Welcome to Neil MacKinnon's Market Commentary blog. This page is updated regularly to cover events impacting the global financial and currency markets.

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In spite of several upside surprises to global economic data, equity markets are hesitant to make further decisive gains. Having said that, daily pullbacks are so far proving to be fairly limited. So is this just a pause for breath before the next 'up-leg' in equities or is there a risk of a much deeper correction?

The 'pain trade' for investors during the summer has undoubtedly been higher equity prices rather than a retest of previous lows and higher equity markets was the scenario we felt would play out. Now real money investors appear to be fully invested and the story of economic recovery seems to be fully discounted. The next step therefore might just be a market shake-out. China is important in this regard and it is interesting to note that the Chinese authorities are already tightening monetary policy through curbs in bank lending and bond issuance. Severe overcapacity and asset bubbles are key features of the Chinese economy. Credit and money supply growth is excessive and M2/GDP growth is at 160%. In the past, the Chinese authorities have tended to pursue a slow and gradual process of tightening monetary policy and I think it will be the same story for the next 18 months or so. A gradual withdrawal of liquidity will not be supportive for the domestic equity market and might have a knock-on effect on global equities.

Elsewhere, the dollar has been a little bit stronger this week though in low volume summer markets it still boils down to range-trading in the majors rather than any major change in trend. Goldman's sentiment index for the dollar is showing the most positive reading since March.  

Sterling is being hurt by worries of fiscal overload and expectations of more quantitative easing (QE). In classic textbook terms, a combination of loose fiscal policy and a loose monetary policy is never good for a currency. Normally, a tighter monetary policy and a loose fiscal policy is a recipe for currency appreciation (higher interest rates attracts yield-hungry investors and a looser fiscal policy is regarded as positive for economic growth thus attracting equity investors). UK inflation has so far proved sticky and should the next set of CPI data show more of the same then the market might revise its view on QE. Technically, sterling looks oversold especially against the Swiss franc where comments from the SNB's Jordan yesterday shows that the Swiss have every intention of maintaining a very accommodative monetary policy as well as a preference for preventing fresh appreciation in their currency.

Yesterday's US economic data was generally positive. The latest readings on consumer confidence (click here) reported an increase to 54.1 in August from 47.4 in the previous month. Also I noted that ‘jobs hard to get’ decreased to 45.1 in the month from 48.5. Not a massive improvement but it might encourage hopes of a further improvement in the upcoming US jobs report. Not all was fine and dandy on the consumer front though as the Redbook same-store sales data showed a decline of 0.7% in August. I guess the improvement in consumer confidence is a function of the 50% rally in the stockmarket and fiscal incentives such as the first time tax credit for house purchases (click here) and the ‘cash-for-clunkers’ programme. Elsewhere, US house prices are starting to recover though the year-on-year decline in the Case Shiller index is still a steep 15.4% (click here). The tax credit is certainly helping sales and I wouldn't be surprised to see the tax credit extended beyond its November expiry.

Mr Bernanke was nominated for another term by the President yesterday. No real surprise. Some commentators are critical of Mr Bernanke in his role in supporting Mr Greenspan through the ‘cheap money’ years which contributed to the credit and housing bubbles. Mr Bernanke generally scores full points in his efforts to use unconventional monetary tools to avoid another depression but some wonder whether another bubble is in the making. The credit crisis resulted in a concentration of power amongst the American financial oligarchy and, so far, efforts to implement a tighter regulatory regime are thin on the ground. The major banks have been the key beneficiaries of a substantial injection of liquidity which might end up in just stoking an increase in speculative activities. Should the Bernanke Fed keep interest rates low for an extended period, it will only increase the attractions of the dollar as a funding currency. The Asian economies are the growth story and the Asian central banks will likely tighten monetary policy first, thus attracting ‘carry’ investments which end up pushing Asian currencies higher. Another bubble (oil? commodities?) is probably not far away.

Which brings us back to the stockmarket. Jeremy Grantham of GMO (who called the March low in equities) now thinks the equity market is ‘overvalued’ by 15% and sees ‘fair value’ in the S&P index at 880. He sees ‘seven lean years’ of a sluggish stockmarket ahead. His warnings chime with my own feelings on the stockmarket, given the exceptional nature of the stockmarket rally since March. At the moment, the market is very sentiment-driven and prone to daily whipsaws of ‘ups’ and ‘downs’ that are without any real conviction it seems. Signs of a frothy market and potential market correction? For the bears, have a look at this chart which might show a ‘bull-trap’ in the making (click here).

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Stockmarkets are turning negative again with Asian markets overnight posting losses on the back of weaker reports from Chinese materials companies as well as signals that Chinese bank lending is slowing. Investors are now becoming very familiar with the almost daily volatility in equity markets but which nevertheless triggers doubts about the sustainability of the equity rally from here particularly given the exceptional scale of the rally from the March lows. In the currency markets, there has been less volatility and the major exchange rates have been range-bound. The US dollar continues to trade defensively as the markets believe that the Fed will maintain an accommodative monetary policy for some time.

In addition, there appears to be some correlation between equity market gains and weakness in the dollar which seems stronger than the correlation with interest rate differentials. Another suggestion is that central banks have excessive long dollar positions relative to some notional benchmark and that risk aversion is the key driver. So when risk appetite improves, the amount of dollars they want to hold declines. Also when risk appetite improves, the appetite for low-yielding US debt declines which is borne out in the monthly capital flow data where there has been a dramatic decline in US capital inflows.

Today's economic data flow will focus on the Case-Shiller home price index and the US consumer confidence index. Both are important bits of data given the role of the housing market in the financial and economic crisis as well as the health of the consumer in contributing to GDP growth. The ‘big picture’ here is that there is some indication of a ‘bottoming’ in the US housing market and some stabilisation in consumer confidence. One of the published components of the consumer confidence numbers is the ‘jobs hard to get’ index which needs to show signs of improvement before we can sound the ‘all clear’ for the consumer. However, any deterioration in the ‘jobs hard to get’ index highlights further weakness in the labour market which can only weigh on consumer confidence.

In the UK, market commentary is still focusing on the fiscal position and a realisation that any meaningful policy correction is unlikely before the next elections which have to held by May next year at the latest. Policy paralysis won't help investor sentiment. In addition, the most recent inflation data is considered disappointing while the Bank of England is intent on more quantitative easing. Inflation expectations in the UK are now moving above their long-term average (as measured by 5-year conventional and index-linked yields) while inflation expectations are declining in the eurozone. Does a more cautious (and maybe hawkish) European Central Bank have something to do with it?

Finally, some ‘must read’ material from the Fed's Jackson Hole symposium: on monetary policy, have a look at Using monetary policy to stabilize economic activity (click here) and on fiscal policy, look at Activist Fiscal Policy to Stabilize Economic Activity (click here). Both papers are very good primers on everything you need to know about how policymakers are using monetary and fiscal policy and give a good overview of policy developments over the past year or so. Another good paper worth reading and keeping for future reference is Financial Crises and Economic Activity (click here). This is the most up-to-date assessment and analysis of the economic impact of financial crises which are more periodic than you might think.

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Equity markets responded positively to Mr Bernanke's speech (Reflections on a Year of Crisis, click here) on Friday in which he was hopeful that economic recovery would prove sustainable. In addition, comments from other Fed officials suggest that the low short term interest rates would remain in place for a while yet. In addition, the latest data on US existing home sales added to investor optimism by posting a large gain in the month (click here).

Last week generally saw a good performance in many investment classes though emerging equity markets under-performed developed markets for the third consecutive week, the US dollar remained on the defensive (click here) and the rally in the S&P index is now bigger and longer than any of the rallies seen during the 1929-32 period. The current rally is up about 52% over 165 calendar days (click here) which is pretty exceptional. If you missed the rally then I guess its too dangerous to participate here and now. The MSCI World Index is up 57% from the March lows and up 17.4% year-to-date. The longer-term picture in the US yield curve (2-10 year) looks as though the curve has peaked which is also a bullish indicator for equities for the medium term.

As I mentioned last week, it does look though that institutional real money is fully invested so we should be careful about getting carried away as far as equity markets are concerned. Retail money could certainly help extend the rally but many technical analysts note that there is an interim barrier in the S&P index at 1060. And it may not be plain sailing as far as the economy is concerned. Professor Roubini thinks that there will be a W-shaped recession and it is fair to say that there are many in the market who are alert to the story of an inventory rebuild plus current fiscal stimulus underpinning one or two ‘good’ quarters of GDP growth. 2010 could be a different story especially as sharply rising deficits and debt levels constrain US and UK policymakers from using fiscal policy to stimulate the economy.

But everything depends on the consumer and it is difficult to see how the consumer can start to recover in the face of falling wage growth, the lagged shocks from the sharp reduction in household wealth and the need to lower debt levels in the face of still tight lending conditions. In certain industries like shipping, things are still difficult and here there was a decline of  16% in the first half of this year. This chart highlights the collapse in charter rates for container shipsand this spells diificulties for the industry generally (click here).

In the currency market, the euro has been a beneficiary of what looks like improving eurozone economic data and the euro/dollar exchange rate is moving to the top of its summer range. I am not sure that the euro will break the top of the range though as the ECB is still cautious about economic recovery. I like the prospect of higher levels in dollar/yen though from a low of 93.42 last Friday. The yen has to weaken in the medium term, I think, to combat deflation and I wouldn't be surprised to see dollar/yen back to the 100 level before year end. I also think that the technical picture for sterling/yen and sterling/swiss in particular looks good and the low in sterling/swiss last Friday is a good starting point.

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A mixed session overnight for Asian equity markets with investors still exhibiting a degree of nervousness in a low volume environment. The latest Merrill Lynch Global Fund Manager survey highlighted two interesting things:

1. institutional investors' cash balances are at their lowest since July 2007
2. fund managers have their highest equity allocation since October 2007

This suggests to me that ‘real money’ is already fully-invested in the stockmarket and the low reading for cash says there is little buying ammunition left. Maybe this is why stockmarket performance in the past few weeks has been poor and why sellers have had the upper hand. You might also be interested in seeing this chart (click here) which shows that equity asset allocators just follow the market.

There is also a disconnect between what bond markets and stockmarkets are discounting. If you look at bond yields (both 2-year and 10-year), they are telling you that the bond market buys into the story of a sluggish economic outlook for 2010 once the inventory upturn and fiscal stimulus fades. The sharp equity rally that we have seen since the lows in March paints an entirely different picture with equity investors discounting much higher rates of economic and profits growth. Somebody is wrong and for what it's worth I am siding with the people in the bond market.

David Rosenberg at Gluskin Sheff makes the point that, historically, after a 50% rally in equities, the economic landscape in the US is typically characterised by:

1. an average expansion in real GDP of 4.5%
2. a rebound in employment of 850k
3. an average reading in the key ISM index of 56.2
4. an increase in corporate profits of 12%
5. an increase in bank lending of 5%

Now, in the current ‘cycle’, real GDP growth, employment and corporate profits are provisionally attempting to make a cycle low with the US ‘recession’ looking as though it ended in June. The ISM index is still below 50 at 48.9 and bank lending remains weak. Of course, the current cycle is exceptional given the severity of the financial and economic crisis and there has been an exceptional monetary and fiscal stimulus so  comparing ‘like with like’ may be spurious but, nevertheless, you take my point. Yesterday's US initial claims data saw the key 4-week moving average go up for the third straight week. This was the survey week for the monthly non-farm payroll data and suggests that the US jobs market is still fragile.

Indeed, in terms of fiscal stimulus, the US government has just announced that it is ending its ‘cash for clunkers’ programme on Monday with the news denting automakers' share price, while in the UK, the dire state of public sector finances is forcing the Chancellor to end the VAT ‘holiday’ (which cost the Exchequer £12 billion by the way, and has to be the biggest waste of money in a Budget for a long time) and put the VAT rate back to 17.5% in January. All this will do is bring forward retail spending prior to January as consumers try to beat the 1 January hike. Thereafter, spending will simply dip.

On this theme, yesterday's UK government borrowing numbers did not make for pretty reading. Net borrowing amounted to £8 billion in July and this compares to a net surplus of £5 billion for July last year. Cumulatively for this fiscal year, net borrowing stands at £50 billion compared with borrowing of £16 billion for the same period in the last fiscal year.  The UK's net debt now stands at £800 billion which is 56.8% of GDP and this number will keeping heading higher. The Chancellor's Budget forecast that net borrowing will be £175 billion looks like an under-estimate and I wouldn't be surprised to see a number nearer £200 billion.

It was not all bad news yesterday as UK retail sales posted a 0.4% increase in July largely as a result of a 3.9% gain in household goods (which was 1.3% down on a year ago). Maybe the recesssion is keeping people at home and they are spending spare cash on an upgrade of household kit.

However, I did note a report in this morning's Times that four million UK homeowners who took out interest rate only mortgages can't repay their loans (click here). A similar phenomenon is taking place in America where US mortgage loans in foreclosure stand at 13.2% according to the latest data (click here). I also noted that UK net lending to businesses dipped for a third consecutive month in June by £0.9 billion with small companies being hurt the most. If quantitative easing is designed to spur lending, there is little evidence that it is having much impact.

Back to markets, the main interest today will be Mr Bernanke's speech at the Jackson Hole Symposium. This is an annual event hosted by the Kansas City Fed and focuses on monetary policy issues. These are worth taking heed of and over the years the symposium has highlighted important developments in monetary policy. This year's event is clearly important given the unorthodox measures that the Fed and its counterparts are pursuing.

On the foreign exchanges, the yen has strengthened during the course of the week in tandem with the slippage in equity markets and increase in investor risk aversion. Dollar/yen is starting to move into technically oversold territory (93.70 spot this morning) and if it should move closer to the lows seen in July at 91.70, you might see yen-sellers come back into the market.

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Overnight, Asian equity markets staged a recovery but they needed to. The Chinese Shanghai Composite has fallen 20% in two weeks and a 20% decline is usually described as a ‘bear market’. The overnight recovery has also see euro/yen recover as well as sterling/dollar, and both currency pairs are barometers of investor risk appetite. Clearly, there is a lot of day-to-day volatility going on which may be a function of low volumes and the absence of real money investors in the markets. Tread carefully – market sentiment is incredibly short-term at the moment and what happens in the market yesterday can very easily be reversed today. It's a very fickle market. Trading ranges in the major currency pairs since the beginning of August have been very narrow. In sterling/dollar, you are looking at 1.6276-1.7044 and in euro/dollar, 1.4045-1.4450.

In yesterday's blog, I focused on the UK's fiscal position and David Cameron's comments about the risk of a UK default. Readers might be interested in Professor Buiter's thoughts on all of this and I re-read his Fiscal options for the UK:sovereign insolvency, inflation or serious fiscal pain (click here). I think we get at least two out of those three options, particularly inflation and serious fiscal pain (i.e., higher taxes). Professor Buiter looks at the sustainabilty of the fiscal arithmetic which if you cut through the algebra means that a sovereign state needs to see real GDP growth higher than the real interest rate otherwise its curtains from a fiscal point of view.

Of course, if GDP growth is higher than the real interest rate, the government can issue debt to finance its interest payments to bondholders which is nothing more than a Ponzi scheme. Professor Buiter makes the point that even when the UK economy returns to trend ratesof economic growth (about 2.25-2.50%), the UK will require a permanent reduction in the primary (or underlying) deficit of 6.5-7.5% of GDP. This is a massive fiscal adjustment by any criterion and is possibly politically difficult to implement. He also notes that if the government was serious about not using higher rates of inflation to reduce the debt burden, it would issue index-linked debt but this is not happening.

Professor Buiter also highlights the possibility of HM Treasury invoking its ‘emergency powers’ in the 1998 Bank of England Act which allows it to take control of interest rates. This effectively pulls the rug on the Bank of England's so-called ‘independence’. In this scenario, sterling goes down sharply and contributes towards a much higher inflation rate.

Almost by accident, I came across a paper by Mervyn King that was published back in 1995 way before the Bank's ‘independence’ and it covers a lot of Mervyn's comments about the sustainability of fiscal policy and the important relationship between monetary policy and fiscal policy (click here). It makes for interesting reading as I suspect his views haven't changed a great deal on this issue. A particular quote that I though pertinent was, "a few years of unexpectedly high inflation can do wonders for debt ratios". Higher inflation is, I think, a serious possibility for the longer term, i.e., in five years time or more, but it would radically change the status of the Bank of England and they might end up just becoming the ‘East End’ branch of the Treasury.

Separately, Olivier Blanchard, who is Director of Research at the IMF, published a paper yesterday on the IMF website that gives the IMF's latest thoughts on how it thinks the global economy will recover (click here). He sees "potential output...lower than it was before the crisis". He also thinks that "as large deficits continue, debt sustainability comes increasingly into question" and highlights the risk that a "dollar depreciation may take place, but in a disorderly fashion". If you want to see everything you need to know (including all the vital statistics on budget deficts/debt/GDP ratios etc.) I suggest you take a look at the IMF's The State of Public Finances: a cross-country fiscal monitor (click here).

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A lot of attention in the media this morning is on comments by David Cameron, the Conservative Party Leader, that the escalation in government borrowing could result in the UK defaulting on its debt (click here and here).

Well, yes, governments can default; and there is no doubt that the UK, like many of the major economies, is suffering a sharp deterioration in budget deficits and debt/GDP levels as a result of the financial and economic crisis of the past two years. Indeed, the IMF has already warned that the UK would see the biggest increase in the debt/GDP ratio of any G20 economy between 2007 and 2014. Even HM Treasury, in this year's Budget back in April, forecast that the UK's debt/GDP ratio would rise from 36.5% in fiscal year 2007-08 to 76.2% by 2013-14 (click here).

The UK is not the only country in this position, and I have previously highlighted the deterioration in America's deficit and debt which is resulting in some extraordinary borrowing. In spite of that, borrowing costs as measured by 10-year bond yields are very low and in my blog earlier this week I highlighted some analysis by Professor Krugman as to why this is so. This doesn't let the UK government off the hook though. International investors will make relative evaluations of fiscal positions and the success (or otherwise) of government efforts to put fiscal policy back on track. This will be reflected in bond yield spreads between countries, movements in credit default swaps and, of course, the exchange rate.

Indeed, while I think the risk of default is actually negligible, the experience of the UK in the 1970s does show that a budget crisis can easily result in a sterling crisis and a sharp devaluation. Whoever is in office – whether it is David Cameron or Gordon Brown – will face difficult choices in the next few years, but the bottom line has to be some mix of tax increases and spending cuts. Policymakers also face another problem – deflation. Deflation increases the REAL value of debt and in the past policymakers have resorted to inflation as a way of reducing real debt levels.

Yesterday's CPI data was reported in the mediaas disappointing with inflation showing a 1.8% increase after market expectations of an out-turn of 1.5%. If you look at the headline Retail Prices Index (RPI), the official data actually reported deflation of 1.6%. The RPI is typically used as a benchmark in wage bargaining and price-setting (including index-linked gilts). So it should be the RPI not the CPI that we should be looking at to tell us what is going on with prices.

Otherwise, yesterday's mini-recovery in equity prices didn't last long. Remember to keep watching the Chinese market. That has come down sharply in recent weeks and can fall further. If it does, then other major equity markets will find it difficult to remain uncontaminated so I expect a bumpy ride for investors in the next few weeks.

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Yesterday saw many equity markets drop sharply. Readers of my blog should not have been surprised by this as I had been warning that many markets looked technically ‘overbought’, but more importantly that the weakness in the Chinese market was an augury of slippage elsewhere in the global market. On top of that, the consensus view that the recession is over took a knock after last week's fragile US retail sales report and the slide in US consumer confidence. Japanese GDP data showed that private demand was negative and that the economy is still deflating. In the UK, the Rightmove survey showed the sharpest decline in house prices in eight months thus questioning the underlying strength of the UK housing market.

Having said that, data out of the US economy yesterday was quite reasonable. The NAHB index reported builder confidence at its highest level in more than a year though the first time buyer tax credit which expires on 30th November is likely to have boosted hopes of sales to beat the expiry date (click here). US housing starts scheduled for release this afternoon will likely reflect the impact of this tax credit. Also, the NY Fed index yesterday surprised to the upside but is consistent with recent inventory rebuilding and the gains in auto output (cash for clunkers) (click here). The Fed extended its $200 billion TALF programme by three months, though the Fed survey on credit standards showed a tightening of lending standards especially for commercial real estate loans. Rising foreclosures and negative equity remains a problem though (click here).

This morning, European equity markets seem to have recovered their poise a little. On the data front, the markets are expecting UK CPI inflation to have fallen to 1.5%, its lowest level in five years. We know from last week's Inflation Report that the Bank of England (BoE) is forecasting the inflation rate to drop to 1% in the months ahead. 1% is a rate that is within the statistical margins of error that could easily take the economy into deflation. That means UK interest rates have to ‘stay lower for longer’ and that you can expect the BoE to extend its quantitative easing (QE) programme from the current £175 billion level. Tomorrow's BoE MPC minutes could be interesting if it shows MPC members discussed extending QE more aggressively.

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Overnight, equity markets started the week on an edgy note following disappointing US consumer confidence data last Friday with the Chinese market staging some further losses. This is putting European equities under slight pressure first thing. The Chinese equity market is regarded as a potential lead indicator for performance (or otherwise) in the rest of the major equity markets. Last week, risky assets took a breather with the MSCI World Index up 0.1%. Developed equity markets outperformed their emerging market counterparts for the second week running. The S&P index fell 0.6% last week with the FTSE100 index down 0.4%.

The Shanghai Composite is down around 12% from its 4th August peak and dropped below its 50-day moving average at 3103. Its 200-day moving average is at 2420 and likely represents an interim target going forward. Interestingly, at the moment, all the other major markets are still above their 50- and 200-day moving averages, but I think there is a good chance that these markets will follow China. The S&P 50-day moving average is at 945 with the 200-day average at 875. The ‘note of caution’ I recommended in last week's blog still applies. To see how markets performed last week, click here.

Last week's economic and policy developments included George Soros asserting that the US economy has bottomed. The Federal Open Market Committee (FOMC) was a bit more optimistic about the short-term outlook after its deliberations concluded at its meeting last Wednesday. The FOMC statement contained a change of language from the "pace of economic contraction is slowing" in its previous statement to "economic activity is leveling out". However, the FOMC did note the headwinds facing the consumer and said that this might warrant interest rates staying low for an extended period. The FOMC announced that its Treasury purchase programme would stay in place until October. For an interesting interactive chart on the status of recession/recovery in the global economy, click here.

There was also better economic news in the eurozone with real GDP declining by ‘only’ 0.1% in Q2. This compares with a 0.8% decline in UK GDP over the same period. Many eurozone economists subsequently have revised up their economic growth forecasts for the rest of this year and next, and are debating as to whether the ECB might tighten monetary policy early next year. As an antidote to all of this I recommend reading Ambrose Evans-Pritchard in The Telegraph (click here). He notes that excess capacity is hovering at levels not seen since the Great Depression. He also notes that deflation exists in all the major economies. He also notes that NOMINAL GDP (i.e., total spending) is actually declining in France and Germany and that Ireland's GDP is now shrinking at a 13% annual rate. Policymakers should be alert to declines in nominal GDP as a decline in an economy's total spending is deflationary rather than inflationary and this should put talk of an early increase in interest rates into perspective.

Professor Tim Congdon, the veteran monetarist, says that "quantitative easing (QE) must be calibrated so that the quantity of money is growing fast enough to stop the recession". Tim has always had some interesting views and insights on the UK and monetary developments and his thoughts are worth reading (click here). Last week's Bank of England (BoE) Inflation Report was regarded as ‘dove-ish’ by the market. Certainly, Mervyn King warned of a "slow and protracted recovery" in the economy and I would not be surprised to see a further expansion in QE during the rest of this year. Andrew Sentance, the BoE MPC member, wrote a slightly more optimistic piece in The Sunday Times yesterday that he sees growth in the Asian economies as leading the global recovery and if this can be sustained it will help underpin the UK recovery (click here).

However, while there has recently been a large increase in intra-Asian trade, I am not persuaded of this type of ‘recoupling’ story. Early in the economic downturn, it was popular in some quarters to claim that thre would be ‘decoupling’, i.e., that growth in China and the BRICS would save the global economy from the problems facing the US consumer (who by themselves account for 20% of world GDP). The UK consumer (and the economy) face similar problems to their American counterparts and the banking sectors still face considerable balance sheet problems. Even Mr Sentance acknowledges that the health of the banks is a key risk for the recovery.

Elsewhere, I was interested in further comments made by the Nobel Prize winner Professor Krugman on the relationship between government budget deficits and interest rates and I have previously highlighted some of his analysis before. It is interesting that the US government will borrow $3.5 trillion for fiscal years 2009, 2010 and 2011. This matches the US Treasury's cumulative borrowing between 1789 and 1994 (yes I mean 1789!). So why are 10-year Treasury yields at 3.7% when you think that such levels of borrowing would have resulted in much higher interest rates? Professor Krugman has an interesting chart that shows that when deficits are high, interest rates are low. Both are a function of the state of the economy and I recommend reading these articles (click here and here). 

This week's economic data features US capital flow data (today) and then, throughout the week, data on the US housing market. Eurozone PMIs will be of interest too. In the UK, the main focus will be on CPI data (Tuesday) and retail sales (Thursday). In the FX market, it remains a summer market with the major currency pairs largely range-bound for now. Should equity markets slip further, the US dollar and the yen might well ‘benefit’, but I am afraid that sterling might struggle. Keep an eye on euro/yen too which we use as an FX indicator of equity market developments. If euro/yen drops below the 130 level (133-134 this morning), that would point to problems for the stockmarket and a return to risk aversion on the part of investors.

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Yesterday's US retail sales fell 0.1% in July, below the consensus forecast of an 0.8% increase (click here for the charts). The trend in retail sales is still down with the year-on-year decline at 5.5%. The component of the retail sales report that is of interest to economic forecasters is what is called ‘retail control’ which is defined as the headline excluding gasoline, building materials and autos. Why? Because this is what the government statisticians put into the consumer spending totals in the official GDP data.

So this gives us a good input in trying to predict GDP as consumer spending accounts for 60-70% of GDP in the major economies. The latest data on ‘retail control’ reported a 0.2% decline in the month and has been flat or down in each of the past five months despite a massive fiscal stimulus. In Q3 (so far), my former colleague at Merrill, David Rosenberg, estimates that retail control has declined at an annualised rate of 1.3%.

Most economists in the financial markets have actually been revising UP their GDP forecasts for the US economy but this is largely due to the impact of a rebuild in inventories and the subsequent positive impact on manufacturing output. Without a sustained contribution from consumer spending, it is inevitable that any increases in GDP will be short-lived. The economic risk going into 2010 is a fading contribution from the inventory cycle with little dynamism from a cash and credit-constrained consumer. 

Also yesterday, the latest weekly US initial claims data, which gives us a timely insight into labour market developments, showed the key 4-week moving average rising to 565k from 556k. While it does look that initial claims have peaked for this cycle – thus pointing to some badly-needed relief in the employment decline – it is estimated that initial claims would have to drop below 400k before total employment stops falling (click here). 

In the eurozone, there was a lot of market interest in the latest GDP data which turned out to be better-than-expected and caused some economists to declare that the eurozone recession ‘almost’ came to an end in Q2. My friend, Holger Schmieding, who is the chief European economist at Bank of America, is revising up his GDP forecasts for 2009 and 2010. Eurozone GDP fell 0.1% in Q2 helped by growth in France (French exports rose 1.0%) and Germany (we get the breakdown of Germany's GDP components on 25th August) but with further weakness in Italy, Spain and the Netherlands. Holger points to national fiscal stimulus programmes (e.g., the temporary car purchase scheme which is estimated to have added 0.25% to eurozone GDP in Q2) and lessdepressed net exports. Goldman's economics team is also raising its eurozone GDP forecasts and looks for GDP in Q3 to rise by 0.5% and to increase by 1.2% for all of next year (compared to Goldman's forecast for the UK of an increase of 1.9%). I noted in one of my previous blogs that it was worth making a distinction between ‘cyclical’ and ‘secular’ economies. Cyclical economies like Germany have responded quickly to the impressive rebound in global manufacturing (and exports) that is currently taking place. ‘Secular’ economies like the US and UK which were at the epicentre of the financial crisis have not recovered quite so well as those economies and still carry a burden of debt and face a period of de-leveraging. The market message is that cyclicals ‘outperform’ the seculars. 

However, market participants will note that UK GDP fell by 0.8% in Q2 thus under-performing the eurozone economy. They will have also noted this week's downbeat assessment by the Bank of England on the UK economy. The euro/sterling exchange rate is likely to be heavily influenced over the shortterm by relative outcomes in the eurozone and UK flow of economic data. If it looks like the UK is falling behind an economic recovery in the eurozone, then sterling could well underperform the euro in the weeks/months ahead. 

All of this focus on GDP growth is very interesting as currency forecasters are focusing on ‘output gaps’ albeit in terms of absolute size or relative growth as a key determinant of currency performance. The ouput gap is defined as the difference between actual GDP and potential GDP, a measure of excess or spare capacity if you like (for a definition, click here). The output gap also has an influence on inflation pressures. If actual GDP exceeds potential GDP (i.e., a positive output gap) then demand-pull inflation pressures escalate and unemployment falls. Likewise, if actual GDP is below trend as it is for the global economy at the moment then inflation declines and unemployment rises.  

In a severe situation (like now), deflation can take hold. It follows on that the output gap, as an indicator of what is happening to both the economy and inflation, is useful for central bank policymakers in setting interest rate policy. If the output gap goes up then you raise interest rates. If the output gap is negative then you cut interest rates to help reduce unemployment.  

Indeed, Professor Taylor formulated a policy rule (not surprisingly known as the "Taylor Rule"!) which sets the nominal interest rate as a function of the ‘inflation gap’, which is the difference between actual inflation and targeted inflation, and the ‘output gap’. The Taylor Rule simply says that you raise interest rates if inflation rises above its desired level and/or actual output is above potential output. In actuality, the Taylor Rule tracks very well the movements in interest rates especially for central banks that target inflation. The ‘rule of thumb’ implied by the Taylor Rule is that: 

1. you lower the Fed funds rate by 1.3% if core inflation falls by 1%
2. you lower the Fed funds rate by 2% if the unemployment rate rises by 1% 

Obviously when official targeted short term interest rates drop to zero, the Taylor Rule loses its attractions; nevertheless it still shows what central banks need to do to reach their objectives. In the US, the Taylor Rule says the fed funds rate should be MINUS 5%. Clearly, interest rates can't go negative so the Taylor Rule highlights the degree of monetary expansion required through quantitative easing (click here for more on the Taylor Rule and click here for further reading). 

As far as exchange rate forecasting is concerned, the academic work on the relationship between currencies and ‘economic fundamentals’ has found to be weak and unstable even though some see the exchange rate as representing the Net Present Value (NPV) of expected future macro fundamentals. The classic study on this by Meese and Rogoff in 1983 (click here).

They claimed that, “a random walk model performs as well as any estimated model at one to twelve month horizons for the dollar/sterling, dollar/mark, dollar/yen and trade-weighted dollar exchange rates". Much of the academic literature on currency forecasting since then essentially deals with what has been called ‘the exchange rate disconnect puzzle’. Does this mean currency forecasting is a complete waste of time and is really just an informed guess? Not quite I think (but I would, wouldn't I?). Most of the exchange rate models in the past focus on relative money supply growth, interest rate and inflation differentials and relative current account balances. The models were essentially based on theoretical notions of Uncovered Interest Rate Parity (UIP) (click here or the definition) and Purchasing Power Parity (PPP) (click here for the definition).

Now, the latest academic literature focuses on the Taylor Rule in forecasting exchange rates, which is where the output gap comes in. I am very interested in a recent paper on this subject Taylor Rules and The Euro (click here). The authors show that the output gap can help (and did) forecast the euro/dollar exchange rate (click here). In particular, they find that:

1. an increase in inflation and/or the output gap increases the country's interest rate and causes immediate exchange rate appreciation
2. an increase in the US output gap relative to the eurozone output gap causes dollar appreciation whilst an increase in US unemployment relative to eurozone unemployment causes dollar depreciation.
3. "bad news about inflation is good news for the exchange rate"...contrary to the message of PPP
4. an increase in US inflation above target causes dollar appreciation and vice-versa

Of course, a practical problem is measuring the output gap and especially trying to measure potential output. If you are interested in these issues I recommend a visit to the following links (click here for information about measuring the output gap,  and click here for more information about potential output, and click here for a paper by the Bank of England The economics of global output gap measures).

What does this mean for the major currencies at the moment? Paul Meggyesi at JP Morgan looks at peak-to-trough declines in GDP for individual countries, thus providing a ranking of recession severity and therefore giving an indication of which countries will be the first or last to normalise monetary policy (he finds a close correlation between output gaps and 2-year swap yields). Paul finds that Japan is bottom of the ranking (losing 8.4% of its output). The UK is third from bottom losing 5.7% of its output. With Norway and Australia at the top of his ranking, it is no surprise he is recommending short positions in GBP/NOK and GBP/AUD. Paul also notes that 2-year swap yields are highest in Australia and Norway and lowest in Japan, Sweden and the UK. Goldman's economics team has also looked at output gaps and finds that changes in output gaps drive FX,especially for emerging markets. They believe that the BRL, IDR, INR and CNY should be facing appreciation pressures.

All of this makes me think that looking at swap yields and yield curves might be a better way of trying to forecast currencies, given that changes in the shape of yield curves effectively encapsulate the market's assessment of changes in output gaps (and hence changes in monetary policy). Looking forward, if the eurozone surprises on the upside in terms of economic growth (especially being more cyclical than secular), you might expect the euro to appreciate against the dollar. Likewise, if you believe Mervyn King's story of a ‘slow and protracted recovery’ in the UK, then sterling should underperform the euro.

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The Federal Open Market Committee (FOMC) concluded its scheduled policy meeting last night. The main things to note from the FOMC's statement (click here) are as follows:

1. "household spending has continued to show signs of stabilising but remains constrained by ongoing job losses,sluggish income growth, lower housing wealth,and tight credit"
2. "a gradual resumption of sustainable economic growth in a context of price stability”
3. "continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period"
4. "anticipates completing its planned $300 billion Treasury purchases by October"

I had suggested in my previous comments that, prior to the FOMC meeting, press reports had suggested the FOMC might conclude its Treasury purchases by September, so the Fed's decision was a month later than expected. A more upbeat statement on the economy by the FOMC suggests that they might be the first major central bank to unwind quantitative easing (QE). For an interactive feature which expalains QE, click here.  Although an early exit from QE should help the dollar, the likelihood of low interest rates for some time actually resulted in some dollar weakness following the statement. Note that the FOMC calls QE "credit easing". Unlike the Bank of England (BoE), the FOMC uses a much wider range of asset purchases to achieve its objectives. A good primer (with charts) on existing FOMC policy in this regard can be found here.

Yesterday's UK Inflation Report and press conference by the BoE was much more downbeat than the Fed. Mervyn King talked about a "slow and protracted" recovery. UK GDP growth is expected to be just 0.8% in 2009. Inflation is expected to fall below 1% later this year but then inflation starts to rise back to 2%. The mean inflation forecast in two years time on unchanged interest rates is expected to be 2.1% from 1.7% in the May Report. All of this took place against a backdrop of a 14-year high in the unemployment rate and a record £14.7 billion slump in lending to non-financial corporations between May and June. Mervyn King is threatening to cut the interest rate that the BoE pays on reserves banks hold at the BoE which totalled £157 billion at the end of June. In my view he should pay zero rates. This would encourage banks to think of more profitable ways to use excess cash like lending it out to the real economy.

Mervyn King, in his press conference, also noted that sterling was still 20% weaker against a basket of currencies than before the crisis. In my blog on Monday I mentioned David Smith's idea that the BoE might have expanded QE to weaken the pound. The apparent preference for a weaker currency is picked up again by Edmund Conway in today's Daily Telegraph (click here).

My guess is that the BoE will expand QE again (the existing £175 billion programme is estimated to be equivalent to an interest rate cut of 4%). As far as the sterling/dollar exchange rate is concerned, the chart technicals apppear to be controlling the price action. Sterling has found support close to the 100-day moving average I mentioned earlier in the week. From a low of 1.6398 yesterday, the pound moved up to a high of 1.6598 this morning. This is encouraging despite the BoE's preference for a weaker pound, but probably more likely reflects a weaker dollar in the aftermath of last night's FOMC meeting.

Finally, elswhere, the Wall Street Journal reports that the leading Japanese opposition party, the Democratic Party of Japan (DPJ), might tolerate a stronger yen (the election is 30th August). They believe Japan is too reliant on exports to kick-start the Japanese economy and would prefer domestic demand growth to be the main driver. A stronger yen would mean cheaper import costs and an increase in consumer purchasing power. As it happens, the authorities have not intervened in the FX market to stop the yen rising since spring 2004. However, I believe that a stronger yen at a time when Japan is experiencing a worsening in deflationary pressures would not be sensible. Deflation would only keep the economy in a recessionary situation for longer. I believe that a weaker yen, not a stronger yen, is part of the solution.

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This morning's Inflation Report from the Bank of England (BoE) is likely to contain a downgrade to the BoE's forecast of GDP growth as well as a warning about the dangers of debt deflation. After extending quantitative easing (QE) to £175 billion in a surprise move, the BoE will likely keep its options open. A quick way of establishing what the BoE's monetary stance is at the moment is to check the latest mean inflation forecast for two years ahead. This stood at 0.4% in February and in May was 1.7%. Anything below 2% can be taken as an ‘easing bias’ with 2% representing a neutral bias. Should the inflation forecast fall below 1.7%, that will indicate an ‘easier bias’.

The markets will also be focusing on the BoE's QE options. To fuel the debate, the IMF has produced a timely assessment of the BoE's monetary policy and I recommend this as worthwhile reading (click here to read Panacea, Curse or Non-Event? Unconventional Monetary Policy in the United Kingdom by Andre Meier).

The IMF claims that the BoE's policy has suppressed long-term government bond yields by about 40-100 basis points. In terms of actual tangible bond purchases from January to July this year, the IMF estimates that the BoE bought assets worth 7% of GDP compared to 6% in the US, 3% in Japan and zero in the eurozone. The BoE has been the most active here of all the major central banks. The BoE now holds 15% of the gilt market as at end-June and 50% of the outstanding issuance. The BoE aims to provide a broad monetary stimulus that eventually aims to get the economy moving, lift asset prices and expand bank lending. The evidence on the last score is mixed, with UK broad money growth expanding by 3.7% in Q2 compared to an average 8% pre-financial crisis. The banks though are alleged to be profiteering as the difference between interest rates that banks charge and rate at which they borrow is the widest since the BoE started collecting data on this 15 years ago. Overdraft rates are at an all-time high of 18.97% (click here). The Daily Telegraph this morning also carries a scare story on sterling and 1.40 is mentioned as a possible target in the rate aginst the dollar (click here).

As far as the Federal Open Market Committee(FOMC) is concerned, the markets expect no change in the Fed funds rate (0.0-0.25%) but look for guidance on what the Fed terms its credit-easing policies. If it decides to announce a halt to its purchases of US Treasuries, the dollar could strengthen. But I think there is a good case for keeping their policy options open. Consumer credit growth in the US is now negative as is commercial and industrial loan growth. Velocity of circulation (nominal GDP/M2) is still trending down. The adjusted monetary base has peaked after strong growth. For charts on all of this, I suggest you look at the latest issue of Monetary Trends produced by the Federal Reserve Bank of St Louis (click here).

Finally, I note that Asian stockmarkets were down again overnight and the mood amongst investors is cautious. Stockmarkets look fragile and some further pullback could continue in the near term. Keep watching China. Some commentators claim there is a ‘Panda Put’ (similar to the ‘Greenspan Put’) to keep the market afloat until the 60th anniversary of the revolution on 1 October. The authorities have a job on their hands in my view and the cracks in a very over-valued market are starting to show.

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The latest RICS housing survey for July contained a number of positive features for the housing market though the survey did highlight supply constraints (click here to see the report and here for an analysis). The main points of the report were as follows:

1. buyer enquiries continue to grow strongly
2. the new instructions net balance edges into positive territory for the first time in more than two years
3. price expectations improved a little further
4. newly agreed sales are at their highest level since August 1999.

There was also a marginally positive report from the British Retail Consortium which reported an increase of 1.8% in like-for-like sales for July, slightly stronger than June but sales seem very dependent on clearance discounts (click here).

Sterling dipped yesterday against the US dollar and tested the 100-day moving average at 1.6430. This morning, sterling is hovering around this area. I mentioned in my blog yesterday that Goldman is warning of a pullback in sterling and on my chart, the next level of short-term support is around 1.6300. If this level goes it could get messy.

Otherwise, overnight the Bank of Japan kept interest rates unchanged and a slew of economic data out of China highlighted a 23% drop in exports. I am not a great believer in the thesis that China (or any of the BRICs/emerging markets) can independently act as a locomotive for the global economy. The decoupling story proved erroneous as the global economy was hit by a credit crunch and trade shock which was global in nature and resulted in a synchronised downturn in the world economy. Although we need to monitor carefully developments in the Chinese economy given China's important impact on commodity prices.

I noticed that volumes in the US equity markets yesterday were at their lowest so far this year. Low volumes always make for volatile markets so I am getting cautious. I came across this interesting chart which compares the stockmarket recoveries of 1929 with the recoveries from the 1970s oil crisis and the 2002 dotcom crash as well as the current situation.The S&P lows in 1974 and 2002 marked the beginning of a sustained market recovery though the Dow low in 1929 failed 11 months later. The current recovery in the S&P index has outperformed the 1974 and 2002 rebounds over the equivalent period. What's next I wonder? (Click here for the chart.)

Tomorrow evening sees the FOMC announce its latest monetary policy decisions. No change in interest rates is expected but there is the possibility that the FOMC announces a halt to its buying of US Treasuries (click here). If they do this, bond yields and mortgage rates could edge higher with potentially adverse consequences on the US economy. I think the FOMC have to keep their options open.

Finally, for those of you who are interested in the latest academic developments in exchange rate theory, I recommend clicking here. Also worth reading is "On Global Currencies" by Professor Frankel at Harvard University. He believes that the new areas of debate for all of us in the FX market will be G20, the IMF, SDR, credit cycle reserves, intermediate exchange rate regimes, commodity currencies and a multiple international currency system. It's farewell to Bretton Woods 2 (click here).

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Overnight, Asian stocks generally moved higher following on from the ‘positive’ reaction to the US jobs report on Friday. The latest news out of Japan also contributed towards sentiment after a 9.7% gain was reported in core machinery goods orders (a key indicator of capital spending). However, a note of caution: Looking at the data for all of the second quarter is more revealing and shows that machinery goods orders fell by 4.9%, which was the fifth consecutive negative quarter. In addition, the official outlook for the third quarter is also negative and the expectation is for a drop of 8.6%. The most recent Tankan survey of Japanese corporates highlighted weak capital spending plans and it is worth noting that typically a recovery in capital spending in Japan lags a recovery in exports by two to three quarters.

However, last week did see the S&P index move above the 1,000 level, its highest level since November and its fourth consecutive week of recovery. Abbey Cohen, the famous equity bull at Goldman, sees 1,100 in the index by year-end. Emerging equity markets under-performed developed equity markets for the first time since May and the Chinese Shanghai Composite Index had its worst performance in five weeks. It is worth noting that Asian stocks are now at a 35% premium to its 200-day moving average for the first time since mid-1999. Some of the emerging market equity performance year -to-date has been massive (up 50% on the MSCI index) and I am starting to wonder whether markets are due a correction. Hence, a note of caution here. Liam Halligan takes a different view and notes that the MSCI Emerging Market equity index is now above pre-Lehman levels, while both the FTSE 100 and S&P index are some 20% shy of their pre-Lehman levels. He also notes that emerging market credit default swaps fell below that of the developed economies for the first time last week (click here for more on this).

Commodity prices moved to their highest levels this year with sugar at a 28-year peak, but the Baltic Dry Index (normally correlated with base metals and Chinese commodity demand) started to break down through key technical levels. The US dollar last week was at its weakest since October but staged a sharp rally last Friday after the US jobs report. Sterling was knocked by the Bank of England's (BoE) surprise announcement on quantitative easing (QE). For a chart of investment performance across the various asset classes, click here.

As far as the UK weekend press was concerned, most of the focus was on the BoE's decision last Thursday to expand its QE programme. David Smith in The Sunday Times (click here) shares my puzzlement over the confusing signals sent out by the markets at the last two MPC meetings. David thinks the BoE may have increased QE as a way of softening sterling. Sterling has moved up impressively both on a trade-weighted basis (up 15%) and against the US dollar (nearly 25%). David may have a point, but it worries me if the BoE is indulging in ‘covert’ FX intervention. The BoE does not have a good track record here.

Anyway, The Sunday Times also reported that the BoE is set to downgrade its UK growth forecast and warn about debt deflation in Wednesday's Inflation Report. Maybe this is the real reason for the BoE's decision to expand QE. Sushil Wadwhani, a former MPC member, is also warning that once the inventory rebuild is out of the way, 2010 could see a setback in the UK economy. I see the Conservative opposition are looking to increase the VAT rate to 20% (a move that I am sympathetic to, incidentally) but the prospect of higher taxes will do little to revive consumer spending.

I also was interested in Crispin Odey's interview in Forbes magazine in which he expresses concern over the UK's fiscal position and warns of a return of inflation. You might want to see what the IMF has to say on budget deficits and debt levels and I recommend their latest report on the fiscal position (click here). It makes for grim reading by the way. In spite of that, Crispin believes the UK equity market is the cheapest around and is bullish on bank stocks and growth stocks (click here). However, today's Guardian reports though that bad debts at the UK banks reached £85 billion since the onset of the credit crunch. Lloyds has bad debts of £28 billion and may have to raise capital of £15-16 billion (click here).

Looking at Friday's US jobs numbers, again the market wants to hear ‘good news’ and ignores the underlying message (click here for an analysis). The fact is that a bounce in auto production (‘cash for clunkers’) and distortions from federal census workers added 100k to non-farm payrolls and would have meant that the actual outcome for the month would have been closer to the consensus forecast of a 325k decline. Likewise, the minor drop in the unemployment rate is down to a decline in the labour force and suggests that people have stopped looking for work. These are not bullish signals and interest rate futures that are now discounting a 25bps Fed rate hike for January next year looks overdone. The fact is that ‘better’ economic news is down to a rebuild of inventories, an increase in auto output (look for ‘good’ US industrial production figures this week) and temporary fiscal measures which are now fading. It will be interesting to see what the FOMC decides on Wednesday and I have seen US press reports that the Fed will announce a wind-down of its Treasury-buying programme. We shall see.

Finally, I said I would review the technical FX charts this morning. Looking at the sterling/dollar exchange rate the pullback from my previous 1.70 target can find support at the 100-day moving average which stands at 1.6431. Goldman's technical people have made a point about the coincidence of cable at 1.70 and the S&P at 1,000 on previous occasions, suggesting that this is an inflection point and that cable could correct quite sharply. The 200-day moving average is at 1.5193. I think this would demand a further recovery in the dollar as well as slippage in sterling.

I mentioned last week growing official concerns about dollar weakness and the risk of intervention. This is still on the agenda in my view ahead of the G7 meeting in September. So again a note of caution. The answer might lie in what happens to equities and investors’ appetite for risk. I mentioned above that emerging market equities have had a very good run so far. Last week saw some crumbling at the edges. Watch China, as I think the Shanghai Comp is a good lead indicator. Further weakness might dent sterling (as a global barometer of risk) and help the dollar (as the safe-haven).

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It's all eyes on today's US jobs data. The consensus forecast in the market is for a monthly decline of around 250-300 thousand in non-farm payroll employment. To be honest, trying to accurately forecast these numbers is at best an informed guess. The market would obviously like a 'good' number thus maintaining the recent investment theme of a rally in equities and other risky assets.

The S&P index is at 1,000 with many technical analysts focusing on short-term technical resistance at 1,040-1,060.

Chinese monetary policy developments are something I am keeping an eye on. Overnight news of further curbs on bank lending unsettled the Chinese equity market.

My view on the US jobs report is that it is likely to again report downward pressure on wages growth (not good for consumer spending) and near record lows for hours worked. The markets ignored all of this in last month's jobs report preferring to focus on the 'headline' news spin.

As far as Fed policy is concerned, I think the Fed has no option but to maintain an accomodative monetary policy. Mr Bernanke, the Fed chairman, has publicly acknowledged the likelihood of little relief in the unemployment rate. Indeed, there is the possibility that the Fed could increase its purchases of debt to keep a lid on bond yields and mortgage rates.

Certainly, the Bank of England (BoE) surprised everyone with its quantitative easing announcement yesterday. Some economists think the BoE has to do a lot more. Others think that the BoE is pursuing a mistaken and ineffective policy. I think that the restructuring of banks' balance sheets still has further to run and that lending will take time to properly recover. With the economic recovery in the major economies at the moment largely a function of the rebuild in inventories, there is a risk that without support from the consumer, the 'recovery' could be a one/two quarter event.

Where does this leave markets? I still favour long equity positions for now as the central banks seem unwilling to exit their current stance just yet. China does worry me and that is something to be alert to. In the currency market, sterling fell back from my 1.70 target to 1.67 on the BoE's surprise announcement yesterday. But the pullback has not been excessive so far and I find this encouraging. Obviously, we need to see the market's reaction to this afternoon's US jobs data before deciding that sterling's pullback offers a buying opportunity. In Monday's blog, I will review the technical charts for guidance on any buying opportunities.

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The Bank of England (BoE) and the European Central Bank (ECB) announce the result of their regular policy meetings today (noon and 12.45 respectively).

The BoE is more interesting as the markets are unsure whether they will expand their quantitative easing (QE) programme or simply pause. If they do expand QE, the market is expecting an increase of GBP25 billion. Recent UK economic data has been better-than-expected with house prices, retail sales, and PMI surveys edging higher. From the BoE's point of view, the UK economic 'glass' seems to look half full rather than half empty. In addition, as I highlighted in my blog at the time of the last MPC meeting, there is a serious debate as to just how effective QE has actually been and economists like Prof. Willem Buiter have been critical about the BoE's policy. The intended aim of trying to revive bank lending to households and non-financial businesses has little actual evidence to show it is working. Whether the BoE do anything today is a close call in my view but I think it is fair to say judging from the rhetoric from the BoE that they have basically done what they wanted to do on QE.

Looking forward, I think it likely they will want to 'normalise' policy and revert back to conventional monetary policy i.e., use interest rates as the main tool of policy.

As far as the ECB is concerned, the markets expect no change in their overall stance. However, there will be a lot of interest in any comment that Mr Trichet might have on the euro and its recent gains against the dollar. Previously, when asked about the currency, he has said that he notes America's preference for a strong dollar. Given that the dollar is on the ropes at the moment, I think Mr Trichet has to come up with something a bit different (and more convincing!).

Separately, equity markets are a little mixed in front of today's interest rate decisions and tomorrow's key US jobs data. Worth noting is that Goldman's economics team revised up its US economic growth forecasts yesterday though it still expects a high unemployment rate. The market expects the rate of decline in non-farm payroll employment to continue easing. However, I remain concerned that wage growth continues to decline and that hours worked are at a record low. Unemployment is likely to remain high for a while yet and a 'jobless' recovery is the most likely scenario for 2010.

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The recent weakness in the US dollar looks as though it is starting to cause some concern. Overnight, there was 'verbal' intervention from the Canadian finance minister who is now worrying about the impact of appreciation in the Canadian dollar on the domestic economy. Such concern is not new. Many Asian central banks have been physically intervening for some time in order to curtail appreciation in their currencies which is not surprising given the high dependency of their economies on exports. Japan has also previously expressed concern about strength in the yen especially when USDJPY starts moving to the 90 level (the rate is about 95 currently). Japan still has a problem with deflation and, if anything, recent CPI data shows that deflationary problems are worsening so the 'pain threshold' for the Japanese authorities is worsening.

China has a 'crawling peg' system for its currency although in the past three years, there has been persistent upward pressure on the CNY which is mainly a reflection of the large Chinese trade surplus. Of course, China's exchange rate policy is, and has been a political 'hot potato' in terms of dialogue between the US and China with the Americans, on occasion, urging further CNY appreciation and threatening trade sanctions at time. Indeed, given that China is America's main creditor, the USDCNY relationship (and capital flows between China and the US especially into US debt markets) is central to the working of the international monetary system.

Incidentally, I recommend the latest publication from The Institute of International Economics entitled "The Future of China's Exchange Rate Policy". This is required reading for anyone interested in this issue (and I know there are a fair number of our clients who have business relationships in China) and you should visit the website here. In addition, for other interesting weblinks on a variety of interesting Chinese economic issues, I recommend clicking here.

In Europe, the Swiss have physically intervened (against the euro) to try and stop the Swiss franc going up. Like Japan, Switzerland has a deflation problem and this suggests that both Japan and Switzerland will not be raising interest rates for some time, thus making the yen and Swiss franc very attractive as funding currencies. With the euro advancing against the dollar, it will be interesting to see what Mr Trichet has to say on this at tomorrow's ECB meeting.

Sterling has virtually already reached my 1.70 target against the dollar but I don't see the Bank of England intervening here. The ERM fiasco left too many scars in terms of FX intervention. This has got to be helpful for sterling, so I would expect the underlying trend in sterling to move gradually upwards over the medium term. Nevertheless, the FX market will become increasingly alert to the risk of joint intervention to stop the dollar weakening.

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Yesterday's economic data showed more evidence of a rebound in global manufacturing activity. That rebound has been impressive and the US ISM index, which is a good guide to movements in US industrial production, reported a significant jump for July especially in new orders and prices paid. Similar improvements have been reported in surveys of manufacturing in the UK, eurozone and Asian economies.

Better economic data inevitably begs the question, is the recession over? Policymakers will certainly hope so as will many investors. From my perspective, the data suggests that the recession is over particularly in terms of the fact that manufacturing output has reached a low point and is now turning up, admittedly from low levels. My guess is that bodies like the NBER, whose job it is to identify peaks and troughs in the US business cycle, will say that the recession hit its low point in June this year. Of course, this has not been a normal recession so it won't be a normal recovery.

Consumer spending which accounts for 60-65 per cent of GDP in most of the major economies remains sluggish. The Fed itself acknowledges headwinds here especially from unemployment. If the recession is over then the debate amongst market participants will be about the nature of the recovery. At the moment, it looks as though it will be sluggish with GDP growth remaining below trend throughout 2010. If anything, it will be growth in the emerging market economies that outpaces that in the developed economies.

In the financial markets, it has long been the consensus view that 'the worst is over'. The next phase in market thinking is certainly that 'the recession is over'. This is reflected in the S&P index moving above 1000 for the first time since November. The copper price (a barometer of industrial demand) is at a ten month high and the oil price is back above $70.

In the money markets, the TED spread (a measure of lending 'distress') is at its lowest in two years. Banks earnings and profits (HSBC, Barclays) are beating estimates and are contributing to the ongoing recovery in risky assets. Interestingly, the US dollar is failing to benefit from good US data and I think this stems from a view that the Fed will be slow to raise interest rates preferring to first unwind its quantitative easing (QE) programme. In addition, real interest rates in the US are still negative at the shorter end of the curve. Historically, the dollar has only bottomed and then recovered when real rates are positive and rising. The dollar can only recover if Mr Bernanke, chairman of the Fed, changes tack and signals that a rate hike is on the cards. Investors should be alert to this.

When business cycles move into an upswing then so do interest rate cycles. This cycle will be different because of the 'credit crunch' and the impairment to the monetary transmission mechanism arising from the shocks to the banks' balance sheets. Nevertheless, investors have to be alert to a sea-change in interest rate dynamics from now on. Rather than trying to predict lower rates and/or an extension to QE, the theme in the money markets will be who is set to end QE and/or raise interest rates.

Overnight, the RBA kept interest rates on hold at 3.0 percent but importantly removed its 'easing bias'. I am not saying that short-term interest rates are about to go up rapidly (so equities should not take fright) but yield curves should certainly flatten. In the FX market, sterling is doing well and I think the Bank of England could be amongst the first to tighten monetary policy. Sterling has been 'undervalued' for some time. Gains in sterling in recent months have removed some of that undervaluation. Against the US dollar, my guess is that 1.65-1.70 is approximate fair value but don't be surprised if sterling 'overshoots' and surprises on the upside.

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This week's main focus is on the European Central Bank (ECB) and the Bank of England (BoE)'s policy decisions at their regularly scheduled meetings this Thursday. As far as the ECB is concerned, the markets are expecting few surprises and they expect Mr Trichet both to keep interest rates unchanged and generally to keep his options open. Eurozone banks, especially Irish and Greek, have been the biggest users of the ECB's very generous one-year liquidity offerings which probably tells you a lot about the trouble they are in. However, there is some evidence that credit conditions in the eurozone are easing which no doubt Mr Trichet will allude to. In spite of evidence of a fairly impressive rebound in global manufacturing activity in recent months, Mr Trichet might be concerned about the strength of the euro on Eurozone export performance. The last thing he needs at this juncture is a break -out in the euro/dollar exchange rate that takes the euro back up to 1.50. There is a risk of this happening as the US dollar is still very much on the ropes. The silence from the US Treasury is deafening. I am not convinced, nor are the markets, that the US Administration really believe in a strong dollar.

As far as the BoE is concerned, things are more interesting. While no change in interest rates is expected, there is much more focus on what the Bank intends to do on quantitative easing (QE). Will the BoE continue to pause or will it keep itsoptions open and look to expand its programme in the months ahead? Well, conditions in the corporate credit market have certainly eased and recent data on retail sales and the housing market have been ‘better-than-expected’. There are those who want the BoE to do more, as was reported in David Smith's column in the Sunday Times yesterday (click here). My guess is that the BoE will not definitively signal an end to QE. However, from a market point of view, there is a rising probability that the BoE might be the first of the major central banks to do so and increasing ‘hawkishness’ can easily manifest itself in market expectations of rising UK interest rates at some stage over the next 12 months.

All of this can underpin sterling and as I have said in previous blogs, a move to 1.70 on the sterling/dollar exchange rate couldn't be ruled out. Well, the pound is getting closer to that target and is shrugging off any bad news related to budget deficits etc.

While the last week or so has been pretty dreary in terms of price action (excepting Chinese equities last Wednesday), the month of July racked up further gains keeping up the bullish momentum. All the main global equity indices reached new highs for the year and the Chinese equity market quickly recovered its losses. The S&P index is closing in on the 1,000 level, closer to the 1,050 target I have mentioned previously. The S&P index has posted its fifth consecutive monthly gain and its 200-day moving average (regarded as an indicator of primary direction) moved up for the first time since January 2008. The bulk of Q2 earnings are now through and 71% of US companies came in with ‘better-than-expected’ earnings making for one of the best quarterly readings in the last ten years. This looks like a cyclical bull market according to the influential equity researcher Ned Davis, as his indicators don't yet pronounce this as a secular bull market (click here). For those of you not so bullish, you might be interested in seeing this chart (click here) which overlays stockmarket performance with what happened in 1929!

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