Great Graphic: 2-Year Rate Differential and Euro

We constructed this Great Graphic on Bloomberg.  It shows the collapse of the premium the US offered over Germany on two-year government obligations.  It also shows how shifting interest rates weighed on the dollar against the euro. 

More broadly, it shows how the dollar's exchange rate against the euro tracks the 2-year interest rate differential fairly closely.    It  does not track tick-for-tick and divergences are often noteworthy, such as in early December when the spread made highs in the dollar's favor, but the did not lend the dollar more support against the euro.  Nevertheless, we find this to be one of the best guides for the general direction of the most actively traded currency pair.

An alternative driver, some suggest, the RoRo (risk-on/risk-off) that links the euro to the S&P 500.  Yet, as we have noted recently, the euro's correlation with the S&P 500 has broken down.  Using a 60-day rolling correlation on the percentage change of the euro and percentage change of the S&P 500 (thus correlating returns), at 0.27, the correlation is the lowest since March 2011.  It peaked in late 2011 near 0.85. 

Looking closer at the chart, one can see that the 2-year rate differential has stopped falling and appears to have entered a choppy consolidation phase.  The ECB meeting next week, and more importantly, Draghi's press conference, is likely to push back against the passive tightening of euro zone monetary conditions, but a rate cut to offset the tightening would catch the market by surprise. 

Quiet into Month End

A fragile calm hangs over the foreign exchange market. as the month winds down.   There have been some sizable moves in the underlying asset markets, month-end portfolio and hedge adjustments seem modest.  Over the course of the month, global equities have rallied.  Of note, among the majors the weakness of the Swiss franc (vs euro) and the Japanese yen looks to have given their equity markets a boost, with the Swiss Market Index up 8.1% and the Nikkei up 7.1%.  The FTSE's 6.8% gain puts it at a close second within the G7 and sterling was the weakest of the major currencies losing almost 2.7% against the dollar (Japanese yen fell 4.7%). 

Benchmark 10-year bond yields generally rose this month.  Two exceptions are rather surprising.  First, the 10-year JGB yield fell almost 4 bp in January, despite the yen's depreciation (and anticipation for more).  Second, 10-year Italian yields fell 16 bp this month, despite the looming national election and increased uncertainty especially in light of the fallout from the Monte dei Paschi losses. 

US GDP Poor, but Weakness Exaggerated

News that the US economy contracted in Q4 for the first time since the recession ended is a shock.   However, the 0.1% contraction (annualized) is an exaggeration of the economy's weakness.

A confluence of factors took a toll.  The preliminary estimate is that inventories took 1.35% off GDP.  Also with an incomplete information set, the next exports took another 0.25% off GDP.  Government spending, which has generally been a drag on GDP (as cuts in state and local government spending more than offset the increased federal spending) took another 1.33% off GDP, with the defense spending accounting for the bulk of that.

Real final sales, which excludes trade and inventories, rose 1.3%, which is the weakest in a year.  Personal consumption expenditures rose 1.5%, almost a third of which was vehicle sales.  Software and equipment spending was also a net contributor to growth.                                                       

Consumption in Q1 will likely be hit by the end of the payroll tax holiday and higher gasoline prices.  However, the drag from inventories is unlikely to be repeated.  Washington's compromise on the fiscal cliff means that a Q1 hit on government spending has been deferred to Q2 and the sequestration.            

The report, noisy as it is, may help ease ideas that had surfaced earlier this month that the Fed may look to soon pullback from its asset purchases.   Inflation, as measured by the core PCE in the GDP report showed a 0.9% increase, down slightly from Q3's 1% increase.  If anything the whiff of deflation is evident and this is keep the Fed on track, buying $85 bln a month in long-term securities.  It also underscores the divergence between the passive tightening of conditions in the euro area and the full throttle easing in the US.

Great Graphic: Consumer Confidence and S&P 500

This Great Graphic comes from Sober Look blog. It shows how well the Conference Board's measure of consumer confidence tracked the S&P 500.  However, more recently there has been notable divergence.  

It is easy to slip into a causal argument whereby increased confidence "causes" people to buy stocks.  Yet we know that for most of the past several quarters money has been leaving US equity funds, which is the primary way retail invests (think 401k plans).  

It is clearer what has been happening most recently.  The fiscal cliff and coupled with the end of the payroll savings tax holiday took a toll just as the Federal Reserve more than doubled the amount of long term assets it is buying every month.  In addition, the rally in US shares is also part of a global reallocation, which is also lifting most equity markets around the world.  

Interest Rates Drive Divergence in FX

The euro has raced higher, with the $1.35 level convincingly breached and the option structure rumored to be struck near $1.3550 taken out.   The US dollar has moved to new highs against the Japanese yen  near JPY91.40.  Beneath both lay interest rate considerations.  

There is more evidence today that a tightening of euro area financial conditions is underway.  This has been a developing story, but two more pieces of the puzzle fell into place today.  First, the ECB itself reported that banks in the area tightened credit standards further in Q4.  This was especially true for residential mortgages and consumer credit.  Overall, loans to households and businesses fell for the eighth consecutive month in December.  There are both supply and demand considerations are work.  The ECB recognized new regulation and capital requirements contribute to the tightening of credit standards.  Weaker corporate demand for M&A, inventories and working capital was also noted. 

CNBC Video Clip: FX Outlook

Here is a video clip of my (short) appearance on CNBC's Squawk Box on January 25.

Swiss Anomaly: Still Negative Nominal Rates?

A dominant meme in the foreign exchange market is that the world has taken an important step away from the edge of the abyss.  It may have been led by three words from ECB's Draghi (as in "whatever it takes"), but has been complimented by a number of other steps, including the IMF mea culpa for under-estimated the fiscal multiplier, signals that the EU will give some countries, including Spain and France more time to reach the deficit targets, and a modification and delay in implementing the new Basel capital requirements.  

Sentiment has improved.  No longer are the naysayers talking about Greece leaving EMU.  Equity markets have rallied.  Core bond yields have risen and peripheral bond yields have fallen.  Of note, the Greece's 10-year yield has slipped below 10%.  Ireland has returned to the capital markets and Portugal is trying to as well.

Great Graphic: What are Chinese Consumers Buying?

This Great Graphic comes from the Financial Times, which drew it from Euromonitor.  The charts look at three categories of consumer goods, beauty and personal care, packaged food and soft drinks.  

Western aesthetic are a powerful draw and western brands dominate the beauty and personal care products.  The market share of these top five firms has increased to 41% from 38%.  

However, dietary preferences are considerably more local.  In packaged foods, Chinese and Asian companies are the largest players.  The sector seems to be more fragmented.  The top 5 companies command a little less than a 20% market share. 

Soft drinks preferences are more mixed.  Coca Cola is the largest soft drink provider in China and its market share has risen over the last few years.  However, in second place is a Taiwanese company, Ting Hsin, which is also partnering with Pepsi, providing bottling and other marketing services.  The sector is also essentially as concentrated as the beauty and personal care segments with the top 5 accounting for 43% of the sales, up from 36% in 2007. 

Flattish Consolidation Featured

The potential for turnaround Tuesday is resolving itself into flattish consolidation in the foreign exchange market.  The light news stream is also denying participants of fresh trading incentives.  The strongest of the major currencies today, the yen, Australian dollar and British pound have been the weakest in recent sessions.  The week's big events, including the FOMC meeting, European PMIs, and the US jobs report still lie ahead.  

Although there has been some criticism of Japanese efforts to weaken the yen, news wire accounts suggest that the G20 are unlikely to come down very hard on the Abe government or claim that it is engaged in competitive devaluation.  Japanese officials have come under criticism for not doing enough to revive the world's third largest economy and to arrest pernicious deflation.  Some want to criticize it now for pursuing policies aimed to do just that.  Japanese officials have tried talking the yen down in the past and have intervened directly in the foreign exchange market (e.g., over $100 bln in late Oct 2011).  

Great Graphic: Central Bank Balance Sheet Changes

This Great Graphic was posted on Sober Look, which got it from Credit Suisse.    It shows the change in central bank balance sheets over the past six months. 

Going forward, the Bank of England has ended its gilt purchase program and the bar to resuming it seems relatively high here in Q1.  The pace of BOJ asset purchases may accelerate a bit after the decision to increase it further at the end of last year, though did not do so at its meeting earlier this month.   

The ECB's balance sheet, as we noted, is poised to shrink further when banks begin repaying part of the second LTRO later in February.   It is possible than some of the long-term funding gets shifted to the shorter term repo operations, but the take down at those too have fallen recently.  

That brings us to the Federal Reserve.  The decision to roll the long-term Treasury purchases of Operation Twist into QE3+ at the end of  last year means that the pace of expansion of the Fed's balance sheet is set to rise.  

While many observers will cite this relative and absolute expansion of the Fed's balance sheet as dollar negative, the dollar's weakness is concentrated against the euro and currencies that track the euro, like Denmark, Switzerland (to a less extent) and the Scandi-bloc.  Sterling and the dollar-bloc are making new multi-week lows against the dollar and, of course, the yen is the weakest of all. 

The Explanatory Power of Interest Rate Developments

The euro has risen almost 2% against the US dollar thus far this year, while the yen has fallen about 4.5% against the greenback.  Beneath this divergence may be a common consideration:  Interest rate developments.  

One of the key developments has been the steep backing up of short-term European interest rates.  Consider that the implied yield on the March Euribor 13 futures contract has risen from about 10 bp in early in Dec to 35 bp last week.  The yield rise in the Dec '13 contract has been even more pronounced.  In early Dec, the implied yield was about 11 bp.  Now it is near 56 bp. 

It is important to note that the increase in yields began at the end of last year and has accelerated this year.  It is being driven by at least three considerations.  First, this may be partly a reflection of less need to safe haven.  There has been a transformation of the main guiding principle from capital preservation to taking on more risk.  

Contours of the FX Markets in the Week Ahead

There are two main forces shaping exchange rates.  The first is the continued depreciation of the Japanese yen and the second is the appreciation of the euro.  

The newly elected government in Japan is pursuing an aggressive stimulative policy to strengthen the economy and finally arrest deflation.  Many, however, doubt that the combination of new government spending and measures by the BOJ are sufficient in themselves to push inflation to even 1% this year.  Neither the BOJ nor the Abe government itself believes it, as reflected in their forecasts.  

Japanese officials are encouraging the market to weaken the yen.  Yet previously Japanese officials have tried talking the yen down, but with little results.  What makes this time different?  Although the push back against Japanese official rhetoric appears to be widening, there is more to the yen's weakness than official desires.

Great Graphic: Behavior of US Capital

This Great Graphic comes from the Economist's Buttonwood blog, which in turn, it got from Andrew Lapthorne, a Societe Generale economist.  Together they tell an interesting story about the behavior of Corporate America that is consistent with the sketch we provided in our skeptical response to arguments of financial repression. 

Beginning with the bottom chart first, we see that corporate profits appeared to have been bolstered by the aggressive monetary policy that that driven down interest rates and spurred the ire of the financial repression camp.  Net income rose faster than earnings before taxes and interest payments. 

The chart second and third from the bottom shows that the short, sharp de-leveraging by corporations initially during the crisis, has been followed by a re-leveraging process, which means the taking on of more debt.  Leveraged loans, high yield bonds and investment grade bond issuance have soared.  The chart also shows one important thing publicly traded companies did withe the funds raised and internally generated:  bought back their own shares.  

The top chart shows that capital spending fell sharply early in the crisis and quickly rebounded to pre-crisis levels, perhaps encouraged by expedited depreciation allowance.  However, more recently as gross operating cash flow has weakened so has capital investment. Indeed, the gap between the two warns of further downside risk to capital expenditures in the coming quarters.  

Cool Video: Potential in Action

This Cool Video found on YouTube.  It is about nothing and everything.  Inspiring.

Currency Positioning and Technical Outlook: Interesting Contrarian Opportunities

It is difficult to talk about the US dollar's performance over the past couple of weeks.  There has been a key divergence.  The dollar has been trading higher against most currencies except the euro and those currencies, like the Swiss franc or the Scandis, that move in the euro's orbit.  Sterling is the exception in that it is in the euro's orbit, but has broken down.  

Last week, we posed the question whether the euro, and the Mexican peso, which was also resilient, were generating the true signal of pending dollar weakness, or whether the yen, dollar-bloc and sterling's decline were  signs of the underlying strength in the dollar.  The issue was not resolved over the past week.  The euro's strength helped pull the currencies in its orbit higher against the dollar, while the greenback extended its gains against the yen, sterling and the dollar-bloc.

Great Graphic: Yen Since Onset of the Financial Crisis

This Great Graphic, created on Bloomberg, shows the US dollar against the Japanese yen since the beginning of the financial crisis.  The dollar fell almost 40% from the peak in 2007 until the low in 2011.  

It has now pulled back, with the help of verbal guidance from Japanese officials, new evidence that deflation has not loosened it's grip and high tensions with its biggest trading partner and regional rival China.  In addition, the need for the yen's safe haven status has been reduced by favorable developments in Europe, the US and China.  

The dollar has recovered nearly 21% of the lows to return to the congestion area from 2010.  The next technical target comes in near JPY94.00.    As we noted earlier this week, we remain struck by the silence of Chinese officials in the face of the depreciation of the yen.  However, the protest by others is seeming to get louder.  South Korea, for example, is believed to have stepped up its intervention to buy dollars and sell won.  The shifting competitive landscape has seen the South Korean and Taiwanese equity markets under-perform here in early 2013.  Of the main Asian equity markets, foreigners have been net sellers of only Korean shares ($1.1 bln) and Taiwanese shares ($206 mln).

Three Impulses Dominate FX at the Week's End

As the week draws to a close, there are three independent drivers in the foreign exchange market.  The first two are the weakness in the yen and sterling.  The third is the push higher in the euro.  

We had not expected the dollar to close above JPY90 in North America yesterday and it has not looked back.  Comments from some Japanese officials, suggesting a dollar move to JPY100 would be acceptable.  Prime Minister Abe apparently dissatisfied with the BOJ moves this week again threatens to revise the BOJ's charter, though his appointments in March-April could rectify the situation.

Cool Video: Bank Lending in US and UK

This Cool Video comes from the Economist.  Although the story of bank lending is more complicated than is told here, I think you'll agree that this is a reasonably good job for a 90 second comparison between the US and the UK experience.

Ten Things You Should Know about the LTRO

1. Banks that borrowed from the ECB under the Long Term Repo Operation (LTRO) can begin repaying, if they want. Banks must notify the ECB on a weekly basis about how much they want to repay. The ECB will publish amount to be paid back and the number of banks every Friday for the next few years, starting tomorrow.

2. Banks borrowed roughly 1 trillion euros in the two LTRO 3-year operations (Dec 11 and Feb 12). Italian and Spanish banks are believed to have accounted for around 60% of the use of the LTRO, German banks a little more than 10% and French banks a little less than 10%. 

3. Estimates of repayment range from 100-250 bln euros, but may come in drips and drabs.

Yen Falls Back

The main feature in the foreign exchange market is the slide in the Japanese yen.  For the first time this week, Japanese banks were sellers of the yen, perhaps encouraged by official comments and a larger than expected trade deficit.  Others may have been emboldened by the Japanese selling and the yen continued to sell-off through the European morning.  The dollar is back within spitting distance of JPY90 and the euro is approaching JPY120.  

Against the dollar, the euro and sterling have been confined to yesterday's ranges.  The only thing of note in terms of the price action is that each day this week, sterling has successfully tested the $1.58 area.  It has yet to close below the Nov 15 low, which marks the neckline of a potential double top.  On a risk-reward basis, sterling exposure is interesting.  

Currency Wars: Causes and Consequences

The Realist understanding of international affairs is that it is a realm of competition.  The competition is multi-faceted, taking place in politics and economics.  It has a cultural dimension.  It takes place even in the writing of history.  

This competition spills over into the foreign exchange market.  It did not begin with the unorthodox pursuit of monetary policy in high income countries beset with crisis.  Even at Bretton Woods countries were jockeying for advantage.  From the time that the dollar-gold standard of Bretton Woods became operational, the foreign exchange market was politicized. The US wanted the German mark and Japanese yen, for example, to be adjusted higher, rather than devalue the dollar.  The attempt to re-start Bretton Woods with the Smithsonian Agreement was shaped by the conflict of national interest.

Choppy Consolidation Featured

Global capital markets are characterized by choppy consolidative activity.  In the foreign exchange market, two major currencies stand out, the yen and sterling.  

The Japanese yen which is continuing trade higher following the outcome of the much anticipated BOJ meeting that seemingly resulted appearance of easing without really doing very much.  In addition to positioning--vulnerable to a short-covering squeeze--reports that Japanese banks were featured yen buyers- -is making participants cautious about resisting.  It may be difficult for the North American session to push the dollar much above JPY88.50-70 today, preferring to await fresh signals from the Japanese banks.  

Great Graphic: Euro, Stocks and Volatility

The relationship between the euro, volatility and the S&P 500 is far from stable. In light of recent developments, it may be helpful to update our analysis.

1. The implied 3-month euro volatility has increased from the 5-year lows seen in the middle of last November near 6.4% to move above 9.0% at the end of last week. It has eased a bit, which is understandable give the 32 tick range yesterday, while the US was on holiday, and that the euro is within the range set last Tues-Wed between $1.3257 and $1.3394. The 100-day moving average of 3-month euro vol is just below 7.9%. A move back below there would suggest the recent increase is not the beginning of a new trend.

2. Yet while the euro vol increased, the volatility of the S&P 500, the VIX, trended lower. It peaked at the end of last year near 23% and has collapsed to multi-year lows below 12.5%. The 100-day moving average of the VIX is near 16%. 

Great Graphic: Value-Added Trade

This Great Graphic, from the Economist, utilizes the new data base created by the OECD and World Bank that we brought to your attention here. Rather than simply look at the dollar value of goods and services that cross national borders, it focuses on the value-added.   

The chart here shows breaks down electronic exports (2009) into their domestic and foreign content.  China, for example, was the world's largest exporter of electronic goods at $467 bln.  However, foreign content was 40% or almost $187 bln.  That has far reaching implications.  For example, the more foreign content there is, the less helpful a currency adjustment would be in correcting trade imbalances  Nearly 30% of the value of what China exports are imported.  That makes trade less sensitive to changes in the yuan-dollar exchange rate than is often appreciated.  

The ratio of foreign content to domestic content may reflects the location of the country in the global supply chains. If one is largely an assembler of imported parts or components that could be reflected in high foreign content to domestic content of exports.  Of the countries in the Economist chart, South Korea stands out as the highest about of foreign content in overall exports (the number in white box on the right of the chart) at 40%.  The US stands the lowest at 11%, though Italy, the UK and Japan are in the teens.  Germany, France, Switzerland are near Mexico and China in terms of foreign and domestic content of exports.  

Two Developments Rattle FX Market

There are two main drivers in the foreign exchange market today:  the much anticipated BOJ meeting and the much stronger than expected German ZEW survey.  

Anticipation of aggressive easing by the BOJ today has kept the yen on the defensive.  However, the combination of "sell the rumor and buy the fact"  activity and, arguably, some disappointment, saw dollar turned back from the JPY90 level, which it has test during the three prior sessions without a convincing break and fall to near JPY88.35 before finding a bid.  Similarly the euro, which had been flirting with the JPY120 area, was sold down to almost JPY117.30 before finding a solid bid. 

The BOJ's announcement seems to be a compromise formation.  It was reluctant to be as aggressive as the government wanted so it gave some appearances of  kowtowing without actually doing so.  For example, it embraced a 2% inflation goal, but does not believe it can be achieved any time soon.  Look at the BOJ's inflation forecasts.  It let the 2013 forecast unchanged from previous (Oct) forecast at 0.4% and the 2014 forecast was nudged higher to 0.9% from 0.8%. Two BOJ members, (Kinchi and Sato) dissented from the new inflation target. 

Great Graphic: Sourcing Boeing's 787 Dreamliner

This Great Graphic was on Business Insider, who says they found it on Zero Hedge, who got it from Goldman Sachs.  

It depicts the internationalization of the production of Boeing's 787 Dreamliner.  The supply chain draws in eight countries, in addition to the US, according to the picture. However, other reports suggest even more countries were involved.
For example, the cabin lighting comes from Germany.  

The coordination among the numerous suppliers was itself a logistical nightmare.  Consider that an automobile has 15-20k parts, while an airplane as as many as 2 mln parts.   Some attribute the delays and cost overruns to the sheer number of partners.  Ultimately, Boeing bought some suppliers and brought production back in-house.   It was ultimately faulty batteries that led to the internationally grounding of the 787, the first such action in 40 years. However, some reports emphasize the too cozy relationship between the regulators (FAA) and the regulated (Boeing) in expediting the initial approval. 

Eight FX Considerations for the New Week

The US dollar begins the week mostly firmer.  The notable exception is the Japanese yen, which has seen some position adjustment ahead of the outcome of the BOJ meeting tomorrow.  In Asia, and Europe thus far, the dollar has found support near its five day moving average and the 38.2% retracement of its latest leg up (from Jan 16), both of which come in near JPY89.30.  The recovery of the yen took a toll on Japanese stocks.  The Nikkei lost 1.5% and posted an outside down day (trading on both sides of Friday's ranges and finishing below Friday's low).

The euro has been confined to an exception narrow range of about 15 ticks on either side of $1.3315.  A break of support in the $1.3260-80 area would lend credence to our argument that a top of some import is being carved out, with a potential double top at $1.34.   Sterling saw follow through selling on top of the pre-weekend losses.  The euro traded at 10-month highs against sterling above GBP0.8400, but is reversing lower near midday in London.  A modest bounce in cable seen in the European morning ran out of steam near $1.5900, which likely now marks the upper end of the new range.

Great Graphic: Europe's Unit Labor Costs and Productivity

These Great Graphics were posted  Fabrizio Goria (@FGoria), a financial reporter for EuroIntelligence.  They draw on research by Societe Generale and data from Eurostat.  

I have posted graphs of Europe's unit labor costs before.  It is probably the best single indicator of not just external competitiveness, but also of internal robustness of an economy.  

Those that saw the largest increase in unit labor costs before the crisis, like Ireland, Greece and Spain have seen the largest correction since the crisis began.  

What is born out by the chart, as we discussed recently, is that Italy now has the highest unit labor costs in the euro area and has seen no substantial improvement since the onset of the crisis. 

France also has seen little improvement.  The labor market reforms are pending and may change change this, but it is too early to tell.   In addition, Portugal's improvement seems to have stalled recently.  

The narrowing of the divergence in unit labor costs in the euro area is not only a function of reductions in the periphery, but also an increase in German unit labor costs.  Germany still boosts the lower unit labor costs, but the increase since the onset of the crisis has been greater than previous decade.  

Unit labor costs have two components, the cost of labor (wages and benefits) and productivity.  

The second chart here shows the changes in productivity several euro area countries.   The productivity gains since 2008 in Ireland and Spain have been the most pronounced.  Greece lags, but has saw improvement last year, which lifted it off the bottom.  Italy has taken its place.   France and Germany appear to have flat lined and Portugal appears to have lost its momentum.   

Cool Video: Is Light a Particle or a Wave?

Hat tip to Maria Popova for spotting this cool video from Colm Kelleher at TEDEucation. 

Currency Positioning and Technical Outlook: Correction at Hand?

The technical tone of the major foreign currencies deteriorated in recent days.  It appears to be a cascading effect.  Favorite risk-on currencies, like the dollar-bloc, failed to participate in the move against the greenback.  The Swiss franc took the dubious honor of being the weakest currency last week, losing 2.2% against the dollar.

Sterling had been flirting with the uptrend line drawn off last June's lows and rebounds looked increasingly halfhearted and then convincingly broke and traded below the 200-day moving average for the first time in a couple of months.   

Of the currencies we examine here, it was the euro, which slipped about 0.15% against the dollar, and the Mexican peso, which was about 0.05% lower over the course of the week, held up the best.   The key technical question now is which set of currencies is generating the correct signal:  The euro and peso, which suggest that the dollar's down trend is still intact, or the other currencies that appear to be signaling a dollar recovery is at hand.

Italy: Economy Rotting While Focus on Elections

The machinations of Italian politics, with the election next month, is overshadowing the underlying rot of the Italian economy.  Two developments today should be seen as a warning sign by investors. 

First, November industrial orders, understood to be a leading indicator, fell 0.5%.  This follows the 1% drop in November industrial output, reported earlier in the week (the market expected only a 0.2% decline).  

Of note the weakness in industrial orders was not a reflection of the lack of competitiveness of the Italian economy.  Foreign orders rose 4.1% in November after a 7.1% gain in October.  The problem is the absence of domestic demand.  Domestic orders fell 13.5% after a 4.7% declined in October.

Dollar Finishing Week on Firm Note

The US dollar is trading firmly.  The official verbal commentary this week by Europe's Juncker and Japan's Amari were more disruptive noise a true signal.  These mis-directional cues whipsawed short-term participants and served to obscure what was really happening.  

One of the most important take aways, it seems, from this week's action is the narrowing of the breadth of the dollar's decline.  It is really limited to only the euro, with itself appears to have stalled near $1.34.  Weighed down by a poor retail sales reports today (-0.1% vs consensus +0.2%, leaving the year-over-year rate at 0.3%, half of what was expected), sterling has broken the uptrend going back to last June's low near $1.5270.  There is immediate support near $.1.5900, the real target is the $1.5830 low from mid-Nov.   The $1.60 area, which had offered support is now resistance.

Great Graphic: New Insight into Global Trade

This Great Graphic is a new tool developed by the OECD and the World Trade Organization.   It allows a more sophisticated understanding of modern trade of goods and services in which the production process has been fragmented. It is not simply global supply chains that we are interest in, but the valued-added chains. The quaint counting of good as they pass over borders is no longer as useful and indeed may be misleading given current practices.

Using this tool, one can see the role of imports in exports. It allows one to decompose the content of gross exports into domestic and foreign content. One can also see bilateral trade flows based on value-added. It offers greater insight into trade imbalances, competitiveness. The OCED provides a note here that explains the insight that can be gleaned.

In my book, Making Sense of the Dollar, I questioned the conventional measure of trade in light of globalization. I suspect the kind of information that the OCED/World Bank make available will, over time, change the way we think about trade.

Deep Dive: Financial Repression Reconsidered

In response to the end of the credit cycle, policy makers and central bankers in the high income countries have exponentially increased their presence in the capital markets.   Debt issued by governments has soared and central banks are pursuing unorthodox policies--the purpose of which varies from country to country.   

The purpose of quantitative easing in the US, especially the latest reiteration, is to accelerate employment growth.  The ECB’s Outright Market Transactions is to ensure a proper transmission of its monetary policy to countries that agree to EU/IMF conditionality and have access to the capital markets. Japan’s asset purchase program, through which it buys not only government bonds, but also ETFs, REITS and corporate bonds, is to fight deflation.  

Initially, the Swiss National Bank bought foreign bonds as a way to arrest the franc’s appreciation that was fueling deflationary forces in Switzerland.  When this failed, it moved to formally cap the franc.  The SNB now buys sufficient foreign currencies to defend it.  The Bank of England’s gilt purchase program seemed aimed at strengthening the economy, though it is much less concerned about the labor market than is the Federal Reserve. 

Euro Bounces Back

Like a beach ball pushed under water, the euro has bounced back across the board as Juncker's ill-thought comments were isolated and overwhelmed by reports of new buyers--from the Middle East to hedge funds and real money--taking advantage of the dip to get with what is understood to be the underling trend.  Short-term momentum and trend followers  were caught leaning the wrong way, aggravating the move.  Over the past two weeks, 3-month implied euro volatility has risen from below 7% to 8.3%, the upper end of its 3-month range.  The firmer volatility also appears to bring in more interest.  

No other currency can keep up with the flows going into the euro.  This is driving the single currency to new 9-month highs against sterling and new 13-month highs against the Swiss franc.   It is firm against the Scandi-bloc (officials there have also issued conflicting comments about their currency assessment).

Great Graphic: Euro and Value

This Great Graphic is a monthly chart of the euro from Bloomberg, with a 120- month (ten-year) moving average.  It comes in now just below $1.32. 

In their pure form currencies do not have an income stream, making valuation more elusive.  Economists have derived many equilibrium models around which currencies ought to gravitate around in the long-run.  

Currencies also gravitate around a long-term moving average by definition.  The OECD calculates purchasing power parity for the euro at $1.24.  Since  the second half of 2002, the euro has traded below the OECD estimate of PPP on two separate occasions, in Q2 10 as the Greek crisis unfolded and again in H1 2012 as pressure built on Spain and Italy. 

Talk Drives Unwinding of FX Positions

After relatively large moves in the foreign exchange market since nearly the start of the year, participants were particularly vulnerable to commentary that encouraged a reversal of trend.  Japan's Amari got the ball rolling, suggesting that the yen's decline has been sufficient and that excessive strength had been corrected.  This encouraged a bout of short-covering and took some shine off the other major currencies as cross positions were unwound.   

Then Juncker's comments hit in the North American afternoon yesterday, claiming that the euro's exchange rate was dangerously high.  Again the market's reaction was more about positioning than about the policy signal.  Part of the demand, after all, for the euro has been coming from some of the largest asset managers returning to the Spanish and Italian bond markets, believing that the Open Market Transaction scheme is indeed a viable backstop. 

Great Graphic: US Seniorage

This Great Graphic was part of Bruce Bartlett's post on the NY Times Economix blog.   It charts the Federal Reserve's annual payment to the Treasury.  

The sharp increase in recent years recent years reflects the increase in the Fed's balance sheet.   The Federal Reserve is obligated to return its earnings in excess of its operational costs to the Treasury Department.  

Drawing on government data, Bartlett discusses other elements of seniorage.  He reports that the Fed pays face value for coins, but not on paper money., where it pays between 5.2 cents for $1 bills and 12.7 cents for $100 bills.  Last year, the Fed paid the Treasury $747 mln for currency production by the Bureau of Engraving and Printing, which roughly covered the cost of minting and printing.  

Bartlett also points out that although the Federal Reserve is part of the Federal government, it is treated as a private sector institution when calculating GDP.  In 2011, for example, the Fed earned about $75.9 bln, which turns out to be nearly a fifth of the profits of the US financial sector and a little more than 1/20 of total profit in the US domestic industries.  

When one thinks of the interest the US government pays to service its debt, it needs to be offset with what the Fed returns.  This year, the debt servicing costs of the US will be nearly $230 bln.  The Fed will likely return around $90 bln, which is almost 40%.   

Great Graphic: Turn Around Tuesday: Now What?

What began off as a consolidative in the Asian session and European morning has turned into a correction.  We suspect that bottom pickers will emerge in the euro ahead of $1.33.  Assuming that stop loss selling has exhausted itself, a test on the upside comes in near $.13360. 

This Great Graphic (made on Bloomberg) shows the 7-month uptrend in sterling.  It was tested today and yesterday and thus far is holding.  Even though it comes in near $1.6030 today, it probably takes a convincing break of $1.60 for the bears to get in control. 

The dollar made a new low for the session as North American session began, near JPY88.30.  Dollar buyers re-emerged, but the market will likely find it difficult to overcome the post-Amari high near JPY89.10. 

Yen Bounce Featured in Consolidative Session

Most of the major currencies are consolidating within yesterday's trading ranges.  The main feature has been comments from Japan's Minister of Economic Revival that appeared to declare victory in the government's attempt to weaken the yen.  News wires quoted him saying that the yen had corrected its excessive rise and was currently in line with fundamentals.  

This triggered a wave of short covering yen positions, driving the down from around JPY89.60 to near JPY88.60 in initial reaction that lasted about an hour.  It has been consolidating since, mostly below JPY88.90.  The sharp recovery of the yen was also felt on the crosses, though a more consolidative tone that was seen in the European morning was fading and the currencies moved back toward the lows as North American traders prepared to return to their screens.   

The yen has weakened about 6.5% since the Japanese election was called that led to the LDP victory and the return of Abe, on promises of monetary and fiscal stimulus for an economy slipping into its third recession in four years.  There was surprising little reaction from Japan's trading partners from its effort to talk the yen down.  That said, Bank of Korea Governor Soo said yesterday it may have to take action to counter the impact of the weak yen on Korean exports and last week, in an unusual reference to the foreign exchange market a regional Fed president (Bullard) said he was " a little disturbed" by the yen. 

Chinese Official Hints at Easier Access to Mainland Markets

The Chairman of China Securities Regulatory Commission (similar to the US SEC) said that China can increase by 10-fold the size of the two main channels by which foreign investors buy mainland financial assets.    

It can, Guo Shuqing said, increase quotas under the Qualified Foreign Institutional Investors and the Renminbi Qualified Foreign Institutional Investors.  The latter would make it easier for the yuan in Hong Kong (CNH) to be used to purchase Chinese securities.     

                                                            
This hint helped lift China shares by over 3%, their largest gain in a month.  The Shanghai Composite's 3% rise brings the gain to 19% off the multi-year low near 1949 (the year of China's Revolution) in early December.  

Six Considerations Shaping the Capital Markets

The underlying trends seen this year have continued, but after strong follow through in Asia, a more subdued tone has been seen in Europe.  The US dollar is generally softer, except against the yen and sterling.  Japanese markets were closed for holiday, but the MSCI Asia-Pacific Index rose almost 0.3%, lifted by more than a 3% rally in China on speculation that there may be a sharp increase in the cap on foreign investors' ability to invest in Chinese equities.

In Europe, the Dow Jones Stoxx 600 is up about 0.4%, led by a rise in financials.  Spanish stock market is at its highest level in almost a year (Feb 2012) and Italy's market is at its best August 2011, though their bond markets are seeing some profit-taking today.   With a light economic calendar in North America today, Bernanke's speech in Michigan after the markets close may be the highlight. 

We identify six key factors shaping the investment climate. 

Great Graphic: Another Look at "Real" Homeownership

This Great Graphic was on Business Insider and it comes from CNBC, which in turn draws on data from Zillow.  It is a map that shows the percentage of homeowners, by county, that own their homes outright, this is without mortgages.

According to Zillow data, overall about a third of US homeowners, or about 20 mln, own their homes outright.   

Five cities with the highest outright home ownership include Pittsburgh, Tampa, New York, Cleveland and Miami.  Zillow suggests that New York and Miami's figures may be skewed by a high number of all-cash foreign purchases.     The other cities have relatively low  home values compared with the rest of the country, making it easier  to buy homes outright and/or pay off mortgages.  

It also makes sense that older home owners are more likely not to have mortgages .  According to Zillow's data, those in the 65-84 year old cohort are most likely to own their homes outright. 

Cool Video: Why We Were All Female

Tip of the hat to Maria Popova of Brain Pickings for bringing this interesting video from ASAPScience to our attention.  

Currency Positioning and Technical Outlook: How Stretched?

There have been some large moves in the foreign exchange market in recent days.  The euro posted its largest rally in four months last week.  The yen has fallen to its lowest level against the dollar since June 2010 and extended the declining streak to nine consecutive weeks, something not seen since 1989.  The Canadian and Australian dollar rose to multi-moth highs, as did the Mexican peso.  

In last week's technical note, we suggested the key question  was whether the sharp drop in the major foreign currencies following the avoidance of the full fiscal cliff in the US was trend reversal or overdue correction.  We favored the latter and looked for the underlying trends to continue.   They did.  

Now market participants face a different question.  Given the out-sized moves, have the trends become stretched?  The answer, we propose, is more nuanced than last week.  There is not one answer for all the major currencies we review here.

Larger US Trade Deficit to Weigh on Q4 GDP Estimates

The November US trade deficit widened sharply and this will likely prompt economists to cut estimates of Q4 GDP. The first estimate is to be released at the end of the month. The pace of growth had appeared to be about half the pace of the 3.1% rate seen in Q3. Today's report risks even slower growth. The real deficit, which adjusts for prices, widened to almost $52 bln from $46 bln.

Exports increased by 1%, led by autos, parts and telecom equipment. Imports jumped 3.8%, the most in seven months. Ironically it may seem, imports of autos and auto parts rose by $1.5 bln and cell phone imports rose $1.8 bln. These two sectors accounted for about a third of dollar rise in imports.