Great Graphic: US Money Printing is Not All That

This Great Graphic was posted on the FT Alphaville, which in turn appears to have gotten it from Credit Suisse, w ho relied on Thomson Reuters data.

A prevalent monetarist argument is that foreign exchange prices should reflect the relative changes in the stock of money.  This is part of the reason why so many expect QE to be negative for a currency.  This is especially true of the US, where many expected the aggressiveness of QE3+ (QE infinity in derision) to have undermined the dollar.

Sequester Fester, No Cliff

The political paralysis means that the $1.2 trillion in spending cuts are set to go into effect with an $85 bln in cuts during the remainder of the current fiscal year.  Assuming that ever dollar cut in spending reduces GDP by a dollar, the sequester will shave US growth by around 0.5% this year.               

However, the way households will be impacted will be a function of their reliance on the federal government: The greater the reliance the greater the impact.  The spending cuts seem rather arbitrary, though evenly divided between defense and civilian activities.
                                                  
A recent Pew poll founds that less than 1 in 5 Americans understand how they will be personally impacted by the sequester.  This warns of the risk of some negative surprises.  It may mean more than simply frustrations with longer lines at the airport security, for example.

Great Graphic: Cross Border Capital Flows

This Great Graphic comes from one of the best reports on the global capital markets. For the last several years McKinsey&Company publishes an annual report on it and released this year's earlier this week. Here is the link.  It is a must read and it is free.  

The question it poses this year is whether financial globalization is retreating of resetting.  It seems to suggest the answer is still in determinate.  In effect, we are at an inflection point that can go either way, depending on the actions of policy makers and businesses.  

Calmer Markets Continue

The global capital markets continue to stabilize after the UK downgrade and Italian election results disrupted the start of the week. Investors appear to be finding consolation in assurances from the major central banks that the extraordinarily accommodative monetary policies will continue to for some time. 

These new assurances, if you will, began last week with new that an increasing number of MPC members, including the Governor King wanted to resume gilt purchases. As we had anticipated, Bernanke corrected the less than dovish read to the recent FOMC minutes. Yes, a few regional presidents are opposed and would like an earlier exit. However, the leadership--BYD--Bernanke, Yellen and Dudley remains committed to the efforts and continue to argue that benefits exceed the risks. 

Great Graphic: Post-PC Era

This Great Graphic was from a post by Eric McWhinnie on Wall Street Cheat Sheet.  He got it from Statista.  It illustrates the new technology era that has begun--the post-PC era.  

Here is how it fits into the larger thesis I am working on--threads of which run through my longer term analysis over the past couple of years (overview here).  

Essentially, I have sketched out a periodization of the post-WWII era as different models of capital accumulation or cash registers.   Each model is associated with a different configuration of relationships and technology.

Abenomics: Where the Rubber Hits the Road

On Thursday in Tokyo, before the Prime Minister Abe has lunch, he will formally nominate the new Bank of Japan management team.  Former MOF and now Asian Development Bank head Haruhiko Kuroda has now been widely tipped to get the nod for governor and the main opposition party informally has indicated its approval.  

As we argued earlier this month,  Kuroda was the superior candidate among the frequently cited names.  He has the strongest international standing and while a critic of the BOJ, did not advocate, as far as we can tell, the purchase of foreign bonds or changing the BOJ's mandate.  The main concern was about leaving the ADB post.  However, our contacts report that at the recent G20 meeting China seemed to indicate it would not contest the completion of Kuroda's term by another Japanese candidate.  

Great Graphic: Economists Divided on Minimum Wage Debate

This Great Graphic comes from the University of Chicago's business school blog.  A tip of the hat to Justin Wolfers for noting it.  It shows the results of a survey of economists and their view and conviction level of the impact of a higher minimum wage. 

The key take away is how strongly divided professional economists are over the issue.  It suggests that it is not a simply technocratic issue, but one of values and, dare one say, ideology.  

Fragile Stability Tries To Emerge

The capital markets are stabilizing as it has now taken the Italian political quagmire on board. Italian yields have steadied after reaching 3-month highs yesterday, and the government, as it were, was able to sell new debt to the market, raising in full 6.5 bln euros. Yields were of course higher than month's sales, but demand was solid. Italy's stock market has also stabilized and 0.4% rise near midday in Milan is outperforming the Dow Jones 600, which was up marginally. 

For its part, the euro has been largely confined to yesterday's range and this is consistent with the signal coming from the 2-year differential between the US and Germany.  That spread rose to 17 bp yesterday, the highest US premium since Jan 9.  The driver of the spread is the German leg and today the Germany 2-year is flat.  The euro can rise into the $1.3130-50 range without really improving the technical tone.  

France's Firebreak Weakens

France had pinned its hope that threat to EMU would be turned back before the wolf came it its door. The Italian political tensions come at the poor time for France. Its ability to absorb shocks is terrible constrained.

Recall what has happened in recent days. Q4 GDP showed a larger contraction than expected. The flash PMI showed the contraction is carrying into 2013 (though not for Germany). The EU's updated forecasts released last week shows France significantly overshooting the 3% deficit target this year.

A confrontation over its budget is looming.  Do not  be misled by German Finance Minister Schaeuble's recent comments.  Many in the media read Schaeuble's comments as defense of France, saying it will not flout the rules.  He wants to prevent a German-French confrontation.  He wants the EU to rule on what this means for the stability and growth pact..

Great Graphic: 2-Year Differential and Dollar vs Euro

This Great Graphic, created on Bloomberg, shows two time series. The bar chart is the dollar against the euro (the inverse of the conventional euro rate against the dollar). The line is the 2-year interest rate differential between the US and Germany. 

We have shown the chart before, but thought it worth updating as it remains a close fit.  

The dollar fell against the euro the divergence between the Fed continued and more aggressive easing and the ECB which was on hold, with seemingly fading need to operationalize the Outright Market Transaction scheme became clearer.  On top of that there was a passive tightening of monetary conditions in the euro area as banks borrowed less from the ECB and began repaying the long-term repo borrowings. 

The Italian Job

The foreign exchange market has calmed after initial follow through to the dramatic price action in the North American afternoon yesterday as it became clear that the Italian election was not going to produce a majority in the Senate.  

While several large countries, like the US, Germany and Japan, have divided houses as it were.  The problem in Italy is no party has a majority.  And with the poor showing for Monti and the exceptionally strong showing of Grillo's 5-Star Movement means that the much heralded center and center-left coalition is insufficient to secure a majority. 

Great Graphic: Rise of the Yuan (in Hong Kong)

This Great Graphic comes from the CME.  We tend not to see the increase in the yuan's deposits in Hong Kong as the same as its internationalization.  After all, Hong Kong is part of China and is just as much, we have argued of the Sino-ification of Hong Kong.  

At the same, time, the graphic shows a stabilization of the yuan on deposit in Hong Kong.  That said, the ability to use the yuan in Hong Kong (CNH) for on-short investments is gradually increasing amid mild liberalization steps.  In terms of a reserve asset, the Chinese yuan is almost non-existent.  To the extent central banks have diversified away from the dollar and euro, they have moved toward the Canadian and Australian dollars, not the yuan. 

Ten Things that should be on Your Radar Screen This Week

The week has begun off with a bang.  Follow through selling of sterling in early Asia saw its losses extended to almost $1.5070 before recovering almost a cent by early Europe to about $1.5165, filling the gap created by the lower opening in Asia.

The dollar gapped higher against the yen on reports that Asia Development Bank Kuroda may become the next governor of the BOJ.  The dollar reached a new 2-year high near JPY94.75 before coming off a big figure to JPY93.75 in the Europe. Japanese stocks liked the yen's weakness.  The Nikkei jumped 2.4%.   The gap extends to last Friday's high near JPY93.52.

Cross rate buying has lifted the euro against the dollar, and has taken out  initial resistance near $1.3250.  Intra-day technical readings warn that it is getting stretch.  European shares are higher with the Dow Jones Stoxx 600 up 0.8%, with all sectors advancing; led by technology and building materials. 

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The Meaning of Moody's Downgrade of the UK: Nothing

Moody's took away the UK's triple A rating late Friday. A ratings downgrade has long been rumored, and although the timing is always surprising, the move itself has long been anticipated. Sterling slumped on the news in thin dealings, losing a cent in about 30 minutes.

When it comes to corporate ratings we can appreciate that rating agencies may have access to private information.  They may also be of value in some developing countries, where information is more difficult to secure.  However, when it comes to large developed countries, the rating agencies have access only to public information and it is the same information that investors use to make their decisions.

Currency Positioning and Technical Outlook: A View of the Long-Term Charts

The Lebanese-American poet Kahlil Gibran observed that sometime a mountain is clearer to a climber from the plain rather than the summit.  In this spirit, we take a step back this week.

Given the sizable moves in the foreign exchange market, we thought it might be useful to look at the long-term technical picture of the major currencies.  Rather than provide analysis using the daily bar charts, we look at the weekly and monthly charts.

Euro:  The recent price action has pushed the single currency through the uptrend that has been in place since ECB's Draghi unequivocally committed to doing what is necessary to save the monetary union in late July last year.   That trendline came in near $1.3220 and the euro has now made two consecutive closes below it.  We should be looking at retracement objectives of that large move.  The first retracement objective is near $1.3070; the 50% near $1.2880 and the 61.8% near $1.2680.

Great Graphic: Dollar Pushing Through Trendline vs CAD

This Great Graphic, created on Bloomberg, shows the US dollar is threatening to move above a trendline against the Canadian dollar drop off the 2011 and 2012 highs. 

The proximate cause is the dismal retail sales report., which collapsed 2.1% in December.  The market had been looking for a 0.3% decline.  It is the largest decline since September 2011. 

In a larger sense, other factors have been weighing on the Canadian dollar.  As we have been tracking in our week technical analysis and positioning piece (latest here). 

Dollar Consoldiates After Big Week

The North American market will put the finishing touches on what has been a generally constructive week for the US dollar. Ironically, the one notable currency that it slipped against is the Japanese yen.  Many had come away from the G20 meeting thinking it gave a green light to sell the yen. 

We read the G20 statement a bit differently. We did not see a significant change from the G7 statement earlier and the draft of the G20 statement. Japanese officials have already moved back into compliance with the general rules of foreign exchange engagement as they have evolved since the Plaza and Louvre Agreements by refraining from offering bilateral targets. Under the rules, countries are indeed allowed to use monetary and fiscal policy to pursue domestic goals. 

Italian Elections: Uncertainty to Linger

Italy goes to the polls Sunday and Monday for national and regional elections. There is great uncertainty about the outcome and this seems to be a major factor behind the under-performance of Italian assets (short and long term debt and the equities) in recent weeks. However, as an event risk, uncertainty is likely to persist for a few weeks after the election. 

Consider that the arcane rules of Italian politics means that the formal announcement of a new government after an election takes several weeks. Even after a landslide victory in 2008, it took Berlusconi four weeks to have his government in place. And that was under the best of conditions.

A Few Thoughts about LTRO II Prepayment

Two big events tomorrow.  One is the EC updated forecasts.  This may have policy implications.  However the second event may be more important for prices immediately. 

Tomorrow is the first opportunity for European banks to declare how much of LTRO 2 they want to pay back early.  Based on the same percentage that LTRO was repaid, it would suggest something near 150 bln euros.  Our understanding is that core banks were larger participants in LTRO II  than LTRO I.  On ideas the stronger banks are more likely to return the funds, it suggests some upside, or larger prepayment. 

FX Spin

The US dollar's gains have been extended against most currencies today, with the Japanese yen as a notable exception. Global equities have followed the slide in North America yesterday.  Bonds, even in the periphery of Europe, are mostly firmer, with the exception of Italy, where there is a certain amount of anxiety ahead the weekend election.  

Turning to the price action, serious technical damage on the foreign currencies is being inflicted.  The euro is falling through the uptrend drawn off last July (Draghi-induced) lows.   It comes in just below $1.3200 today.  The next technical target is near $1.3070-80.  Sterling has been pushed well through our $1.53 target and is now trading at 31 month lows. It has bounced off $1.5130 area, but the $1.5250 area looks set to cap corrective upticks.  

Dollar Extends Gains on FOMC Decision, but Key is BYD

The dollar has been generally firm all day and the FOMC minutes have been seized as a handy reason to extend those gains. The equity market has come off as have US Treasuries. The minutes of the Jan FOMC meeting showed the wide range of opinions at the Fed regarding the pace of long-term asset purchases.

The broad range of opinions may make it difficult to ascertain the signal. That there is a range of opinion, however, is hardly a surprise. The key, in our view, is that the leadership at the Fed, what we call the real Troika of Bernanke, Yellen and Dudley remain in charge of policy and they are dovish.

Great Graphic: Key Euro Trend Lines

This Great Graphic was created on Bloomberg.   It shows uptrend (white) the euro has held since ECB President Draghi committed to do whatever it takes to facilitate the survival of EMU.  

It shows a slightly steeper uptrend since mid-November (green) as the passive tightening in the euro area became increasing evident, especially in contrast to the Fed's decision in December to more than double the amount of long-term assets it was purchasing on an outright basis.  

However, since the start of the month, the euro has been trending lower (red line).  This has coincided with easing back of short-term euro rates and in particular the German two-year note.  It has resulted in shift of the spread (or swap) rate back toward the US.  Recall that 2-year differential was about 30 bp in the US favor in mid-Dec and it fell to a discount of 2 bp at the end of Jan.  As of yesterday , the US premium was nearly 10 bp, the most in nearly a month.  It is slipping back today, which would seem to be consistent with a euro recovery.  That said, the FOMC minutes later today is the wild card.  We suspect they may be more dovish than the market may expected, if it is looking for more concrete signals about an exit from QE. 

Sterling Pounded on Dovish MPC

Sterling is has eclipsed the yen as the main focus in the foreign exchange market. The surprising news that has kicked it to fresh multi-month low was that the BOE is closer to easing policy than has been suspected. While it was a unanimous decision to leave rates on hold as expected, it was a tighter 6-3 vote on new asset purchases. The market had expected a 8-1 vote. 

Of particular interest, it is the fourth time Governor King has been outvoted. This a peculiar feature of King's tenure--a governor being outvoted. Would Carney accept that? That said, it may have taken a little while, but the majority more often comes over to King's view than the other way around. While UK rates are a touch softer, the focus is more on renewing gilt purchases rather than cutting rates. The MPC did discuss a range of options and the take away is that inflation is not a formidable obstacle to additional easing. New gilt purchases are the most likely channel and it can be announced as early as next month, but most observers will likely focus on the April-May period.

Great Graphic: From Where will the Next Pope Come?

This Great Graphic is from the Pew Research Center. It shows the global distribution of people of the Catholic faith.

Over the past century there has been a large shift away from Europe and toward Latin America, and Sub-Saharan Africa. 

Ultimately, as in any organization, the country-origin of the next leader of the Catholic Church may matter less than the ideology/theology. 

European Auto Sales Plummet

Most observers have focused on the stronger than expected German ZEW survey that showed expectations jumping to its best level since mid-2010. Yet what has been largely overlooked is a collapse of auto sales throughout Europe.   Sales in January fell 8.7% from a year ago to levels not seen since at least 1990.  

The only large country spared within Europe appears to be the UK, which reported an 11.5% increase in sales.  Germany, which has the largest auto market and one of the more resilient, saw sales drop 8.6%.  Sales in Spain were off 9.6%.  French auto sales fell by 15.1%.  Italian sales fell 17.6%.  Finnish auto sales fell 28%,  while the Dutch reported a 31.2% collapse.  Greek auto sales were off 34.5%.  

The Dollar's Five Keys in the Week Ahead

With the end of Asia's lunar new year celebration and the return of the US and Canadian markets after yesterday's holiday, there is full liquidity in the global capital markets for the first time in over a week.  The currencies are mixed, with the yen, sterling and the Australian dollar posting modest gains, while the euro, Swiss franc and Canadian dollar have heavier tones.

The Chinese yuan has weakened for the second day after returning from the extended holiday and is near 2-month lows.  After reversing lower yesterday, the Shanghai Composite led the regional bourses lower with a 1.9% decline.  The Composite is approaching its 20-day moving average (~2365) which it has not traded below since early December.  European equity markets are higher and the Dow Jones Stoxx 600 is up a little more than 0.5% led by consumer goods and basic materials.  Of the main industrial sectors, only telecom is lower.  European bond markets, core as well as periphery are lower. 

Broadly speaking, we identify five factors that will shape foreign exchange rates in coming days.

Great Graphic: A Notable Decoupling

This Great Graphic was created on Bloomberg. The bar chart is sterling's performance against the dollar over the past six months. The line is the euro.  

One can readily see how well they tracked one another until mid-January.  The euro has traded sideways to higher, while sterling has been, well, pounded.

There are several factors that may have played a role in this notable decoupling.  There has been a continued re-weighting of international portfolios toward Europe.  The timing also corresponds to the passive tightening of the euro area financial conditions.   

On the UK's side, economic data has been poor to dismal and, although monetary policy is on hold, further easing of policy seems necessary especially as the government remains committed to fiscal austerity.  There has also been a shift in speculative sentiment.  As we noted,   the net speculative sterling position is now short for the first time since last September and by the most since last June.  

Overview of the Capital Markets on Monday

There were a few developments in the capital markets on Monday, when the US and Canada were on holiday, that are noteworthy.  Asia initially reacted to the G20 statement by extending the yen's pre-weekend weakness. 

Recall before the weekend, a draft of the G20 statement was leaked and the dollar rose from about JPY92.25 to JPY93.85.  For its part, the euro had rallied from just below JPY123 to almost JPY125.50.  The follow through buying in early Asia carried the dollar to just above JPY94.20 and in early Europe, the euro was bid to almost JPY126.  

The Importance of the G20: Not What You Think

There was something important coming from the G20 meeting, but it is not the currency wars that have captured so many imaginations in the media and blogosphere. It was about corporate taxes, but before turning to it, let's try to put the currency statement in perspective.

As many recognize, the currency market is prone to being used to pursue beggar-thy-neighbor policies of competitive devaluations.  The danger is that it leads to trade wars and then shooting wars.  The rules of engagement, as they have evolved over the last quarter of a century or so, are essentially three-fold.

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Currency Positioning and Technical Outlook: High Noise to Signal Ratio

The official talk around the G7 statement and the G20 meeting generated a great deal of needless noise in the foreign exchange room. It is almost like a librarian yelling "Quiet".   It may be more disruptive than the initial noise.

With the meetings out of the way, we expect the official jawboning about the currency market to die down.  Of course, there is a chronic low level murmur of economic commentary that may have broad implications for foreign exchange rates.  

Over the course of the past week, the currencies we analyze here, with the exception of the small gain (0.25%) by the Mexican peso, all fell against the US dollar.  The Dollar Index (DXY) itself closed above the downtrend drawn of the mid-November highs.  The strong close before the weekend drew it near the retracement objective in the 80.70-80 area.  The next target would be 81.35 and 82.00.

The Coming Push: France

Many investors understandably have not focused on France. The threat of scandal in Spain, the need for yet another round of government support for Italy's third largest bank and the country's upcoming election have commanded attention. What seems to have been a free ride for France may be coming to an end.

Even though the German economy contracted twice as much as the French economy in Q4, we learned this week, the implications for France are greater. Recent data suggests that the German economy has stabilized and may be expanding albeit slowly this quarter. French data continues to disappoint. 

This is particularly important because the French government's growth forecast for this year is optimistic, well above the consensus.  It was on the basis of the optimism that the Hollande government forecast that its deficit would fall to 3% of GDP, as the EU requires. 

Apocalyptic Week Winds Down

The resignation of the Pope was followed by a lightning strike on the Vatican. A meteor storm has killed more than 150 people in Russia. UK retail sales collapse in January, falling 0.6% increased of rising 0.5% as the consensus expected. Insult was added to injury as the November and December series were revised lower.

Sterling made a new low for the move, to bring its loss against the dollar since the second of January to 5.6%. How much worse can the news get for the sterling? It is not simply the retail sales report. Most of the economic data has disappointed. 

Financial Transaction Tax: Sand in the Wheels?

The European Commission formally endorsed the financial transaction tax agreed to by eleven of the 27 members.  The tax will be set at 0.1% for stocks and bonds and 0.01% for derivatives.  The tax will go into effect at the start of 2014, by which time the participating countries will give it formal approval. 

There seems to be two purposes of the tax.  The first is to raise revenue.  The EC projects the tax will raise 30-35 bln euros annually where ever and whenever an instrument from eleven is traded.  This would seem to block the ability to avoid the tax by moving transactions out of the eleven countries.  It reinforces the "residence principle".  This essentially means that if some one is a resident of the eleven countries, or acting on behalf of a resident, the transaction will be taxed anywhere it takes place. 

Poor GDP Sinks Euro

After trending gently higher for the first half of the week, the euro has been sold to new three week lows in response to the disappointing Q4 GDP figures. The GDP figures are of course backward looking and more recent data, such as the PMI figures and German factory orders suggest the regional economy is stabilizing here in early Q1.

There is a middle step to go from the GDP figures to the euro and that is the interest rate channel.  There has been some speculation that the passive tightening of the euro area financial conditions (including the shrinking of the ECB's balance sheet) and the strength of the euro would prompt the ECB to cut the refi rate later in Q1.  The poor GDP readings bolster such expectations and this can be seen in short-term interest rates.  The March Euribor futures contract is now implying 0.24% rate, having matched the lowest rate since Jan 23, or before the early repayment of LTRO I was announced.

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This Cool Video is from ASAP Science. It shows the material basis of love and how the chemical changes associated with love is similar to the chemical changes associated with some drugs.

Great Graphic: China's Debt Estimates Vary

This Great Graphic comes from the Wall Street Journal's News Graphics.  It shows a broad range of estimates for Chinese debt.  The bank and economic research firm's estimates include local government debt and apparently the IMF's estimate does not.  

However, that would suggest that local government debt is almost twice as large as the central government's debt.  The state debt is usually funneled through a special purpose vehicle and much of the debt has just been rolled over by state-owned banks.  This is a problem that will eventually have to be dealt with, but the day of reckoning does not seem to be at hand.  

It may also be of interest that as the chart shows, the estimate of US Treasury debt, which does not include the state and local government debt, or the debt held by Social Security is just shy of 75% of GDP, according to Office of Management and Budget.   

Thoughts on the Great Rotation

Reports indicating that Americans have invested more in equity funds here in 2013 than they did all last year have given rise to talk of the "Great Rotation".  The idea is that Americans are selling fixed income investments bought during the financial crisis and now buying shares.  

We are less sanguine.  There is a third asset class that needs to be integrated into the analysis:  cash.  After surveying the data and various reports, it looks to us that the flows into equities is not coming out of fixed income but rather money market funds and deposits.  

Choppy FX Conditions in the Fog of War

The price action in the foreign exchange market is choppy  as short-term participants seem nervous after being whipsawed yesterday.  Sterling fell nearly a cent to new multi-month lows following the BOE's inflation report that confirmed official expectations that price pressures will remain above target and King welcomed the recent depreciation of the point.   Also of note the Australian dollar, which staged a sharp recovery off the year's lows yesterday and has seen follow through buying today, helped perhaps by gains in a consumer confidence measure.  

The was nothing in the rogue G7 sourced comment yesterday that Japanese Finance Minister Aso did not say prior to the G7 statement and before the weekend.  The pace of the yen's depreciation was too fast.  The market reacted to it at the time.  

Kuroda Campaigns for BOJ Post

The BOJ meets on Wednesday and Thursday this week.  After choosing not to expand this year's asset purchase plan when it met in January, it is unlikely to reverse itself now.  In addition, recent data suggests that the Japanese economy has begun a recovery, whose strength is yet to be determined.  Japan reports Q4 GDP during the BOJ meeting and it is likely to be slightly positive after the 0.9% contraction in Q3.  The BOJ may upgrade its assessment of the economy.  

With the IMF, US, and now the G7 seemingly endorsing Abe's drive to reflate the world's third largest economy, the focus will shift more earnestly to the next BOJ governor.  The governor and two deputies will be named in the coming weeks.

Great Graphic: Euro near Long-Term Average

This Great Graphic, created on Bloomberg, is a long term chart of the euro.  Each bar represents a month and the purple line is a 120 month (ten-year) moving average.  It comes in now just below $1.32. 

Purchasing power parity is understood by economists as the level currencies gravitate around in the long-run.  A long-run moving average is by definition a level the currencies gravitate around in the long run.   

The long-term moving average may offer a quick guesstimate of PPP or fair value.  The OECD's measure of the euro's PPP is near $1.24.  At current prices the euro would be about a dime or around 7% more than OECD's fair value estimate.  Among the major currencies a 7% deviation from fair value is well within the normal vagaries. 

G7 Calms Currency War Fears

With currency war talk distracting investors and policy makers from the more serious and significant issues, the G7 issued a statement today reiterating its "longstanding commitment" to market determined foreign exchange rates.  

Fiscal and monetary policy is directed to domestic policy objectives and not a foreign exchange target.  At the same time, it recognizes that excess volatility can generate disorderly markets, which in turn, may have a negative feedback on the economies and financial market stability.  

It is true that some comments by senior Japanese government officials seemed to have violated these principles, but in the past few days, we argue, there has been a shift in the rhetoric, away from providing guidance for the dollar-yen exchange rate.

Great Graphic: US Profit Margin Expectations

This Great Graphic was posted on Business Insider by Sam Ro.   In appears to originally come from Goldman Sachs.   It captures expectations for US corporate profit-margins. 

The chart contrasts the bottom up consensus with Goldman's top down forecasts.   The former calls for a 9.3% increase in net margins,while the latter (Goldman) says 8.7%-8.9%. 

Earnings, Goldman argues, are more sensitive to changes in margins than to GDP or sales growth.  It argues that a 50 bp shift in margins equals $5 a share. 

Euro Area Financial Conditions Continue to Improve, but...

The ECB reports that in the week to Feb 1, its balance sheet fell by 160 bln euros top 2.77 trillion.  This is the largest decline since Jan 2009 and largely reflects the early repayment of the first LTRO.  It is the smallest the ECB balance sheet has been since just before the second LTRO a year ago.     

   
In addition, new bank borrowing from the ECB has not replaced the longer dated funds.  In fact, on Friday, euro area credit institutions did not borrow overnight funds from the ECB for the first time in a month.

Searching for the Signal in FX

Many of the major Asian markets are closed for the Lunar New Year.  This week's G7/G20 meetings are drawing attention amid reports that officials may release a statement to address the fears of a currency war.  Even a formal statement is not forthcoming, we expect 1) such statements to come from the G7 rather than the G20 and 2) for the usual boilerplate commitment to fx prices best set in the market and that certain exchange rates are not the objective of monetary or fiscal policies. 

The reason that the statement is more likely to come from the G7 than the G20 is that there are too many countries in the G20 that do not really embrace floating exchange rates.  Japan is more isolated in the G7 than the G20 on that issue.  

Great Graphic: High Costs of Consumption in China

The low cost of living in China is often confused with a low price for consumer goods. This Great Graphic from Economy Watch, shows that many consumer goods, particularly international brands, are more expensive in China.   Economy Watch drew from data on three different web sites:  e.weibo.com, East-West-Connect.com and sohu.com.  

To understand why this is the case requires shedding light on the cost structure of good that consumer purchase.  We have discussed this in terms of the good imported to the US and how 30-50% of the price American consumers pay is incurred locally for marketing, storage and transportation. 

While many foreign brands have a cache, associated with higher status and prestige, there are fundamental economic reasons why China's consumers pay more.  It has to do with the cost of internal movement of goods in China.  

Currency Positioning and Technical Outlook: Correction or Reversal?

Last week the euro was the weakest of the major currencies and the recently beaten up sterling and yen were the strongest.   A similar pattern was also evident in the dollar-bloc.  The New Zealand dollar had been the strongest and last week had was the weakest, with the Canadian dollar faring somewhat better.  The Australian dollar has been trending lower, but staged a potentially important reversal before the weekend.  

The key issue facing market participants this week is whether the price action represents a correction to the recent trend or a reversal or the start of a new trend.  After reviewing the technical condition of the market, we continue to conclude the price action is corrective in nature, but the price action, especially in the second half of the week, warns that the correction may be extended in the coming days.

Draghi Strikes Again: Talk, but No Change

The euro fell to below our $1.34 corrective target in response to ECB President Draghi's comments.  However, bids near $1.3375 appears to have stemmed to rout, at least for the moment.  It is not clear yet, if the low is in place for the day.  However, we continue to believe this decline is corrective in nature and anticipate the resumption of the uptrend.  This is the kind of pullback--more than 2% from the high, that offers opportunities for short and medium term participants.  

The key factor driving the euro higher has been the passive tightening of monetary conditions.  There is nothing Draghi said that suggest the ECB is going to take action to offset the passive tightening.  He suggested that it reflected constructive developments.  Many banks borrowed LTRO funds for precautionary reasons and no longer require it. Draghi also explained that monetary policy remains accommodative and funding is available on a full allotment basis, which is to say as much funding as the banks have collateral for, will be provided.

Great Graphic: Income, Wages and Productivity

This Great Graphic captures a key economic fact that shapes the political discourse.  Nearly every issue is informed by it.

It was created by a couple progressive think tanks and kudos to Michael Scherer from Swampville a Time blog for popularizing it. 

The social, political and economic implications of this chart are critical.
Yet, I suggest three caveats.

First, household income is misleading because it includes transfer payments (entitlements, which is the basket of goods and services our grandparents on both sides of the political spectrum fought for, as citizens of the largest economy in the world).  Transfer payments have been accounting for an increasing part of household income.

Second, to the extent that wages are an important part of household income, it is highly concentrated as this chart from the Economic Policy Institute illustrates. Lawrence Mishel and Nicholar Finio find that since 1979, wages of the highest earners grew faster than all other earners before the Great Recession and afterwards. Moreover, the gap between 1% wage earners and every one else has grown dramatically.

Third, it seemingly arbitrarily begins in 1992.  The trends it documents began before end of the early 90's recession and Clinton's election.  The decoupling of wages and productivity took place in the late 1960s or early 1970s and accelerated in the 1980s.  

Great Graphic: Big Macs in the Euro Area

This Great Graphic was on the Bruegel blog.  It re-organizes he Economist's Big Mac Index to look at the euro area. 

Recall that what the Economist did was take the concept of purchasing power parity and make it, well, palatable.  The concept is that a basket of tradable should sell for the same price in different countries.  To the extent they do not, a misalignment in the foreign exchange market seen. 

Of course, there cannot be current adjustments within the euro area, a fixed exchange rate zone.  Instead, the divergence in the price of Big Macs reflects the divergence in competitiveness. 

The fact that Big Mac's in Germany have risen more than the euro area average may be the most important observation from the chart. To the extent that this means that Germany is experiencing somewhat greater than average inflation, is a favorable development for reducing the region's imbalances.  Falling unit labor costs in the periphery is helpful to restore competitiveness, but slightly higher German inflation would also help the adjustment process.  It does so without putting more pressure on the clearly fragile political climate in much of the periphery.   

The fact that the price of Big Mac's in Italy have risen more than average (within the euro area) is problematic.  However, it is consistent with what we have seen in unit labor costs and productivity.    Italy appears to be moving in the wrong direction.  It suggests that regardless of the electoral outcome in a couple of week, the next government faces serious competitive challenges. 

Nervous Market: Key Developments

The market is  becoming a little skittish ahead of tomorrow’s ECB.  Although the euro’s recovery off the $1.3460 low yesterday was impressive,   follow through buying has not materialized.  The spread between US and German short-term rates, that is doing a good job of tracking the euro-dollar exchange rate, has stabilized and correcting the sharp move against the US.   

Many are wary of comments by Draghi that could either dangle the possibility of a rate cut or in other ways signal displeasure at tightening of financial conditions in the euro area.       Recall that in December there were many on the ECB that wanted to cut rates, but in January apparently no one did.   There is also some apprehension ahead of Spain's bond auction tomorrow, which is the first since the latest scandal broke, and more importantly, since the LTRO funds were repaid.