FX is in Slo Mo

The foreign exchange market is a bit like a soap opera these days.  There is a major/macro story arc. Currently that is one of slowing or subdued growth among the major industrialized countries.  It is characterized by ongoing but slow recovery from the 2007-2009 financial and economic crisis.  And this despite historic amounts of fiscal and monetary stimulus.   It is also characterized by weak political institutions and/or leadership.  Unelected central bankers have moved into the gap, but they do not have the tools or legitimacy to completed fill the vacuum.    

The arc does not change often and rarely rapidly.  What does change are the little stories that over time accumulate to shape the larger arc.    Here is where I think we are:

U.S. Spending Eases Q3 Worries

News that US personal consumption expenditures rose 0.8% in July should go a long way toward easing anxiety that the world;s largest economy is slipping into a new contraction.  It means that even if Aug and Sept consumption slips back to trend (~0.2%) and no other major surprises, Q3 GDP is looking no lower than 1.5%.  This of course is nothing to write home about, except in the context of the dismal survey data and recession fears.   

That said, it is possible that the rebuilding from the storms help inflate spending in Aug and Sept.  In addition, money supply growth has picked up and withholding taxes have also reportedly increased (and we know people do not pay taxes on phantom income).

Nothing New from Bernanke

The much anticipated Bernanke speech in Jackson Hole is under-whelming. He did not break any new ground. While much of the recent history is re-hashed, the only forward looking guidance is to reaffirm the recent FOMC statement and boilerplate language about being prepared to deploy its range of tools as appropriate. He did not go into much detail about those tools. In this sense he was more revealing at his April press conference.

While the Fed has downgraded its economic assessment-with formal forecasts due in Nov to reflect this--it has not indicated a policy response, except to take the step of putting a time frame on "extended period". He has announced that the one-day FOMC meeting in Sept (20th) will be extended to a second day.

Why I am Going to Worry about Italy on my Summer Vacation

I am about to take a two week vacation (though will update the blog). I had some time off earlier in the summer, but it was dominated by the concerns of a father of a Little League baseball pitcher. Rather than worrying about mechanics and scoring, I will be contemplating the tragedy that is Europe and I think Italy is the keystone.

Italy is the largest piece of counter-evidence of the German-ECB narrative that the lack of fiscal discipline is at the center of the crisis. Italy's actual budget deficit in 2010 was 4.6% of GDP. The deficit for the euro zone as a whole was 6%. The Dutch reported a 5.4% deficit and France showed a 7% shortfall. Spain's deficit was twice Italy's.

Waiting for Godot

Bernanke's Jackson Hole speech is the main event.   The way the market has traded this week, despite most observers playing down the likelihood of a new policy announcement, many are positioned for something.  Disappointment would still seem to be the greater  risk.   The S&P 500 is up 1.6% on the week even after yesterday's decline of the same magnitude.

A new estimate of Q2 GDP will be delivered.  Estimates vary--depending essentially if one believes the drag from the trade balance is offset by the better capital spending/inventories in the durable goods report.  The CBO's new estimates for 2011 GDP is 2.3%, which would put H2 growth around 1.5%.  Its forecast for 2012 is 2.7%.

CNBC: Trading Block, Gold Broken for Good?

Thursday in FX: Wait and See Mode

Trading in the major currencies is choppy but largely directionless.  Bernanke's speech tomorrow is seen as the near-term key.  The Greek situation is still devolving as the dispute over collateral threatens to transform the small orderly restructuring into a larger disorderly event.   Yet the euro remains firm, above the 20-day moving average (~$1.4322) and the 5-day average (~$1.4410).   From a technical and fundamental perspective, the foreign exchange market appears posed for a big move.

Looking for Alternatives: Indonesia

The favorite safe havens have been the Swiss franc and Japanese yen. The policy response has encouraged some participants to look for an alternative.

Norway is often seen as an alternative safe haven. It is a large net international creditor and has relatively financial system and robust economy. New oil finds in the North Sea and the national oil company also has a large stake in new findings in the Gulf of Mexico, also underscore the fundamental attractiveness of Norway.

Much Heat, Little Light

There have been a number of important developments, but the US dollar remains confined to relatively narrow trading ranges.  There is a heightened degree of anxiety that does not appear to be being reflected in the currency markets.  It is not simply Bernanke's Jackson Hole speech on Friday, ahead of which markets are trading as if they are anticipating QE3 or some other bold action to be announced/signaled (I still am not convinced).  Yesterday, for example credit default swaps on Bank of America surpassed levels 2008 when both Bear Stearns and Lehman Brothers ceased to exist. 

Bloomberg: Global Currency Markets, U.S. Economy, Fed Policy

Now for Something Completely Different: WPA

With the US economy stalling in H1 and poor survey data, it is hardly surprising that Bernanke's Jackson Hole speech is anxiously awaited for fresh signals about how the Federal Reserve will respond.

Yet, unlike a year ago, the risk of deflation has all but disappeared. Core CPI is just below 2% and core PCE in Q2 stood at 2.1% (compared with 0.8% in Q3 2010). Not only is the Fed's preferred (but not sole) inflation gauge elevated, the $600 bln of Treasuries the Fed just finished purchasing and continues to hold appears to have done very little in real economic terms or in rekindling the animal spirits of risk taking.

Sentiment and Real Activity

Sentiment indicators have been unequivocally poor in the US, but real sector data appears to be faring somewhat better.   This point is underscored by today's releases of the July Chicago Fed's National Activity Index.  The market expected a -0.48 reading and it came out at -0.06.  This actually represents an increase from the upwardly revised June reading of -0.38 (initially -0.46).   It bottomed out in April.  This would suggest talk of a renewed contraction in the US economy to be premature. 

When it comes to core inflation and headline inflation, the historical record is clear.  Headline inflation, over the past 30 years or so, have converged with core inflation, rather than the other way around.  It is not so clear about the sentiment readings.

Sweden Update

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Capital preservation has once again has become mantra. The safety offered by Japan and Switzerland are meeting resistance from policy makers. As the market looks for alternatives, the Swedish krona has much to offer, including a relatively robust economy, low public debt and a current account surplus.

However, the economy is slowing, led by industrial production and exports, and the anticipated rate hike has been taken back by the market. June industrial output fell 3.3% on the month and the July PMI reading was just above the 50 boom/bust level at 50.1. The export sub-index was at 46.9. The August reading is due out on Sept 1 and the risk is additional deterioration.

Thoughts at the End of a Tumultuous Week

This has been an extremely tumultuous week throughout the capital and commodity markets. August itself has been a cruel month. The German stock market has lost around a quarter of its value. A marked slow down in the US and Europe in Q2 has given rise double dip fears in the former and compounding difficulty achieving deficit targets in the latter. There are a number of take-aways for investors from this week's developments.

1. The euro remains very resilient. Many of the indicators that have often provided guidance into the euro's direction would suggest the euro should be weaker. These indicators include the euro's correlation with the VIX and the S&P 500, two-year interest rate differentials, which are at levels not seen since the start of the year, and the elevated basis swap.

Yen Update

The Japanese economy is recovering from disruption of the earthquake/tsunami. Supply chains have mostly been re-established. The economic contraction is likely to end this quarter. However, the yen strength is not a function of the domestic economic performance. Yet market participants seem to intuitively understand the yen's strength more than the euro's resilience.

The yen is a safe haven, after all. That assertion seems so obvious, that why it is the case is rarely explored. It does not seem to be a function, as some suggest, of its trade surplus, but rather its position as a net international investment surplus country. That means that Japanese investors own more foreign assets than foreign investors own of Japanese assets. In fact, Japan is the world's largest creditor. Last year, it was in surplus by over $3 trillion. China is the world's second largest creditor at about $2.2 trillion and Germany is in third place with a $1.2 trillion surplus. Next are Saudi Arabia and Switzerland, both of which are net international investment creditors at a little more than half the size of Germany.

Canada Update

The US dollar fell to 4-year lows against the Canadian dollar late last month near CAD0.94. In the tumultuous markets in the first half of August, the US dollar rallied about 6.5% into August 9th to briefly poke through CAD1.0 for the first time since early Feb. With today's weakness, the US dollar has surrendered a little more than a third of its rise.

There is scope for additional dollar losses against its Canadian counterpart. While the CAD0.9700 area draws immediate attention, there is potential toward CAD0.9640 in the coming days.

Wednesday's Buzz

The global capital markets may be more stable than a week ago, but the tone remains fragile. Asia equities reversed earlier losses and the MSCI Asia Pacific rose about 0.5%, for the third consecutive gain. Of note, foreign investors were net buyers of Philippine shares for the first time since Aug 3. European bourses are mostly lower as yesterday’s poor GDP data weighs on sentiment. Financials are under pressure, but the technology sector even more so. Core sovereign bond markets are steady to higher. UK gilts are outperformers following a worse than expected employment report and news that for the BOE’s decision to keep rate on hold earlier this month was a unanimous decision, the first since May 2010, as both members calling for a hike, Dale and Weale joined the majority.

CNBC: Euro Banks and China's Currency

Interesting Case of Malaysia

Malaysia will report July CPI figures and Q2 GDP data on Wednesday. The data is expected to show that inflation pressures remain near 2-year highs of around 3.5% year-over-year. With the o/n policy rate at 3.0%, Bank Negara has been under pressure to raise rates. It has hiked rates once this year after three hikes last year.

However, what blunts this pressure is the global economic uncertainty and the fact that domestic economy likely slowed markedly in Q2 to 3.6% year-over-year from 4.6% in Q1. This will be the slowest pace since the recovery began in Q4 09. Each quarter has seen the pace of growth moderate since Q1 last year.

Merkel /Sarkozy, King's Letter and Asia Update

Global equities are unable to match yesterday’s US 2% rise which put the S&P 500 close back up 1200 for the first time since August 3. Asian shares did manage to rise for the second consecutive session, but the gains were trimmed following news of Germany’s disappointing Q2 GDP of 0.1% (quarter-over-quarter) and the MSCI Asia-Pacific Index finished up 0.2%.

The standout was South Korea’s Kospi that tacked on 4.8%, which was on holiday on Monday. Foreign investors were net buyers of Korean shares for the first time in two weeks. Commodities, financials and technology were the strongest sectors. European bourses are sharply lower, with most major courses off 1.5-2.0%. Commodities and industrials are among the weakest sectors, following regional growth data, and financials in the Dow Jones Stoxx 600 essentially market performers. Major sovereign bond markets are subdued, but Italian and Spanish 10-year bonds are finding the 5% yield level sticky and prices are rising in the CDS market.

CNBC: Markets, So Far so Good

Mexico Update: Peso Poised to Recover

The Mexican peso has been among the worst performing of the more actively trading currencies against the dollar since the start of the month. Yet in the coming weeks, if a more stable tone in the markets emerge, the peso is a likely candidate for out-performance.

There are two main considerations for this optimism. First, the slide in the peso of nearly 10% at its extreme has seen the over hang of long positions scaled back considerably. As recently as mid-July there were nearly 100k net long speculative contracts. In early August, there were still 88.5k net speculative longs. In the week through last Tuesday, August 9th,those net speculative longs were slashed by more than half to 41.3k, this is the lowest since last September.

Bretton Woods, R.I.P.

Richard Nixon unilaterally closed the gold window 40 years ago today.. No longer would the U.S. permit other countries to exchange their dollars for gold and by breaking that link, he ended the Bretton Woods international financial regime and ushered floating exchange rates that characterize the modern era.

Since nearly the day it died, there have been policy makers, investors and academics who have called for a new Bretton Woods. It is perfectly understandable. The macro-economic performance under Bretton Woods was remarkable. Real per capita income growth throughout the industrialized world was higher than during any monetary regime since 1879, according to Anna Schwartz, Milton Friedman’s co-author to the landmark “A Monetary History of the United States”. Inflation and its variability and persistence were low. Nominal interest rates were low and stable.

Five Key Events for the New Week

There are five key events for investors this week. The first is the size of the ECB bond purchases. The market does not learn about these directly, but only indirectly through the size of the ECB’s sterilization operation. Until the resumption of its bond purchases, the ECB was sterilizing about 74 bln euros. The consensus is that the ECB’s announcement at around 13:30 GMT (9:30 EST) will indicate they spent around 10-15 bln euros, though the range of estimates extends to as high as 50 bln euros, according to one survey.

A Euro Bond without Treasty Changes?

It has been long and widely recognized that a critical flaw in Europe is a monetary union without fiscal union. Although the founders of European integration back in the late 1950s seems to see the customs union as simply the first step toward greater union and were drawn to the idea of a United States of Europe, the desire seems to be lost on the current generation of officials. Nevertheless, the crisis arguably is pushing Europe back into that direction.

Three Thoughts for Friday

The past two weeks have seen large disruptions in the global capital markets and various policy responses.  Market participants are having a difficult time getting a handle on these developments.  There are three things investors should consider before the weekend:  1) German-French meeting next week is suggestive of a new initiative, 2) FOMC decision to keep rates low for 2 years may be tantamount to a type of QE and 3) while a peg of the Swiss franc seems to be a non-starter, officials have succeeded in breaking the powerful one-way momentum. 

Thoughts on the Big Picture: The Ugly Contest Just got Uglier

Summers are supposed to be fun and relaxing. Not this one. A combination of events in late July and early August caused market strains that have not been seen since those dark days in the fall of 2008 and winter of 2009. Policy makers responded, though options are more limited. The risk is that the investment waters remain treacherous into next year.

Keynes once compared investing to a beauty contest where the challenge is not to pick who you think is the most beautiful but who everyone else thinks is the most beautiful. Yet in the post-Keynesian world, where fiscal excess are being corrected, perhaps rather than a beauty contest, investing has becoming more of an ugly contest. In this light,the race has been between the European debt crisis on one hand and the US poor growth and debt ceiling and rating concerns on the other.

Where There is So Much Smoke, Perhaps There is a Fire

There are two spotlights in Europe today. France and Switzerland and their problems are intertwined. Despite denials by various French officials, the market suspects there is sufficient smoke to indicate a fire. Reuters reports that an Asian bank has cut credit lines to top French banks and other counter-parties are considering the same.

The French banks are perceived to be too big to fail--not that there is real talk at this juncture along those lines. However, the share and bond prices are eating away at their Tier One capital and the market situation is getting worse, not better. If push comes to shove, France can recapitalize its banks. However, to do so would likely be at a cost of its triple A rating, even though all three leading agencies have a stable outlook on France's sovereign rating.

New Pressures

Market speculation that France was about to be downgraded has effectively been denied by the three top rating agencies, but it has offered little relief to the markets or to European (including French) bank shares.  There is speculation that a French bank is having serious difficulty and some talk of a French bank raising cash by selling gold forwards. 

Stabilization Taking Hold

Intra-day activity may still be a bit unsettled, but some semblance of stabilization is emerging.   Global equity markets are advancing in the wake of yesterday's neck-breaking moves in the US that left the S&P 500 4.75% higher net-net on the day.  Other bourses haven't matched that, but the direction is generally the same.   The dollar itself is mixed; flattish against the euro and dollar-bloc, stronger against sterling and the Swiss franc and weaker against the yen.    With yesterday's FOMC commitment to keep rates low until mid-2013 at least and the rally in the US 2-year note that pushed yields to within the Fed funds target range, has pushed the US premium to lows not seen since the early 1990s.  While the dollar is below levels seen before the recent round of BOJ intervention, the loss of the Japanese discount suggests a fundamental force behind the yen's strength. 

Despite the signs of stabilization, something remains amiss.   The euro is encountering resistance near $1.44 and the ECB bond buying seems to have reached a point of diminishing returns as Italian and Spanish bonds yields gravitate around 5%, from above 6% last week.  Even though equities are hgigher and peripehral bonds are higher, Germany bunds have also rallied and spreads have widened at lower yield levels today. 

After the FOMC: Norway and the UK

Last week, the policy focus was on the Swiss National Bank, the BOJ and ECB. The SNB lowered its 3-month libor target and pumped up its money supply (sight deposits). This action seemed to force the BOJ's hand. Once the moved, if the BOJ didn't, it would have increased the upside risk on the yen as the "easier" safe haven play. The ECB in some ways responded to the pressures by re-introducing the 6-month refi facility, extending the 3-month refi operations into next year and resuming its bond purchases. At first it seemed reluctant to buy Spanish and Italian bonds, but changed its stance following new austerity commitment in both countries.

The focus today is on the FOMC. In light of the 0.8% growth in H1 and the increased market turmoil--which may have knock on effects through sentiment and the wealth effect--as well as the fiscal drag implicit in the debt ceiling resolution--if the Fed does not do anything new, Bernanke and Co risk disappointing the market and the fallout that may follow. QE3 at this juncture does not seem a likely and few observers disagree.

Markets Trying to Stabilize

The capital markets are beginning to show their first signs of stabilizing after follow through selling of equities and major foreign currencies, save the safe haven yen and Swiss franc, materialized. The market remains nervous and the situation remains fragile.

European economic data was poor, but the European bourses are recovering from the steep opening losses as the S&P 500 also recovers from yesterday's slide that brought the much watched index to near 1100, 38.2% retracement of the advance off the early 2009 lows. News that S&P indicated that some local and state governments may retain a higher credit rating that the federal government and that banks rating will not be cut simply because of sovereign cut.

ECB's Pyrrhic Victory

The ECB has succeed in driving down Spanish and Italian yields sharply today. Italy's generic 2 and 10-year yields are off around 80 bp. Spanish yields have declined even more dramatically, with the 2-year off 110 bp and the 10 year yields off almost 90 bp.

These are greater declines than many would have expected. Some observers are trying to extrapolate from the price action the size of the ECB's operation today. It seems to be repeating the same mistake as the initial estimates of the size of BOJ's recent intervention.

S&P Downgrade Implications and Possible Policy Response

Standard and Poor’s downgraded U.S. creditworthiness to AA+, becoming the first to remove the triple-A status from the world’s largest economy and largest debtor. Moreover, a negative outlook has been retained. The element of surprise lays in the timing more the in substance of the decision. Many, like us had expected a decision to be made after the special bipartisan fiscal commission had made its report later in the year. The other two main rating agencies, Moody’s and Fitch have not joined S&P. Last week, Moody’s reaffirmed the US triple-A rating but adopted a negative outlook. Fitch has not formally reaffirmed its AAA rating, and is expected to announce the outcome of its rating review late August or early September. We will first look a bit closer at the S&P decision, discuss some of the market implications and then turn our attention to the possible policy responses.

S&P Decision

Few can argue against the proposition that the U.S. fiscal trajectory is alarming. The recent debate in Congress over the debt ceiling gives air to reasonable concerns about the U.S political process and its ability to address the fiscal challenges, for which the financial crisis and recession have brought forward in time and intensified.

BOJ, ECB Surprises, Makes for Treacherous Markets

The failure of euro zone and US officials to give the markets any sense of meaningful closure to their policy challenges is eliciting a response by central bankers.  Switzerland got the ball rolling yesterday, with a new attempt at quantitative easing and symbolic rate cut.  It has been joined by the BOJ, which announced an increase in its asset purchases plan and intervened directly in the foreign exchange market.  This in turn has now been followed by the ECB.  It has confirmed that it was re-opening the 6-month refi facility and was going to resume its bond purchases.  At the same time, ahead of tomorrow US employment report, there is much speculation about increased risks of a renewed economic downturn in the world's largest economy and potential for QEIII. 

Swiss Surprise, but France More Telling

The Swiss National Bank took the market by surprise by announcing what amounts to another version of quantitative easing.  Its first attempt was via foreign bond purchases and sales of Swiss franc for euro and dollars.  It failed miserably and leaving the august institution with significant paper losses.

This new attempt includes: 1) a formal adoption of a near-zero interest rate policy, 2) a cessation of renewing maturing repos and SNB bills, while actively repurchasing bills, to achieve 3) a substantial increase in sight deposits to CHF80 bln from CHF30 bln.  In June, repos and bills outstanding stood near CHF25 bln and CHF107 bln respectively.  This leaves it plenty of room, if needed to overshoot its CHF80 bln to the upside, indicating some ability to scale today's policy response to what by all metrics is a terribly over-valued Swiss franc.

Atlantic Council Interview: US Budget Deal

Here is an interview I did with the Atlantic Council on the US Budget Deal.

US Economic Headwinds Restrain the Dollar

The US dollar advanced in Asia and Europe but news of the first outright drop in US consumption in 2 years has seen the greenback surrender much of its earlier gains.  

June personal consumption expenditures fell 0.2% in June.  The consensus had looked for a small increase. Consumer spending on durable goods, a good cyclical indicator, has been falling since the end of Q1and in recent months, non-durable spending has also been weakening.  The main culprit arguably is the slowing pace of real income increases and high level of job insecurity.

A Few Observations about the US Deficit Deal

The deal that has been struck by party leaders in the US now needs rank and file support.  Some modifications even at this late date are possible, but there are several points that are worth considering at this juncture.  

First, even though the US has technically defaulted in the past (a similar episode as now took place in the late 1970s) a significant default never seemed like the most likely scenario and now this seems even more remote.

Two Major Developments at Start of the Week

There have been two major developments.  The first is what appears to be the basis of a US debt deal that will avoid a technical default and may in fact avoid an imminent downgrade of its credit rating.  The second development is batch of purchasing managers surveys that warn of powerful economic headwinds.