A Few Observations to Start the New Week

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

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

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

 The same can said of the euro area, though admittedly the contraction likely to be reported later this week is most like 0.1-0.2%.   It follows a 0.2% contraction in Q2 and the early figures points to a contraction in Q4 as well.   

 In a rare occurrence, the BOJ has eased monetary policy two months consecutive months.  It is off the table until next year, perhaps under the leadership of a different governor.  ECB President Draghi did leave the door ajar for an additional rate cut at some juncture.  New staff forecasts will be produced for next month's meeting, but if a cut in the refi rate is forthcoming, it seems more likely in Q1 13 than Q4 12.

India reported an unexpected decline (-0.4% year-over-year) in October industrial production earlier today.  The Dow Jones consensus was for a 2.8% expansion.  Manufacturing, which accounts for a full three-quarters of the index fell 1.5% from year ago levels and capital goods output, a proxy for capex, fell by a sharp 12.2%.   Separately, India reported a record $21 bln trade deficit as imports, thanks to oil, surged 7.4% (year-over-year) and exports fell 1.6%.   Despite more pressure from industry to ease rates, the central bank remains concerned about price pressures.  Wholesale prices will be reported on Wednesday and are expected to have risen about 7.9% year-over-year. 

The US fiscal cliff is a critical issue in the market.  There is an underlying confidence that because the outcome would be so painful, politicians will find a way to avoid going of the fiscal cliff.  What seems most striking is the divergence between the multi-year high in consumer confidence (Conference Board and University of Michigan measures) on one hand and the heightened anxiety of business executives and fund managers, on the other.   Our understanding of the incentive structure warns that it maybe easier to address the fiscal cliff after than fact rather than before.   Before a decision is likely on fiscal policy, the Fed may have to make one on monetary policy.  

The FOMC meets in a month. This week's minutes may offer some insight whether into its inclination to replace the long-term Treasuries being bought with the sales of shorter-term notes under Operation Twist, which will be completed by the end of the year, with outright purchases under QE3+.    The economic data in recent days, especially trade and inventory reports, suggest Q3 GDP may be revised higher from the 2% estimate.  Early Q4 data suggests something a touch softer.  However, it is not clear how much this matters, in the context of the impact of the fiscal cliff, which if taken fully could force the US economy to contract as much as 0.5% next year, according the Congressional Budget Office.  The impact would be the sharpest in the first half.

The pressure on Spain's Prime Minister Rajoy is increasing.  Spanish bonds have sold off for three consecutive weeks.  The beneficial impact of the ECB's announcement of Outright Market Transactions is wearing off.  Moody's and Fitch rating agencies have warned of the risk of a credit downgrade is aid does not materialize.  Before the weekend, the EU expressed its frustrations, saying that Spain's efforts to close its budget deficit had "hardly advanced."  It forecasts that Spain's deficit this year will be near 8% of GDP, not the 6.3% adjusted target.  Spain is headed for more difficulties.  It is assuming the economy contracts 0.5% next year.  The EC and IMF forecast a 1.5% contraction.   This gap is likely to be unpleasantly resolved in the kind of conditionality that will likely be demanded in exchange for additional aid.

Meanwhile, Rajoy is still playing hard to get.  Last week, two months after the OMT was unveiled, Rajoy articulated, perhaps  the clearest thus far, of what he wants, but at the same time it seems to reflect a profound misunderstanding.  He wants the ECB to specify in advance how far it would be willing to push down Spanish interest rates if OMT was invoked.  This is seems to exaggerate the ability of the ECB to dictate short-term interest rates.

It also misunderstands Draghi's intent.   Draghi is trying to walk a fine line between ensuring the transmission mechanism is working and that investors are only exposed to Spain's credit risk not exit risk, but not enough to remove the market pressure.  Draghi is not giving as much as Rajoy would like, though more than Germany's Weidmann can approve.   Social tensions are also rising in Spain.  Unemployment is just below 26% and industrial output has fallen for thirteen consecutive months.  Rajoy responded to the social disintegration by seeking new mortgage regulation to reduce evictions (~400k since 2008 bubble popped).

Samaras secured parliamentary support just barely for the privatization program, for the austerity package, which includes more pressure on labor, and the austere 2013 budget. The price is measured in political and social terms.  The center is melting in Greece.  Syriza on the left and Golden Dawn on the right have seen their support rise around 3 percentage points each since mid-year.  New Democracy is seeing a commensurate decline in support.    Unemployment, reported at the end of last week stands at 25.4%, more than twice the euro zone average,  and youth unemployment stands at an incredible 58%.

There are many moving parts for Greece's aid.  The size of the payment and the escrow feature need to be sorted out.  A cut in the interest rate on some debt owed to the EU and EFSF and some extension will be ultimately agreed up.  If Greece does not get the payment in shortly, the ECB may be forced again to raise the ceiling on Greek T-bills that the Greek central bank can accept in exchange for emergency lending (ELA).  Reports suggest that the Greek central bank is within 3.5 bln euros of its T-bill limit.  This scenario has already been played out once.  It could become a habit.

Many central banks, including the Federal Reserve and the Bundesbank, transfer much of their profits earned back to the federal government.  What is interesting about the Bank of England's announcement at the end of last week is that it will return the interest earned on the GBP375 bln of gilts it owns under its asset purchase scheme (QE) back to the government with the understanding that it will be used to reduce the stock of existing debt.

BOE Governor King suggested that this was equivalent to an easing in financial conditions insofar as it reduces the gilts in private portfolios and increase their cash holdings.  This is not debt forgiveness that had been previously discussed.  It is more of an interest free loan, tantamount to 25% of GDP,  made by the central bank to the government with reserves that it created.    The interest payments are also a buffer to help cushion an decrease in price.   Both the BOE and Her Majesty's Treasury know that what the BOE may pay today it may need to receive later.  

The Chinese yuan has appreciated about 2.5% against the US dollar since July.  A period of consolidation is likely.  There seems alternating strategy between focusing on the currency mechanism and the capital flow mechanism.  Over the weekend, China signaled it will soon announce an increase in the quota allowing CNY offshore to be used for portfolio investment onshore (known as RQFII (remnimbi qualified foreign institutional investor).  A CNY200 bln increase is anticipated (~$35 bln).  Officials also indicated that it will also likely increased the QFII (qualified foreign institutional investor) quotas as well.  A little more than six months ago the quota was raised to $80 bln from $30 bln.  There appears to be also some sympathy for lifting the $1 bln individual cap.  

A Few Observations to Start the New Week A Few Observations to Start the New Week Reviewed by Marc Chandler on November 12, 2012 Rating: 5
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