Best of Q4 Posts

Here is the selection of our best posts from the fourth quarter.

1.  The Passion of Monti:  A Christmas Story  An allegorical analysis of Italy's political situation and Mario Monti's ambiguous legacy.  

2.  Great Graphic:  Fiscal Cliff Negotiations  A graph that shows the differences between the Democrats and Republicans proposals to avert the fiscal cliff.  Contrary to the partisans' claims, this is really a case of a hubris of small differences. 

3.  Misunderstanding IMF COFER Adjustments   The IMF is considering breaking out the Australian and Canadian dollars from the "other" category.  This simply reflects what central banks are already doing and does not mean that IMF is recommending them as reserve assets.  It is noteworthy that China's yuan has not yet reached the critical mass that would suggest it too ought to be recorded separately.  

4.  Misdirection of Currency Wars This has been a popular topic in the conventional media and blogosphere.  We argue that currency wars cannot be simply the attempt of the central banks in high income countries pursuing monetary policy to revive their economies during the de-leveraging phase.  It also has to do with medium income countries refusing to allow their currencies to participate in the adjustment process.  Capital flows to the emerging markets have actually slowed despite the unorthodox monetary policies among the developed countries. 

5.  The French Connection We argue that German reforms were spurred by the fall of the Berlin Wall and that the peripheral of Europe's reforms have been imposed by investors and European officials.  France has not been as fortunate.  We suspect that the European debt crisis will not be over until France too acquiesces to structural reforms. 

6.  What is Rajoy Waiting For? Some Thoughts Since the ECB unveiled its Outright Market Transaction scheme, Spain's Prime Minister Rajoy has hemmed and hawed, but has refused to sign up.  Spain has benefited from the sharp decline in yields spurred by the announcement and cannot be assured that actually implementing the program will produce a further significant decline in interest rates.  We suspect if and when Rajjoy acts it will be in the heat of a crisis and potential capital strike. 

7.  Yuan and Won:  Now This is New We have argued that much of the internationalization of the Chinese yuan is about appearances more than substance and the Sino-ification of Hong Kong rather than the increased international use of the yuan.  However, the development to use bilateral swap lines to promote trade settlement in local currencies is noteworthy and could be the model of the next stage of development. 

8.  Japan:  Slip Sliding Away A look at the forces that would be brought to bear after the Japanese elections.  Abenomics is simply the aggressive easing of monetary and fiscal policy with the aim of depreciating the yen, stimulating the economy and ending defllation's grip on the world's third largest economy. 

Politics Not Economics Push FX into Year End

It seems only fitting that politics, which have shaped the investment climate to such a large extent this year, dominates on this last day of 2012.  To be sure though, activity is thin and it seems only those who must transact are.  The US dollar itself is mixed.  It is slightly firmer against the euro, Swiss franc and yen, while softer against the dollar-bloc (which had lagged last week) and sterling.  It is also mixed against emerging market currencies.  

Equities are mixed, though on the back of a stronger China PMI (from HSBC), the Shanghai Composite tacked on 1.6%, extending its impressive recovery to 16.5% since the multi-year low was recorded on December 4th near 1949.  European bourses that are open are mixed, though France's CAC is up almost 1%.   Utilities and health care are leading the most, but all sectors are advancing.  Meanwhile, bond markets are little changed, though US Treasuries are firm, with yields off 2-3 bp.  

Great Graphic: Solar Energy and Swanson's Effect

Technological progress is live changing. Economies of scale of powerful.  Combine the two and the consequences are far-reaching.  This Great Graphic comes from the Economist.   It charts the dollar price per watt of electricity generated by photovoltaic cells going back to the late 1970s. 

Essentially, the cost of photovoltaic cells need to generate solar power falls 20% with each doubling of global capacity.  This has been dubbed the "Swanson Effect" after Richard Swanson the founder of SunPower, the large US-based manufacturers of solar cells.  

It is parallel to "Moore's Law" that the number of transistors on an integrated circuit doubles roughly every two years.  The eighteen months, often cited, was added by an Intel executive that combined the number of chips and their performance.

The Swanson effect reportedly more life in it as there are technological advances that have not been commercialized yet.  The price per watt of solar-generated electricity will continue to decline.  However, the technological progress in carbon-based fuels, especially natural gas, risks deterring the adoption of energy alternatives.   In addition, energy independence may encourage greater unilateralism at a time when the international ties that bind, such as financial integration, appear to be going in reverse.  

Great Graphic: Surprising Demographics

This Great Graphic comes from the World Bank.   While we are all familiar with the demographic shock in the high income countries.  For a few years already, Japan is experiencing a shrinking work force and a shrinking population. Part of Europe, such as Italy, does not seem far behind. The retiring of the baby boom generation and the declining reproduction rates are generally well known.

What is new about this graph is that it shows that the developing, especially Asia and Latin America, are approaching their own demographic challenge in the form of aging populations.  In China's case, as a consequence of the one child policy, the question has already been asked whether China will get old before it gets rich.  

Note too that, as a species we are living longer.  There the gap in longevity between what the World Bank calls the developing and developed regions has narrowed at higher levels and this is project to continue, albeit slowly, over the next few decades.  

The claim that in 2050 80% of the world's older people (60 years and over) will be in the emerging and developing economies is striking, but perhaps a bit misleading given that the vast majority of people live there.  Moreover, the gap between the size of the population in the high income (developed) countries and lower income countries (developing and emerging) countries is project to also widen.  

Currency Positioning and Technical Outlook: Weak Signals, Lots of Noise

The holiday week saw the dollar consolidate against most of the major currencies.  The yen was the main exception as its losses were extended under the aggressive signals coming from the new Japanese government.   

At the end of the week, the other key consideration, the US fiscal cliff made its presence felt.  The recent pattern remained intact.  News that gives the participants a sense that the cliff may be averted encourages risk taking, which means in the foreign exchange market, the sale of dollars and yen.  

News that makes participants more fearful that the political dysfunction failed to avert the cliff and send the world's largest economy into recession, generally see the dollar and yen recover.  This is what happened in very thin markets just ahead of the weekend as Obama's ling last ditch negotiating stance seemed to reflect a retreat from his earlier compromises.

Great Graphic: Central Bank Balance Sheets

Business Insider ran a series recently of charts from a number of different economists and strategists.  These Great Graphics  come from that series and are essentially different renditions of the same data.  

We are looking at the balance sheets of a number of central banks.  One of the features of the policy response to the end of the credit cycle has been the employment of a number of central bank balance sheets.  

China is an exception as the expansion of its balance sheet is driven by its exchange rate policy.  When it buys dollars, it sells yuan bills.   Few observers seem to recognize it, but the balance sheet of the People's Bank of China has actually grown more than the Federal Reserve's or the ECB's balance sheet.  

We have suggested a historic parallel.  The Great Depression resulted in the permanent use of the government's balance sheet to underwrite aggregate demand.  The Great Recession has seen the deployment of central bank balance sheets.  This too seem to be a quasi-permanent development. 

Euro Winds Down

The relatively calm foreign exchange market and equity market in Asia ended abruptly in Europe.  It is difficult to find the culprit, other than position squaring in thin markets, but the euro has come off a cent, dragging the franc.  

The MSCI Asia Pacific Index gained more than 0.5%, while European bourses are broadly lower, with the Dow Jones Stoxx 600 off 0.3% near midday in London, led by utilities and financials.  Fixed income markets are subdued.  Italy's bond auction was adequately received, especially holiday conditions.  

There have been a few developments to note.  Japan's data was disappointing and this can only bolster the new government's attempt to stimulate the economy both monetarily and fiscally.  Worker cash earnings fell a whopping 1.1% in November, nearly three times larger than the consensus.  This may have been a factor behind the poor retail sales, which were flat.  The consensus had expected a 0.4% increase.  Weak incomes and domestic demand may have, in turn, weighed on output.  In November, industrial production fell 1.7%,  more than three times the decline expected. 

Great Graphic: Japan and Korea

These Great Graphics come from Bloomberg.  I created them as part of an investigation into the impact of a weaker yen outside of Japan.  Japan and Korea compete in various industries. 

As is well appreciated, the newly elected Japanese government is determined to weaken the yen as a means to fighting deflation and reviving the economy. 

Thus far there has been very little push back against the purposeful attempt to depreciate the yen. 

Within Japan, the weaker yen has helped fuel strong gains in the Nikkei.  This seems understandable, as the weaker yen will boost the competitiveness of Japanese companies.  However, the prospects of currency depreciation have not sparked a commensurate increase in Japanese yields (to compensate for the currency risk).  

The 10-year JGB (generic) yield reached a multi-year low on December 7 near 0.685% (according to Bloomberg).  Today the yield briefly poked through 0.80%.    What is important is not the percentage move, but the absolute yield relative to the anticipated currency depreciation.

Abenomics and other Drivers of Holiday Markets

The main feature in the foreign exchange market continues to be the yen’s weakness.  This weakness, based on expectations that the new Japanese government will succeed in driving the dollar to JPY90 with a combination of more aggressive monetary and fiscal policy (“Abenomics), is offering support to the other currencies.  The yen sales are a combination of momentum and carry strategies. 

 

There are two other forces in the market as well.  First, the market is anticipating a further reduction in tail risks in Europe.  Of course the large moves away from the abyss this year are clearly the doing of the ECB with its long-term repos and offer of (conditional) outright purchases.   

However the European Commission will reportedly do its part by granting several countries, including France and Spain, an extra year (and maybe two for Spain) to reach the 3% deficit target.  An official announcement has not been made, but the signals from the EC and the Commissioner for Economic and Monetary Affairs Rehn are unmistakable.

What's Up Dock ?

Labor disputes at ports on both US coasts could disrupt trade in the new year and skew high frequency employment data.  In could produce shortages of some consumer goods.  The resulting higher prices could filter through into measured inflation.  

The proximate cause of the disputes differ, but at its heart is a push by the employers to boost competitiveness through forcing changes in labor practices.

In 15 ports from Massachusetts to Texas, including the New York and New Jersey, the employers' union association, the U.S. Marine Alliance, seeks to cap the "container royalty", which are payments made to workers based on the weight of container cargo.  The dock workers, represented by the International Longshoreman Association, are resisting.  The workers also insist on maintaining the eight-hour a day (of pay guarantee).  

The Passion of Monti: A Christmas Story

The political dysfunction of the world's largest economy is epic.  Even though Mr. Market is not forcing the US hand, the political class is intent on shooting itself in the foot.  Yet the uncertainty over next year's marginal tax rates has not impacted the hiring process as the average monthly non-farm payroll growth has not diminished.  Nor have investment plans been adversely impacted.  Non-defense durable goods orders, excluding aircraft, a useful proxy for capital investment, rose 2.7% in November after posting a 3.2% increase in October.   

Italy is not as fortunate.  Its economy is contracting.  Mr Market is likely to be less patient.  Although Italy's net debt issuance in 2013 appears less than in 2012, there is little room for error.  

Monti was looked upon as the savior of Italy after Berlusconi had undermined its gravitas on the world stage with his antics that are unbecoming of a man of his stature.   Yet Monti took his role too seriously and not seriously enough.  

Great Graphic: True Cost of Health Care

This Great Graphic was posted by Sarah Cliff on the Wonk Blog of the Washington Post.   The obvious point it makes is that it takes a little more than 58 days of work on average to secure one's health care spending in the United States.  This a four-fold increase over the past 50-years.   

On another level, the graph offers a metric that few use, but we find illuminating (discussed as well in Making Sense of the Dollar:  Exposing Dangerous Myths about Trade and Foreign Exchange).   The gold bugs argue that the yellow metal is a constant and therefore a valid metric and basis for a stable monetary order.  We disagree for numerous reasons well beyond the scope of this short post. 

Yet they are right that money is illusory especially when comparing it over time and space.  An alternative metric is an hour of work.   It sidesteps the problems using money per se and the abstractions of economics by putting people back at the center.  Admittedly, it does have a short-coming.  It cannot capture the time cost of new technologies, so the reference in the chart of the iPod seems out of place.  

A comprehensive survey of the of the time cost of goods and services would show that the majority have indeed fallen.  That is, after all, what productivity means.  Those items whose time costs have increased, like health care and college tuition, are the exception that prove the rule.  They invite closer examination.  

Great Graphic: Extent of the Fiscal Cliff

This Great Graphic is from Foreign Affairs.  It shows what is involved with going over the fiscal cliff.   Our base case remains the fiscal cliff will be easier to address after the  Rubicon is crossed than preemptively.  A coalition in favor of restoring some tax cuts seems more likely than an agreement on whose taxes to raise.  

Notable Weekend Developments

Yes, it is the holiday season.  Yes, you are unlikely to be taking action with your investments.  Yes, the morphing of what is into what will be continues uninterrupted.  

There were several developments over the weekend that will influence the direction of the markets in the days ahead, with the usual caution about the impact of the thinness of conditions.  

First, the major focus remains the US fiscal cliff.  One of the most important ways in which the US fiscal crisis differs from those seen in Iceland, Greece, Portugal, Ireland is that it has not been triggered by a capital strike. Investors have not fled the US.  Interest rates have not trended higher.   It is not a fiscal crisis.  It is a political crisis.

Currency Positioning and Technical Outlook: Holiday Mode

The US dollar rebounded smartly at the end of last week as the realization that it was increasingly likely the US would go over the fiscal cliff.  This has been our base case, but many seemed to expect it to be averted and were looking past it.   

The collapse of Boehner's so-called Plan B, due to the lack of sufficient Republican support, would not have passed the Senate, where the Democrats enjoy a slim majority, in any event.  The entire negotiations are now in disarray, as is the national Republican Party.

After a holiday break, new negotiations will begin on December 27, giving officials five days to reach an agreement.   A fall back plan--an interim agreement--aimed at avoiding the tax increases and spending cuts that would drive the economy over he cliff, risking new increases in unemployment,  will also being discussed.  

The dollar's recovery, ironically, was a product of the heightened concerns about the US political dysfunction and market positioning.  We have noted in our recent weekly reviews that the speculators  in the futures market were reducing short currency positions and building on the longs.  Respecting the holidays and the lighter market participation, we offer an abbreviated review of currency positioning and technical outlook.  We share the following six observations.

Great Graphic: Chart Your Effective Tax Rate

This Great Graphic comes from Ritchie King at Quartz.  Follow the link and you can access an interactive aspect and see your effective tax rate back to the eve of WWI, if you 'd like.  

What is striking is that for most incomes, the effective tax rate is lower than in 1980 and yet cost of the basket of goods and services the government provides has risen and that basket has been expanded, by both Republicans and Democrats.  

King went further and showed the effective tax rate for a $1.5 mln income under Obama's proposal and Boehner's Plan B, which appears to have died an embarrassing death; killed by a wing of the Republican Party.

Obama would have the person earning a $1.5 mln income to pay $552,126 of income tax, a 36.8% effective tax rate.  Under Plan B, the same person would pay $523,889 in income taxes, a 34.9% effective tax rate.  The difference of $27,237.  As we have argued before, the difference is not about ideology, but about politics and personality.  

Market Discovers Fiscal Cliff, Sends Dollar Higher

It had seemed that many participants were looking past the US fiscal cliff and were to be content taking on more risk.  However, yesterday's late developments have provided a cold slap of reality.  Our base scenario, under which the US does in fact go over the cliff appears more likely now that Speak Boehner's "Plan B" failed to draw sufficient Republican support to allow a vote.   Indeed, there is some speculation that the failure of Boehner's gambit may see a leadership challenge right after the New Year.  

The lack of a coherent Republican strategy has prompted a large unwind of risk-on and thin holiday market conditions may be exacerbating the price action.  In the risk-off mode, the US dollar and yen have performed best.  The dollar-bloc, which has generally lagged in recent days, remains under pressure.

Yen Rebounds, Dollar Soft

The US dollar is sporting a softer profile today.  It had initially extended its gains after recovering in North America yesterday. In Japanese candlestick terms the euro and sterling had recorded "shooting stars", in essence opening on their highs and finishing on their lows.  Additional profit-taking was seen in Asia, earlier today.  The euro was pushed below its 20-day moving average for the first time since Dec 11.  Sterling fared better but still extended yesterday's losses.  However, in the European morning, both currencies have recovered to move back into yesterday's ranges.

The price action can be attributed to thinning market conditions and the recovery of the yen.  Indeed, "sell the rumor buy the fact" gains in the yen, may have pressured the other currencies as cross positions were also unwound.   The dollar has stabilized after slipping through the JPY84.20 area to trade below the previous day's low for the first time since Dec 10. 

Great Graphic: Political Affiliation of Gun Ownership in US

This Great Graphic comes from an interesting blog Explore, that is edited by Maria Popova of Brain Pickings.   It shows gun ownership by political affiliation.   

In the previous post, we argued that evidence suggest the debate over the fiscal cliff was small beer.  Here, we see an unambiguous difference. 

Taken together, the two posts suggest that the profound fissure may not be economics but cultural values. 

Great Graphic: Fiscal Cliff Negotiations--Must See

This is one of the most revealing graphs we have posted.  This Great Graphic comes from the Washington Post's Wonk blog.  

First, it shows that a step toward fiscal adjustment is coming to the US.  The difference between Obama's plan and Boehner's is how the burden of the adjustment should be distributed.  

Second, the chest thumping and the hand wringing that has surround the negotiations seems dramatically out of proportion with the differences.  This is a case of the hubris of small differences.  

Third, the main difference, in terms of broad categories is that Obama seeks to extend some of the stimulus and is paying for it through discretionary spending cuts.  Obama has a bit more in tax increases ($1.2 trillion instead of $1 trillion)  and a little less in Social Security/Medicare/Medicad mandatory cuts ($750 blns vs $1 trillion). 

Fourth, claims that Obama is a socialist while the Republicans are defenders of the free market and liberty cannot be supported by these differences.  Contrary to the heated political rhetoric, most of the economic debate between the Democrats and Republicans would take place within the Tory Party in the UK.   This is just another way to say that the US political spectrum is relatively small and is located in the right of European politics.  

Fifth, and related, the graph bears out a point that Obama made recently to a Hispanic audience.  In response to a reporters question that some accuse him of being a socialist, Obama noted that his policies would have made him a moderate Republican in the 1980s.  The point here is not just that the American political discourse is on the right, but that the entire spectrum has shifted to the right, contrary to conventional wisdom.  Consider that in the early 1970s,  Republican President Nixon imposed price and wage controls. That Obama could be to the right of Nixon in terms of economic policy is indeed thought provoking. 

European Currencies Rally, Dollar-Bloc Heavy

This week's pattern remains intact.  The US dollar continues to trend lower against the European currencies, but is firmer within the dollar-bloc and against the yen.  Spanish and Italian bond yields are lower, while the long-end of the Japanese curve is heavy.  Equity markets are finishing the year with a firm note, with board gains in Asian, with the notable exception of Shanghai and Jakarta, and in Europe, with the exception of Stockholm. 

The euro is at 7-month highs today, pushing toward $1.3300. The next target is near $1.3385.    Sterling has been bid to near the year's high set in late September just above $1.6300. There is little chart resistance until closer to $1.6500.   The dollar's slide against the Swiss franc has extended to CHF0.91 and appears headed for CHF0.9000.

The dollar-bloc is not participating in this move against the greenback.  This week, for example, the New Zealand dollar has fallen as almost as much as the yen (1.03% and 1.08% respectively).  The Australian and Canadian dollars are off 0.04% and 0.57% respectively.

A Few Developments Augment Holiday Mood

The US dollar is mixed.  Softer against the European complex, but firmer against the dollar bloc.  It is essentially flat against the yen.  Equity markets are advancing and the Nikkei, which gapped above the 3-year downtrend line yesterday, extended its gains by another 1%.   Spanish and Italian bond yields are lower.
   

Japanese yields continue to edge higher, with the long-end of the curve continuing to steepen gradually.   The 10-20 year spread is near a 13-year high, for example.  The BOJ's Shirakawa met with Abe briefly (20 minutes, according to press reports).  The last big event of the week is the BOJ meeting that concludes on Thursday.  

Cyrpus: The Dog that Didn't Bite...Yet

Last week Eurogroup head Juncker warned that the situation tiny Cyprus was more worrisome than Greece.  While this seemed to be an exercise in hyperbole, sure enough Monday, a Cyprus official was quoted on the news wires warning of an imminent default.  

Hang on.  Didn't Cyprus reach a memorandum of understanding with the Troika ?  Indeed, it did.  However, it will take some time to deliver the funds.  

Essentially and in principle, there was an agreement on aid in the neighborhood of 17.5 bln euros.  This is for the bank recap (roughly 10 bln euros) and for funding the government for three years (7.5 bln euros).  An audit of the banks is needed to ascertain their condition and determine the recapitalization needs.  PIMCO recently conducted a preliminary audit for the government but the results have not been released.  A full audit is expected in mid-January.  

Great Graphic Warning Sign for Japanese Shares

In response to the electoral victory by the Liberal Democrat Party, the Nikkei gapped higher today in Tokyo trading.  The gap put it above the downtrend line drawn off the 2010, 2011 and 2012 high.  Since it occurred on a Monday the gap is not only to be found on the daily bar charts, but the weekly as well, which theoretically gives it even greater significance. 

Gaps are not uncommon in the Nikkei, which often seems to be influenced by developments outside of its time zone.  The frequency of gaps may undermine the validity of gap theory. 

This Great Graphic we created on Bloomberg,  It is a weekly chart of Japan's Nikkei and shows the violation of the downtrend.  The Nikkei opened on its highs today and drifted lower to finish the session on its lows.   Monday's low was 9826.30.  The pre-weekend high was set near 9775.75.  The difference is the gap that remains.   If there is much of a decline through the bottom of the gap, the next of support is seen in the 9672-9687 area and then 9600. 

The yen and the Nikkei are strongly inversely correlated.  In terms of simply direction, the inverse correlation stands near -0.85 over the past 60 days, which is a 5-6 month extreme.  The correlation of returns (percent change), the correlation is almost -0.46, which is the most for the at least three years. 

Japan's Election and BOJ in Focus, Monti's Decision Awaited

There was a lively start to trading as the yen gapped lower in immediate response to new of the LDP's  victory in the weekend elections in Japan.  The greenback traded around JPY84.55, the highest level since April 2011.  The euro traded to about JPY111.30, just below the year's high set in March near JPY111.45.  The Nikkei gapped higher.  

However, as the results were largely as expected.  The LDP and its traditional ally, the New Komeito secured a 2/3 majority, which will prevent the upper house, in which the DPJ has a majority, from blocking the new government. 

In addition, there is some speculation that the BOJ may stand pat at this week's meeting to enhance its negotiating position with LDP-led government.  Before the weekend, the consensus was for the BOJ to expand its asset purchase plan by JPY5-10 trillion in the face of data pointing to the second consecutive quarterly economic contraction.

Initial Thoughts on Japan's Election

The outcome of Japan's election seems to be largely in line with market expectations.  The Liberal Democrat Party won handily.  It appears to have secured a majority of lower chamber of the Diet.  

There had been some reports suggesting that it might be able to achieve a super-majority of 2/3, but this does not look to materialized.  However, with its traditional party, the Komeito, together it may. 

In any event, this is a strong mandate for the LDP's agenda.  It is a combination of nationalism and what passes for socialism in the neo-liberal age, namely increased government support for the economy via 1) massive public spending and 2) unlimited monetary easing.

Great Graphic: Key to House Prices

This Great Graphic was posted on Sober Outlook, which in turn comes from JPMorgan, drawing on CoreLogic and BLS data.  It tracks two times series, per capita income and house prices.  

The compelling idea here is that over the long-run, the appreciation of house prices tracks per capita income.  

Admittedly, there is great variation of house prices.  It is difficult to conceive of a national market as something more than a summation of the local markets.  

In any event, the question of the trend in house prices is transformed here into a question of the trend in per capita income.  Per capita income has tended to grow around 5% a year in the US historically, but considerably slower since the end of the credit cycle.  Next year, 2013, is likely to be another year of subdued growth in GDP, which at best will be a little more than population growth.  This suggests little lift for house pries, generally speaking, next year.  

Currency Positioning and Technical Outlook: The Trend wants to be Your Friend (Again)

The US dollar moved lower over the past week against the major currencies, with the notable exception of the Japanese yen.  The greenback's technical tone has deteriorated.  The euro and sterling appear to have convincingly broken above significant down trend lines.  With the holiday season upon us, there seems to be no compelling technical reason not to look for a continuation of dollar weakness into the end of the year.  Few are incentivized to fight the trend.

The extent of the Fed's easing, and the implication of its guidance, suggests an even more dovish posture than the expansion of QE3+ (remember it was purposely open-ended, unlike QE1 and QE2). While the euro zone economy appears to be contracting this quarter at a slightly faster pace than in Q3, the slowdown in the US is more dramatic.  Growth may be more than cut in half from the 2.7% annual pace seen in Q3.   The fiscal cliff is the main cause of consternation at the moment.  Although there is private negotiations taking place, the public posturing is what investors have to guide them, and it is not particularly flattering.

Europe: The Vision Thing

The euro has been the strongest currency this week.  At pixel time it is up about 1.2%.  The Dow Jones Stoxx 600 made new 18-month highs earlier in the week before consolidating in the second half of the week.  Bond markets were mostly lower, though Greece, for obvious reasons, Spain and Portugal were exceptions to the generalization.   

European officials also had a good week.  Aid to Greece was approved, averting a more serious crisis. The broad strokes of the ECB taking on the responsibility of supervisor for important (nationally or systemically) banks has been agreed upon.  

Yet there is still much to be concerned about.  Some critics took the Federal Reserve to task for generally offering relatively optimistic GDP forecasts only to revise them lower later.  European officials generally do the same.  In particular, Spain and France's official forecast are well above market expectations.   As is now more widely appreciated, slower growth translate into deficit overshoots, requiring additional corrective measures.

Four Drivers, Little Movement

With few exceptions, the global capital markets which began the week with a bang, are finishing with a whimper.  The US dollar is little changed against the major and emerging market currencies.   Asia stocks were by and large flat, with the notable exception of Chinese stocks, where the major indices jumped a  little more than 4%. 

European bourses are mixed, with gains and losses mostly less than 0.25% near midday in London.  Spanish and Italian bond yields are slightly lower, but activity is quiet.   

Despite the subdued tone, there are four developments to note.

Great Graphic: Pew Poll on Fiscal Cliff Proposals

This Great Graphic comes from Pew Research.  It shows one of the reasons why the fiscal cliff talks are so difficult.  Few proposals really have a majority of support. 

Yet it seems clear that the three proposals that have the highest support are to focused on getting the wealthier among us to pay more.  

While some will see this as class war, one wonders where these sensibilities were during the period in which the disparity of wealth and income increased to historic proportions. 

Great Graphic: Spain Woes Continue

The Greek bond buy-back, the machinations of Italian politics and the European agreement on bank supervision all seem to have pushed Spain out of the limelight. Yet the economic situation is does not appear to be stabilizing and it will likely return to center stage early next year. 

This Great Graphic is was posted on Quartz and comes from a survey by the rating agency Fitch.   The chart is a bit counter-intuitive.  The blue bar shows decline in Spain's housing prices based on the year of sale.  The yellow dot registering the number of sales the rating agency studied.  

Foreign Exchange Frustrates

The US dollar saw its post-FOMC losses extended only against the euro as the perhaps the passable success of the Greek bond buy-back and bank supervision deal lent support to the single currency.  

Yet, even it succumbed to selling pressure in the European morning and returned to pre-FOMC levels near $1.3040.  Against most of the other majors, the dollar has been confined to yesterday's ranges.  This is somewhat reminiscent of the price action after QE3+ was announced on Sept 13, with the dollar bottoming either that day or the following day. 

Doves Rule at the FOMC

The Federal Reserve was as aggressively dovish as any one expected. It added to QE $45 bln a month in US Treasuries, keeping the $40 bln of month of MBS purchases. It also changed from time reference for guidance to use of inflation and even there it is dovish, indicating rates will remains low as long as inflation is below 2.5% and unemployment is above 6.5%.

This was the main focus of the statement. The general economic assessment seemed little changed and Lacker continued with his dissent, opposing the new asset purchases and the "characterization of conditions" that exceptionally low interest rates would be justified.

The euro had been bid just prior to the FOMC statement on news that Berlusconi indicated he may withdraw his candidacy if Monti would run. The FOMC announcement saw the dollar decline across the board. Treasury yields rose. The 30-year yield was already at one month highs prior to the FOMC outcome. The 5-year/5-year forward that Fed officials has sometimes cited for a measure of inflation expectations was near 18 month highs and spiked higher on the announcement. The equity market advanced on the news.

The expansion of the open-end QE is not surprising. There may be some disappointment that the Fed did not boost its MBS purchases. We had suggested the possibility that the Fed would not double down on QE. The move to macro-economic guidance has been discussed, but most thought it likely to be adopted in early 2013. The guidance is such that it reinforces the idea that the Fed will not be raising rates in for some time--not in 2013, and not in 2014 and maybe not even in 2015.

Sweden's Riksbank To Bolster Reserves

The accumulation of reserves is primarily limited to developing countries.  There are two notable exceptions among the high income countries. Japan, which is traditionally willing to intervene in the foreign exchange market to curb the yen's strength.  The last intervention took place in Oct-Nov 2011, when the BOJ bought over $100 bln.  

The other exception is the Switzerland, where the SNB has capped the franc against the euro, leading to something on the magnitude of tripling their reserve holdings.  

The announcement that Sweden's Riksbank will boost its reserves drew our attention.  The Riksbank currently holds about $40 bln worth of currency reserves.  It will boost it by about 37% or around $15 bln (SEK100 bln).  The reasons behind its decision is interesting and reflective of more modern thinking about currency reserves.  

Dollar and Yen Remain Soft

The US dollar and yen remain soft.  The news stream has encouraged the so-called risk-on trade.  The Greek debt buyback appears to have gone well enough that it will get dollop of aid.  Spain reportedly received 40 bln euros of bank aid.  There seems to be a potential compromise banking supervision in Europe.  On top of that, of course, the market expects the Federal Reserve to announce an expansion of its quantitative easing later today and keep the door open to further steps if necessary. 

The dollar made new eight month highs against the yen, just shy of the JPY83 level.  These dollar gains ahead of the FOMC meeting underscores one of our interpretative points that the old drivers of dollar-yen, like interest rate differentials and general risk appetite, have broken down, trumped by Mr Abe and his aggressive monetary and fiscal rhetoric. 

Great Graphic: What Happened Since QE3+ ?

The FOMC concludes its meeting tomorrow and most observers expect at least some part of Operation Twist purchases to be folded into QE3+.

There remains some criticism that easy monetary policy by the US and other high income economies fueling inflation and de-stabilzing capital flows.  We have consistently argued against such interpretations.   Yet even today, Brazilian President Rouseeff was complaining to French President Holande that the easy monetary policy by Europe and the US (seemingly ignoring the strong appetite Japanese investor have had for Brazilian exposure).  

As Bloomberg's David Biller notes, Rousseff's comments reiterate what she has said at the UN a few months ago and earlier this year in Germany. 

These Great Graphic was  created on Bloomberg and the show the price action since the Sept 13 FOMC announcement of an open-ended QE with the opening gambit of $40 bln purchases a month of MBS.  

The top chart looks at the performance of what Bloomberg regards as "major currencies".  Of the 16 currencies, half advance against the dollar and half have fallen.  In terms of magnitude, the currencies that declined fell more than the advancing currencies rose.  There are high yielders and low yielders on both sides of the divide.  

The second chart looks at the Brazilian real.  It has lost about 2.75%.  In fact recently it fell to 3-year lows against the dollar and Brazil's central bank intervened to slow its descent. 

The third chart shows the CRB index.  It appears to have put in a peak the day after the FOMC meet in mid September and has trended lower since.  It is now about 9% off that peak.  Gold is about 3.5% lower.  Copper prices are about 1% lower.  Crude oil is about 13% lower. 

Berlusconi to Run Against Merkel

Draghi's pledge to do what is necessary, within the ECB's mandate, to save the euro clearly reduced the extreme tail risk in the euro zone. Greece is about to receive a large dollop of aid so it can continue to keep its public sector creditors whole at the expense of domestic financial institutions. 

While the risk of a Grexit, which many thought was so imminent, has receded, euro skeptics have turned their attention to Spain and/or Italy.

The Wall Street Journal reports of a euro skeptic hedge fund note warning of a 40% chance that Spain leaves EMU 2014-2015.   Some economists have also identified rising unemployment as the breaking issue.

Dollar Soft, FOMC Awaited

Some indication of progress on US fiscal talks, anticipation that the Fed extends QE3+ tomorrow, speculation of a cut in China’s required reserve, healthy Spanish T-bill auctions and a much stronger than expected German ZEW survey is encouraging risk-on plays, with the dollar and yen laggards, peripheral bonds firmer, and emerging equity markets extending recent gains. European shares are advancing for the seventh consecutive session.

Outside of the euro, the major currencies are struggling to extend gains against the greenback. The sterling may be struggling on the back of reports that suggest two large UK banks will be paying $2.5 bln in fines to the US though it is a bit simplistic in this day of high finance to expect the banks simply to go to market and purchase the dollars. Separately the UK’s RICS house price balance fell to-9% from -7%, while the market had looked for improvement.

Great Graphic: Shifting Trade Patterns will Reduce Target2 Imbalances

The Target2 imbalances caused much consternation earlier this year as some economists focused on them as either signs that a transfer union was a fact on the ground, or alternatively, as a sign of the pending costs to Germany, which German politicians fail to acknowledge. 

This Great Graphic comes from the Brussels Blog at the London School of Economics, who in turn got it from Place De Luxembourg

Much ink has been spilled trying to decipher the true meaning, but we know that the Target2 imbalances are nothing more or less than a reflection of the intra-euro area current account imbalances.  Before the crisis those imbalances were financed largely by the private sector.  That was part of the financial integration process whereby creditors would recycle their surpluses by primarily buying bond in the debt countries.   

FX Drivers and Themes

News of greater political uncertainty in Italy and poor European data is spurring risk-off moves, with the dollar and yen firmer, emerging market currencies mostly softer, global equity markets lower and core bonds a bit firmer.  

Following much weaker than expected German industrial production figures last week has been followed in kind by disappointing French and Italian output figures today.  Italy reported a 1.1% decline.  The consensus was for a 0.2% decline and the Sept series was revised lower.   French output fell 0.7%.  The consensus was for a 0.3% increase.  Yet it is really the Italian political scene that is the key driver today with the benchmark 10-year yield up more than 30 bp, dragging up peripheral yields generally.  Italian shares have been particularly hard hit and a couple of banks were limit down and stopped trading.  

This week is the last before the holiday mood sets in.  We identify ten considerations that will drive the capital markets. 

Italy Trumps Greece

News that the Greek bond buy scheme did not get sufficient takers to reach the 30 bln euro target, set the commentariat ablaze.  This may prove to be a minor technicality, as Greek banks initially offered 75% of the Greek bonds, but were prepared to pitch them all if necessary to ensure EU aid is forthcoming, which is the source of their recapitalization funds.

The bigger story is the fall of the Monti technocrat government in Italy.  Berlusconi's PDL party pulled support by abstaining from economic reform votes at the end of last week.   After a series of consultations with the Italian president, it appears that parliament will not be dissolved until two important pieces of legislation are approved, the 2013 budget and financial stability measures.  The former is needed for obvious domestic reasons.  The latter is needed to maintain credibility in  EMU; assuring its partners.

Cool Video: Does the Universe Have a Purpose?

This is an an example of disciplined analytic thinking .  It is also concise and entertaining.  Enjoy.

Great Graphic: IMF GDP Projections

This Great Graphic comes from Bloomberg's Business Week, which itself is drawn from IMF data.  We have noted before how poorly the IMF has forecast Greek GDP and this helps explain why the debt/GDP ratio is deteriorated more than expected.   

The first panel shows how poorly forecast euro area growth.  It recently admitted it under-estimated the fiscal multiplier or how much of an economic drag is created by every euro of deficit reduction. 

The second panel shows, among the industrialized countries, where the IMF forecasts has been off the most on a per capita basis.  Of note, the IMF under-estimated per capita growth in Canada and Japan.  The miss in Canada may be due to the positive terms of trade shock.  The miss in Japan may be a function of the fact that its output has held up despite the shrinking population.  

The third panel shows that despite the misses, overall, the IMF's 2009 forecast for the advanced economies in 2012 was in fact quite accurate, off by 0.1%.  While we have been skeptical of  true decoupling of the emerging markets from the high income economies, the IMF under-estimated growth in developing Asia by more than a quarter.  

Great Graphic: Italy's Challenges

This Great Graphic comes from the Economist. It shows that despite the decline in Italian bond yields, confidence in Prime Minister Monti continues to slump.  This in turn explains why the center-right feels emboldened, let alone Berlusconi's ambitions.  

If the first chart illustrates the political problem of the Monti, the second chart depicts the economic problem Italy faces and the fact that Monti's reforms have not changed the trajectory.  Italy's unit labor costs continue to rise.  

This is one of the dimensions of competitiveness.  The reason unit labor costs are rising is not just a function of compensation but is also the result of the erosion in productivity. 

Currency Positioning and Technical Outlook: Stirred but not Shaken

We have been tracking the deterioration of the US dollar's technical tone over the past three weeks.  That ended abruptly.  Weak euro area data, a more dovish than expected ECB, and heightened political uncertainty in Italy, saw the euro reverse lower after briefly moving above an eighteen month-old downtrend.   

The UK also cut its growth outlook, and poor data increases the likelihood that the BOE  may have to resume its gilt purchases in the new year, though consumer inflation expectations have ticked up recently.  

At the same time, there appears to be little progress on the US fiscal talks.  Whenever a top official signals this, the dollar seems to tick up on risk-off considerations, though with diminishing impact.  The stronger than expected November employment data is not sufficient to stay the Fed's hand and the FOMC will most likely expand the long-term assets purchased under QE3+ at its meeting that concludes on December 12.

Great Graphic: US Productivity

This Great Graphic is from the St.Louis Federal Reserve.   It shows the recent Q3 productivity report. 

The 2.9% increase in Q3 was the strongest since Q3 2010.  In turn, the increase in productivity with minimal increase in the wage package illustrates what we think is an under-appreciated development and that is the competitiveness of US unit labor costs.  

Unit labor cost fell for the second consecutive quarter in Q3 and has fallen consistently since the end of 2008. In the seventeen quarters since then, unit labor costs have risen in only three quarters, one quarter in each year 2010, 2011 and in Q1 this year. 

The combination of low unit labor costs, increasingly cheap energy, and the chronic threat of protectionism will likely continue to encourage production to move back to the US.  Apple's decision to produce some computers, shifting some production from China is reflective of this larger development.