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This is the last blog entry for 2009. I have written a light-hearted tale for your entertainment over the holiday season. We will be returning to a normal service on Monday 4th January. All of us at ECU would like to wish our readers all the best for the season and look forward to greater prosperity in the New Year.

Please click here to read a new take on Goldilocks.

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Good Morning. If you are hiding from the weather and enjoy a bit of scary analysis, here’s a link to the latest Bank of England Financial Stability Report (click here). I may settle down with a glass of wine later and read through it properly but here are three snippets. Firstly, from page 8: ‘Over the next five years, UK banks also need to refinance over £1trn of wholesale funding’. That’s in addition to the need to improve the health of the balance sheets to make them safer. Secondly, from page 39 on the subject of restrictions on leverage: ‘Meeting a 20 times leverage target solely through assets would require a reduction of almost £1.5trn. While some of this could be achieved through a reduction in non-core trading assets, reductions in domestic lending on anything like that scale could have a negative effect on the speed of recovery’. Finally, there is a chart on page 20 of cross-border capital flows and bank lending which shows the dramatic repatriation of bank lending from non-G20 countries to the G20 in late 2008. This is what (almost) killed the British banks which had relied heavily on deposits from non-G20 banks to fund their balance sheets and their lending. The UK suffered disproportionately from this withdrawal because of the size and location of the UK banks and this was a major driver of sterling’s decline in 2008.  

If all that’s a bit heavy for the Friday before Christmas, here’s a very quick run-down. The Bank of Japan left rates unchanged but said they would not tolerate falling CPI. It’s a bizarre statement because the CPI is falling. Surely it implies more monetary accommodation in 2010. The yen is the second weakest G10 currency this year (up half a percent against the US dollar, down 25% against the Australian dollar). I reckon it will drop to bottom in 2010.

The UK has seen a revision to Q3 business investment data – from -3% to -0.6% – that implies an upward revision to the GDP figures next week (from -0.3% to -0.1% or flat). This will please the Goldman Sachs economics team no end since they poured scorn on the initial GDP release. I wonder where that figure will eventually end up? We also got a less awful public sector net borrowing figure for November of ‘only’ £20.3bn. £23bn had been predicted. It is still awful. Bank lending data was sluggish. In Europe, the German Ifo business confidence index came in at 94.5, a bit better than expected and its best level since August 2008. There is no US news for release but some post-close earnings results came in better than expected and that sets up for a stronger S&P open this afternoon. The end of year equity rally may get itself back on track. That may, in turn, bring the dollar’s short-squeeze to an end as well. Last year, the squeeze was the other way around and EURUSD rose from 1.24 in late November to a high of 1.4720 on 18 December. It reversed the entire move in early 2009.

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Two days, two data points on the UK economy and two totally different stories. UK unemployment data yesterday (for November) were remarkably resilient. November retail sales released this morning were very soft. It’s yet another reminder that placing too much emphasis on a single month’s data can be very misleading.

So, what to make of the data? Starting with retail sales, where all the anecdotal evidence tells us there is a recovery underway. Retail sales volumes fell 0.3% in November after a 0.6% increase in October, with household goods stores and food retailers showing positive numbers, others soft. The year-over-year increase slowed slightly to 3.1%, though a 3% volume increase is OK. My favoured way of looking at these figures is to look at the three-month average of the year-over-year trend to get a smoother picture. That is at 3.2%, its strongest level since June 2008. It is worth adding that Christmas spending patterns have changed dramatically in recent years, so the seasonal adjustment process is a shambles. Once upon a time, we went shopping before Christmas, buying food from supermarkets and gifts from department stores and then we went out again and took advantage of the post-Christmas Sales. Now we buy gifts at food stores (for less money), go to sales in October and spend increasing amounts of our money online. And we are not averse to waiting until the last minute before we buy anything. So we really have to look at November/December/January sales as a whole before we know how the spending season shapes up. But that three-month trend probably tells a reasonably accurate picture – getting better, but not back to the heady levels of 2007.

As for the employment data, November saw a 6,300 fall in claims for unemployment benefit, a second monthly decline which keeps the claimant unemployment rate at 5%. The ILO unemployment measure (more realistic) stayed at 7.9% and appears to be peaking, while average earnings (including bonuses) picked up to 1.5% from 1.2%. The FT carries a good analysis (click here). The downside of the data is that employment is holding up in part because more people are working part-time and that will obviously slow the pace of any employment recovery. However, it fits with an underlying story of recovering demand and recovering corporate profits. This is helping employment and will provide some help to support income and therefore spending in the first half of next year – before tax increases and spending cuts probably cause the recovery to lose momentum around the middle of the year.

The main story last night was the US FOMC meeting. I wrote about it yesterday and again, the FT carries a good article (click here). In a nutshell, the Fed upgraded its assessment of the economic outlook but left its very accommodative policy language intact – rates are still set to stay at exceptionally low levels for an extended period. Treasury yields dipped as a result given the prospect of rates staying low, but the dollar has continued to rally. This adds further support to the view that the dollar’s current rally is less about ‘fundamentals’ than year-end positioning. Shorting the dollar was a very popular trade this year and even with this bounce, it remains the weakest of the major currencies. Now we are seeing thin markets and positions being squeezed out. There really isn’t very much science about how far the move could go as people are forced out, but I don’t think it changes anything at a fundamental level – reflation is the core US policy to get the economy moving and that policy will continue to undermine the dollar in 2010.

Finally, Standard & Poors, the rating agency which put Greece’s A- rating on CreditWatch negative a week ago duly downgraded it to BBB+ last night. So much for considered action. This keeps sovereign creditworthiness in the spotlight but to my mind it further erodes what little credibility the rating agencies have left.

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Good morning. Today’s main event is the announcement of the latest interest rate policy decision by the US Federal Reserve’s Open Market Committee this evening (19:15 GMT). I have to confess I have not been focused on this until very recently, taking it for granted that rates will be left on hold and that the accompanying statement, while slightly more upbeat on the economic outlook in line with recent comments, would make it clear that rates are on hold at low levels for a long time. But there has been speculation that the Fed would ‘tighten up’ its language a little as it starts to point the way towards an exit strategy in the light of recent strong data. It has been suggested that this is one factor behind the dollar’s recent rise and the sell-off in the Treasury market which has moved almost 40bp since the end of November.

The best of the so-called ‘Fed-watchers’ in the press is the FT’s Krishna Guha (in my opinion anyway). His latest thoughts on how the Fed will navigate exiting the various policy measures they have put in place are worth reading (click here). My own thoughts can be summarised as follows: The FOMC will continue to err on the side of tightening later rather than earlier because, despite yesterday’s producer price inflation data, they have no concerns about inflation and because the current reflationary policy, which weakened the dollar and boosted asset prices, is a deliberate policy and one which is working. They will, however, ever-so-slowly step away from the unconventional measures they took, always watching the impact on the Treasury market. I cannot believe that the current 3.58% 10-year Note yield, for example, causes much lost sleep but they will want the path back to yield levels above 4% (where we will spend most of 2010) to be very gradual. I also agree with Mr Guha’s conclusion that the Fed doesn’t know where rates are heading in the long term. The impact of the credit crisis on the balance sheet of the Fed and the US government and on the borrowing behaviour of the US publicis so huge that a return to the traditional neutral policy rate close to 5% may be totally inappropriate for years to come.

We will see what the FOMC announces. What is certain is that the Fed target rate is not moving. How markets react is even less clear. To the extent that speculation of tougher language has driven recent moves, the dollar may be a little vulnerable and stocks (and gold) may get a boost.

Winding back to yesterday’s news: The UK saw consumer price inflation edge up to 1.9%, a little above expectations. German investors’ economic sentiment dipped slightly according to the ZEW index. And in the US producer prices rose 1.8%, far higher than the 0.8% expected as gasoline prices jumped. Excluding food and energy, the increase was 0.5%. That was followed by a sharp drop in the December Empire State manufacturing index to 2.55 from 23.51, and a jump in November industrial production, up 0.8%. This output jump is yet another important input into the fourth quarter GDP data which increasingly looks like coming in at a rate in excess of 4%. And that puts the battle lines in currency markets clearly in place: stronger data in the US than expected, and stronger than elsewhere, support further dollar strength. The Fed and the US Administration more widely will do nothing to encourage the currency to appreciate. Medium term I remain nervous of the dollar, whose downtrend remains in place. But if it does dip back tonight I suspect that it will only be a temporary move.

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Good morning. There is almost a week to go until the shortest day of the year yet yesterday was the longest I can remember for a while, with minimal volumes in markets and not much to report on. Today, however, has a new theme coming to the fore – euro weakness as concerns about sovereign creditworthiness are compounded by worries about the Austrian banking system. Yesterday, the ECB ordered Austria to nationalise the Kartner Hypo Group as a result of losses in Eastern Europe (click here). The fear is of whether other banks have also suffered losses. The focus today is on OeVAG bank, with talk (and it is only talk, I stress) of losses up to €20bn, with Die Presse running the story in German last night (click here). An English summary from an investor blog is also worth a read (click here).

On quiet days, this is the kind of story which can easily have a magnified impact and just as fears about Dubai fade somewhat, the last thing the market needs is to find a fresh source of worry in the European banking system. These banks are not of themselves a huge threat to Austria’s finances but there will naturally be fears about the wider potential for Eastern European losses among European banks and this will just add to concerns about the final extent of the bail-out burden for European countries. 

Three conclusions are easy to draw. The first is that corporate credit quality trends are looking better than sovereign credit quality because there has been such a huge transfer of debt from the private to the public sector. Secondly, Eastern Europe will remain a drag on European growth prospects for a while and we can expect relative growth forecasts for the eurozone and the US to diverge (I have already received a lot of upward revisions to Q4 GDP forecasts in the US after the trade, inventory and retail sales data for November). And finally, all of this will add to a rapidly growing feeling that even if risk appetite is returning, in general that may not undermine the dollar between now and year’s end. Sentiment surrounding the euro could get pretty bearish in the coming days. Now that British Airways have ensured that I will not, after all, be heading out of the country after Christmas, I shall be watching to see if we get an exaggerated downside move in EURUSD and even EURGBP.  

Other ‘bits’ today: The UK sees the release of November CPI data shortly, the market expecting a rise to 1.8% from 1.5%. The big jump comes when VAT goes up in January. Worries about Gilts remain to the fore. RICS report a further modest improvement in the housing market. The Europeans see the ZEW business sentiment survey in Germany (expected to dip to 50 from 51.8), and in the US we have November producer prices (expected to be up 0.8%) and industrial production (+0.5%). There’s a chance that the S&P index makes a new high for this move this afternoon, breaking above 1,120, and if that happens at the same time as the dollar rallies, those who think rising equity prices are always going to correlate with a weaker dollar may have to think again.

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Good Morning. British Airways cabin crews vote this morning on whether to take strike action. Since this will have a big impact on my post-Christmas travel plans, I am taking an interest as well as wondering if the UK can feel any more like the 1970s than it does this morning. Still with the BRC reporting a 13% increase in like-for-like sales in London I wonder whether blocking flights out of the country is actually a cunning ploy to make us all take the children to Toys ‘R’ Us on Boxing Day instead.

The big news this morning is the announcement that Abu Dhabi is providing $10bn in funding to bail out Dubai (click here for the FT comment). Those who believed that the entire Dubai debt rescheduling crisis was about geopolitics will see this latest twist as entirely supportive of that view. Abu Dhabi always had the means to bail out the Dubai government but it suited their purposes to flex their muscles and change the perception of what that support might mean. The first reaction this morning has been to view this as a crisis averted, and ‘risk friendly’ trades are benefiting. Equity indices are higher, credit markets have rallied and the US dollar is weaker.

Easing of concern about Dubai is a ‘good thing’ but it was always a special case. A property investment bubble with a very wealthy neighbour who could (can) bail it out in extremis. The bigger and more lasting story is about the scale of sovereign intervention to transfer debt from the private sector (owed to banks, mostly) to the public sector. Greece’s woes are back on the front page of the FT (click here) and the Sunday Times had an excellent piece on sovereign debt (click here). The question is, could this be the next leg of the crisis? The answer is that this crisis is defined by the shift of debt from private sector to public sector and its implications. The first conclusion is that sovereign debt is a riskier investment in many instances than private sector corporate debt now. For asset allocators, buying high-quality corporate bonds rather than Gilts or other government debt, makes sense. The second implication is that interest rates have to stay low because that is how governments keep the cost of servicing debt down. And the third conclusion is that reflation remains a centre-piece of policy. With governments saddled with so much debt, reflationary policies are vital to avoid the size of the debt growing in real terms. And on that front, I worry about the eurozone which looks – in economic terms – far more like Japan than the UK or US does.

I avoided writing about the bonus tax last week but here’s an excellent piece from the City AM paper (click here). There are a lot of overpaid people in the City who get paid because of the earning power of the franchise they work for. Just as there are a lot of premiership footballers who are overpaid. But when putting together a tax, it is important to figure out what you want to achieve. This particular tax seems to me to be a net drain on the overall tax take of the Treasury, which at a time when the country’s finances are a mess is an odd thing to aspire to. It doesn’t make any significant difference to the banks’ capital base so it achieves no economic purpose. All it does is satisfy the political urge to punish a group of people held in popular contempt.  

After a start to the week dominated by appetite for risk, I expect currency markets to be driven by relative interest rates again before the weekend. As a result, and after more strong retail sales data in the US on Friday, I am looking for the dollar to find some support and push higher against the Swiss franc, the euro and the yen. I also expect sterling to find some solid ground in due course. Other than central bank buying, there isn’t much to recommend government bonds, so Gilts may struggle, with yields rising as we focus on tomorrow’s inflation data.

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The UK press remains fixated with the pre-budget report (PBR). The FT observes that investors take fright at ‘fiscal fiction’ (click here), the Telegraph says Darling wanted a tougher report but Brown blocked him (click here). And the Times covers the Institute for Fiscal Studies (IFS) which has done the maths and worked out what it will take to get the country’s finances back on track (click here). The IFS analysis is independent and detailed. As for the rest, my problem is that this PBR was what Mr Darling says he will do if he is still Chancellor after the election. He probably won’t be and if he is, he will probably come up with a new plan anyway. However, the one asset class for which the penny is rapidly dropping is the Gilt market. Huge upcoming supply will only be digestible with the help of higher yields once the Bank of England stops quantitative easing. And fears about the UK’s triple-A rating just linger in the background. So no good news for Gilts.

As for sterling, its near-term fate will be determined by the pace of economic recovery. Friday morning always gives me the latest John Lewis sales figure (click here). Either John Lewis is doing much better than the rest of the High Street, or it’s alright to go on believing in Santa Claus. “The biggest week in its history” is the headline.

The UK Office of National Statistics (ONS) released the results of its survey of household wealth yesterday for the UK (click here). The US has long been looking at household balance sheets and the UK is finally following. The ONS survey tells us that private household net wealth totalled £9trillion in 2006/2008, which immediately exposes the flaw with the survey. I want to know how much wealth has been destroyed in 2008 and how long it will take to recoup. However, it is worth noting that 39% of wealth comes form housing – the same as from pensions. Boost house prices, boost wealth. That is why the current global policy of low rates and asset reflation can have a bigger impact on demand in the UK than in many other countries. So retail sales data are strong, though industrial output and employment data may lag.

Overnight news included comments from Moody’s that the UK and US triple-A ratings are not going to reviewed any time soon (click here for the Economist’s observations), a poor auction of 30-year US government bonds and a 19.2% annual increase in Chinese industrial output in November. The result is that government bond yields are a little higher and equity markets are stronger as well. The spreads on corporate bonds (i.e., not sovereigns), are at their tightest levels of the year also. UK PPI data are due for release this morning but the main focus will be on the US retail sales report for November. The consensus looks for a 0.6% increase which would take the annual increase back into positive territory at 0.9% as we unwind the 8.2% decline we saw in the fourth quarter of last year. US retail sales are a volatile, much-revised and therefore unpredictable indicator. Despite that, a strong figure would set the tone for the next few days, reinforcing the dollar-positive message that came from the employment report a week ago.

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To everyone except the City folk who were terrified about what Mr Darling would do to their bonuses, there were few surprises in the PBR though that hasn’t stopped it making the headlines in the papers. “Darling starts to tighten the screw” is the FT headline (click here). At the other extreme “Chancellor raises eyebrows” is the Sun’s read (click here) and more people read the Sun than the FT. Without getting into politics, I find the way this government makes tax and spending decisions ever more complex and somewhat baffling. This PBR has announced some tax increases and promises about spending cuts, but it was all just too complicated. Complicated tax systems are expensive to administer and easy to avoid, so they are inefficient at raising money. The size of the public sector is a political choice as is the extent of income/wealth re-distribution. But wherever you are on the political spectrum, collecting, spending and re-distributing the income should be done as simply and efficiently as possible. Anyway, the PBR does not bring forward or push back the threat to the UK’s triple-A rating, and doesn’t answer the key questions about public finances because those cannot be  answered until after the election.  

For markets, the implications are bad for Gilts (because we will be deluged with them in the coming years, and yields will rise sharply once the Bank of England stops buying them). For sterling it was neutral, but that seems a net positive to me if only because the pound has been sold so heavily in the run-up to the PBR. And because interest rate differentials are the biggest driver of currencies at the moment, the fact that the PBR is bad for Gilts and Gilt yields are rising relative to other markets, would seem to me to justify some sterling strength in the coming weeks.

There are two bigger global themes underway. The first is a growing fear about sovereign creditworthiness with the downgrade to Greece’s credit rating followed by a move from S&P to adjust Spain’s outlook from stable to negative as a result of deteriorating public finances. And this morning the ECB warned that the Baltic States risk being sucked into a second debt-fuelled crisis if governments fail to impose adequate austerity measures. This continues a steady stream of bad news we have heard since the Dubai World debt re-scheduling announcement. We are going to continue to hear bad news on this front. There have been several common components in the reaction to the debt crisis, but two of the biggest have been to cut interest rates and to shift private sector debt to the public sector. Both have helped private sector creditworthiness, at least for the stronger corporate borrowers. But they have damaged the creditworthiness of the countries which have done the ‘bailing-out’ and the low rates have probably pushed the peak in default rates further into the future. So the peak in defaults, in general, will be in 2010 rather than 2009. And relative to past cycles, the sovereign and quasi-sovereign default rates will be higher than for corporates.

The second theme is of risk reduction, of what the team at State Street Markets calls’ reflation fatigue’. Cross-border equity investment flows jumped this year to the highest levels in years. More recent data suggest they have fallen back to ‘average’ levels in recent weeks. That’s not risk aversion, it’s merely fatigue. Aversion has everyone running for cover and safe assets. Fatigue just sees widespread position-squaring. My read from this is that as long as the reasons for reflation are intact (low rates and the US acceptance of a weak dollar), we will see a rested market put positions back on perhaps before the end of the year. Australia came out with strong employment data overnight (the unemployment rate falling to 5.7%) and the Australian dollar may be set to start appreciating again.

Today’s UK MPC meeting is almost certainly a non-event and I doubt we will get much from the US trade data which are expected to show the deficit steady at $37bn.

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Did Friday’s strong US employment data ever happen? The dollar is soft (against the yen, mostly) and the US bond market is strong with yields edging lower on the back of soothing words from Fed Chairman Ben Bernanke who spoke to the Economic Club of Washington (click here). The New York Fed President Bill Dudley provided more of the same at the Columbia World Leaders Forum (click here). The bottom line is that the Fed remains extremely anxious to get across two messages. Firstly, while things are getting better, the economy is not out of the woods. And secondly, the Fed, guarding against complacency, intends to keep rates at very low levels for a very long time and does not intend to change the accommodative language it has been using.  

This is consistent with the position the Fed has been taking for some time. It is why the downtrend in the dollar is not over. It is why the bond market, while expensive, is not going to see a marked move to higher yields yet. And it is why equities and gold are still in clear uptrends. The bias to central bank policymaking is clear – if things get worse, they will pump more money in. If things get better, they will do nothing. Reflation continues in other words. The short-term question is how to balance this against the reality of improving economic conditions at a time when market positions will be jostled by year-end considerations. That is what makes me suspect that we will see a stronger dollar into year end as short positions are put under pressure. The only US economic news yesterday was a smaller than expected decline in consumer credit in October (a $3.5bn fall). Today we get more very minor data in the form of the IBD/ITT economic optimism index which is expected to be stronger.

In Japan overnight, the main news was a widely expected $81bn stimulus package that had been delayed since the end of last week. The general verdict is that it will help a bit but it does nothing to address structural problems including deflation. In the long run, the solution to that is an increased pace of quantitative easing but that’s another story. The yen was in any case benefitting from the softer US interest rate tone (click here for the FT comment).

In the UK, the main overnight news was a soft BRC retail sales report for November. It’s made most of the papers (for example, the Telegraph here). On a brighter note, Tesco was upbeat about sales and Manpower indicated the most positive hiring intentions for over a year. October industrial production data are due in at 9.30 with the market expecting a 0.4% increase and the CBI December Industrial Trends survey is out at 11am. But both are somewhat overshadowed by the Pre-Budget Report out tomorrow. The biggest threat to sterling is fear of the UK’s creditworthiness as the government struggles with the public finances.

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The world’s leaders are mostly focused on the Copenhagen climate change conference and the press is focused on the UK pre-budget report (PBR), bankers’ bonus-bashing and Tiger’s private life. A different question is pre-occupying me, however: what kind of a turn is the dollar making here?

The catalyst for the dollar bounce came with the US employment data for November released last Friday. The bare bones of the report show that the unemployment report fell back to 10% from 10.2%, and a mere 11,000 jobs were lost with significant upward revisions to past months. It was all much better than the forecasters had expected, though in fairness it merely reflects the improvement in the more forward-looking economic indicators in recent months. Employment is a lagging indicator. When animal spirits encourage people to spend more money, the first thing that happens is that inventory levels are reduced to meet the demand. Then, after a lag, output picks up. But initially, this is achieved through increased productivity. Only when the pick-up in demand is established does employment increase. However, in this cycle, employment matters because only when employment picks up can income growth recover. The handover from public sector to private sector driven growth is crucial, and in the US at least the private sector means the consumer more than anything else. So lagging or not, the payroll data matter.

To this extent, I think any step-change in employment trends is hugely significant. At a more mundane level, the dollar’s downtrend is so clear, the weight of speculative positions betting on its continuing so great and the end of the year so close, that these figures are enough for a significant correction into year end. There is a temptation to focus on caveats – this was only one month’s data, employment is still falling, the unemployment rate is still in double digits, the number of ‘under-employed’ people is so high that getting unemployment on a sustainable path will require monthly employment gains well in excess of the 120,000 or so typically needed. None of these matter in the short term. For the rest of this year, I am focused on consumer demand data. If November US retail sales – due for release on Friday – show a solid increase (better than 0.5%, net of revisions), that will be enough to give the dollar a positive month.

Current trends, as I wrote last week, still indicate positive payroll data in Q1 and a durable turn in unemployment in Q2. I see no reason to alter that view. We will need to watch forward-looking indicators in the New Year, as these are showing some signs of potentially turning lower, and I remain nervous that it is simply not in the US interest to see the dollar strengthen. So it is far too early to call a durable dollar turn. But that does not alter the risk of a spike now.

The UK PBR will be a topic of conversation all week. I really don’t foresee it telling us much we did not already know. The state of the UK’s public finances is horrific with a public sector net borrowing requirement in 2009/2010 of £175bn likely and 2010/2011 will, if anything, be slightly worse. Spending is up and tax receipts have been decimated by the recession. The measures announced in the PBR will, however, be entirely politically driven. A bit of banker-bashing, increased taxes on wealth in general and some promises of (unrealistic) savings in spending, will be married to assurances that now is not the time for a major fiscal tightening. The Gilts market won’t like the size of the future funding need but should not be surprised. Sterling has dipped this morning, but I don’t think that trend goes much further. Certainly, the industrial production data tomorrow (for October) are more important in terms of potentially confirming that the economy is turning a corner.

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Has the December calm finally descended? There really isn’t a lot of news out there. Markets yesterday started very brightly but ran into a brick wall with the release of the US non-manufacturing ISM survey. This survey has a lower profile than its counterpart in the manufacturing industry despite the service sector being significantly larger. It fell sharply to 48.7 from 50.6 in a surprise to a market which was looking for a further increase. The inference is that service sector output is falling again. Put the two ISM indices together and they suggest growth is running at a rate of 2% or so and concerns that the recovery is running out of momentum are in danger of returning.

The net effect of this one piece of data was to reverse an upward move in bond yields and a strong day for stocks and gold. The reaction owed something, surely, to the fact that today sees the release of the November payroll report, traditionally the most-watched indicator of economic activity in the month. A newswire headline reading ‘White House has seen signs unemployment rate to be announced tomorrow might tick upward’ added to nervousness. The ISM data point to softness which is at odds with the improving tone of weekly unemployment benefit claims, and the notion that someone at the White House had seen the data and was prepping us for a rise in the unemployment rate was enough to trigger a reaction. The data are released at 13:30 GMT, with the market looking for a 125,000 decline in employment as the improving trend continues. The unemployment rate is expected to be steady at 10.2% after jumping last week. Unemployment will go on rising until the monthly payroll figures turn around to register an increase of over 120,000, which is what it takes to mop up the average monthly increase in the labour force. On current trends, payrolls will turn positive in the first quarter and the unemployment rate will peak below 11% but above 10.5% just before the middle of the year.

Earlier yesterday, the ECB president Jean-Claude Trichet spoke about exit strategies and in particular what they plan to do with their exceptional long-term repo operations. The ECB is issuing a final one-year repo this month and instead of announcing that they will charge a fixed 1% rate for this liquidity, they have decided to index the rate to that charged on shorter-term repos in the year ahead. This will prevent a surge in demand for one-year money at 1% from banks who expect rates to creep higher in 2010, which makes sense. However, it does represent a first tiny step towards tighter monetary policy. That fits neatly into the notion that the ECB is temperamentally more hawkish than any other major central bank. Risk aversion after the US data stopped the euro’s advance, but it looks set to move higher between now and year’s end (click here for the FT story).

And finally, because it’s Friday: a US economist called Joel Waldfogel is in London pushing his latest book, ‘Scroogenomics: Why You Shouldn’t Buy Presents for the Holidays’. He gave a speech at the Royal Society for the Encouragement of Arts, Manufacturers and Commerce last night, telling people that we waste $25bn on Christmas presents each year. If you want to buy this tale of ‘Bah Humbug’ as a gift for someone, click here! Maybe this is the ideal present for Alistair Darling to send to the boards of the major UK banks. Personally, I think that in the interests of the global economic recovery it is our duty to get out there and have fun.

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Good Morning. It’s a slow day for news, with the financial press talking about City bonuses. The biggest market-moving story was the news that Bank of America (BoA) intends to repay $45bn in TARP funds to the US government in order to escape the heightened supervision that came with government rescue. Perhaps they have been casting an eye at the standoff between the board of RBS and the UK government. The significance of the BoA move is that they are in a position to be able to do it. This, surely, is a massive endorsement of the monetary policies we have seen in place for the last year. Zero rates and quantitative easing have created an ideal environment for investment banks to make money, and at the same time an excellent environment for them to raise new capital. That is a good thing for the return to health of the financial system. Markets responded enthusiastically overnight and S&P futures point to a move to a fresh high in US equity prices this afternoon, while gold moved up and the dollar and yen have weakened.

One piece of good news from the TARP repayment is that if it goes through the US Treasury will book a $3.6bn profit on its investment in BoA, which Tim Geithner, the Treasury Secretary, will doubtless be quick to emphasise (click here for the FT article).

This doesn’t mean all is well in the world of banking, however. The ability of banks to make money in the absence of super-low rates, steep yield curves and huge provision of cheap liquidity form the central banks must be seriously doubted. And the weakness of lending, which I wrote about yesterday, points to the underlying problems the banks face. That’s why bank equity prices are languishing after their jump earlier in the year and is also why investors remain nervous of bank debt. Banks are going to earn less and issue more capital in the years ahead, irrespective of how quickly they can exit state support.

The other overnight news was release of the US Federal Reserve’s Beige Book summary of regional economic trends. Getting a bit better, slowly, is probably a reasonable summary. Meanwhile, the Wall St Journal carried an article commenting on a speech by Brian Sack, the head of the markets group at the New York Fed, whose comments echo those of Bank of England Chief Economist Spencer Dale (click here). The official line from central banks is that rates are staying down and reflationary policies are in no way threatening bubbles. Behind the scenes, there are those who argue that when the world is a safe place again, the Fed and the Bank of England are going to have to either sell the assets they bought for quantitative easing pretty quickly or raise rates sharply. Right now that would be a good problem to have, because it will only be a relevant issue for policy-makers when the financial system and global economy are firmly entrenched in recovery. But it’s a reminder that there will be a day when bond yields are a good bit higher, and also a reminder that the weaker dollar trend is going to last a while yet, but is not going to last for ever.

The first central bank to talk about reversing exceptional policy measures will be the ECB. They meet today. I believe rates won’t be moved, but the press conference could be a delicate balance. Growth forecasts will be raised and there will be some observations about exiting exceptional policies, but these will be balanced against fears of causing fresh concerns about European banks, particular those in places like Greece where the market is nervous about sovereign credit quality. If I were Mr Trichet, I would try to say as little as possible in as long-winded manner as I could! But experience suggests he will struggle to avoid sounding hawkish, even if the terms of next week’s 1-year repo are left unchanged at 1%.

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The standout overnight market move is, yet again, the surge in the price of gold which breezed through $1,200/oz and is heading higher. We’ve flagged $2,000 as a target before. I’ll get back to that, but first a mention of the UK money supply figures which were released on Monday, a speech by Bank of England (BoE) Chief Economist Spencer Dale, and why quantitative easing (QE) is or isn’t working, depending on your point of view.

The BoE released detailed October money supply data on Monday. They don’t release a handy press release but a 185-page set of tables. However, the raw headlines were that M4 money supply increase by 1.6% and the 6-month annualised rate of growth increased to 7.9%, while M4 lending increased by 1% on the month. That looked OK, though the release on lending to individuals (click here) gives a taste of the make-up of the data. Overall lending to individuals increases by £0.3bn, an annual growth rate of 0.7%, and lending secured on dwellings (mortgages to you and me) increased by £0.9bn for annual growth of £0.8bn. That leaves a net repayment of £0.6bn in unsecured credit. Overall, this is very weak. Sure, we are seeing growth in loan approvals for home purchases but approvals haven’t yet turned into lending. The weakness in money supply growth is best seen, though, in a series called M4 excluding intermediate and other financial organisations. This strips out the distortion to the money supply data from the banking sector bail-out and provides what the BoE describes as ‘an economically more relevant measure of M4’. This measure saw M4 fall by 0.7%, and fell at an annual rate of 5.3% in the last three months. M4 lending on this basis also fell at an annual rate of 3.4% in the three months to October.

It’s all long-winded, but the conclusion is simple. Banks still aren’t lending which prompts the conclusion that QE isn’t working. That’s not, however, the conclusion I would draw. QE is not causing banks to lend, but it is sending gilt yields down (as the BoE buys gilts) and, as owners of gilts are pushed into other assets, it is driving those asset prices (corporate bonds, equities, houses and yes, gold) up. And finally, of course, it has been a major factor driving sterling lower since it was introduced. These are all good things. Tighter credit spreads make it easier for large corporates to fund themselves; an M&A revival is underway; and I for one, am delighted that the value of my house is going up, just as long as the idea of taxing houses (LibDem) or imposing more capital gains tax on housing (Adam Posen) doesn’t catch on.  

The challenge for the MPC however, is what to do as asset prices rise courtesy of QE, but the banking sector still isn’t lending to the wider economy. That is the backdrop to Spencer Dale’s speech this morning (click here). The MPC is going to be increasingly caught between worrying about rising asset prices and needing to keep their foot on the pedal of QE until the banks are in a position to resume lending. How will they respond? Whether QE gets extended or not is very much in the balance, but a rapid reversal is inconceivable at this stage. The MPC will err on the side of getting the economy growing because inflation is not a threat (this winter’s spike notwithstanding). However, what Dale’s speech highlights to me is that the rise in asset prices is going to cause more concern to the MPC than it will to the Federal Reserve. That reflects the importance of the housing market to the UK economy both in terms of a potential bubble and in terms of its ability to drive consumer confidence. I think this is a positive for sterling relative to the dollar as the QE debate rages on.

What has this got to do with gold? QE is part of a reflationary strategy that has driven asset prices higher as I have written before. But as equity and other asset prices rise, and as QE struggles to have real underlying economic impact, more and more people will turn towards hard assets like gold.

Other market themes today will include the Beige Book from the US Federal Reserve, and the ADP employment survey which will be looked at as an indicator of the payroll report on Friday. The S&P almost made it to a new high yesterday and whether it does succeed to do so today or not, the December theme of asset allocation towards equities seems intact to me. If only because bond markets suffer from low yields and corporate bonds now have very tight spreads. I’ve attached a link to an article in today’s FT which highlights just how far the credit market has gone in bringing back some of more creative featuresof bonds that we last saw in the go-go days before the crash (click here).

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December has started with a further 25bp rate hike in Australia (to 3.75%, with indications that we will now see a pause). HSBC released its Chinese manufacturing PMI index which rose further to 55.4. The Bank of Japan (BoJ) held an emergency policy meeting that left rates on hold at 0.1% and put in place a new three-month lending programme for the banks, but failed to increase outright purchases of government debt (quantitative easing). In Europe, we saw some solid economic data as manufacturing surveys were revised up in France, Germany and Italy, unemployment fell in Germany and house prices rose in the UK (according to Nationwide, click here). The UK also saw the November CIPS manufacturing index dip back to 51.8 from 53.4, which was disappointing but remains in positive territory. Later today, we will get the US ISM manufacturing index for November. This is the first major economic data for the month and yesterday’s Chicago regional index rose sharply, so that market expectations of a slight dip in the national index from 55.7 may be insufficiently optimistic. We will also get auto sales data and data on last week’s store sales.

The data all paint a familiar picture of patchy economic recovery. They don’t answer questions about the durability of that recovery as fiscal stimulus runs out of steam next year. However, I don’t really think that any of this is what will drive markets today or this week. We are now into December and the battle is between how investors start positioning for January and the pressure on speculators to cease trading ahead of year-end. I suspect that the closing out of speculative positions was the big theme last week but the pressure to put money to work will be the theme for December.

The driving force behind markets is unchanged – very low interest rates in the US and across the G7. The 2-year US dollar swap rate fell 25bp in November and is sitting at 1%. The yield on 2-year treasuries is a paltry 0.67%, within a couple of basis points of the all-time lows reached in the heart of the financial crisis at the end of last year. When I joined ECU three months ago, I foolishly thought (and wrote in this blog) that with 2-year yields below 1% and economic data pointing to recovery, there was no more downside to rates, just a long period during which policy rates would be unchanged and market rates would start forming a base. The data has been positive, the Federal Reserve has been dovish and so have all the other major central banks. But a combination of reserve managers buying government bonds and commercial banks buying high-quality assets with the help of cheap central bank funding, has seen the rate trend go on and on. I can’t see this changing in December.

This drives all market trends. So the Australian dollar has bounced after initially dipping back when the Reserve Bank of Australia hinted at a pause. The price of gold is testing $1,200/oz, and S&P futures are back above 1,100. Investors are under pressure not to ‘miss the boat’ on the reflationary trends. I expect to see equities thrive, government bond markets perform reasonably, and I also look for some additional upward momentum to EURUSD and AUDUSD and GBPUSD this week/month. I think CADUSD may also test parity this month.

A brief mention of two longer-term themes. Firstly, we have confirmation of the debt re-scheduling talks between Dubai World and its creditors, with the Dubai Government reminding everyone that they are not liable for Dubai World’s debt. Maturities will be extended and terms of the debt will be changed. But the immediate risk of contagion has faded. The longer-term implications though are that the flood of investment money out of the Gulf into banks, property and football clubs will now slow. The second key theme is Japan. The BoJ could have shifted to outright purchases of bonds today. They didn’t. Faced with deflation and an appreciating currency (against both US dollar and Chinese renminbi) it seems to me only a matter of time before we see unsterilized FX intervention and/or more quantitative easing. The yen will remain too strong until we see either concrete action to drive yields lower and weaken the currency, or until the global rate cycle turns. When the rate cycle turns, the dollar can bounce, and bounce a long way against the yen. Today was another missed opportunity to get that process underway.

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