The Financial Squeeze in Spain to Intensify

The Greek finance minister says Greek banks should accept the second hair cut of the year out of a sense of patriotism.  They are understandably balking, but may concede if the officials grant them full recognition of deferred tax assets in capital calculations.   

The Greek bond buy back is the main talking point in Europe and upon it rest the hard won agreement to fund Greece so it can keep its creditor whole.  

Spanish banks may quickly take the spotlight.  Earlier this week, the European Commission cleared the last important hurdle to a 37 bln euro injection into Spanish banks by approving the restructuring plans which comprise the conditions of the assistance.  

Yen Weakness Drives FX Market

The main driver in the foreign exchange market as the week winds down is a new sell-off in the Japanese yen, ostensibly recorded on the back of LDP leader and expected new prime minister in a little more than two weeks time.  Although Abe appears to have soften some of his aggressive rhetoric regarding the BOJ ostensible independence, he did reiterate his desire for it to buy foreign bonds. 

This helped send the dollar to new highs for the week against the yen near JPY82.75.  Market talks suggest some optionality in front of last week's high near JPY82.85 may be restraining the greenback a bit here.  Meanwhile, the yen's weakness and the euro's recovery from the decline seen in NY yesterday in response to headlines about the lack of progress on the fiscal cliff talks in the US. kept the cross rates in play.  Cross rates adjustments helped lift the euro and sterling to new multi-week highs against the dollar. 

Great Graphic: Trajectory of Greek Debt

This Great Graphic comes from Bruegel.   It shows the trajectory of the Greece's debt to GDP ration over until 2030 under different scenarios, drawing on some of the components from the agreement struck at the start of the week.  

The details have been sparse at best and the deal itself will not be finalized for a couple of weeks (Dec 13).  The German parliament will take it up tomorrow and once again Merkel will rely on support from the opposition Social Democrats to ensure passage. 

Much hope is put in the bond buy backs.  It is understandable why.  If the EFSF loans Greece 10 bln euros and Greece uses those funds to buy bonds at 30 cents on the euro, Greece will experience a net 20 bln euro reduction in its debt and experience some savings on debt servicing costs.  

Yen Weakness and Shifting Capital Flows

LDP head Abe woke the yen market out of its slumber with aggressive campaign rhetoric.  The polls show that he is most likely to be the next prime minister of Japan and will be in a position to enact his plan to ease monetary and fiscal policy dramatically.

The yen has weakened since he began ramping up his comments.  It is the weakest of the major currencies and the weakest among the Asian regional currencies since the beginning of the month.  

Mr Market Feeling Better

Mr. Market is feeling a bit better today, and the dollar and yen's safe havens are not as needed.  Global equities and emerging markets generally doing better.   Peripheral bond yields are mostly lower, and core bond yields marginally higher.  

The news stream has been favorable for risk taking.  The recovery in US shares yesterday, perhaps on some optimism the fiscal cliff can be averted, provides a constructive backdrop for today's price action, though we are still skeptical that there has been much progress.

However, it is the news stream from Europe today that is lifting sentiment.  The dollar tended to consolidate in Asia before Europe took it lower as a series of economic reports were better than anticipated.  This includes Swiss and Swedish GDP figures.  The Swiss economy expanded 0.6% in Q3.  The consensus was for a 0.2% expansion, after contracting 0.1% in Q2. 

China is not Manipulating its Currency: US Treasury

When President Obama has a private lunch with Romney, his recent rival, tomorrow, one issue that is unlikely to be discussed is the Administration's decision not to charge China with manipulating the yuan.  Romney said he would cite them on his first day in office.                                               

The US used to cite China as a manipulator, but it has not done so since 1994--through Republican and Democrat Administrations.  To be sure, the Administration still realizes the Chinese yuan is significantly under-valued. Work by the IMF, however, suggests the yuan is nearing fair value.

US Consumer Credit: Deleveraging Continues, but...

The Federal Reserve issued the quarterly consumer credit report late yesterday.  The four-year downtrend in aggregate consumer debt continued, falling another $74 bln in Q3 to $11.31 trillion.  This is a 0.7% decline over the quarter.  At the end of Q3, US consumer debt was $1.37 trillion below  the peak in Q3 2008. 

Mortgage debt is the largest component.  It fell 0.15% on the quarter to $8.03 trillion, which is the lowest since 2006.  However, the bulk of  the reduction of mortgage debt may be over.  New mortgage debt rose 2.3%, while  home equity debt continued to fall (-2.%). Rising home prices, increase in residential investment, coupled with a mutli-year high in consumer confidence, warns that mortgage debt may begin growing again. 

Non-mortgage debt increased.  Auto loans increased by $18 bln in Q3, the sixth consecutive quarterly increase and at $768 bln, it stands a a 2-year high.  Student loans increased by $42 bln.  While the delinquency rate of mortgages has fell (5.9% from 6.3%), student loans in arrears have increased.  Credit card debt rose by $2 bln. 

Fox Interview: Euro Rally Loses Steam

Here is an interview I did on the euro.

Great Graphic: Irish Banks' Bond Holdings

This Great Graphic comes from Vic Duggan's blog.  The data comes from the Irish Central bank Monthly Statistics (October 2012). 

The first one depicts Irish Banks' holdings of sovereign debt.  It illustrates what we have called "financial disintegration".  This is the process of financial integration in reverse.  

It is characterized by a return of the home bias.  The chart shows that Irish banks increased their holdings of Irish sovereign bonds and reduced their holdings of non-Irish government debt, including the debt of other euro zone countries. 

The lower chart looks more closely at Irish banks' holdings of Irish debt in the context of Ireland's rising debt.  Simply put, Irish banks have dramatically increased their holdings of Irish government bonds, from a very low base.  

This reflects the recapitalization efforts and tightens rather than loosens the linkages between the sovereign and  domestic banks.  The largely nationalized banks are funding a large share of the government's deficit.

A Few Developments while FX Grinds

The US dollar managed to extend yesterday's recovery against most of the major currencies, but a consolidation tone has emerged.  Narrow ranges continue to dominate.   

We suggested here yesterday that the euro could pullback to the $1.2880-$1.2910.  The euro tested $1.29 in late in the London morning.  Similarly sterling tested the $1.60 level, and below that we identified potential toward $1.5950-60.   

Part of what is happening is a bout of profit-taking on yen crosses.  The yen is the strongest currency today, gaining about 0.33% against the greenback and about 0.66% against the euro, which is the weakest of the majors. 

Great Graphic: Residential Investment Not A Drag on GDP

This Great Graphic comes from the Center for Economic and Policy Research.   It shows residential investment in the US as a percentage of GDP. 

For our purposes here, what counts is the change in the change in residential investment.  The key take away is that the headwind from housing  is waning.  It may not be much of a tail wind, but the absence of the head wind is significant in the road to recovery. 

Portugal and Ireland: Us Too, Please

Greece has had trouble implementing the structural reforms demanded in exchange for aid.  The large and rising debt/GDP ratio is also a function of the larger than officially (Troika) expected contraction in the Greek economy.  The resolution achieved after protracted debate includes an easing of the debt servicing vis lower interest rates, deferred payments, and lengthened the maturity schedule.                                                                          

Doubts expressed by the deputy leader of Germany's CDU, questioning whether an official sector hair cut is embedded into the agreement may have weighed on the euro in an already offered market.  Recall that Merkel has frequently had to depend on the opposition SPD to support her European agenda.  A vote on the Greek deal, which could be taken before the end of the week may not be an exception.   

                                                                   

An under-appreciated twist to the plot, however, comes from Ireland and Portugal.  Recall that 2011 mid-year summit, European officials adopted a principle of equal treatment under the framework of the EFSF.  Essentially, this means that consideration given to Greece out to applied to the other countries who are receive EFSF assistance, namely Ireland and Portugal.              

Ireland and Portugal are consistently evaluated positively by the Troika, but are now required to have a more onerous debt servicing burden--higher interest rates and shorter maturities than Greece.  Some market participants see the likelihood that the official sector restructures Ireland and Portuguese debt.  Portugal's benchmark 10-year yield has fallen 14 bp today, second to the 24 bp decline in Greece's 10-year yield.   Counter-intuitively, Irish yields are slightly higher on the day..

Great Graphic: A Critical Imbalance

This must be a Great Graphic.  Both Zero Hedge and Walter Russell Mead posted it.  It is from the Food and Agriculture Organization (FAO) of the United Nations.  

It shows the significant deterioration of China's food self-sufficiency and the improved US agricultural surplus.  Europe is roughly in balance after previously being an importer.   

Given the intensive use of water to produce foodstuffs and fibers (roughly 1000 to 1), China's widening agriculture deficit reflects water shortage.   China is home to about 20% of the world's population, but has less than 10% of the world's supply of fresh water.  

There are numerous implications for development, power politics and, Zero Hedge suggests, the role of the dollar.  This discussion comes on the heels of the IEA's recent estimate that the US can be the world's largest producer of oil by 2020 and essentially energy self-sufficient by 2030. 

Buy Rumor+Sell Fact=Turnaround Tuesday

News that a deal was finally struck to ensure Greece can repay its largely official creditors saw the euro test the $1.3010 area twice in Asia before Europe took profits, knocking the euro below $1.2940.  The euro has now traded on both sides of Monday's range and a close below yesterday's low (~$1.2944) would undermine the technical tone.  It would signal potential for a deeper pullback toward $1.2880-$1.2910.  

The Greek deal has many moving parts, but there are key pieces.  A formal decision will not made until December 13 and needs formal approval by a few parliaments.  A German vote is possible at the end of the week or early next week.  Merkel may have to once again rely on support from the opposition Social Democrats for her European agenda.  

Commitment of Traders Updated: Speculators Caught Wrong Footed

The CFTC reported released the Commitment of Traders report on Monday due to the US holiday last week.  It covers the week through November 20.  That means that it does not capture the rally from seen at the end of last week.  

Our hypothesis was that the dollar's sell-off against the major currencies, except the Japanese yen, was not a function of some ill-placed optimism about a Greek package or optimism about the US avoiding the fiscal cliff, or the unexpected improvement in the ZEW report, all of which had been suggested by other observer.  

Instead, we suggested that the price action might be explained better by the political rhetoric coming from the anticipated head of the next government in Japan.   The large sell-off in the yen forced the position adjustment that led to a short squeeze of the other major currencies.  

Quick Thoughts on Carney's Move to the BOE

The UK surprised many by naming Bank of Canada Governor Mark Carney to replace Meryn King as the head of the Bank of England.   

Immediately pundits weighed in.  Some saying this was somewhat hawkish for the UK and sterling initially ticked up.  Others said this was a loss for Canada and the Canadian dollar initially ticked down.  

Yet both sides miss the point.  Carney was not chosen for his monetary policy biases.  On the contrary, what speaks the loudest is Carney's regulatory experience.  The Bank of England is in the process of securing the broadest and farthest reaching regulatory authority.  This is Carney's bailiwick.  He is, and will continue to be the head of the International Financial Stability Board.

Political Developments in Europe

There have been several political developments in Europe to note.  Although the immediate market impact seems modest, these developments will help shape the ongoing policy response to the financial crisis.                                  

First is the Catalonia election.  Many financial journalists look at the results and see the votes that went to nationalist parties was around 2/3 and they conclude that secessionist forces carried the day.  We are less convinced and note that many of the Spanish papers ran headlines suggesting Mas' gambit failed.   Mas' CIU remains the largest party, but it lost nearly 20% of its seats. 

FX Drivers in the Week Ahead

The last week of November has begun with a mildly consolidative tone in the foreign exchange market.    The US dollar is trading in relatively narrow ranges around its pre-weekend lows.  Its performance against the yen is the exception.  It has traded on both sides of last Friday's range. A close below Friday's low just above JPY82.00 would increase the risks of a deeper correction after the 4.6% advance in the past week and a half.

Consolidation is also the flavor of the day in the other capital markets.   MSCI's Asian-Pacific Index closed fractionally higher and most European bourses are paring last week's gains.  In in the debt market core bond yields are mostly softer, while Spain and Italian benchmark yields are 3-7 bp higher.

Great Graphic: Preliminary Election Results in Catalonia

This Great Graphic was posted just now on Presseurop, which it took from a local television report.   It gives a quick and preliminary look at the election results in Catalonia.  Mas' CIU party appears to have lost a few seats, but the left nationalist party ETC picked them up and more. 

Recall that until September Mas was not a secessionist.  Mas sought the same deal Basque Country receives.  However, Prime Minister Rajoy refused to renegotiate the fiscal transfer program that is a source of the region's 42 bln euro debt.  

Assuming the most optimistic results of this preliminary estimate, the center-right and center-left nationalist parties would have about 59% of the members in the 135 seat chamber.  This would be a little more than it has now.  However, for those seeking to turn the snap election into a referendum on independence, the results are not compelling.  Surely such an important, even unprecedented decision of secession requires more than such a slim parliamentary majority.  

Nevertheless, Mas may have succeeded in getting Rajoy's attention.  It does not mean Rajoy will cave-in, but negotiations can resume.    

Great Graphic: Shift in Structure of German Trade

This Great Graphic was posted on Economy View by Kostas Kalevras.  It illustrates the shifting structure of German trade. 

It is clear that the European periphery had to change and become more competitive.  This process, even if not smooth and with some foot dragging at times, internal devaluations and structural reforms are changing the competitive landscape.   

Less appreciated by many observers is that a periphery that is not leaving beyond its means as much and one that is experiencing falling unit labor costs will force Germany to change as well.  How did the periphery live beyond their means for so long?  German banks' exposure to the periphery in essence financed about half of German exports--a variant of producer financing.  

The chart illustrates that the debt crisis and policy response in changing this.  German exports cannot count on the periphery to absorb their output.  German prowess and competitiveness, with what is a soft currency for domestic producers, is such that it has found alternative markets to  the recessionary (or slow growing) EU and a more competitive periphery.   The growth in the non-EU trade surplus has offset roughly three-quarters of its reduced EU surplus.   

FX Technical Outlook: Yen and Dollar Weakness Set to Continue

Due to the Thanksgiving holiday in the US, the Commitment of Traders report of positioning in the currency futures market has been delayed.  We will review that separately when the data is available next week.  Here we present an overview of our near-term technical outlook.

Last week, we recognized that the US dollar was overstretched and anticipated some consolidation/correction.  Yet the pace and magnitude of the move was surprising, especially in light of the series of disappointing developments in Europe, which include the initial failure to resolve Greece's funding problems and the EU's next 7-year budget.  Nor was the economic data inspiring, as the main report of the week, the Nov flash PMI reading, suggests the euro area economy continues to contract here in Q4.  

Overview of Liquidity Conditions in Euro Area

The euro has surpassed the 50% retracement of the slide since Oct 17 when it peaked near $1.3140.  The 61.8% retracement comes in near $1.2960 and is seen as the next immediate objective.  

The driving force is not the fundamental strength of the euro area economy.  The PMI trumps the IFO and points to a Q4 contraction, including for Germany.   Nor it is it a reflection of the successful conclusion of the recent meetings on Greek aid and the EU 7-year budget.   Of course, a deal is likely, but the rancor and mental and accounting gymnastics that are required do not speak well of the process.  

Euro Rises despite Official Failures, Yen Consolidates

One would not know it by looking at the euro sitting at its best level in three weeks that European officials have failed to reach not one, but two agreements this week--to secure Greek funding and to agree on a new 7-year budget for the EU.  

Of course some observers are playing up the stronger than expected German IFO and the better French business confidence, but to do so, one needs to forget that yesterday's flash PMIs remained sufficiently weak to signal to the Markit economists that the German economy is contracting this quarter by 0.3%, completely wiping out the Q3 gain of 0.2, while the French economy may contract 0.7%.

Catalonia: Much to Do about Nothing and Everything

Catalonia, one of Spain's most important economic regions hold elections on Sunday, November 25. Artur Mas, the premier, called a snap election when the Rajoy government refused to reset the internal transfers that result in Catalonia paying Madrid more than it receives in benefits.  These transfers are one of the factors that lie behind Catalonia's own deficit and debt issues. 

Mas has tried casting the election as a referendum on independence.  A referendum itself has been rejected by Madrid as a violation of the 1976 constitution.

Great Graphic: Deficit Reduction American Style

This Great Graphic that shows that deficit reduction in the US over the past three years is largest in more than 60 years.  I found it at the Investor's Business Daily, which of course, is  not known for its leftist leanings.  

The US budget deficit has fallen 3.1% in the 2009-2012 period.  Besides the demobilization after WWII, the other time the deficit was cut quicker was the tightening of fiscal policy in 1937 served to extend the Great Depression.          

This has gone largely unrecognized and did not even come up during the most expensive presidential campaign in history.  The sub-par growth in the US since the economy bottomed in 2009 is partly a function of balancing the needs of fiscal consolidation with the demands for growth. 

This also puts the "fiscal cliff" in a different light.  The "cliff" is of America's own making.  It is not being imposed by investors, as has been case for the peripheral countries in Europe.  Capital is not striking against the US.  But more, the fiscal cliff itself is not as much an economic problem as a sign of the dysfunctional political process.  How it is avoided, mitigated or postponed, is itself a reflection of that same dysfunctional process.  

No Greek Deal, but did Germany Blink?

Everyone is talking about European finance ministers failing to reach an agreement on Greek funding.  There is another meeting scheduled for Monday.  It is clear that a Greek exit, which many observers had thought was inevitable six months ago, is not in the cards. 

Instead, what is being debated is how to fund Greece, which we continue to note is not really about aiding Greece as much as ensuring the country's ability to service its debt, which is primarily in official hands.  Still that does not stop some officials from proposing to give the private sector another haircut through the buy back of government bonds at a 50 cents or so on the euro.  Anticipation of some buy back may be helping to drive Greek bonds higher today. 

Europe Disappoints; Euro Resilient, Yen Weak

European officials disappointed investors by not reaching an agreement on Greek funding.  The euro quickly dropped about three quarters of a cent to just below $1.2740 in the Asia session.  Perhaps European dealers, more accustomed to such disappointment, or instead focused on the resumption of the discussion on Monday, helped bid the euro back to $1.28. 

There are many moving parts, between a moratorium on interest payments for several years, lower interest rates, bond buy back, but one thing that does not appear to be on the table is an official sector haircut that the IMF has advocated (but refuses to participate in), and that Bundesbank President Weidmann acknowledges is necessary.  

Great Graphic: How Israel's Iron Dome Works

I found this Great Graphic on Thomson Reuters. It illustrates how the Israel's "Iron Dome" works and how it is planned to evolve in the coming year.   Reports suggest that it has had a 90% hit rate on incoming missiles.

While futurists talk about the competition for a low-carbon economy or a post-automobile transportation system, there is also a competition for a missile defense and Israel has solidified its lead.

During the Cold War, until Reagan, there was little development of missile defenses.  The idea being that a missile defense negated or weakened "second strike" --retaliatory capability--which was the basis of MAD (mutually assured destruction).

This "second strike" capability acted as a significant deterrent.  Israel's deterrent has been a casualty of the skirmishes in recent years.  The Iron Dome and Israel's current actions seem to be aimed, at least in part, to re-establish deterrence.

Misunderstanding IMF COFER Adjustments

There is a buzz from the sidelines of the foreign exchange market that the IMF is considering classifying the Australian and Canadian dollars as reserve currencies. This is a misleading way to characterize what is happening.

It is already well documented that a number of central banks, including German, Swiss, and Russian central banks have added one or both of those currencies to reserves. There can be no doubt that the Australian and Canadian dollars are minor reserve currencies.

Another Brick in the Wall

There have been several developments to note, but price action has been minimal through the European morning.  

The biggest talking point today is Moody's decision to cut France's rating one notch to AA1 and maintaining a negative outlook.  This saw the euro jerk lower in thin pre-Asian activity to ~$1.2765, which should now offer initial support, but as participation increased, the euro recovered fully and even briefly traded above yesterday's North American high ~$1.2820.   Resistance extends toward $1.2845. 

Moody's Cuts French Rating, Matches S&P

In what is really a dog-bites-man story, Moody's cut the French sovereign rating to AA1 from AAA, matching what S&P did at the start of the year.  The market reaction--taking the euro down from around $1.2820 to about $1.2765--can be largely explained by the thinness of the markets--after New York closed, but before Asian markets opened and the technical implication of the failure of the euro to hold above the $1.28 level.  This area, as we have noted has important technical significance in terms of retracement objectives, moving averages and traditional chart patterns. 

Moody's did not say anything we have not already written or that one cannot read about in the current issue of the Economist.  Yes, the long-term outlook of France is being clouded by the need for structural challenges.  Yes, the fiscal outlook is uncertain.  Hardly news.

CNBC: High Speed Trading Losing it's Edge

Here is an interview I did a while back on CNBC. Shame on me for not telling my brilliant webmaster so she could get it up on the web faster!

Great Graphic: Components of the Fiscal Cliff

Here is a Great Graphic from Also Sprach Analyst blog, who picked it up from Deutsche Bank.  It shows the seven main components of the fiscal cliff.

The press is full of stories claiming that the framework of an agreement may be taking shape.  The reports suggest  a two-prong approach.  The first is some agreement to reduce next year's deficit by another $50 bln.  The second is an agreement on the framework to cut $4 trillion over the intermediate term.  

Another hopeful sign was seen by the Obama Administration indicating that Treasury Secretary Geithner will lead the White House's negotiations and not Jacob Lew, who had been instrumental in last year's talks that failed.  

Many observers and reporters are linking the firmer tone of equities and the more general risk-on behavior today, which is weighing on the dollar to optimism that the fiscal cliff can be averted.  We are skeptical of this reasoning, which seems to be an exercise in post-hoc narrative building.  

The fact of the matter is that there were no significant developments over the weekend.  There are still profound disagreements over the so-called Bush tax cuts.  Even though Democrat candidates in the House of Representatives won more votes than the Republican candidates, the Republicans hold a majority of seats and it is not yet clear which wing of the party is going to lead it. 

In any event, there is no sign that the Republicans are rolling over. Given the cast of characters and the incentive structure, a resolution should not be expected until the last moment, if not early next year.

Pain in Spain

The euro area finance ministers will focus on securing aid for Greece at tomorrow's meeting.  The aid that it will receive will enable it to service its debt, of which three quarters is in official hands (ECB, IMF and EU).  It will not be used for other government expenditures.  In this sense, the aid is not bailing out Greece but keeping its official creditors whole

.                       
The finance ministers meeting keeps Greece front and center, but Spain is on the wings.  Earlier today the central bank reported that non-performing loans rose to 10.7% (roughly 182 bln euros) in September from 10.5% in August.  It is the fifteenth consecutive monthly increase.  

Forces Shaping the Investment Climate

The US dollar is beginning the new week under modest pressure after the soft close before the weekend.  All the major currencies are gaining against the greenback, as are most of the emerging market currencies, including the Israeli shekel, which had weakening in light of the increased hostilities.

The euro, however, has remained below the $1.2800 level.  Stops are thought to be above last week's high seen just above there.  Additional resistance is seen near $1.2845.  Sterling did move through last week's highs (~$1.5915), but has been unable to make much headway from there after recovering a full cent since last Thursday's lows.  The greenback was initially pushed to almost JPY81.60 in early Asian trading, but Japan-based offers pushed back sending the dollar to almost JPY81.10.  In effect, the dollar has traded in about a 20-25 tick range on either side of Friday's North American close of about JPY81.35. 

Great Graphic: US Debt/GDP Long View

This Great Graphic comes from the Atlantic.  The US public debt that that chart tracks is federally publicly traded debt. It stood at $11.4 trillion last week and does not include the $5 trillion of debt that the US government owes itself via the trust funds, like Social Security.  

The large fiscal overshoot of the "Great Recession" was a function of both the collapse of revenues as well as a sharp increase in spending.   

Stronger growth would help reduce the cyclical adjusted deficit, but the underlying problem is more structural.  In effect, the clash between the two main parties in the US has resulted in a broad stalemate, where each side, in effect, got what it wanted:  low taxes and increased government outlays.  Those outlays, which are ideologically labeled as entitlements, are really the basket of goods/services that the sovereign provides to the citizens.   They were mostly won after years of debate and campaigning.  

We have suggested that capitalism is about relationships, and on the other side of the crisis many fundamental relationships will be transformed.  The relationship here is the relationship between the citizens and the sovereign.  What basket of goods/services should citizens receive and how are they financed?   At the same time, it must be recognized that the basket of goods and how it is financed over time may change. 

This is not a purely economic question of course as the relationship is not simply governed by the cash nexus.  It is about politics and power as well.  It is also about values.  

Currency Positioning and Technical Outlook: Dollar Bulls have Over-Reached

The US Dollar Index bottomed on September 14, the day after QE3+ was announced.  It reached a 2-month high before the weekend.  It has now retraced half of the ground lost from ECB President Draghi's pledge to "to do whatever it takes" through hints, and then delivery, of Fed's new balance sheet expansion program.  During this period, the US economy has generally out performed expectations, while the euro area underwhelmed.

While we retain a favorable outlook for the dollar, we are concerned that in the near-term, the bulls have over-reached.  We note below that in the latest CFTC reporting period, the speculative community reduced the gross long positions in all the futures we look at except the Australian dollar.  

Thoughts about the Euro and Yen Price Action

The euro has spent this week inside last week’s trading ranges.  It is consolidating the break of the $1.28 support, the lower end of the trading range from mid-September through last week.  This former support is now resistance as seen in Thursday’s price action.  That area now also corresponds with the 200-day moving average and the 38.2% retracement of the euro’s slide since the October 31 high near $1.3020.  

A weekly close above the $1.2800-20 area would be a constructive technical development.  Fundamentally nothing was resolved this week, but it does seem that the Eurogroup  is moving toward a deal on Greece that will get it some aid, but leave the 2015-2016 funding unresolved  The fact of the matter is that no matter how imminent it may have looked to some observers, Greece will finish the year still in EMU.  The sooner Greece runs a primary budget surplus the better its negotiating position with its creditors.

Great Graphic: IMF Forecasts of Greek Economy

This Great Graphic was posted on Zero Hedge.  It shows the IMF's forecast for the Greek economy and the actual performance.  Obviously the track record is dismal.  

The take-away for Zero Hedge is that the Troika's forecasts are a "joke".  It seems to me that this is not a very help way to frame the issue.  Moreover, the IMF has most recently acknowledged that its models under-estimated the fiscal multiplier--how much output is reduced per unit of austerity imposed.

It is common to see various explanations for Greece missing its deficit targets, including many that attribute it to rampant tax evasion and a deeply rooted in an exaggerated sense of entitlement.  No doubt these play a role, but the fact that the Greek economy is imploding faster than the Troika expected, and around which it made its aid projections, also needs to have a central part in any narrative.  

Jousting in the FX Market

There are several important developments today.  In terms of price action, the yen is the most noteworthy.   It has sold off as the market anticipates next month’s election will produce an LDP-led government that is talking very aggressively about breaking deflation’s grip and arresting yen strength, through open-ended QE, interest rates at or below zero and an elevated inflation target (3% has been bandied about rather than 1% current goal).

The dollar moved above JPY81 for the first time in seven months.   Implied volatility (3-month) has jumped today from about 7.5% to almost 8.5%, the highest since July amid talk of demand for JPY82-JPY83 dollar calls.

 

The Australian dollar has the dubious honor of being the second weakest currency today behind the yen.   It is off about a cent from yesterday’s highs to near a 2-week low.  It has fallen out of favor amid talk of a bond redemption and S&P warning that the country’s AAA rating may be at risk if the government fails to deliver a fiscal surplus in 2014.  

Great Graphic: Data Surprises in the US and Europe

This Great Graphic was posted on the Sober Look  blog.   It took it from research from JP Morgan.  It compares the bank's data surprise models for the US and Europe.  It documents what we have experienced.  

US data has generally surprised economists on the upside is early summer.   European data was improving relative to expectations July and August, but then has disappointed consistently. 

Data surprise models are common, but often misused.  There are two components to the "surprise" and neither is stationary.

The Misdirection of Currency Wars

(This is a summary of my views on "currency wars" that was the topic of the recent panel discussion at SIBOS in which I participated)

A standard ploy of magicians and politicians is called misdirection. The audience is distracted from the real movement by a feint. “Currency war,” which has become the title of books, articles and conferences, is such a misdirection.

Some officials, notably Brazilian Finance Minister Guido Mantega, have been leading the charge that through pursuing unorthodox monetary policy, the U.S. has sparked powerful forces that destabilize the emerging market economies through capital flows, driving the currencies sharply higher. 

Four Key Developments

The US dollar is broadly mixed here at midweek.  The euro is at its best levels of the week and is consolidating the break below $1.2800.  The Swiss is being dragged for the ride, but is trading near two month highs against the euro.  

The yen is the weakest of the majors and sterling fell out of favor following a more dovish BOE inflation report.  The dollar-bloc is little changed, with the Canadian dollar out-performing, even though late yesterday the finance minister acknowledged that the balance budget goal is going to take longer than previously anticipated.  

Great Graphic: Fiscal Cliff

This Great Graphic is from the Washington Post and Pew Research. It finds that by a margin of 51%-38%, Americans believe that President Obama and the Republican-led House of Representatives will not reach an agreement that avoids the fiscal cliff. 

Given the cast of characters and pledges not to raise taxes, we had suggested that the fiscal cliff may be easier to address after the fact than preemptively.  

Taking remedial action will allow some to honor the letter of their pledge and support the reinstatement of some tax breaks.  The economic impact may not be so severe if the US remains over the cliff for a short period of time. 

Debate over Greece Rages On

The German paper Bild reported that Germany may be willing to make a lump aid payment to Greece of 44 bln euros.  This popped the euro up a little more than half a cent to the session high just below $1.2730.

Color me skeptical.  To give Greece such a large sum at once is counter to the underlying strategy of doling out the aid in tranches to provide assurances of compliance.  This is tantamount to unilateral disarmament by the creditors.  Second, three euro area members require parliamentary approval, Germany, Finland and the Netherlands.   It is unlikely to receive support. 

Storm Clouds Continue to Gather

The euro was sold to new two-month lows against the dollar following the failure of the euro area finance ministers show any progress toward an agreement on Greece or bank supervision.

News of a worse than expected German ZEW survey (expectations -15.7 vs -9.8 expected and -11.5 in September) saw the low put in.  However, news that Greece was able to raise sufficient funds in a bill auction to cover the November 16 redemption saw the euro stabilize. 

The euro found a bid near $1.2660 and there is potential in North America today to see $1.2700 or a little more.  A move above yesterday's high near $1.2740 is needed to stabilize the short-term technical tone.  

Japan: Slip Sliding Away

There is a stark contrast between the deterioration of the political and economic environment in Japan and the relative strength of the yen.  The mystery is resolved by recognizing that the drivers of the yen's exchange rate has little to do with the macro-fundamentals in Japan and more to do with the general investment climate and interest rate differentials.  

Make no mistake about it, although Japan did not experience the US real estate implosion or Europe's sovereign and banking crisis, its economic crisis is just as profound.  And, as appears to be the case in America and Europe, Japan's political institutions or politicians may not be up to the task.  

A Few Observations to Start the New Week

The US dollar is little changed against most of the major and emerging market currencies.   Asian equities were mostly lower, while European bourses are decidedly mixed.  Core bond yields are flat to lower, while peripheral bond yields are mostly higher.

The lack of fresh trading incentives and holidays in the US and Canada are contributing to the choppy though consolidative tone.  The Australian dollar is the out-performer, gaining about 0.4% against the dollar.  It has been helped by an increase in domestic home lending, better Chinese trade figures and a local press report playing up Russia purchases for reserve purposes. 

In broad terms, the American and Chinese economies are reporting better figures, while the conditions in Europe, Japan and India have deteriorated.    Japan reported a largely as expected 0.9% contraction in Q3 GDP (quarter-over-quarter) for a 3.5% annualized paced.   A further contraction in the present quarter looks likely as well.

Great Graphic: France's Slide

Here is a Great Graphic posted on Zero Hedge, which in turn came from JP Morgan research.  It highlights several economic time series from France that shows the deterioration of the French economy since the start of last year.   

It dovetails nicely with our recent note on France.   Our thesis is that with structural reforms taking place  in much of the periphery, including a decline in unit labor costs, France is losing competitiveness from "below" and has been unable to keep up with German producers from "above".    

We suspect the European debt crisis will not be over until France too undergoes a retrstructuring that was forced on Germany after the Berlin Wall fell and is being forced on the peripheral countries by uncoordinated, though not completely separate pressure from the Troika and investors.  

We do take exception with the red vertical line that identifies a large lead that Hollande over Sarkozy in opinion polls.  First, that lead did not take place overnight and is a bit of political editorializing.  It seeks as the title of suggests to imply that there has been some important shift in the economy under Hollande from Sarkozy.   Second, the key event of that period around that horizontal line is the two interest rate cuts and the LTROs from the European Central Bank.  

Currency Positioning and Technical Outlook: Respect the Price Action

The US dollar appears to have broken out of the ranges that  dominated since mid-September against the major currencies, except the Japanese yen and Australian dollar.  

We had not anticipated the break out, believing that the resolution of the US fiscal cliff and the Spain/Greek issues in Europe were not imminent.   Nevertheless, we did recommend that if the break did materialize, the price action ought to be respected, especially if it took place in the direction that was consistent with our understanding of the fundamental backdrop, ie a stronger dollar.

BOE Eases (slightly)

Sterling is being dragged down by the falling euro, but also the Bank of England just said it had eased monetary policy slightly today, which caught the market by surprise.  

The Bank of England announced that it would transfer the interest it collects on the gilts it has bought under QE back to Her Majesty's Treasury.  Treasury, in turn, plans on using those funds to retire debt.  Therefore, the market will have somewhat few gilts and more cash.  Q.E.D.  

This might explain why the BOE did not extend the asset purchase program when it met earlier this week.  In essence, recycling of the coupon back to Treasury, which will pay down its debt (by retiring gilts) is similar, King argues, to the BOE buying the gilts--and removing them from the market.