctance of Chinese officials to allow its currency to be another shock absorber in the circuit of capital means that other liquid flexible or floating currencies have to shoulder a greater burden of the adjustment. Some, like a well respected analyst at a recent industry conference in New York, suggest that as long as Asian currencies remain under-valued that the European currencies will remain over-valued, and by implication other currencies as well.

Euro Slides on Long Liquidation, ECB Noises

Liquidation of the euro is leading the dollar advance today. The pace of the euro's decline seems to confirm what the option pricing had warned of, namely that longs were getting increasingly concerned. The precipitating factor is not clear.

Some are linking the move to social tensions in Egypt. There is talk, unsubstantiated of SNB intervening to slow the franc's appreciation.

US Growth Curbed by Huge Swing in Inventories

At 3.2% the Q4 US GDP came in a bit lower than expected. Inventories were the main reason for the miss. In terms of inventory, the key is the change in the change. Inventories rose a little more than $7 bln in Q4 after a $121.4 bln rate in Q3. This subtracted 3.7 percentage points from growth--the most since the late 1980s. Final sales, which is GDP minus inventories rose 7.1%, the most since 1984. Final sales domestically rose 3.4%. Another notable takeaway is that the US economy has surpassed the pre-crisis peak. This is to say US GDP in real terms has never been greater.

US GDP, Japan, and Observations on Europe

The initial release of Q4 US GDP is the main economic highlight left of the week. The consensus is for 3.5%-3.6% print, which would be the fastest growth in about 3 years. The risk is that the market is disappointed, as recent trade and inventory data would have suggested economists should trim their forecasts a bit and yet the consensus does not seem to reflect that.

Switzerland and India, Really...?

A number of Indian banks have begun issuing Swiss franc denominated bonds, ostensibly to raise cheap funds and meet the demand in Europe for emerging market debt. Reports suggest that this is the first of such issues in almost a quarter of a century.

While Indian banks seem well capitalized presently, the new international rules will require them to boost their capital. The Swiss franc denominated Indian bank bonds yield about 80-100 bp above some similarly rates Swiss banks bonds.

Euro Outlook

The dollar's strong rally in the first week of the year seems like ancient history now, overtaken by the swing in interest rate expectations and sentiment toward European officials ability to get ahead of the curve of market expectations. I am less sanguine about these developments, but see little indication that the pendulum is done swinging. Patience is required if one shares my views.

Today's Outlook

There are two noteworthy developments today: S&P cut Japan's sovereign rating one notch to AA-, citing the lack of a coherent fiscal strategy, and the continued heavy tone of the dollar. The S&P downgrade was surprising especially in the timing. The BOJ had increased its growth forecast for the current fiscal year to 3.3% from 2.1% earlier this week and the government had just reported that exports rose in December for the second consecutive month. The 13% year-over-year growth in exports was well above expectations (~9.3%). The downgrade was announced after the close of local markets, but the impact may be minimal. Foreign involvement in the world's biggest bond market is minimal; recent data suggests no more than 10%.

Fed Says Little New

The FOMC did what was largely anticipated. Recognizing that consumption has picked up, it slightly upgraded its assessment of the economy.

However,this has been blunted by labor market assessment. In December it has said that the deterioration in the labor market was abating but now says the improvement is not sufficient. This slightly more emphasis on the labor market is the new element. The continuation of Treasury purchases, coupled with the modification of the labor market assessment triggered a quick push lower on the dollar, but it quickly bounced backed. The rise in commodity prices while acknowledged did not alter the longer-term inflation expectations. There were no dissents. Future meetings, especially as the $600 bln purchases near completion may be more contentious.

UK Surprises Again

For the second consecutive session, the UK has surprised the market. The impact of yesterday's shocking 0.5% Q4 contraction has been blunted by the unexpected BOE vote 7-2 in favor of steady interest rate policy, as the newest member (Weale) joined Sentance's dissent for a 25 bp rate hike. Given that the MPC would not have known that the economy contracted, suggested that the minutes might be too historical to be of much interest to the markets. Instead, the news and the somewhat hawkish tone to the overall minutes has prompted a sharp sell-off in UK debt, with implied yields on the short sterling futures give back the lion's share of yesterday's gains.

Bloomberg Pannel: German View of European Debt

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.

EFSF and Euro

The European Financial Stability Fund (EFSF) is planning its first issue this week. Talk was of a 3-5 bln euros of a 5-year issue priced 8-10 bp on top of swap rates. This would imply a yield of about 2.85% compared to 2.32% German 5-year yield. The EFSF bonds are expected to be priced tomorrow. As was the case of the EFSM bonds sold earlier this month, we expect demand to be strong, as there is a shortage of AAA paper in Europe.

Seeing how strong the demand will be, market talk now suggest 5 bln euros will be raised. A number of sovereigns, including China, Japan and Russia, seemed to express interest, but not necessarily in addition to current holdings.

Monday Market Forces

The tick up in the flash euro zone composite PMI to 56.3 from 55.5 in December has not done the euro any favors with new session lows being recorded in quiet late morning turnover in London. We have emphasized in explaining the euro's recovery over the past two week to shifting interest rate expectations. Since the ECB meeting a number of ECB officials have played down the hawkish interpretation of Trichet's comments. The ECB President himself, in a Wall Street Journal, offers toned down rhetoric, recognizing that higher commodity prices are not feeding into wage increases. He clearly signaled a willingness to look past temporary jump in inflation. Note that German January CPI figures are due Thursday and a downside surprise at this juncture would likely have more impact that a small increase.

Chinia Speculation

Speculation that China will tighten monetary policy this weekend is likely to prove for nought. The focus may already be shifting to next week, ahead of the Lunar New Year celebration. We have suggested that medium term traders need not get so caught up in the guess work of what the PBOC will move and focus instead on the fact that more tightening is likely forthcoming and front-loaded at that.

Thoughts on the Evolution of the Foreign Exchange Market

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The Bank for International Settlements, set up after WWI to collect war reparations from Germany, who at the end of last year made its last payment, organizes a global survey every three years, conducted by central banks, to assess the parameters of the foreign exchange market, such as turnover, geographic distribution, and instruments.

The preliminary results were available in late September 2010 and in late December, within its quarterly publication an essay highlighted the growth of the foreign exchange market.

Euro Firm, Consolidiative Tone Elsewhere

The euro made new highs since late November today. Investors have shrugged off the latest comments from Fitch that outlined potential triggers to credit downgrades of the periphery. In fact this has been a good week for peripheral bonds. Ten year yields have fallen 16-25 bp in Greece, Portugal and Spain. Ireland is the exception as its 10-year yield rose 10 bp.

For the record, the German 10-year yield is up 11 bp on the week. Meanwhile, it does not seem like European officials are any closer to carving out that comprehensive strategy that has been promised. Indeed the latest idea is that if Germany is balking at boosting the size of the EFSF, that perhaps the countries with less than triple-A credit should boost their contributions. It seems hardly practical that Italy and Spain for example can really afford to increase their external commitments.

Currency Market Update

The foreign exchange market appears to have entered a consolidative phase as it waits for fresh incentives. Slightly firmer short term rates in the euro zone and UK appear to be helping cap the US dollar, while ongoing concerns about the European debt crisis and the potential stagflationary conditions in the UK deter enthusiastic buying for the euro and sterling.

Market talk suggests Asian reserve managers continue to diversify some of their recent dollar purchases into euro, but of course this is difficult to verify. Sterling's advancing streak extended into its ninth consecutive session yesterday, but is struggling today to maintain the upside momentum. The CBI trends survey for January was much weaker than expected (-16 vs consensus -2) and tomorrow's report of December retail sales may similarly drive home the point of weakening growth despite the price pressures.

Some Thoughts on Tunisia's Implications for Investors

Through the Middle East, Tunisia's recent experience is prompting policy responses. Officials seem concerned that the ease at which the Tunisia's government was toppled could embolden the disenchanted elsewhere. High food prices and mostly soft growth prospects leave many countries vulnerable, especially non-oil producing Arab countries.

Confused? What to Watch

The focus of the market has shifted from the euro zone debt crisis, which seemed to have helped lift the dollar in the first week of the New Year to the shifting interest rate expectations, especially in the euro zone and UK.

This has clear implications for market participants. Watching 10-year bond yields and/or credit default swaps may not important guides currently. Rather short-end rates that capture short run interest rate expectations may be more important. OIS/LIBOR spreads may be preferable, but as you will recall from the crisis, LIBOR used in these calculations is the composite of numerous banks and there is some divergence, which may reflect risk appetite of the contributing banks and the counter-part risk associated with it. For example, today the 3-month LIBOR was fixed at 0.30313% and range of contributors was 28 bp to 40 bp.

Dollar Remains Soft, Recovery Looming (?)

The shift in interest rate expectations in the euro zone and UK continues to be a dominant force in the foreign exchange market. The euro poked briefly through the $1.35 level for the first time late November. Sterling is trying to extend its advancing streak to the ninth consecutive session and remains near yesterday's highs, which was its best level since mid-November. We think the market is getting too aggressive in bringing forward ECB and BOE rate hike expectations. At the same, however, there has been increased speculation around Asia's dollar sales. In recent days there has been much talk about Asian official demand for euros in particular. We suspect the market may be misunderstanding the seemingly supportive comments from Japanese and Chinese officials about the euro.

ECB Officials Soft Pedal Trichet's Hawkishness

Market participants are not the only ones surprised by the seemingly hawkishness of ECB President Trichet's comments at last week's press conference. ECB officials themselves seem surprised and several have moved to contain the collateral damage. ECB's Nowotny is the most recent. Of course in diplomatic-speak, it is not that Trichet misspoke but rather than the market misunderstood.

TIC Data: Foreigners Large Buyers of US Assets after QEII

Foreign investors stepped up their purchases of US assets in November after FOMC decided to resume its Treasury purchases. Foreign investors bought a net of $85 bln of US equities, notes and bonds after an upward revised $29 bln in Oct. The Nov purchases were the most in a few months (Aug). Perhaps related to QEII, foreign investors were net sellers of short-term US securities, like bills and stock swaps. When these short-term instruments are taken into account, foreign investors bought $39 bln of US assets, more than twice the $15 bln purchased in Oct.

Shifting Rate Expectation

What began off last week as a correction to the dollar's surge in the first days of the new year morphed into something much more last week and has continued into this week's activity. There has been a profound shift in interest rate expectations. Seemingly hawkish comments from ECB President Trichet as December euro zone CPI was confirmed at 2.2% put the proverbial cat among the pigeon. Meanwhile in the UK, anecdotal evidence warned of the stubbornness of UK price pressures and there was more speculation of a hike later this year. Today's stronger than expected CPI data (3.7% vs 2.% in November and consensus expectation of 3.4%) drives home that point.

Yankee Weight on the Dollar

Foreign businesses, especially financial firms, are issuing a great deal of debt in the US and as they convert out of dollars this seems to be one of the factors that may be weighing on it.

In the first two weeks of the news years, foreign financial firms, notably European banks and insurance companies, have raised $36.4 bln in the US. This is the most for the first two weeks of a year since at least 1995, according to industry data. There have been 53 deals, which is more than twice the deals of the first two weeks of 2010.

Key Points For MLK Holiday Markets

The US dollar is mixed against the major currencies, but the key development is the sharp drop in the euro as last week's lofty expectations are scaled back. German officials still seem to be balking pressure to increase the EFSF. The euro's decline brought it within a whisker of the 38.2% retracement of last week's gains (found near $1.3230). European players have generally been buying the euro allowing its to claw back some of the steep losses registered in Asia.

Bloomberg: Euro May Weaken to $1.18

Here is an interview I did for Bloomberg on the Euro.

Market Watch: Global Currency Plays

Euro and Swiss franc Outlook

As the European debt crisis reemerged as a central driver of the foreign exchange market in early November 2010, the euro slumped more than 10% against the Swiss franc. Given the size of the Swiss capital markets, global funds managers typically do not have large exposure in Switzerland. Many of the world class Swiss companies have duel listings and/available on an ADR or GDR basis. Yet performance the Swiss franc is important as many have seen it as fulfilling the function that the German mark used to play before its steel was mixed with some weaker alloys. We suspect the story is more complicated that that, as the SNB proved mostly ineffective in stemming the Swiss franc's appreciation despite massive intervention and quantitative easing. Also, given that the Swiss current account surplus is driven by its investment income account rather than the trade account, meaning that the impact of the franc's appreciation on exports is somewhat less significant.

Europe: Lacking Proper Diagnosis, Cure Remains Elusive

Europe’s debt crisis remains among the most important factors in the global capital markets. By some market-based measures, like interest rate spreads and credit default swap prices, the crisis is more acute now than it was before an assistance package was belatedly cobbled together for Greece and the establishment of the temporary European Financial Stability Facility (EFSF) more than half a year ago the ECB’s covered and sovereign bond purchases, and at the end of 2010, the assistance package for Ireland.

The premium, for example, that Greece is forced to by over Germany reached a new record in the first week of 2011, but it is Portugal that is in the cross-hairs. Portuguese 10-year yields rose nearly 60 bp to new euro era highs in the first few days of the New Year. Some of its banks’ shares fell to 17-year lows. This came despite the Prime Minister Socrates assurances that Portugal reached its target of reducing the budget deficit last year to 7.9% of GDP from 9.3% in 2009.

Investment Flows Week One 2011

At the end of Dec ICI reported the first inflow into US equity funds in several months. EPFR is reporting that flows into US equities may have continued into the week ending Jan 5. It reported $3.75 bln went into US equity funds. This is greater than the $3.38 bln that EPFR reports went into emerging market equities. Another $385 mln it says went into EM bonds. US bonds funds continue to see some unwinding of the large inflows recorded since the beginning of the financial crisis. EPFR lastly reports that flows into Latam were particularly strong, while there seemed to be a more cautious stance toward China, which it says continues to be a drag on flows to some Asian funds.

Be Prepared to Buy into Potential Dollar Decline

There has been an obvious build up of expectations about the US jobs report today. The dramatic jump in the ADP estimate spark a large upward revision in expectations even though the short-comings of its estimate and its track record are well known. In part the optimism also reflects the recent string of data that has convinced even many of the cynics that the US economy has accelerated. Given the price action and the pendulum of market expectations the risk today is for disappointment.

The disappointment could lie in the difficulty to live up to some of the inflated expectation--talk of a 500k rise. While the US economy gaining traction, many observers have simply ignored the fact that the employment component of both the manufacturing and service sector ISM reports weakened. The risk is, as we noted here yesterday, of a "buy the rumor sell the fact" type of trading today.

Dow Jones Newswire: Annual Market Forecast

Belgium: From the Frying Pan into the Fire

Belgium's political crisis is deepening and since it is part of the euro zone, it is being reflected in the Belgian debt market. The 10-year bond yield is up 10 bp today to above 4% and the 2-year yield is up 4 bp. Late yesterday the seven parties failed to resolve their differences and put in a new government. Recall that last month, S&P put Belgium's AA+ rating on negative watch due in large part to the political stalemate which prevents strong action to stabilize Belgium's debt, which is among the highest in the euro zone (as a percentage of GDP).

Beware of Buy the Rumor Sell the Fact

The price action this week underscores our view that participants have unwound year-end developments. The euro has returned to back to the 200-day moving average it had been toying with until late Dec.

Perhaps even more illustrative of this point is that the weakest G10 currency in the last two weeks of December was sterling, which has been best performer against the dollar this week. Similarly the strongest currencies from mid-December were the antipodeans, yen and Swiss franc, which have been the poorer performers this week.

Dollar Bulls Return from New Years

There appear to be three main drivers in the foreign exchange market today. First, the failure of the euro yesterday near the upper end of its recent range is both the cause and effect of dealers expressing bearish sentiment by re-establishing short positions squeezed out in the thin holiday markets.

The convincing break of the $1.3250 area would likely signal a return toward the 200-day moving average (~$.13085) that had been toyed with in the second half of December.

Currencies and Commodities

One of the market developments that is capturing the imagination (and wallets) of investors is the rally in commodities. As an example, since late Aug '10, when Fed Chairman Bernanke seemed to signal QEII and US economic data began improving more noticeably, the CRB index has rallied about 30%. Roughly a third of the gain was recorded since late Nov.

If one is bullish commodities, one can simply buy those commodities. This is especially true for equity investors given the various ETFs. However, often foreign exchange market participants are look ways to express (or hedge) commodity views in the currency markets. At the same time, there is a bit of a debate in the academic work as to what leads and what lags. For example, some work suggests that currencies adjust faster than real activity and that as a consequence stronger so-called commodity currencies lead the movement of commodities, rather than the other way around, where, for example, some participants may want to buy Australian dollars after gold prices have rallied.

The Pound is Sterling, Aussie's Shine Tarnished

The value-added tax is set to rise in a handful of European countries this year, with the UK's 2.5 percentage point rise (to 20%) is the largest followed by Portugal's 2 percentage point hike (to 23%). Slovakia , Poland and Latvia have 1 point hikes (20%, 23% and 22% respectively). The UK's Telegraph reports that retailers may raise prices 5-8%. Consumers apparently tried to get in ahead of the VAT hike and high frequency retail sales reports, like John Lewis, showed a large rise.

While these purchases likely borrow from early 2011 purchases, the pricing pattern warns of upside risks to CPI. Meanwhile, CIPS manufacturing survey (~PMI) rose to 58.3, the highest level since late 1994. Input prices, as was seen in yesterday's US report as well, jumped in the UK to 81.2 from 72 and is the highest in the UK since the time series began almost two decades ago.

Hungary: EU Presidency, but Full of Controversy

Hungary assumes the rotating EU presidency for the first half of 2011. Yet its is mired in controversy, but with the government enjoying a 2/3 majority in parliament, there more pressure is likely to have to be brought to bear on Prime Minister Orban if Hungary is going to adjust its positions.

The controversy is at least threefold. First, the media law, which allows large fines on media organizations for "unbalanced" reports or those that "offend human dignity" is being objected to throughout Europe. Second, the Orban is implementing increases retroactively, in violation of the constitution. The taxes levied on large companies in energy, financial, retail and telecom.

Four Themes To Start the New Year

In still holiday-thin markets, the US dollar has started the New Year off on a firm note, recovering a good part of the slide recorded last week. There a 4 themes that I expect to dominate investment considerations in the coming weeks. They are:

1. The US economy appeared to accelerate in Q4, maybe toward double the 1.7% annualized pace seen in Q2 10. Home sales and prices remain weak, but outside that important sector, the recovery seems to be broadening. The Chicago PMI at the end of last week bodes well for the national survey to be released today. Also this week the Dec auto sales will be reported and they are expected to be the best of 20110 at around 12.3 mln unit pace and capping the best three month performance since late 2008. This coupled with the chain store sales data point to another robust retail sales report. The data highlight of the week, though is the US jobs report. Recall that the Nov jobs report disappointed and that disappointment was concentrated in the retail space. At the time we suspected a seasonal adjustment fluke. The Dec report should be payback and the early consensus is for private sector jobs to rise 3-times faster than the 50k increase in Nov.