Welcome to ECU's Market Commentary blog written by Neil MacKinnon, ECU's Chief Economist. This page will be updated from time to time to cover events impacting the global financial and currency markets.

The most recent post appears at the top – scroll down for older entries.

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30th January 2009

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Corporate earnings news out of the US pulled the rug on equity markets yesterday and overnight. Ford reported its worst annual loss in its 105-year history and overnight economic news out of Japan took 3% off the Nikkei. Unemployment in Japan now stands at 2.7 million and is rising at its fastest rate in 44 years. In addition, the latest reading on Japanese industrial production reported a record drop of 9.6% in December. However, risk aversion and repatriation have pushed the trade-weighted exchange rate up sharply since last September, something which concerns the Bank of Japan and may result in FX intervention if the $/yen exchange rate starts challenging the previous record high around the 80 level. The FTSE100 recovered its poise this morning helped by Shell reporting the biggest annual PROFIT in UK corporate history. All eyes will be on US GDP data released this afternoon. Don't expect any good news here as economic growth is predicted to have collapsed by 5-6% on an annualised basis.

George Soros is reported as saying that the euro might not survive the financial and economic crisis. Certainly the euro remains under pressure and reports that Iceland is to be ‘fast-tracked’ into the EU can't be good for the longer-term viability of the euro. Reykjavik-on-the-Rhine almost certainly will accentuate the fiscal stresses and strains afflicting the eurozone. The ECB need to step up the pace of interest rate cuts but the markets are only discounting a measly 25bp cut at the March meeting. Too little, too late. The beneficiary of all of this is likely to be the US dollar in the short term while the ‘risk’ currencies like the yen and the Swiss franc might resume some short-term strength. I note that at last night’s US Treasury 5-year auction there was good central bank demand. Also the weekly Fed H.4.1 report published last night highlighted foreign central bank purchase of US agency debt for the first time since September. All this suggests that those calling for the demise of the dollar will have to wait a little longer.

Read George Magnus in the FT today ("Why this hysteria about sterling is misplaced"). George is senior economic adviser at UBS and is on our Investment Committee. George's views are worth reading especially as he was prescient in forecasting the credit crisis (Minsky moments etc.). George reckons that the prevailing market bearishness on sterling is overdone and presents some good arguments. He believes "it is hysterical to imagine that a debt default and currency crisis are likely." It doesn't mean that a sterling bull market is around the corner necessarily, but it does suggest that a sterling collapse is less of a danger than some think.

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29th January 2009

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More bad news for the UK economy. The IMF says that the UK will have the worst economic slump in the developed world with real GDP dropping 2.8% this year (click here to read more about this in The Times). In addition, the Institute for Fiscal Studies says that the UK will be saddled with government debt for more than 20 years with tax increases and spending cuts of £20 billion inevitable by the end of the next Parliament (more about this in The Guardian).

Sterling has held up reasonably well in the face of this news this morning. Even George Soros says he is not shorting the pound at the moment (click here for The Telegraph article). However, equity markets have been firmer this week and investor risk appetite seems to be improving which I think helps sterling if you believe that the currency is a proxy for global risk.

Elsewhere, the US House of Representatives passed a $819 billion stimulus bill (more from The Guardian) and the Federal Reseve kept interest rates close to zero and indicated that they would be prepared to purchase longer-term Treasury securities. This suggests that the ultimate objective is lower private sector interest rates and the Fed is using the asset side of its balance sheet to bring credit spreads lower thus helping to free up credit markets. The spread between Fannie Mae and the 10 year US Treasury yield (click here for the Bloomberg chart) is narrowing (which will help bring down US mortgage rates). Also lower credit spreads imply a lower VIX index (which measures equity market risk and volatility). A lower VIX means higher equity prices.

So, the UK and world economy are showing few signs of recovery and the news remains gloomy (apart from Starbucks announcing the closure of another 300 stores) but financial markets are currently a little more optimistic, with investors wanting to believe that various government and central bank measures will work. I think this makes for a bumpy ride as there is always scope for disappointment.

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28th January 2009

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The Federal Reserve conclude their two-day policy meeting this evening and the meeting is expected to be the least consequential meeting for some time. The Fed has already implemented a zero interest rate policy (ZIRP) and this is likely to remain in place for some time. I expect the Fed's statement this evening to be fairly downbeat about the prospects for the US economy in the short to medium term. For bond market aficionados, there will be more focus on the Fed's proposals to purchase longer-dated Treasury securities. The idea behind this is to prevent longer-term interest rates from rising. Given that US mortgage rates are priced off longer-dated bond yields, the Fed wants to ensure that mortage rates and longer-term rates generally do not capsize any future economic recovery or lead to a dampening of credit demand. The US Treasury has a lot of bonds to sell this year, though there seems to be good investor demand as witnessed by a well-received two year auction last night. I think all of this is quite positive, as is news that a ‘bad’ bank will be set up to clear banks' ‘toxic assets’. Press reports also suggest that the President's stimulus plan may end up being nearer $900 billion than $800 billion.

This should help underpin sentiment in the equity markets in the near term. As far as the FX market is concerned, sterling is holding up well against the US dollar, the yen and the swiss franc, and the trade weighted exchange rate is starting to edge up from its lows (see Bloomberg chart here). The market is still very short of sterling and sentiment has been extremely bearish but it looks as though the ‘one-way bet’ on sterling is less secure. Even the American media wants to buy sterling (click here for an article in Business Week).

Finally, if you are worried about debt, you should read Martin Wolf in today's FT (click here for the article). The ratio of US public and private debt to GDP reached 358% in the third quarter of 2008 – the highest in US history and surpassing the 300% previous peak in 1933.

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27th January 2009

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Sterling had a better day yesterday. Indeed, so did equity markets with the FTSE100 closing up 3.86%, the S&P up 0.56% and overnight the Nikkei up 4.93%. Other ‘risk assets’ such as gold moved to a five month high, copper jumped 9.4% yesterday and the price of crude oil rose 1.6%. This suggests the market is looking for a ‘reflation’ trade and, as far as FX is concerned, any increase in risk appetite due to ‘hope’ of growth is negative for the yen. As I have said before on my blog (and see David Smith's column I referred to yesterday), sterling can be considered a proxy of global financial risk. So when risk appetite goes up, sterling goes up (click here to see the Bloomberg chart outlining sterling and risk correlations). This is precisely what happened yesterday and into this morning. Sterling is generally firmer on the crosses and is causing the overwhelming majority of sterling bears to think again and cut their positions.

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26th January 2009

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Happy Chinese New Year! The Year of the Ox is said to be a sign of prosperity through fortitude and hard work. Let's hope so. This time last week it was ‘Blue Monday’ – the most depressing day of the year according to researchers who investigate these sorts of things. It was certainly depressing for UK Government ministers who saw the markets give a frosty reception to the latest measures to bail out the banks. On top of that there was talk of the UK going bust with the media giving plenty of headlines to Mr Jim Rogers, a former associate of George Soros. Sterling took a sharp knock as a result. A good antidote to the sterling bearishness can be found in David Smith's column in The Sunday Times which is worth a read (click here for the full article).

Barclays’ share price is actually up this morning which is a good start to the week with the FTSE350 bank index up 5% first thing. Anatole Kaletsky in The Times this morning argues that the markets have misunderstood the government's bank support package and believes that they will work (read the article here).

More good news: The Guardian this morning claims that the UK Government is likely to introduce a second package of measures for the economy either in March or after the G20 meeting in April. The size of the package is expected to be substantial. It certainly needs to be, as the VAT reduction in the previous Budget was a mistake in my opinion (click here to read the article).

So maybe there is light at the end of the tunnel for sterling. The latest positioning report from the Commodity Futures Trading Commission (CFTC) shows that speculative FX traders continue to have extreme short positions in sterling. Everybody knows the bearish story on sterling and FX traders have the position on. Could what looks like a one-way bet surprise the traders? (Click here for the Bloomberg chart).

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23rd January 2009

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Continuing problems in the financial and banking sectors continue to weigh on equity markets. The S&P index closed down 1.52% last night and the Nikkei was down 3.81%. The FTSE100 index is now down around 9% year-to-date with the German DAX index down some 14%. With risk aversion rising, sterling is down and the yen is up. Morgan Stanley see UK debt auctions becoming ‘risk events’ and David Cameron, the Conservative Leader, sees a danger of an IMF bail-out.

The negative newsflow on sterling this week is probably the worst I have ever known, with the markets focusing on prospective nationalisation of the UK banks, escalating government borrowing and worries about the UK's credit rating (click here to read more about this on The Telegraph website).

This morning's UK GDP data underscores the weakness in the economy with a 1.5% decline in Q4 and down 1.8% year-on-year (click here to see the Bloomberg chart). The reported 1.6% gain in UK retail sales in December has to be treated with caution according to government statisticians. There is certainly plenty of price discounting going on but I think the real picture is one of consumers tightening their belts, so most definitely not a "green shoot". 

Elsewhere, the new US Treasury Secretary Timothy Geithner said, “a strong dollar is in America's national interest," but said China is manipulating its currency. So a weaker dollar against the yuan but a stronger dollar against everything else? Sounds contradictory to me. It is worth noting that on a trade-weighted basis, China's exchange rate is some 10% higher than a year ago (click here to see the Bloomberg chart) so I don't see much sign of currency manipulation here (China's exports are down 2.8% year-on-year according to the latest data). The Bank of Japan noted this morning that the Japanese economy is ‘deteriorating significantly’ and Finance Minister Nakagawa says he is watching financial markets closely so the threat of intervention (even if unilateral) remains in place. The upcoming G7 finance ministers meeting in Rome on 13-14th February gives policymakers an opportunity to clarify their position on currencies generally. Any breakdown in the G7 consensus on exchange rates could be destabilising for financial markets as it has proven to be in the past.

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22nd January 2009

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Currency volatility in all the major currency pairs is at its highest in 10 years and is starting to rattle some finance ministers and central bankers. Last night, Christine Lagarde, the French finance minister, noted concern about sterling's decline and said it could be a topic on the agenda at the next G7 meeting in mid-February. So far, her concern does not seem to be reflected at the Bank of England or HM Treasury. Also last night Philipp Hildebrand of the Swiss National Bank threatened intervention to prevent further strength in the Swiss franc. Adding to the chorus was Japan's vice-Finance Minister, Kazayuki Sugimoto, who says abrupt FX moves are undesirable.

Yesterday saw the yen move to its highest level against the US dollar since 1995 with the latest trade data reporting a 10.7% slump in Japanese exports for December. However, incoming US Treasury Secretary Timothy Geithner appeared to cool enthusiasm for FX intervention by saying that "it is very important for the United States and the global economy that our major trading partners operate with a flexible exchange rate system in which market forces determine the value of exchange rates". I disagree with those who think that the Obama administration wants a weaker dollar. In fact, quite the opposite in my opinion. At the very least, a stable dollar is likely the preferred option.

So where does that leave us? There is no doubt that excess volatility and disorderly price action in the FX market is starting to concern policymakers BUT there is clearly no firm consensus. As far as the US is concerned, historically they have never been keen on FX intervention but when push comes to shove they have intervened on a G7 basis especially if currency instability threatens financial market stability. A dollar collapse, for example, would not only push oil prices much higher it would also threaten much-needed capital inflows into the US and perhaps undermine foreign investor confidence in US policy. Presumably, the new White House administration would not want a dollar collapse right this minute.

For Japan, I think it is blindingly obvious. A stronger yen hurts the Japanese economy which is already in recession and intensifies deflationary pressures. I think the BoJ will intervene especially if the yen looks as though it will make new highs against the dollar (i.e. below 80).

All of this makes  the FX market look exciting. My guess based on past experience is that once the FX market smells fear amongst policymakers, they will test their "pain threshold" on currency intervention levels. So in the very near term, it would be no surprise to see slightly stronger levels in the swiss franc and yen.

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21st January 2009

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The financial media this morning is full of features on sterling's recent decline. The reasons for the decline are numerous: bad news on the economy; worries about the UK banking sector and the impact of bail-out costs on the UK budget deficit and debt/GDP ratios; as well as worries over potential downgrades to the UK's sovereign credit rating. At the CBI East Midlands dinner last night, Mervyn King, the Bank of England (BoE) Governor, paved the way for an early implementation of quantitative easing. I think this is a good thing and aligns the BoE with the Fed. However, I was disappointed that he did not take heed of what is happening to sterling. It is illogical to think that sterling's weakness helps exports at a time when world trade growth is collapsing (click here to see Bloomberg UK exports chart). To get some idea of the weakness in world trade, look at this chart which shows the sharp drop in US and Chinese imports (click here to see chart). What the BoE and the Government don't understand is that weakness in sterling increases the UK banks’ FX denominated liabilities. This creates more of a black hole in the banks' balance sheets and thus means the Government has to put in more cash. A little short-sighted don't you think? Robert Peston's blog on the BBC website – "Faith In Banks" – (click here for the link) gives a good explanation of the link between sterling and the banks. A sterling crisis is the last thing we need. If the BoE and UK Government understand this then there is an opportunity for sterling to end its decline, something that foreign investors would welcome.

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20th January 2009

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The problems at RBS – and UK banks generally – are creating fresh investor nervousness. The FTSE350 bank index hit a new low yesterday (click here for chart of the bank index against sterling/yen). The UK government's latest ‘bail-out’ or ‘work-out’ is generally regarded as lacking in detail with some commentators anxious that taxpayer exposure to unknown bank losses could be exceptionally severe. With the UK economy expected to be in a deeper recession than previously forecast by the UK government, this will almost certainly lead to a much greater increase in government borrowing. Nationalising RBS alone would increase the national debt by 370%, given that RBS has liabilities of £1.8 trillion. Ultimately though nationalisation might end up being the end-game for the banking sector. A budget deficit of around 8% of GDP (on the UK government's own forecast) now looks as though it will be closer to 10% of GDP. The markets are getting wind of all of this and are fearful that an escalation in the budget deficit alongside a policy of ‘benign neglect’ towards the pound can only mean two things. Higher gilt yields and a slide in sterling. Already 10-year gilt yields are 50bps higher than they were at the end of the year. Sterling hit a record low against the yen overnight with some talk that a ratings agency would downgarde the UK's sovereign credit rating. Jim Rogers, the famous US investor (and former colleague of George Soros) says, “the UK is finished". Well, let's hope not. Perhaps all of this will concentrate the minds of Bank of England (BoE) policymakers. I am sure that at some stage – maybe quite soon – the BoE will change its tune on the pound. If they do then a sterling crisis could be avoided.
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19th January 2009

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The headlines this morning are dominated by fresh UK government measures to bail-out UK banks. The ultimate cost to the UK taxpayer might be more than £1 trillion. It is disconcerting to discover that 80% of UK bank lending is to overseas companies and institutions. Whether these measures work is unclear but one thing is for sure: there is still further significant restructuring of banks’ balance sheets required. A total nationalisation of the UK banking sector cannot be ruled out.

UK economic newsflow looks negative (again!!). The latest house price data from Rightmove reported a 1.9% drop in January. Ernst and Young expect UK unemployment to hit 3.4 million by the end of 2011. They also predict that UK real GDP will drop 2.7% this year, the largest peacetime decline since 1931. Will Hutton in the Guardian this morning (click here to read the article) claims that the UK risks bankruptcy. No wonder that the money markets (short sterling futures) are predicting a further reduction in interest rates to 1%. Against this background, sterling may be in for a bumpy ride over the near term.

In terms of financial market sentiment, much depends on the aftermath of the US Presidential inauguration tomorrow. There is a lot of hope and expectation that stimulus measures will generate an economic recovery sooner rather than later. If that hope is disappointed then equities could slump. It has to be said that it is difficult to get constructive about global economic prospects and I think 2009 is likely to be a write-off. 

In the eurozone, the worries about further strains are highlighted by a former Irish central bank official talking about a potential Irish exit from the euro.

German banks are said to have about €1 trillion of risky assets on their books (according to Der Spiegel) and in the Daily Telegraph this morning, there is a good account of problems in the Baltic States which is worth reading (click here to read the article) and on the possibility of a eurozone default see this article in the FT.

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16th January 2009

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Since the ECB's inception in 1999, it has cut interest rates 26 times compared to 47 times for the Federal Reserve. Yesterday's cut of 50bps by the ECB was the minimum you would have expected given widespread evidence of a slump in the eurozone economy. Why didn't the ECB do more? Unlike the Fed, it is hidebound by an exclusive inflation mandate and an internal dynamic of achieving consensus from the European national central banks. As a result, the ECB seems destined to be ‘behind the curve’ when it comes to setting the appropriate level of interest rates.

Certainly, last summer's increase in ECB rates will probably go down in history as a massive policy mistake. As the eurozone economies deteriorate further, the ECB will be forced to act. Mr Trichet, in his press conference yesterday, hinted that any further rate cut is unlikely to happen until the March meeting. My guess is that ECB rates will end up at 1% or below, compared to the existing rate of 2%. Add in worries over rising sovereign yield spreads in some eurozone countries and a high corporate financial deficit then the outlook for the euro does not look good.

Next week, all eyes will be on the presidential inauguration. President Obama's speech is expected to be a ‘tub-thumper’. For those of us in the financial markets, it will be interesting to note the reaction of the equity markets. Bank stocks are under pressure and the Bank of America is getting support from the TARP programme. Rumours are circulating that Citigroup will be nationalised over the weekend while in the UK, measures are expected from the UK government to provide additional support for banks and the housing market. However, there is a lot of cash on the sidelines and equity markets look under-valued. Maybe it's time for equities and risk appetite to recover. 

Comments from Sir John Gieve, one of the Bank of England's (BoE) Deputy Governors, this morning said that the drop in the pound is good for exports. I'm disappointed to hear this as it sends the wrong signal to foreign investors and the Debt Management Office does need to sell £150 billion of gilt-edged securities this year to fund a budget deficit amounting to 8% of GDP (according to the government's own forecast). At some stage – and quite soon I think – the BoE may have to change its tune on sterling otherwise it is probable that it will have severe external financing pressures to contend with. 

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15th January 2009

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The financial markets expect the ECB to cut interest rates by 50bps to 2% today. This still leaves the ECB with the highest interest rate level of all the major central banks. At their last meeting in December, the ECB cut rates by 75bps but there is a strong case for the ECB to be more aggressive today and for choice I would like them to cut by 100bps.

The economic picture for the eurozone looks grim. German exports and industrial production are collapsing as Germany falls victim to the slump in world trade. The deterioration in the economic picture is not limited to Germany. All the other eurozone countries are seeing sharp declines in output and a steep jump in unemployment. Inflation is falling and now stands at 1.6% – below the ECB's 2% CPI target. Further declines in the inflation rate are likely in the months ahead as the drop in the oil price (and other commodity prices) starts to filter through. The ECB needs to be careful not to end up with deflation.

In addition to cyclical economic pressures, structural cracks in the eurozone are starting to appear. Yesterday, S&P downgraded Greek sovereign debt and warned Spain, Portugal and Ireland that they could face downgrades. Greece also has the largest current account deficit in the eurozone. Europe's banks are also under pressure and Deutsche Bank warned of a loss of $6.5 billion. So, rather than being a ‘safe haven’ and the euro being a challenger to the dollar as the world's leading reserve currency, the structural fiscal cracks put a question mark over the euro in the medium term.

In the FX market, while a lot of bad news is being discounted, the euro/$ exchange rate is just drifting lower rather than collapsing but with few, if any, reasons for buying the euro, don't be surprised if euro/$ starts breaking down through 1.30. If the ECB cuts its rate by anything less than 50bps today, I would expect that would certainly disappoint the markets and result in fresh euro weakness.

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14th January 2009

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Yesterday's UK trade data was pretty awful. A trade deficit in November of £8.3bn was the biggest (in absolute terms) since records began in 1697. As a percentage of GDP, it stands at 7% which is the highest since 1974. Export volumes (excluding oil and erratic items) are down 10.9% despite the previous weakness in the pound. Of course, this is a story of collapsing world trade growth which is hurting the exports of many countries. For example, yesterday's US trade data reported that US exports dropped 5.8% in November, while Chinese exports dropped 2.8% (year-on-year) in December with German exports reporting the biggest drop this decade. Japan reported a record decline in exports in November with its trade surplus falling for the ninth month in a row.

In this environment, using a weaker exchange rate to gain export competitiveness is fairly pointless. Indeed, trade surplus countries are more at risk from a downturn in world trade than trade deficit countries.Trade surplus countries should implement policies to expand domestic demand rather than resort to competitive devaluations or protectionism which was what happened in the 1930s. 

However, for trade deficit economies like the UK that also have a (rising) budget deficit, it is external financing of those deficits that matter. This is why the Bank of England's policy of ‘benign neglect’ towards the pound is not sensible and will only deter foreign investors from buying UK gilt-edged securities.  

Nevertheless, there are tentative signs that sterling can at least stabilise. The speculative trader market is now very short sterling and so the prospect of a short squeeze looks better. Against the yen (where there is a very long speculative position), any recovery in equities – an Obama effect next week perhaps? – (click here to see the Bloomberg chart) or in commodities (click here to see the Bloomberg chart) could see sterling/yen recover. Elsewhere, the outlook for the euro remains poor. News reports this morning suggest that the Irish PM will call in the IMF if the economy worsens. Also, latest data reported a steep drop in Italian industrial production and a 29% year-on-year drop in German foreign machinery orders. A move in euro/$ below 1.30 looks likely.

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13th January 2009

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It was risk-on now it is risk-off. By that I mean that it appears that investors have abandoned the notion of a mid-year/second half economic recovery which sponsored the equity market rally through the Christmas period and they are now selling equities. Risk appetite is diminishing and in the FX world that means yen up and sterling down (given its role as an indicator of global risk). Sterling/yen could move to 125 in the near term. In addition, the flow of bad news out of the eurozone is intensifying with the latest being that S&P are threatening to downgrade Spain's long-term credit rating. Also, the French non-financial corporate deficit now stands at 5.7% of GDP, the worst since the early 1980s. We have previously noted the slump in German exports as world trade growth contracts and previous euro ‘overvaluation’ dents competitiveness. The ECB is regarded as being ‘behind the curve’ with the market consensus looking for just a 50bps cut on Thursday. This would be disappointing I think and could augur further weakness in the euro especially against the dollar.

Overnight UK economic news reported little improvement in the RICS housing survey and further weakness in the BRC retail survey. No green shoots of recovery here. Ultimately, the BoE will have to cut interest rates again and adopt quantitative easing.

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12th January 2009

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The poor US jobs report last Friday was not really a surprise. Nevertheless, it highlights the severity of the economic crisis and underlines the need for urgent policy action. President-elect Obama is expected to respond with a sizeable stimulus and, together with zero interest rates and ‘quantitative easing’, this hopefully paves the way for the US economy to eventually recover. I think pre-emptive and pro-active policy action by the US will be rewarded. Indeed, you could argue it is being rewarded in the currency markets through a slightly firmer US dollar.

In the eurozone, policymakers are seen as being tardy. The ECB meet on Thursday and the markets are expecting a rate cut of 50bps. At 2%, this would still leave the ECB with the highest interest rates of all the major central banks. In terms of fiscal policy, the eurozone is not able to fashion a fiscal stimulus of note given wide structural disparities and the absence of a ‘national’ finance ministry. As far as the euro is concerned, if ‘valuation’ is a key driver of exchange rate determination then the ‘overvalued’ euro is set to decline against most currencies. ‘Fair value’ for euro/$ is estimated to be in the region of 1.25-1.30 (and against sterling, about the 0.75 level).

In the UK, last week's 50bps cut in interest rates is seen by many as disappointing (for example, click here to read Anatole Kaletsky in the Times this morning). I see plenty of evidence that the UK economy is continuing to deteriorate so the Bank of England will have to cut rates again I think. As far as sterling is concerned, there are one or two positive factors emerging. The share price of the FTSE real estate index and the FTSE350 bank index are stabilising. It was a sharp decline in these indices that pulled the rug on sterling through mid 2007 into 2008. Sterling is ‘undervalued’ on a trade-weighted basis which should, at least, attract value buyers. In the short term, the latest weekly positioning report shows that speculative traders have only slightly reduced short positions (yen long positions were extended a little). This suggests that there may be scope for the ‘short squeeze’ in sterling that has been a feature of recent price action to continue in the near term.

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9th January 2009

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Economic news in the eurozone continues to disappoint. Unemployment in Spain hit 3 million – 13% of the workforce – yesterday, which is the worst in 12 years. German exports collapsed 10.6% in November (according to data released yesterday) and German manufacturing orders dropped 6% in the same month. The world's biggest exporter is being squeezed by the slump in world trade growth and previous strength in the euro. A stronger euro hereonin would crush the German economy. In Ireland, Dell is slashing its operations and moving its European operations to Poland. Dell is Ireland's second largest corporate employer and its biggest exporter. The focus at next week's ECB meeting is how much the ECB will cut rates. The ECB have tended to be cautious but this week's CPI inflation data reported a decline in the inflation rate to 1.6%. Against this background, it is difficult to be positive on the euro. Today's latest reports on German and French industrial production are likely to confirm the downturn in activity.

Last night's US 10-year bond auction (US$16bn) was well-received (contrast this with the failure of the German bond auction earlier this week). The bid-cover ratio was 2.59, the highest since last August. In spite of a likely trillion dollar US budget deficit (about 8% of GDP), the auction results indicate that there is still a decent investor appetite for US debt. The Fed's weekly H.4.1 report published last night highlights foreign central bank purchases of US debt and the latest data report a US$8bn increase in central bank holdings. Again, this is a positive for the dollar at a time when global foreign exchange reserve growth is declining (mainly slower growth in China's FX reserves) and there is much talk of reserve diversification away from the dollar.

Today's market focus will be on the US non-farm payroll report. The consensus looks for a decline of 525k in employment though the market is discounting anything up to a decline of 750k. The US unemployment rate currently stands at 6.7%. Prof Roubini (‘Dr Gloom’) reckons the US recession will last two years with real GDP declining every quarter in 2009. He sees the unemployment rate peaking at 9% in early 2010 (which coincidentally is what the Congressional Budget Office thinks will be the average for 2010 in its latest projections released this week). But I wonder whether this will prove an under-estimate and we end up with double-digit rates of unemployment.

A jobs shocker today (ie, something worse than a decline of 750k, say) will hardly bolster investor sentiment and could make for a bumpy ride in the equity markets. Hopes of any economic recovery this year will be well and truly dashed.

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8th January 2009

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All eyes on the Bank of England (BoE) today. The market expects a minimum cut of 50bps but I think it could be 100bps given the deterioration in the UK economy since the last rate cut. Unemployment is rising fast. The BoE is also likely to say something about 'quantitative easing', ie, printing money (click here to read the article in The Times). Sterling continues to track the interest rate gap against the euro (click here to see Bloomberg chart) and any widening in the gap might dent the pound near term. The good news is that the ECB thinks the UK does not meet the entry criteria for the euro (click here to read the article in The Telegraph). For sure, the BoE is losing its operational independence anyway and, like the US now, monetary policy decisions will be taken jointly by the central bank and finance ministry. The chancellor in the FT yesterday acknowledged that hopes of a second half recovery look ambitious. Certainly, the equity market rally of the last few weeks stalled last night with the Dow closing down 2.7% on the Intel profits warning and fears that tomorrow's US jobs report might be a shocker.

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7th January 2009

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I am in the camp that believes the Bank of England (BoE) will cut interest rates by 1.0% on Thursday and that they will announce they are considering a range of proposals/measures that effectively imitate what the Federal Reserve is doing with the asset side of its balance sheet. Other measures might include 'underfunding' of the budget deficit. In the meantime, the recent rally that we have seen in sterling might give way to some profit-taking especially as the recent buying of sterling seems to have been carried out by speculative traders rather than real money. However, rather than signalling the beginning of a fresh downturn in sterling it might present sterling bulls with better levels to buy.

Although UK economic fundamentals are likely to remain poor for some time, sterling is closely linked to indicators of global risk appetite. Equity markets want to believe in 'good news' and they want to believe that the whole range of monetary and fiscal measures being proposed and implemented will eventually work. There is a lot of cash on the sidelines and this 'hope' factor could easily lift equity markets higher during the rest of the first quarter. Let's see how equity markets react to any bad news in Friday's jobs report.

Elsewhere, the Japanese government is announcing proposals to reduce capital tax gains on foreign investments in Japanese equities. For Japanese institutional investors who are traditionally offshore investors, anything that improves sentiment at home increases the incentive to invest abroad especially as currency-adjusted fixed income yields in the US and UK deficit economies look very attractive. The Japanese authorities have said they do not want a stronger yen and, given the precarious state of the Japanese economy, a weaker yen is a likely outcome.

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Date:

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6th January 2009

A hesitant start for the equity markets as the global economic news continues to remain grim. In the UK, Marks & Spencer is expected to announce 1,000 job cuts and elsewhere in the UK retail sector the news is of more store closures and job losses. Unemployment is now rising faster than during the 1990s recession. This will maintain the pressure on the Bank of England (BoE) to cut interest rates aggressively on Thursday. The aftermath of severe financial crises shows deep and lasting effects on asset prices, output and employment. Real house prices decline by an average 35% over 6 years while equity prices decline 55% on average over a downturn of 3.5 years. The unemployment rate rises an average of 7 percentage points over an average 4-year downphase in the economic cycle while the real value of government debt explodes by an average 86% in the major post-WW2 financial crises (click here to see Reinhart and Rogoff's "The Aftermath of Financial Crises").

In the FX market at the start of the year, sterling has held up reasonably well despite all of this presumably reflecting the unwinding of previous short positions rather than anything fundamental. One thing I will be looking out for is whether the BoE signal displeasure with further sterling weakness. If they do then I think this provides a platform for positive gains in the currency.

Elsewhere Prof Buiter (ex-MPC member) warns of a dollar collapse in his Telegraph column (click here for the full article). I think the risk of a dollar collapse is small. The dollar is still the world's leading reserve currency and has the most liquid financial markets. The US household savings rate is now going up which not only rebalances the US economy but reduces reliance on foreign savings to finance budget deficits. Higher US savings (and less US consumer spending) also translates into a narrower US trade deficit.The idea that recent Fed monetary measures (zero rates and expansion of the Fed balance sheet) is a precursor to debasement of the currency also needs examination. A recent speech by the Fed's Janet Yellen made a distinction between the Fed's 'quantitative easing' and the Bank of Japan's (BoJ) 'quantitative easing'. In the BoJ's case, the focus was on the liabilty side of the balance sheet via an expansion of excess reserves. In the Fed's case, Yellen says the focus is on the asset side via interventions in various asset markets and says it is not so much a policy of 'quantitative easing' rather it is a policy of "interest rates on steroids". So Fed policy is designed to reduce market rates and spreads rather than deliberately reflate, inflate and (ultimately) depreciate the currency. This is an important distinction for the dollar I think.

Separately, in the very short term, it is worth noting that seasonal factors tend to support the dollar in January with 71% positive returns over the past 10 years with Q1 typically the best performing quarter in the year for the dollar. As far as the euro is concerned, Bank of America's economic team point out that the non-financial corporate sector is more leveraged in the eurozone than in the US. Corporate profitabilty has already been hit by higher debt service and the amount of debt to rollover in the eurozone is huge. So watch out the euro.

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Date:

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5th January 2009

Welcome back. Let's hope 2009 is a better year. However, most of the economic newsflow during the first quarter is unlikely to lift the gloom particularly as most of that newsflow will relate to the tail-end of 2008. The bottom line is that the global economy is fighting to stave off both depression and deflation. In the UK, the economic news, whether it is Marks & Spencers Christmas sales results or deteriorating employment surveys remains poor. The British Chambers of Commerce are calling for a 1% interest rate cut on Thursday. I think they are right as there seems no point in hanging about. As far as sterling is concerned, what turned out to be a one-way bet is now looking more like a two-way bet. I believe sterling is oversold and undervalued and wonder whether we may have already seen the peak against the euro just short of parity. A further slide in sterling would do little to entice foreign investors to fund the UK budget deficit. Sooner rather than later I think the Bank of England and UK government will change their tune as regards the trade benefits of a weaker pound.

Elsewhere, President-elect Obama is inaugurated on the 20th January and the markets are hoping that there will be a fresh stimulus package. This Friday's US jobs report is expected to show a further rise in unemployment. The Federal Reserve has already cut targeted short-term interest rates to virtually zero and the monetary base and central bank balance sheet has expanded sharply. However, I think the payback for the credit and housing market bubbles will take time, so those with hopes of an early economic recovery stand to be disappointed. Interestingly, the dollar is holding up. What is bad for the US economy is doubly bad for the rest of the world economy. The eurozone will get hit from a collapse in global demand and monetary and fiscal policies that are too restrictive will dent domestic demand. A strong euro does the eurozone no favours especially as some countries in the eurozone have double-digit current account deficits as a percentage of GDP. So I expect a weaker euro this year. I note that Goldman this morning released a "top trade" recommendation to sell the euro against a basket of sterling, Norwegian krone and Swedish krona. They also want to go long cable at 1.48 for an initial target of 1.65.

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