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It had been my view for a few weeks that the market had become too polarised on the headline inflation level in the UK. I believe very strongly that consumer confidence and activity levels were and are much weaker than January’s data suggested. One reason is that there was a very large transfer of activity from December to January due to the weather, a transfer that flattered the real level of activity in January.

Today’s downward revision of the Q4 GDP data highlighted that, even discounting the ONS estimate for the impact of the snow, output in the quarter would still have contracted as services (by far the largest contributor to overall GDP) subtracted 0.7 percentage points. Household spending also fell for the first time since Q2 2009 and the only real boost to the data came from Government spending – a sector that will see dramatic cuts as the austerity measures start to bite.

This comes in addition to the first indication of February consumer data (after the January bounce) – the CBI Retail Sales Index. The February index fell to an eight month low of 6 from 37 in January, against an expectation of 28. The CBI report said that stores expect “no growth next month as Britons curtail spending”. A separate CBI quarterly prices index showed selling prices rising at their fastest pace in almost two decades, while the consumer services sector saw falling sales for the fourth consecutive quarter.

On the back of the disappointing data in the UK and the growing geopolitical risks emanating from the Middle East, GBP has underperformed particularly on the crosses, where CHF and JPY stand out as notable beneficiaries.

While this has been a move that we had expected – and while it is indeed possible that we will see an extension of GBP weakness into next week – over the longer term, we feel that this may provide us with some very interesting levels to engage in debt reduction opportunities as the current bout of economic and market jitters pass and the normalisation of growth, interest rates and value emerges.

Have a nice weekend.

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The current state of financial markets is nervous and uncertain. The daily gyrations that are occurring as a result of short-term factors driving intra-day risk takers are generating a level of ‘noise’ that is far greater than usual and, while the long-term picture for almost all major economies is one of conflicting contingent outcomes, structural position-taking remains light.

In the US this week, we witnessed the release of the January FOMC meeting notes and, despite the markets hopes that the new additions to the voting panel would bring a slightly more hawkish tone to proceedings, the tone remained sanguine about the near-term prospects for inflation and stated a clear expectation that unemployment will remain elevated. The disappointment was met with a move lower in US yields that was compounded by the tepid CPI release yesterday and a safe haven flow into US treasuries as a result of ongoing uncertainties and concerns about the rising tensions in the Middle East.

In the UK, the inflation debate continued at a frenzied pace as the arch-hawk on the MPC, Andrew Sentance, speaking at the Institute for Economic affairs, argued strongly in favour of an early rate hike. He stated that, “inflation has run persistently above target because the upward impetus of global price pressures and the fall in the pound have been much stronger than any downward pressure we have seen from spare capacity in the aftermath of the recession”. He also intimated that an early rate rise, which would likely put upward pressure on GBP, would also have benefits in tempering imported inflation.

So we are now clearly in a ‘two camp’ MPC with Governor Mervyn King arguing that there has been a one off shift in the price level, brought about by higher import prices (largely from a lower pound), a rise in energy prices and a rise in VAT.

My view for a while has been that the fundamental macro-economic backdrop is still too fragile to withstand a rate hike and the inevitable rise in future rate hike expectations (a steepening of the curve) which would likely follow. The economic backdrop has been further muddied by the ‘weather’ impact of the December data, but I see it as extremely unlikely that the majority of the MPC will sanction a rate hike until after we have seen the Q1 GDP data and assessed its strength relative to the dip in Q4. In the short term – and with a zero bound on rates the aggressive opinions of Sentance along with the inclusion of Martin Weale to the hawkish camp – UK interest rate expectations and GBP have been driven higher. The current juncture is very important to the medium-term trajectory of UK rates and GBP and, as such, every piece of data will be forensically assessed.

This morning’s retail sales figures for January that have just been released show that there was a considerable transfer of retail expenditure between December and January. Whilst the headline January retail sales figures were much stronger than expected, there were significant downward revisions to the December data which means that, as a whole, retail sales between December 1st and January 31st rose just 0.5%; a positive but unspectacular outcome. Further retail evidence suggests that after the early January ‘bounce’, sales have fallen to more modest levels. The macro backdrop is muddied further by disappointing mortgage approvals data showing just 41,000 for January.

In the eurozone, the data has continued to be mixed, yet while the focus of attention has been on the US and UK interest rate developments, the further slide in peripheral spreads and rising cost of funding for the monetary union’s weakest members has gone largely unnoticed. EUR has seen losses against CHF where safe haven flows on rising Middle Eastern tensions and the loss of support for USD from falling long-term rates has been dominant. However, across the board, EUR has been broadly supported.

With a long weekend in the US and the G20 Finance Ministers meeting in Paris this weekend, markets will be vulnerable to position squaring and geopolitical concerns. Good luck and have a nice weekend.

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Financial markets yesterday were dominated by just one main driver – UK inflation. While fears of a data release beyond the 4% analysts’ forecast for consumer prices over the month of January proved exaggerated, the high level of prices required the Governor of the Bank of England (BoE) to write a letter to the Chancellor of the Exchequer to explain “...[why] inflation has moved away from the 2% target, the period within which we [BoE] expect inflation to return to target” and “the policy actions that the Committee is taking to deal with it”.

The letter outlined the now well versed core drivers of UK inflation (VAT, previous GBP falls and rising commodity prices, particularly energy). While Mr King continued to point out the great deal of uncertainty surrounding the medium-term outlook for inflation (and, in doing so, highlighted both the differences of view within the committee and the fact that inflation is likely to remain above target for this year before falling back in 2012), there was one very important addition to the statement which drove GBP and UK interest rates to recent highs.

King stated, “The MPC’s central judgement, under the assumption that Bank Rate increases in line with market expectations remains that, as the temporary effects of the factors listed above (VAT, GBP, commodities) wane, inflation will fall back so that it is about as likely to be above the target as below it two to three years ahead.”

This is very important and perhaps an excerpt from today’s inflation report in that it essentially accepts the market profile for rates. With 75bp pre the CPI and ‘letter’ publication priced in (and up to 86bps after), this is an acceptance that rising rates are inevitable in the UK this year.

We will of course require confirmation from the Inflation Report today that this is indeed the case but, if the “in line with market expectations” language is repeated, we will very quickly get to a point where at least three interest rate rises are fully priced into interest rate, currency and equity markets as well as all derivatives.

So what does this mean for investors now? Far from advocating that you should be buying GBP in anything other than the very short term in response to the Inflation Report, I believe that we are now set for a period of volatility in economic and confidence data in the UK and the current GBP strength will not be well received by the manufacturing sector, the bastion of hope for UK GDP growth.

The BoE is currently the only major central bank that is considering raising rates. We have mooted the possibility of central bankers being forced into a decision which history may later view as a mistake previously on this blog (click here). The MPC is now treading on potentially dangerous ground.

Governor King’s letter to the Chancellor also points out the main downside risks. The main risk is that spare capacity will cause inflation to fall below the target in the medium term. He said, “that risk could be exacerbated if growth in the economy is weaker than expected, for example if household saving is higher than expected”.

Headline news that the consumer can expect a 0.75% increase in borrowing costs is not likely to spur economic growth either at the consumer or business level and saving may well be a good way to benefit from the monetary tightening at the same time fiscal tightening starts to hit.

Second round effects of inflation have yet to make a convincing case and at this point of a still nascent recovery, raising rates would put further downside pressure on the already heavily burdened consumer. There is a raft of data scheduled for the rest of the week including employment, consumer confidence and retail sales. A negative retail sales print for the second consecutive month will surely make even the most bullish economists take note.

There will continue to be some interest rate hike supportive data over the next few weeks, but my suggestion is that these will become fewer and further between as we move towards the decision-making point for the MPC (likely to be in May) and by that point I don’t think it will be so ’obvious’ that the BoE raises rates.

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“People who are always making allowances for themselves soon go bankrupt”

Mary Pettibone Poole

“It has always been the weak, the insecure, the dim, the small or those with few principles that cause the angst, the troubles, the conflicts, the losses or the failures in nations. Rarely is it the fault of the matter at hand.”

Anon

Reading the UK financial press this weekend, one could really believe that we are in a financial bull market all over again as media topics range from bankers’ bonuses to the potential gains to be realised from equity bull markets in 2011, as assets diversify out of emerging markets (where inflation threatens higher interest rates, or higher currency values or both) and into developed markets where inflation is deemed to be a good a thing, as are rising interest rates (via higher bond yields).

My problem with writing a response to this sentiment is that there is a camp of economists and strategists out there (who appear regularly on TV and in print) who are trying to make a name for themselves with some really wild calls for market direction over the next 10 or so months, without evidence to support their predictions. I too have a view on the future, but I do not wish to be part of a sensationalist crowd.

There also exists the establishment bloc, who are undoubtedly thumping the tubs of in-house positions and paymaster or client desires. Part of the reason is that they work for large banking institutions who are so deeply internally – and often externally – politicised and thus they are compromised by their desire for a continuation of a salary cheque that they cannot say it how it is (if they are bearish of equities, they upset the entire equity and M&A division, if bearish of bonds, they upset all fixed income divisions, not to mention senior management, busy politicking but with a keen eye on turnover, and government and central bank clients).

So when I respond to the current consensual sentiment, I should preface it with a caveat; I have nothing to gain, as a manager of assets, by trying to scare investors and potential investors with assets to manage. I am writing to our client base only.

Throughout G7, the completion of a bear market correction in equities appears imminent. The low in interest rates has passed. Global liquidity is about to contract. Central banks will try to offset this contraction with further money printing (QE) and purchases of bonds (QE), and some central banks may pretend, for a short while, to be sterilising this intervention. But further central bank liquidity expansion will have the opposite effect of its intention – interest rates will rise further as fiat money gets further debased.

You see, my problem with concurring with the current bubbles in both economic optimism and equity prices is that the lowest and lower tiers of the consumption pyramid are getting poorer not wealthier, and the top tiers can’t get rid of their toys and surplus assets fast enough, having ’had’ them (ie, enjoyed the fling) and having sobered up to two ’growup’ facts. Firstly, few of your friends cared in the first place as to how many and how wonderful your toys were unless you were treating them for free continuously, as they had to focus more on their overstretched lives and unhappy wives; secondly, since their toys are now declining in both their value and enjoyment factor, then they represent a consumption tax on scarce revenue and need to be disposed of. Ageing mistresses know all about this ’grow up‘ effect.

The lower rungs of the consumption ladder are getting poorer because they are earning less each year in real terms (ask the wives what they have known about food bills for the last two years each time they go to the supermarket – they know exactly what the real world household inflation effect arising from higher food prices means to their family); people are realising that they are not as financially clever as rising property and equity markets in the 80s, 90s and 2000s encouraged them to believe, and this rising financial insecurity, allied to a demographic fact that suggests that the baby-boomer generation is now in saving mode, and food and energy prices are taxing them heavily, combines into a very powerful fact: consumers will just not spend at a level that economies need them to in the future to sustain a recovery.

Too many of the current crop of baby-boomers have had to be financially responsible for their parents in retirement homes and hospitals, and have been shocked at the cost. Too many of the baby-boomers know that we will live longer than our parents, and worry at the cost to our dependants. We need to cut back. We need to save. Our children are not finding jobs easy to get. Maybe they can’t look after us when we are in our wheelchairs. Maybe we have already enjoyed the (unprecedented) golden years as widespread wealth contracts. It surely has never before been so widespread. It adds up to a deep and current social insecurity, a deep and current saving mode and a deep and righteous mistrust of government to spend our precious taxable income wisely for our old age benefit.

If consumers don’t do what the force of establishment needs them to do (ie, spend big), then we have a financial implosion on our hands, as governments continue to spend beyond their means and central banks continue to print money, both to prop up high and potentially rising unemployment, while ageing populations feel increasingly insecure about how to finance their increasing longevity as they spend less and less. At this point, you have to throw in the declining credit availability in the property market (which has led to and is sustaining falling prices for those that have to sell their first, second, third or fourth homes), and we can now use this analysis to get to our next point. I believe that the ’easy’ cuts have been made by government and do not incorporate a growth and spending slowdown. The numbers will not add up, and the painful cuts leading to social protest and possible disruption either need to be executed or abandoned. I favour the latter. It means default.

Equity prices are close to a peak. No, I do not believe that equity nirvana is ahead. I believe that money is fleeing into equities and of course from emerging markets into developed markets, making it as irresistible as any other item that makes your life easier and better, regardless of whether it is good for you in the longer term. I truly believe that equity prices will be lower by the fourth quarter of 2011 than they are now. We will re-visit this statement then. But for now, I do not believe that the sums add up, as I have said this before about European government debt, and I believe that this quite big chicken is due to roost in the second quarter of 2011 too, via some default. Governments and central banks, via every artificial means they can – including pumping up asset prices (the equity markets) to generate a wealth effect (noted constantly by Alan Greenspan in public speeches) – are the generators of the equity rally. Not rising wages, consumption or innovation. Until we get the next generation of the latter, we will have a labour surplus that sustains, and will be the cause of troubles to come.

Yes, this is bleak and bearish. No, it does not suit me to be so. But you tell me how we generate growth at a time when it is clear that global rebalancing is being forced on emerging market growth that remains too export driven. As those exports contract on account of rising domestic interest rates (cost of capital) to finance production and rising currency rates (to combat inflation), it can only result in rising export prices or lower competitiveness, which means adjustment imminently. At the margin, and in the short term, this will mean less liquidity recycling to our financial markets and rising imported inflation on previously cheap goods, which goes back to the degree of consumption tax in the absence of rising wages.

Bunker down, now. Trouble is ahead. It’s why I remain so bullish of gold and silver, as the populist politicians, unused to making hard decisions, go for the electoral vote which in the 1800s used to be known as “pork barrel” politics. They will spend more and print more. And it will end in tears in short order. In FX, this will mean that in the near term the dollar is going to rise, indeed is rising as we have forecast. Higher interest rates in a bullish environment will create sufficient optimism that gold and silver face a near-term sell-off. We will be buyers into that sell-off, and I have previously given you the area I am focused on. Equities appear to me to be the lemming running full tilt at the cliff edge. There will be plenty of opportunity for profit in this deep degree, imminent bear market. But I advise you to get prepared for it right now, whilst optimism is all around you.

Happy Valentine’s Day.

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China surprised markets on Tuesday (in the timing) by raising the interest rate on the lending and deposit rates by 25bps. Despite this being wrongly ignored by the FX, commodity and equity markets (according to the PBOC, hiking rates during a holiday week and earlier than expected is designed to send a message of concern at the strength of inflation), the pace of Chinese tightening and the implications for the trade-off between an orderly slowdown and a hard landing for the economy continues to be the major focal point for the region and its ultimate global implications. In this regard, the Chinese CPI data on Tuesday will be an important gauge, expected to rebound back to the 5.50% – 6.00% level for January after the dip in December.

A weak 3-year US Treasury auction on Tuesday was the tipping point for further capitulation in US bond markets as yields marched higher across the curve, with 2- and 10-year treasuries breaking out of their recent ranges. The market has an acute focus on both yields and yield differentials as drivers of foreign exchange rates as the interest rate term structures of the major economies continue to price in normalisation, something that the central bank governors have since tried to temper. In this regard – and perhaps unsurprisingly after the recent spike in yields – the 10-year US Treasury auction last night drew record demand, further confusing the yield debate and causing the US yield curve to weaken from the highs. The next important driver this week will be the 30-year auction, before the bond/equity relationship can return as the predominant driver.

Today is a very important day for market psychology, particularly in respect to the USD debate. Since the second week of the year, there has been broad pressure on USD against EUR, GBP and CHF in particular, as the interest rate differential argument has been dominant. However, over the last week, US yields have rallied significantly and the 2-year yield differential between US and Europe (which had been giving EUR a firm undertone) has narrowed sharply. With an aggressive hiking cycle still priced into the euro curve, we see further potential for euro yields to underperform US yields in the near term.

In my opinion, there are two main forces in play from this point. I think that there is further to go in the correction of the yield differential between the US and Europe; the market has been quick to react to the rise in European yields since the January ECB meeting, possibly with the comforting thought that the Ecofin meeting in March will solve all the ills of the disparate monetary union. However, in the background, peripheral spreads have been widening again, Portuguese bank reliance on ECB funding has been back in focus and pressure will remain as 10-year yields hit 7.40% this morning (the IMF and the Portuguese Finance Minister have stated that it is unsustainable for Portugal to fund its deficit at yields above 7%).

There are currently more than three 25bp hikes priced into the market for the UK and the eurozone this year. Neither has economic growth which is stable, or is self sufficient enough to withstand that degree of tightening and rate expectations will likely diminish from here. The threat of external inflation from food and energy prices, however, has not disappeared and there will continue to be a great deal of pressure on central bankers. There is a much greater than usual probability in markets – given the intensity of inflationary pressures, zero bound rates and the growth inflation dichotomy – that one or more central banks make what history records as a mistake. It is the BoE’s chance today to avoid such infamy, which we think they will.

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“He uses statistics as a drunken man uses lamp-posts, for support rather than illumination”

Andrew Lang

“You will never destroy a tree without destroying its root”

Chinese Proverb

What is the current “big conundrum” focusing the minds of the macro world?

It is food supply and food and energy price inflation. Is it cyclical or secular, short or long term?

Some of us have been through this weather-induced supply disruption before, but none of us have witnessed the degree of increase of demographic demand on a scale which Asia and Latin America is now generating. I do not see how commodity price inflation ends in the near term. There are many solutions out there for the medium and long term, other factors remaining stable, but not in the near term. Markets are more focused on the rate of change than the absolute level having already priced it in. Does food price inflation worsen?

The consequences would be several. Firstly, given socio-political problems in North Africa and the Middle East, Chinese rulers in particular will be fearful of food strife ahead, as will other countries everywhere. Excluding Japan, Asian inflation rose to 5.3% in the 12 months ending in November 2010, up markedly from the 3.5% rate a year earlier. Trends in the region’s two giants are especially worrisome, with inflation having pierced the 5% threshold in China and running in excess of 8% in India. Price growth is also worrisome in Indonesia (7%). They will have to deal with this and it will lead to higher currencies, slower export growth, more reliance on domestic growth and better global re-balancing.

So, interest rates are going to rise further in China and India, which will have a negative impact on commodity currencies such as the Australian dollar, but less so on energy currencies such as the Canadian dollar.

Secondly, it is in the US that I feel the greatest shock is unfolding. Nowhere in any market is there the level of investor complacency and consensus as there is in US money markets, where everyone believes that the Federal Reserve will keep its effective zero interest rate policy in place for the foreseeable future and maybe beyond. I am not so sure. Twice this weekend alone, analysts have told me that Bernanke sounds far too dovish to even begin to contemplate a tighter US rate policy. Maybe, but Mervyn King’s dovishness in the UK has not stopped UK money market rates from pricing in 75 basis points of tightening into the near future.

In our Roadmap to Returns (click here), I wrote: ”bond yields want to move higher in the next few weeks until they reach a probable tipping point for equities causing severe market weakness [which] could see the US 10-year Treasury yields as high as 3.70% (3.30% as of last Friday’s open)”. Well, since that was written, 10-year yields have now risen to 3.65% and the risk to my view is that they go through 3.70% and on towards 3.85% and possibly even 4%. More importantly, 2-year Treasury yields have risen from their low of 31bp to 78bp now. US interest rates are rising, and this has significant and positive implications for the US dollar.

Euro and UK rates have already priced in significant tightening by their respective central banks starting in May this year and progressing throughout 2011 and into 2012. Hence, why there have been rallies in both sterling and the euro over the last three weeks versus the dollar. It is not conceivable to me that more tightening can be built into their respective money markets. But there is plenty of room for US rates to tighten and with the US unemployment rate falling sharply last week, the bias of focus in the US has to be on excess dollar liquidity in the global system, which some blame for the higher food and energy prices, and thus for the political turmoil in North Africa and the Middle East.

Another FX consequence of rising rates is to throw increased focus on the other zero rate currencies, the Swiss franc and the yen. I feel that GBPJPY, USDJPY and USDCHF trades at this time look highly attractive, if only for a short time, before the equity market rolls over. Yes, you will need a tight stop on the GBPJPY trade as higher UK rates are already priced, but as the realisation grows that US rates are rising, (if only temporarily), the move on USDJPY will be more aggressive than the sell-off in the GBPUSD rate from this point.

Elsewhere, I still wait for gold to come to just under $1,300 where I will try to establish a long position for our Global Macro hedge fund and managed accounts, and for equities generally to start feeling negative pressure from interest rates, which may just begin to happen as early as this week. I am not bullish of equities at these levels; in fact I am starting to build a short position.

But the message of the week is that I feel that the dollar is going higher as are US money market interest rates for a short period of time. Good luck.

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Foreign exchange and interest rate markets have reached a very important juncture. As the mismatch between realistic expectations of physical policy tightening and the directional implied rate rises in the (predominantly euro and UK) interest rate term structure become extreme, one side of the ‘tug-o-war’ will have to yield.

Ultimately, the market is wrestling with two conflicting arguments. The first is the possibility that the inflation and rate rise expectations (on the back of continuing rises in food and energy price pressures) ‘force the hand’ of policy makers to defend their inflation-fighting credibility. The second scenario sees rate hike expectations come back to reflect the macro-prudential approach to policy tightening that central banks must adopt in order to prevent choking of the global and respective local recoveries.

The recovery in the UK services sector PMI from contraction in December to an above expectation reading in January will be noted with relief by the UK exchequer, particularly after the validity of the Budget (and more specifically the attainability of OBR growth estimates) was questioned this week by the IFS. However, far from bringing clarity to the recovery trend in the UK, the picture has, if anything, been made more uncertain. It is clear from the data that there was a negative impact – most likely from the snow – that depressed December. The transfer of activity between the two months, however, masks the trend for activity in the economy’s most important sector.

It can be argued that the trend is still in a downward trajectory with current output, even on a three-month basis (to smooth the volatility), still only providing an underlying GDP trend of around 0.2% – 0.3%, even incorporating the strong manufacturing data. However, the most pressing influence on the UK exchange rate and interest rate dynamic is not one of growth, but of inflation. Whilst there are currently no significant signs that the current pressures are impacting second round effects, unless the quarterly inflation report provides a convincing argument for the transiency of inflationary pressures, then the MPC may find itself having to bow to the pressure and raise rates. In my opinion, the negative Q4 GDP print will allow the MPC some time to further assess the data, and as I still see the first hike being carried out in a quarterly inflation report month, May now looks like the focal point.

Earlier this week I commented on the intense focus with which the market would analyse the specific wording and intimation of the ECB statement. The expectations following on from the surprisingly hawkish – perhaps illusory – January statement were that there would be a gradual shift in the language building towards a rate hike and interest rate markets had already begun to price aggressive hikes into the futures curves ahead of the statement.

In reality, while Trichet will argue that the content of this month’s statement was the same as previous months, there were some very subtle changes to the intimation and emphasis. For example, last month president Trichet stated that there was no pre-commitment ‘not’ to raise rates at future meetings, which this month was moderated to “no pre-commitment to policy course”. Very subtle differences, but by reigning in the concern about short-term inflationary pressures, he seems to have succeeded in two things: (i) he was successful in sounding a warning shot to markets in terms of the apathy of the ECB to rising inflation and in doing so, cleverly divert the attention of the market away from the debt concerns of the periphery; and (ii) he has now caused the market to take an objective view of the rates market and the reality of policy action and, in that respect, there is still further to go.

The big event of the day, however, will come from the US and, after the recent rises in US yields, this afternoon’s employment report will be very keenly watched. For a considerable time the unemployment rate has been the key focal point for the monitoring of interest rate expectations in the US as Fed chairman Bernanke has often stated. He stated last night that, you “cannot consider the recovery as truly established until we see a sustained period of stronger job creation”. A strong jobs report this afternoon will likely see the 10-Year US yield breaking the December rally highs which will be a very significant development for interest rate differentials, US assets and the USD.

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The market has been wrestling with the risk profile of financial markets over the last couple of weeks as global socio-economic uncertainty grows. The Egypt situation took another turn last night as President Mubarak announced that, while he will stay in office, he will likely not run for re-election in September. While global PMI measures were better than forecasts yesterday, cost-pull inflation continues to be a huge global issue and, despite some positive signs on global growth, the IMF warned yesterday that “old global imbalances are re-emerging and new ones are being created, leading to the possibility of another worldwide crisis”.

The current focus is a risk positive tone to interest rate and FX markets, with global equities continuing to power ahead. This positive polarity of the market is being further confused in FX where the traditional risk barometers of CHF and JPY are moving in opposite directions and interest rate markets continue to price in rate rises, particularly in the eurozone and the UK that, if enacted, would be hugely detrimental to the recovery and medium-term growth prospects. However, the respective currencies continue to benefit for now.

Yesterday saw a very strong manufacturing PMI release in the UK. The index hit the highest level since the survey began, with the employment balance also hitting the highs. The output balance left quarterly manufacturing output growth at around 2.5%. From here, however, the potential for further improvement is not obvious. It is important to note that manufacturing only accounts for around 13% of GDP and, while this may be the peak of manufacturing momentum, the peak of UK inflation expectations, which has been the key driver of GBP this year, is less clear. What is clear, at least to me, is that a UK interest rate rise driven by supply-side inflationary pressures with an already fragile UK consumer  is a recipe for disaster for the nascent UK recovery (according to a Telegraph survey 34% of credit card owners used their plastic for day to day expenses to see them through to the January pay cheque – click here). It is interesting that the money supply and mortgage lending data that accompanied the manufacturing data yesterday was significantly weaker than expected. Though this was largely ignored by the markets, the relative size of the export and manufacturing sector in the UK means expectations in comparison to weakness from consumption and consumer activity will soon have to be reigned in.

The more important UK services sector PMI is out tomorrow and, with c. 75% of GDP coming from services, it is both a bigger test and a more rounded indication of current economic momentum. The December contraction in the sector was quickly dismissed as ‘weather impacted’ and expectations for a bounce back to expansion will be relied upon for inflation and GBP continuation.

For the rest of the week there are three main focal points for the major economies. I have already mentioned the UK service sector PMI, and for GBP and UK interest rate expectations this will define sentiment for the next week or two.

In the eurozone there will be a very close focus on the statement accompanying the ECB announcement tomorrow. After President Trichet shifted the market focus away from periphery debt concerns to a broader inflationary threat at the last meeting, the market is now looking for the hawkish rhetoric to be developed further, as has been the case prior to previous ECB interest rate hikes. FX and interest rate markets will apply a forensic lexicography of the statement in search of signals that the ECB is moving closer towards the normalisation of monetary policy that the interest rate market (and arguably to some degree the FX market) has already priced in. Any intimation in the statement that developments of the EFSF which, it has been recently mooted, are approaching agreement, will also be seen as EUR supportive.

Lastly Friday’s focus will shift to the US and the employment report for January. After the disappointing data from the last couple of months, analysts are looking for a bounce back in January. These expectations have been supported by some of the survey evidence so far this month and the private sector employment report (ADP) this afternoon should provide a further guide.

I am still much more negative on the global environment than the broad market at the moment, but the remainder of this week will be key to driving the short-term dynamic and will define the direction of major markets for the remainder of Q1.

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