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“Beware of meat twice boiled, and an old foe reconciled”

Benjamin Franklin

“People hate those who make them feel their own inferiority”

Lord Chesterfield

1. The case for buying the euro?

I recently read an analysis that promoted why the euro was a better currency to own than the dollar at present. The summary of this ’analysis’ is:

• Europe’s exposure to emerging economies will positively surprise its equity markets.
• There is an improving sentiment towards Europe’s major banks, combined with the possibility of a strengthened European bailout fund.
• Despite the negative implications a stronger euro may have on European exporters, the improvement of underlying economic fundamentals could help overcome any currency drag, potentially implying higher valuations for Europe’s global conglomerates.
• Industrial orders in the eurozone grew 2.1% month-to-month last November, slightly higher than forecast, and 20% year-over-year.
• Germany’s orders rose 5.3% between October and November 2010.
• Germany’s gross investment in plant and equipment grew by 9.4% last year, and this year is expected to approach the 2008 record level of €201.6 billion.
• Companies that deferred capital spending during the financial crisis will have to reinvest sooner or later due to the depreciation of the capital stock, and this reinvestment will create a virtuous cycle of demand that could have a profoundly positive effects on overall economic activity (and inflation).
• The widely-followed Ifo Business Climate Index, derived from a survey of 7,000 German executives, jumped from 109.8 in December to 110.3 in January – the highest level since German reunification began in 1991.
• Germany’s economy grew 3.6% in 2010 – the fastest growth rate since reunification – with domestic demand contributing 2.5 percentage points to growth and net trade adding 1.1 percentage points. Exports grew 14% and unemployment fell by over 260,000, with December’s seasonally-adjusted unemployment rate of 7.5% also marking a post-reunification low.
• Domestic demand is now picking up in Germany, yet it’s doing that hardly anywhere else in the eurozone.
• Germany should comfortably beat the EU’s budget deficit rules this year, with an expected deficit of 2.5% of GDP, comfortably below the EU’s 3% benchmark. Economic growth is conservatively estimated at 2.3% this year, which also exceeds the eurozone’s average estimate of 1.7%.
• The Markit eurozone composite PMI for services and manufacturing expanded from 55.5 inDecember to 56.3 in January – considerably higher than economists’ estimates of 55.6.

You will see the problems in the analysis immediately – hyperbole (is an increase of 55.5 to 56.3 in a verbal survey ’considerable’? Is an increase from 109.8 to 110.3 an increase or a ’jump’?), and a very heavy reliance on Germany to impress the statistics implicitly attributed to the eurozone.

The conundrum is this – you may well wish to buy the euro because of Germany, but the euro is not German. In fact, the problems in the eurozone are all non-German, although some of them have been created because of German economic policies. Yet, it is as clear that the euro is viewed as German by euro bulls as much as it is viewed as a PIIGS currency by euro bears, a bit like the South African Rand is viewed as a precious metals currency by simplistic analysis when in fact it is a services driven economy. People believe what they want.

The debate will continue on how to view the euro. My analysis is to stop wasting one’s time. Germany is exposed to the economic growth of emerging markets, Asia in particular. If China’s attempt to control rising domestic inflationary pressure results in a necessary and sustained tightening of Chinese monetary policy, which is my base case (see previous blogs below), then China faces a hard economic landing which will hurt Germany severely. If German economic growth and its fiscal picture weaken in the second half of 2011, don’t look to France or the rest of the eurozone to mop up the slack in peripheral countries. The euro is a flawed currency that has now had to resort to money printing by national central banks beyond the ECB (unimaginable pre-2008) with the associated obscure fiscal and misleading accounting.

The euro lacks fiscal cohesion and, like all businesses, will only prove as good as the lowest common denominator within it, no matter how strong the highest common denominator is to cover the cracks in the short term. In addition, compare current German economic statistics to those of the US (the latter’s export growth is stronger than Germany’s); US current economic growth is stronger, US fiscal unity will prevent calamity from occurring at a state level in 2011, US long-term demographics are significantly healthier, and US labour markets more flexible. Yes, its housing market is in disarray and may even be worsening, and its Federal debt continues to expand. But we remain in a developed world bear market, so you should not be looking for perfection anywhere. With geopolitical risks rising in the Middle East and Pakistan, with equity markets beginning to look fragile, I have to be bullish of the dollar in the short term.

If, sometime in the next few months, either the ECB or the BoE raise interest rates to combat external inflation (which really would be repeating the madness of the ECB raising interest rates in August 2008 to combat a rising oil price which served to push the US dollar-priced oil market up a further $35), then one should find the right spot to sell both currencies shortly but not immediately thereafter. In the meantime, I remain focused on a re-test of the $1.52 level versus GBP and the $1.30 level versus the euro.

2. Technical Analysis

What are the merits of technical analysis in one’s investment research? It is a highly contentious debate. The most intelligent reasons to look at charts that I have heard are:

• A chart shows the momentum and likely investor positioning (and thus ’pain’ areas) in a specific market.
• ’Almost everyone’ follows them so ’everyone else’ must follow them too, so they become self-fulfilling.

I find both of these arguments to have either little intellectual value in the first reason or none at all in the second. In addition, given the efficiency of pricing and valuation in most markets in the fully transparent world we live in, trend line breaks (the event when an old trend line is rubbed out and a new one is drawn) too often these days are false breaks to profit the market makers and trading desks at investment banks who know exactly where their clients have stops (which they trigger) prior to reversing the market back to its starting point.

Despite this cynicism, I would be hypocritical if I did not admit to focusing on technical analysis as a part of our investment process, if only to know how the non-fundamental sector of the market is thinking and positioned. We try to leave nothing alone, even if our subscription to technical analysis is based on a second derivative approach. One of the best technical analysts that we have recently come across is Sylvain Asimus of Phinamics, which is an independent research portal providing technical analysis of the global financial markets with animated charts (click here to view some of their analysis). Demos of the major Stock indices (click here), FX crosses (click here), Bond futures (click here) and Commodities (click here) can be seen by following the links too. Narration is included, therefore it is best with your computer’s sound on.

3. GBP, interest rates, opportunity and then trouble to come.

One chart to focus on at present is GBP. Neil Staines, my colleague, has been writing to you recently about GBP and the potential for stagflation. It is a real risk. However, in the medium term (2-4 months), I believe that the UK economy, subsequent to a very sticky patch of economic data in January and maybe February that drives GBP lower, will prove somewhat more resilient than expected, whilst simultaneously seeing no respite from external inflationary pressures (food and energy) and being subject to increasing labour unrest seeking higher wages. This cocktail is GBP bullish for a short period probably in Q2 2011, and I really can see an opportunity in the next few weeks to be buying GBP for a significant gain in value of some 5% to 10% versus other currencies, as the BoE is forced to tighten interest rates probably in March or April, and possibly in tandem with the ECB.

Now, I would not be supportive of this move in BoE or ECB monetary policy, but it is not about what I believe but about what key policy makers do. It is an analysis that I am spending a lot of thought on, and ’feel’ a significant GBP buying moment is ahead. I will write more about this (as will Neil) in the coming weeks. In the meantime, we remain focused on the imminent opportunity to buy gold below $1,300, which we have been patiently waiting for as the gold price descends to our buying zone (seeing a low last week of $1,308). Nigel Atkinson, our commodities expert, sees no relief from the strength in the sugar or corn bull markets; and I expect equities to weaken by some 5% to 8% from last week’s highs in the coming weeks. In sum, 2011 is setting itself up to be a very interesting and opportunistic year for global macro investment opportunities as the profligate fiscal policies of 2009-10, which artificially neutralised underlying fundamentals and caused significant capital destruction for many technical analysts, diminish in influence, allowing economic fundamentals to re-assert themselves as the principal driver or price movement. Good luck.

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The price action in the foreign exchange markets over the last 24 hours has been dominated by central bank meetings and their board minutes. Recently, the word ‘uncertainty’ has been a mainstay of rhetoric and report from the world’s major central banks and while there has been a common theme among most – ZIRP, or zero interest rate policy – the approach to unconventional monetary stimulus has varied.

In the UK yesterday we witnessed the release of the January Monetary Policy Committee (MPC) meeting minutes. It was very apparent from the minutes that, at the time of the meeting, the MPC was under a lot of pressure to acknowledge the rise in inflation and, while the core of the committee remained in the ‘wait and see’ camp, there was an almost reluctant admission that there had been a rise in the upside risks to inflation. Cynics may say that the tone of the minutes expressed an understanding of the concerns of the MPC’s critics (even going as far as to explain its understanding of the origins of inflationary pressures and highlighting that it is fully aware and alert to their developments) but stood by its call that inflation will come back to target in the medium term (by which they mean the two year forecast horizon).

There is little doubt that on the face of it, the minutes expressed a more hawkish tone across the board. However, a lot has changed in the two weeks since the MPC meeting and, following on from the shock negative Q4 GDP release, the continued dovish statements uttered by Bank of England (BoE) Governor Mervyn King on Wednesday should give the economy’s still nascent recovery more comfort that a rate rise is not imminent. King, while acknowledging that inflation may rise further over coming months, maintained that the outlook is to be “shaped by the fiscal squeeze” with “UK domestic spending still facing strong headwinds” and that the BoE sees “UK inflation slowing ‘quite sharply’ next year.”

Last night’s FOMC was broadly as expected with very little change to the statement. The market had been tentatively expecting a slightly more dovish tone due to the new arrivals on the voting panel. However, as we suggested earlier in the week, the additional ‘hawks’ toed the line with a unanimous vote for maintaining rates and the completion of QE2. The fact that the sole dissenter for past months, Hoenig, is no longer a voting member gave the statement a slightly more dovish feel but, with President Obama’s initiation of a more fiscally prudent stance in the state of the union address, this was likely at this stage of the recovery. The Fed will gradually get more hawkish as the recovery develops (as was suggested by the subtle changes to the statement in upgrading its view on household and business spending) but for now the status quo continues and the core focus of the Fed, and as such the market, is on improvements in the unemployment rate.

This is a very important juncture for FX markets and particularly in respect to the UK and GBP. The blog from earlier this week that outlined our view that the press, and indeed the market, would begin to focus on stagflation has, in some respects, been postponed as the more hawkish bias to the (albeit outdated) January MPC minutes allowed some commentators to raise the possibility of a pre-emptive move in UK interest rates.

I firmly maintain that an interest rate rise in the first half of the year would be a mistake. However, if the weaker macro-economic data that we are expecting in Q1 does not start to appear, there is a possibility that the BoE may start to talk the pound up. The benefits of this would be a defence against imported inflation rather than having to use the more conventional monetary policy tools, which would risk curbing growth through further slowing the property market and, as a result, consumer spending. There are risks to this strategy in that it potentially impacts the main driver of current UK growth, manufacturing exports, but the core implication remains important. There is likely to be a very strong opportunity to benefit from buying GBP.

In our preferred scenario, this will come from the full removal of the interest rate/inflation driven premium that has been built into GBP and will allow us to build a structural long GBP position from our preferred lower levels. Alternatively, as we have discussed above, there is an argument that the data in the first quarter is more robust and the case for a more structural GBP rise even from current levels can be built.

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The start of 2011 has witnessed a sharp turnaround in interest rate rise expectations in the UK, particularly following the higher than expected CPI release for December at a 3.7% annual rate. In fact The Telegraph even uttered the ‘s’ word yesterday in its editorial comment (click here). 

Philip’s piece yesterday outlined the increasingly important impact of rising food prices on the global economy and this is also being felt in the UK. Despite the fact that the proportion of disposable income that is spent on food in the UK is much lower than in the emerging world, its impact on overall prices is significant with food price inflation running at around 5.7% per annum.

The transiency of the impact on overall price inflation from food, energy and tax rises has been an important moot point, not just among financial markets but it is at the heart of the policy debate at the Bank of England (BoE). Adam Posen, whilst retaining his position as the leader of the ‘doves’ on the MPC, was clear in his published discussions last week that he expects UK inflation to slow “well below” the 2% target by the two-year policy forecast horizon. Posen went further to express a concern about downside risks to housing and reiterated that the surge is temporary and that CPI – ex currency, commodities and vat impact – is low.

To counter the sentiment of Posen, the other end of the ‘hawkometer’ at the MPC was expressed overnight by Andrew Sentance. Sentance, whilst conceding that inflation is a result of sterling and commodity prices, failed to cede to the proposition that global factors affecting prices are short term. He went on to highlight that some data shows spare capacity at lower levels than expected and made further reference to BoE inflation fighting credibility in stating the “time has come for BoE to act on inflation.”

My view, which I suspect mirrors the rest of the MPC, is between the two. At the moment, the pressure to act (out of a defence of credibility and a fear of being behind the curve) is misplaced. The risks of hiking rates at this point of the recovery will lead to a market immediately pricing a series of hikes into the term structure and this seriously risks killing off the recovery altogether as was the case in Japan in the 1990s. GBP will have its day in the sun, it may even be relatively soon, but for now the market has got ahead of itself and GBP is vulnerable. 

An import factor to note in terms of the market reaction to Sentance’s comments last night was that, despite the hawkish nature of the comments, the front end of the interest rate curve was unchanged to slightly lower this morning, suggesting the market applies at least a small amount of discount to Sentance – at least until he is joined internally by another voting member.

Also interesting to note this week is the first US FOMC meeting of 2011, where the composition of the voting members is likely to swing more towards a moderately hawkish bias as the four new (voting) members (Plosser, Kocherlakota, Evans and Fisher) have expressed scepticism of the ‘too low for too long’ Fed policy. The implications for their inaugural meeting are limited given the current state of Fed policy workings and it is very unlikely that policy is altered in any form at this week’s policy meeting. However, I would expect the bias to begin to shift to a more neutral tone in Q2 as QE2 is completed.

In the eurozone, an unwinding of negative sentiment towards the periphery and a growing consensus that the EU will unveil a comprehensive solution to the medium-term funding concerns of the monetary union, has continued to benefit the single currency. Interest rate expectations have been a key driver of this move as eurozone fixed income has sold off. Arguably, however, the default role of EUR as the funding currency of choice in the last quarter of 2010 across the EM market as well as the major FX space, is a major contributor as the market reviews its long-term view of eurozone weakness.

Following the much weaker than expected Q4 GDP figure from the UK, the ‘s’ word – stagflation – will start to appear more and more in the press as we have alluded to in previous blogs. The -0.5% quarter on quarter Q4 release confounded even the most sceptical forecast and, despite the ONS comments that the weather may lead to bigger than usual revisions to the data and Osborne’s comments post the release that the weather was the key driver of the release, this is simply not enough to put the shine back on GBP or expectations. There is a lot of exuberance that needs to come out of interest rate expectations and GBP will bear the brunt.

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“Man is the creature of the era he lives in; very few can raise themselves above the ideas of the time”

Voltaire

“Whatever others may say about your faults (that you know you do not have), do not respond emotionally”

Sai Baba

1. Food Prices – the big Global Macro theme?

The fall of Tunisian President Zine el-Abidine Ben Ali has increased speculation across the region of further unrest on account of food price rises. Revolutions can be like dominos. The combination of soaring food prices and unemployment is not unique to Tunisia. Egypt, Algeria, Libya, Jordan, Morocco and Pakistan, with its 14.56% year-over-year inflation and unstable political situation, are all primed for similar upheaval. In the past few days, the governments of Libya, Jordan and Morocco have all taken steps to control food prices. The Indian government has banned the export of onions in an attempt to keep the lid on vegetable prices. China has cut road tolls for food trucks. Even the South Korean government has released emergency stocks of pork, fish and cabbages.

Billions of people are moving up the food chain – piling their plates with meat instead of rice and grains. Increasingly erratic weather patterns and higher oil prices are compounding price pressures. Earlier this month, the FAO (the UN’s Food and Agricultural Organisation) said its food price index jumped 32% in the second half of 2010, soaring past the previous record set in 2008. Prices rose again last week after the US Department of Agriculture (USDA) reduced its already limited grain inventories. Estimated reserves of corn were cut to about half the level in storage at the start of the 2010 harvest; soybean reserves are at their lowest level in three decades, largely due to heavy buying by the Chinese. The ratio of stocks to demand is expected to fall later this year to “levels unseen since the mid-1970s”, according to USDA.

History has shown us time and time again that people respond violently to rapid food inflation – especially in the developing world where close to 50%, sometimes 75% of incomes goes towards food. Pakistan’s worsening economic malaise is a ripe breeding ground for extremism and trouble with India as a deflection. Nearly 80% of the Pakistani population is food insecure, 73% suffer from various illnesses and inflation is at record levels. A weak government and a growing number of extremists are making it impossible to finance the budget deficit through foreign capital inflows, so the government is undertaking inflationary borrowing from the State Bank. The balance of payments deficit is placing intense pressure on the exchange rate and there is a danger that the depreciating exchange rate could begin feeding off the domestic inflation rate. If this happens, the inflation rate could rapidly reach a three-digit figure as it did in Germany in the 1920s. Political commentators believe that Pakistan and India remain the most likely place for war in the world, exceeding the Middle East.

Mayhem in the agricultural markets could intensify in 2011. Following the devastation of Russia’s wheat crop last summer from extreme heat and drought, the world was largely looking to Australia, the world’s fourth largest exporter of wheat, to fill the gap. However, the likelihood of this happening is fading as torrential rains are shifting south into primary wheat growing areas of Victoria and New South Wales (NSW). As a result, 40% to 50% of Victoria’s wheat crop could be downgraded to lower quality suitable only for feed grain. Further downgrading is also likely in NSW. Up to half of Australia’s national wheat crop, estimated at 23.37 million tons, could be downgraded. NSW has been hit even more severely by torrential rains and is expecting a 50% crop downgrade to feed quality. Treasurer Swan this weekend stated, “for consumers, we’ll inevitably see a spike in prices mainly from fruit and vegetables.”

The spreading disaster in Australia comes as wheat crops in China and the US are threatened as well. Conditions in Kansas, the nation’s largest winter-wheat state, range from abnormally dry to severe drought, according to the University of Nebraska. Nearly one third of the state’s winter wheat crop is in poor to very poor condition. In China, roughly 4 million hectares of crops in Henan, Shandong and Hebei, which are responsible for more than half of the country’s wheat output, are experiencing extended, extreme drought, receiving up to 90% less rain than last year. Rainfall has dropped to its lowest point since 1970, affecting roughly 4 million hectares of crops and leaving 2.2 million people short of drinking water. Shandong’s worst drought in half a century has impacted over half of its winter wheat fields, or about 2 million hectares. Recent snowstorms and sleet in China’s southern provinces, including Guizhou, Yunnan, and Hunan and Guangxi, have also negatively impacted crops of winter wheat, rapeseed, vegetables, oranges and tea. Ukraine also said this week that its wheat harvest fell 19% to 16.8 million tons in 2010.

Meanwhile, demand is increasing. This week, Turkey bought 145,000 metric tons of US wheat, bigger than the combined total of US shipments to the nation during the last three marketing years. Japan also purchased 149,114 tons of milling wheat from the US and Canada, its highest level in six weeks. Morocco, North Africa’s third largest importer of wheat, is also increasingly seeking to import more wheat from Argentina and the US after French prices have surged. Corn and Soybeans also advanced this week in anticipation of increased Chinese imports.

We maintain our theme of previous blogs: food is already the number one global macro factor in 2011. Watch this space very closely. The global economy is at risk once again.

2. The US municipal bond market: worse than Europe?

Meredith Whitney, a top ranking bank analyst in the US, has predicted “hundreds of billions” of defaults in the US municipal bond market. State Medicaid, unemployment and other social support costs have already risen and are trending higher. Public pension and healthcare liabilities are enormous. Depressed home values will soon start manifesting in lower property tax revenues which towns and municipalities rely on for at least 25% of their revenue. While local tax revenues have started to pick up, state governments will now have to confront their fiscal deficits without as much federal support. According to the National Conference of State Legislature, states will have about $37.9 billion less in aid in the fiscal 2012 year, which for most begins on July 1, than in the current fiscal year.

Municipal borrowers will also no longer enjoy the benefit of the Build America bond program. This year, States will also have to begin paying back to the federal government the $40.9 billion they borrowed interest-free through the stimulus plan. And then there is the problem of the banks. The big banks backstopped billions of dollars of municipal obligations with letters of credit – letters of credit that are coming due which they do not want to renew. The immediate under-the-radar problem for the municipal bond market is that borrowers relied on banks to backstop their credits and lower short-term funding costs when the credit crisis shut the door on auction rate preferred financing. While most municipal borrowings are long term, they still have short-term obligations that need to be rolled-over. And although their ratings remained intact during the crisis, investors demanded higher interest on their loans to even the strongest borrowers. To keep borrowing costs from exploding, municipal borrowers sought big bank letters of credit as backstop guarantees on the shorter-than-they-wanted variable-rate demand obligations they turned to. According to Bank of America Merrill Lynch, $109 billion of different kinds of credit backstops and guarantees will be expiring in 2011. Thomson Reuters estimates that $53 billion of those guarantees are bank letters of credit. Shut out of low interest rate borrowings by banks, which face new restrictions on risk, rising rates on variable-rate demand obligations could be the tipping point for Muni issuers. Roll-over crunches played a big role in the financial crisis of 2008...and more recently in Greece and Ireland’s unravelling. The Muni bond market remains a big threat in 2011 to US financial stability should the global economic growth story slow down significantly.

I feel that the perfect debt storm is ready to happen. This does not mean it will happen. But you can now connect the two points of this blog, and conclude that if weather-related supply and demographic-related demand factors continue to push up food prices, real problems may occur in tenuous political regimes (which include China and India) directly or indirectly. Should their approach be to slow domestic growth further with additional monetary tightening and thus slow demographic internal demand, the impact on exports production in Europe and the US will be deeply damaging. If economic growth stalls in the US and Europe, debt defaults will soon follow, in the US municipal bond markets and the peripheral eurozone sovereign bond markets. It’s not just revolutions that act like dominos. At this time, my feeling is that there is no less than a 50% chance of debt defaults occurring in either market in the second half of 2011, and the skew of risk to this view is heavy to heightened risk. Watch this space too. The western credit markets are also at major risk of descending into systemic trouble once again.

What does this mean for macro markets in the short term? Well, gold is moving towards our buying zone below $1,300. It will be scary to buy it below there, as levels of volatility and fear will be high, but the opportunity may be brief. The EURUSD FX rate has challenged the $1.35 to $1.38 area as I suggested that it might in this blog last week, and I am expecting it to stall and reverse as early as this week, with a target back towards $1.30. GBPUSD too has stalled at $1.60, and I also expect this rate to begin to react more weakly to poor UK economic news which will combine with higher than desired inflation to prove negative for sterling. Our target remains $1.52. Also in FX, a key focus for me now is EURCHF…if we are right to be worried, this rate also needs to hold at the current level just above 1.30 and turn back down.

Equities look precipitous, and I would be out of all equity positions at this time, despite all of the bullish forecasts everywhere else…being short is a tough call (albeit one we have now made), because the weight of money and ’need’ of investors, the financial community and the central banks for higher equity prices is obvious. But there are many things that we may want to happen. It doesn’t always happen as you want it to.

It’s going to be a pivotal week for the financial markets. By the end of it, I expect the dollar to be moving higher and sterling moving lower along with equities. Good luck.

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FX markets are gyrating in broad but defined technical ranges in major currency pairs amidst low levels of conviction and high levels of uncertainty about prospective interest rate moves in the US, the eurozone and the UK.

In the US, the focus continues to be on the sustainability and strength of the financial recovery and how the Fed’s objective for full employment plays out against the fear of the implications of fiscal laxity that the current high level of monetary accommodation may have on its other core mandate, price stability.

Internally, the US has clearly begun to examine – and put into practice – fiscal measures at a state level after the municipal bond market groaned heavily under the burden of pressure from state government finances. The US has some large adjustments to make. It has longer-term concerns over the sustainability of its fiscal deficit, yet in the short term in my opinion, the US is clearly a safer place to hold funds when compared to the UK and the eurozone. When the focus of market attention turns to ‘risk off’, USD will be the clear winner. That moment might just be imminent.

In the eurozone, the core focus continues to be on the financing of the periphery countries and the potential measures that are likely to be put in place as a long-term structural financing replacement to the emergency measures enacted by the ECB at the height of the funding difficulties. 

The changes being considered include: an increase in EFSF (European Financial Stability Facility), the ability for it to buy bonds, debt buybacks, lower rescue loan interest rates and giving aid to banks, not just sovereigns. However, there is yet to be any formal agreement or proposal, and the conflicting rhetoric from within the member states does nothing to dispel the uncertainty.

Eurozone peripheral spreads have narrowed as a result of successful bond auctions and syndications over the last week, and the immediate funding concerns of Portugal and Spain in particular seem to have ebbed from the core market focus. 

The issue, however, remains. Suggestions that old debt could be bought by the AAA rated EFSF to repay periphery debt, with or without a haircut, seem to me to be dangerously close to the principle of grouping together assorted sub-prime loans and giving the ‘portfolio’ security a AAA rating, and this ultimately continues to increase the burden on the core countries (especially Germany). How long before one of the core countries begins to face pressure on their AAA rating or worse?

In the UK, the market has become more acutely focussed on the rate of inflation and the policy reaction of the Bank of England’s Monetary Policy Committee (MPC), with the rate of growth of consumer prices hitting 3.7% in December, above expectations and considerably above the upper bound of the MPC’s target at the two-year forecast horizon. There has been a very sharp move in interest rate expectations with the market pricing in rate hikes prior to the CPI data in expectation of a high print and, since the release (and whether it is a function of concerns over stagflation or some acceptance of the transiency of the current price pressures), we have seen rate expectations pared back by around 20bps in the June short sterling interest rate futures contract. Adam Posen’s comments last night will likely have persuaded some of the hawks that the MPC are in no desperate rush to tighten.

We are now in a period of reflection for the UK. Inflation has exceeded expectations, yet the reality of growth data is yet to be validated. Expectations of Q4 GDP have been revised lower and disappointing data will test the resolve of even the most stubborn GBP bull. Our views that GBP (and indeed EUR) will suffer in the near term remain. This move is likely to accelerate as the market begins to price out the irrational rate exuberance in the eurozone sparked by ECB president Trichet’s (diversionary) rhetoric and, similarly, the reversal in UK rate expectations will weigh on GBP.

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“He then remains equally calm when the majority is on his side as when he finds himself in a minority for he has done his part: he has expressed his convictions; he is not lord over minds and attitudes”

Goethe

“The whole problem with the world is that fools and fanatics are always so certain of themselves, but wiser people so full of doubts”

Bertrand Russell

The ECB’s President Trichet proved to be cleverer than his audience on Thursday at the monthly press announcement. The ECB is faced with a seemingly endless road of having to prop up the peripheral European bond markets as the market continued to press on the fiscal cracks in Portugal and Spain (and Greece, and Italy, and Belgium); armed with information that the market was positioned heavily short of the euro, he neatly switched investor focus, emanating optimism that his concentration need no longer be on the European credit crisis but on the risk to inflationary growth in the future. The euro exploded higher as short positions established by both medium-term players over the last few months and short-term players who had positioned short since the start of the year, were covered. The European credit default swap market, which insures against credit risks, dropped significantly in price too.

All the financial media could talk about into and throughout this weekend was the ECB monetary policy, euro inflation concerns and the prospect for higher ECB interest rates. Now you know why my previous blogs have been so disparaging about the usefulness of strategists and economists – unless you are ECB President Trichet who knows how to manipulate people who purport to know more about financial markets than they really do, who command an audience who have ceded their own intellect and education to anyone who has a view that can make them money in a desperate search for performance.

So here is my response: the ECB will not be raising rates in 2011. The fiscal crisis in Europe has gone nowhere and remains the biggest credit risk in financial markets today, exceeding internal fiscal issues in the US. Europe’s fiscal sums did not add up prior to last week, and won’t add up after this weekend. Rather than listen to sales desk noise and central bank manipulation (the latter an evident key driver of short-term profitability), financial investors should be much more focused on the medium-term macro event that remains the key determinant of both global economic growth and the fate of the FX markets.

China’s growing battle against food price inflation is being exacerbated by rising wage growth, extraordinary weather distortions and financial market liquidity driving a trend in motion at an even faster pace to a greater extreme. Food is a matter of human necessity that not even the Chinese Communist Party can control, much as they might try (they are buying up huge swathes of farmland in Africa and South America). Production simply cannot respond sufficiently in short order. Our weather expert (we think he is amongst the best in the world), Kevin Marcus, comments in an internal note as follows:

“We have been in a climate forcing regime that is more meridional (north/south) in nature rather than zonal (east/west). The result is the extreme weather events you [have seen recently]. This new regime seemed to kick in strongly about three years ago and is similar to what was observed in the 1950s ad 60s. Another added element is the very weak sun activity that seems to be making weather conditions more extreme in some cases than what was observed 50 to 60 years ago. Indications are that we will continue to be in this meridional flow pattern for at least 10 more years, resulting in continuation of extreme weather events. When you overlap that with tight food stocks and increasing demand from population growth and wealth creation in India and China, you indeed have a perfect storm, which will be with us well beyond 2011.”

It is our bet that China has to continue its tightening in the first half of 2011 in order to manage food price inflation and quell the rising risk of social unrest. News emanating out of Tunisia this weekend (where rising food prices were the catalyst for political upheaval) will certainly not have gone unnoticed in Beijing. As I have stated previously, the risks to current market-wide global growth forecasts in a world painted as one of nirvana by most of the investment bank economists (aka salesmen), are significant. There is minimal risk, in my opinion, of growth surprising to the upside. What this means to you is that the best news on economic growth is probably fully priced, and anything less is probably not.

So, here is the problem for Europe: any slowdown to both real global economic growth data and to forecast economic growth data (which will occur as the banks react as usual to an extreme degree with revisions in a knee jerk fashion) will have serious implications to European trade data…and the associated industrial production data…and then employment data…and then income or wage data…and then unemployment benefits…and then electorate unrest and so on. The fiscal sums will just not add up. Germany, which by then will be weakening itself because of its huge exposure via exports to emerging market growth, will simply not cough up the necessary support required to bandage over peripheral Europe’s inability to finance their national debts, as Germany has done to date in a belief that the bandaging would not last long if the global recovery stayed on track. Europe has been buying itself time in the belief that stronger economic growth will generate rising tax revenues and would heal, in due course, fiscal deficits, and the short-term bill for supporting Europe was a price worth paying. This will change in 2011 as I expect global growth to disappoint.

Might I be wrong? Of course, but our analysis of risk and reward in conjunction with the prevailing global growth view is that there is little upside risk to current economic forecasts; we are seeing no measurable income growth in G7; unemployment remains secular not cyclical; central banks know that there is minimal room for wage price hikes (the second round effect that drives their monetary policy especially in the UK), given labour’s lack of pricing power; property markets continue to decline in price, leaving a speculative equity market as the only driver of asset wealth to a deleveraging consumer, and the most open and optimistic consumer economy in the western world is witnessing deflationary risks more than inflationary ones according to its central bank, the Federal Reserve. If there is minimal inflation growth in the US, what could the near-term inflation problem really be in Europe and the UK, other than that induced by too much rigidity in their labour markets?

You should focus on Chinese monetary policy, and indeed wider Asia’s monetary policy more than on the words of the ECB. Macro markets will be driven by what happens to Chinese economic growth from the consequences of the global battle against food price inflation. I think that Asia has an inflation problem that has consequences for its growth rate, and that we will be bequeathed the growth problem sooner rather than later.

The implications for financial markets: does the euro squeeze higher against the dollar to 1.37 or 1.38? Does sterling push higher to $1.61 or $1.62? Possibly, but the risks are that both do not, although I expect them to try to for a few days longer. Do equities continue to grind higher crushing shorts along the way each day? The US equity market has not had a daily correction of more than 1% since late November, and last Monday’s 0.32% sell-off was the biggest daily correction since the beginning of December, which itself is extraordinary given that in the previous 50 years, there have only been three 30-day periods when the US equity market has not evidenced a maximum daily correction of more than 0.33%. Equities are climbing a wall of optimism and have nothing but a big chasm beneath.

We are bearish short term of both euro and sterling versus the dollar, continue to question why USDJPY is trading at less than ¥83 and EURJPY trading at less than ¥111 if European interest rates are about to rise, and bearish of global equities from this point. The tightening in Asian monetary policy is also negative in the short term for precious metals (although we are noticing the short-term strength of platinum as a sobering indicator – nothing is ever easy in financial markets), as we continue to focus on gold presenting a big buying opportunity below $1,300, once equities start to fall. So, all our eyes are on food price inflation and not on the successful façade of confidence and deflection from a clever ECB President. Good luck.

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All of the focus of financial markets yesterday was on the ECB and the Spanish and Italian debt sales. The reaction to the decent, yet widely expected, demand for Spanish and Italian paper was much the same as that to the Portuguese auction on Wednesday. While the result was very much expected, there was an air of relief that the immediate funding requirements of the three (biggest) PIIGS, were satisfied. It was no surprise to us. What else did you expect – the eurozone to risk a rout?

The story is not over for the periphery, however; the redemption calendar for Portugal and Spain next month is onerous and the funding requirements over the next four months are very large. The concern over this funding need is exacerbated by the level of rates that the periphery is having to pay to borrow money, and the key concern going forward, at least in the short term, is not whether the periphery raise funds, but whether it can afford to finance itself at the prevailing market rates? The Germans have stated that they will not further subsidise the periphery at this time.

The big ‘event’ of yesterday, however, was the ECB press conference with a subtle but important change to the recent ECB message of a neutral stance to monetary policy. President Trichet caught the market by surprise by explicitly referencing the fact that “risks to the inflation outlook could move to the upside”. He maintained that “inflation pressures are to be contained over the medium term” and that the key risk of (rising) inflation expectations “continue[s] to be firmly anchored”. Further intimation that growth divergence within the eurozone would not prevent the ECB from raising rates combined with the broadly upbeat rhetoric saw eurozone interest rates move sharply higher.

In response to questioning, the ECB President also asked governments for an expansion in quantity and quality of the European Financial Stability Fund, which added fuel to the fire of EUR buying as rates and FX markets shifted sharply in favour of EUR. What followed was a huge position unwind in EUR and EUR crosses.

So what does this mean for FX from here? Despite market reaction to rhetoric combined with the substantial position unwinding that we have witnessed this week, I don’t see that anything has materially changed. The periphery still has funding issues and this is an issue for banks and governments alike. Growth rates in 2011 in the region are not going to be high enough to pay the bills, especially with growth risks in Asia (read China) heavily tilted to the downside. There is a negative convexity of rates being higher for those that are least able to pay. Despite the movements in EURIBOR yesterday, the ECB is not on the verge of raising rates.

At the moment, despite the occasional news highlights of US woes, I am still a strong advocate that there is no better alternative than to hold USD at the moment, as the concerns or uncertainties are greater elsewhere. Ultimately, this means that despite the (in some cases extreme) volatility in the first two weeks of this year, the global macroeconomic picture is still developing in line with our Roadmap for 2011 (click here). China remains the key macro volatility driver and, at the moment, they are trying to slow growth. Weather factors are slowing emerging market growth generally. Yet strong economic growth and thus tax revenues are critical to the PIIGS to pay the bills. The “wolf” (creditors demanding loan shark rates in return for funding) is at their door, despite the degree of economic growth optimism being propagated by the investment banks. This storm is building not dissipating.

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“The most exhausting thing in life, I have discovered, is being insincere”

Anne Morrow Lindbergh

“He has no enemies, but is intensely disliked by his friends”
Oscar Wilde

“People with courage distinguish what is right from what is wrong, and what is fact from what is not”
Kok Yim Ci Yuen

The dollar is strengthening, or is it that the euro is weakening? Or is it all just ‘early year noise’ so far in 2011, as not much has changed from a fundamental perspective from the last week of December 2010? Traders were intensely focused on last Friday’s employment report in the US, although I never know why. One feels like a kid playing a dice game as the hours and seconds tick towards the release. I know it is a stupid affair and so do most professional investors, but because everyone is so focused on this data release, we have to be too – it is a part of our lives which I have little respect for. Employment is a lagging economic indicator which gets severely revised in subsequent months in a world where we know that the US and Europe have a structural employment problem no matter what the monthly numbers state, which will prevail for some years to come in the absence of  new technical inventions.

The dollar is strengthening because the euro is weakening and because there is no other reserve currency alternative to alter this inverse relationship (other than gold, on which I will write about below). You should ignore the ’stuff’ that the investment banks are promoting about the US economy growing so strongly this year, that global growth forecasts look better with each new bank forecast, and that you should buy everything that they are selling. Isn’t that what they were writing and selling to you in 2003-7, with their structured products which were a cause of the sub-prime debt bust in 2007/2008? It is, you know.

We rely mostly on my own observations and analysis which are anecdotal, intuitive and economic. We focus on prevailing mass investor psychology and positioning and try to identify where their pain would be severe. We refuse, more than ever, to listen to the noise emanating from self serving spokesmen (a.k.a. economists, analysts or strategists or whatever), including public newsletter writers that have to appear more sensational than each other so as to catch the headlines and improve subscriptions. They don’t know, nor do I, nor do we. But we can think and analyse as well as anyone, and better than most.

Isn’t it perfectly clear what is going on most of the time? Macroeconomics really doesn’t change that quickly. Do you really need to become co-dependent on sell-side spokespeople for your economic research? Do you really think that they would be working in that horrendous big company institutional environment of vicious internal politics, company-wide inefficiency and mutual distrust if any of them knew where financial markets were really headed? Of course not.

Trust your own instincts. I do. And at present, my instincts are quite strong for the current short-term phase that I am limiting myself to, which may last no longer than a week at most before we review them all again; each week; each time.

What do I know now? That employment is not going to significantly improve in the US and Europe and, in properly measured full-time real jobs terms (exclude the part timers and “consultants”), unemployment is closer to 20% in most western countries. I reckon that this rate is not going to improve soon, because the G7’s labour demands are too high in a globalised world. I also think that incomes are not going to rise sufficiently to create any measurable consumer demand because there is a glut of labour; and I believe that banks are just not going to open the lending spigots because they have about as much faith in the merits of the average consumer and countrywide housing markets as I do.

So expect more of the same from the US in 2011 as you saw in 2010…continued Fed balance sheet expansion (quantitative easing) if allowed by Congress, which is something that needs focusing on now that the composition of Congress has altered. You can also expect continued fiscal expansion by the federal and local governments, albeit with stated commitments at both state and federal levels (which won’t be fulfilled) to rein in the debt in the years to come. The difference in 2011 is that the US municipal bond market may well come under life-threatening strain, as certain US states come under bankruptcy pressure, with Illinois already being highlighted. Are these reasons to own the US dollar in the medium term? No.

But Europe is also suffering from fiscal sums that will not add up and which Germany alone cannot compensate. Whilst I do not expect anything dramatic to happen anytime soon (although I do remain on alert that it may happen on any given day), the fiscal saga in Europe has a long way to run in 2011. Why do the fiscal sums not add up? Because the global economic growth story will probably not be robust enough to generate the tax revenue to service the debt. Why not? Because the engine of most of the current eurozone growth, Germany, is too reliant on Asia for its export demand and the risks to growth in Asia in 2011 are all heavily tilted to the downside, much as the risks to Asian inflation, global food prices, Asian interest rates and global weather turbulence are all heavily tilted to the upside. By the way, have you watched the performance of the Baltic Dry Index, a proxy for global trade via its relationship to shipping freight rates (click here)? It hardly suggests Chinese growth or even global growth is strengthening; and if it isn’t strengthening, then the markets have already priced in too much growth.

In the short term, I am expecting precious metals and some commodities (note some, not all) to continue to weaken and I am targeting silver to move below $27.00 and gold to move below $1,300. I do not think that these lows will last long, prior to a resumption of the bull market in both metals. This pretty much defines my short-term view of the US dollar, which I expect to move to €1.2750, and for sterling to be buffeted this week by weaker than expected economic data as it moves below 1.53 versus the dollar.

Sterling is finely balanced between the bullish potential for the Bank of England (actually the MPC) to either raise interest rates and/or sound more hawkish by moving one member off the fence to join Andrew Sentance, who has wanted to raise rates to fight above-target domestic  inflation on the one hand; and the risk that both the media and investors actually diagnose the problem as one of stagflation if the economic data is as moderate to weak in the next quarter as Governor King has been predicting, which would be bad for sterling. My view is that the latter conclusion will prevail later in the year and not before the former has gained more publicity. I am bullish of sterling against both the dollar and the Swiss franc from lower levels, using 1.51 and 1.44 respectively as my risk tolerance points. One other thing: watch the Liberal Democrats within the UK government coalition. They will need a fight with the Conservatives in the months to come (and should have used the university fee issue to have one), as their poll ratings drop off the charts. They need more of an independent status within the coalition or they risk losing their identity altogether. The grass roots of the party will not allow this. So I expect some political turbulence before the summer in UK politics. There is a by-election in the UK this week.

Why the Swiss franc? Have you been to Switzerland lately? It is ruinously expensive, so don’t go. Their exports rely on Germany. My view is that German growth is now peaking. The Swiss franc versus the euro will peak imminently too, absent any immediate fiscal default in peripheral Europe. Unless equity markets fall deeper and faster than I currently expect in Q1 2011, and it’s a finely balanced view, then the Swiss franc will trade more on its own developing domestic problems than as a safe haven from this point for several weeks. A meeting has been called by the government with unions and large corporations at short notice in Bern at the end of this week which demonstrates growing concern with the Swiss franc’s overvaulation.

What of the yen? It has a dreadful domestic debt to GDP ratio (210%) and Japan is dependent on two major economic regions (North America and China/Asia) for its exports, whose growth I believe is peaking right now. But Japan’s demographics suggest the prevailing repatriation of savings from overseas investments will continue throughout 2011, and that US bond yields are not ready to climb vertically at this time, albeit that the historical relationship between the yen and US medium-term interest rates has weakened significantly in 2010. I am aware that the speculative and momentum investment community believes the yen will weaken immediately ahead. I am not sure one way or another, and trust the yen even less.

But consistent with my theme of investment time horizons above, we are reviewing our macro views each minute of each day, and are focused on making money more than on being right. The way to make money in 2011 so far has been to be long the dollar and short the precious metals, whilst standing aside in equities. By the end of February, I expect the reverse to be true of the first two, and that equities will have started a long-term downtrend as the economic reality of low to moderate growth at best for years to come in G7 dawns on electorates and more puritanical politicians get elected because they “promise to be fiscally responsible for the benefit of future generations”. Let’s see.
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Outside of the much publicised concerns of the eurozone and its peripheral indebted nations (growing concerns over Belgian political rule, Spanish reliance on ECB funding, Portuguese (and Spanish) debt raising next week and rising peripheral yield spreads being the current focal points), there are some very interesting dynamics developing in the UK and the US, currently reflected in their respective currency dynamics.

In the UK and for GBP, we are at a very significant juncture for the prosperity of the UK and indeed of GBP. All key forecasts are, at the moment, dominated by a structural view of interest rate expectations and growth. However, the primary cause for concern for policy makers and analysts alike is the level of inflation (particularly in the first half of 2011) and its implications for policy, growth and its impact on GBP.

The high frequency economic data for October and November 2010 was strong, as positive survey sentiment was confirmed and GBP performed relatively well with the FX market pricing out further quantitative easing, despite the US embarking on further expansion of the money supply. The debate, however, is largely dependent on how the level of inflation will interact with the likely slowdown in the economy as the fiscal austerity measures begin to impact in the UK. Many economists now believe that the negative knock-on effects of the VAT rise at the start of this year are likely to be larger than anticipated and the likelihood that consumer inflation hits 4.0% in the first quarter is now high.

The UK interest rate curve has already risen (though so have the curves of all major economies) and the pressure on the Bank of England’s Monetary Policy Committee to raise, or at a very minimum make more noise about the potential to raise, interest rates to maintain both its grip on inflation and its credibility as an inflation fighter, are intensifying.

While over the course of 2011 we feel strongly that there is significant opportunity for GBP to appreciate significantly versus the USD and EUR, we feel at the moment that the market has got ahead of itself in focusing on the positive impact of rising interest rates, as yesterday’s service sector data highlighted, showing a December contraction. It is worth noting that the service sector accounts for approximately 75% of the UK economy. We are likely to hear the frequent use of the word ‘stagflation’ in the press before we can get too bullish for GBP on the foreign exchange markets.

The US is enjoying a day or two in the sun at the moment as confidence data and business surveys continue to point to growth, albeit unspectacular. Today brings us to an important juncture, however, with data on the core defining facet of US policy – or Bernanke’s ‘primary source of risk’ to the US recovery – unemployment.

While one set of employment data is unlikely to change the global view or trend in the US labour market, it is likely to define near-term sentiment and positioning in USD. The median market estimate is an increase of 160k in the headline unemployment claims change, yet recent private sector survey data suggests this afternoon’s release may be more likely to surprise.

Interest rates in the US continue to pressure the upside, despite Bernanke’s attempts to push term rates lower through his second expansion of the money supply and in the short term, this will continue to be a significant driver of USD sentiment.

It is important to note, however, Treasury Secretary Geithner’s warnings to lawmakers yesterday that the national debt could hit the legal limit on borrowing as soon as 31 March 2011. He also urged quick action to avoid a government (municipal) default that he said would spark “catastrophic economic consequences” that could last a decade. These two factors are not at the forefront of the markets concerns at the moment but they will become so as the first half of the year progresses and Phase Three of our Roadmap for 2011 takes hold (click here).

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Financial markets were very thin over the festive period, and indeed for a longer than usual period in the run up to the end of the year, as apathy grew on the back of mediocre performance and a confusion over ‘value’ and the future course of global prosperity and international economic differentiation.

As we start 2011 in earnest this morning, the market will now have to take a view on the developments of a number of defining economic and political factors that are key to the FX space in 2011. Global growth is likely to continue positively yet modestly, and differentiation offers significant opportunity. Whether it is the differentiation of growth potential, economic and political fragility, sustainability of finances, or any number of relative value bases, opportunities for 2011 are significant.

The disparity of opinion and hence strength of opportunity is perfectly highlighted by the UK. I am a very strong advocate of GBP outperformance in 2011, however, market realisation of this outperformance is likely to emerge slowly as the year progresses and the fog surrounding the impact of the government’s austerity measures begins to clear.

This morning’s FT leads with an article that the UK’s deficit reduction programme will remain on track as the planned and implemented austerity measures will not stunt growth enough to cause a double dip recession (click here). In an ‘extensive survey of leading economists’, the consensus thought that the deficit reduction plan will be on track by the end of the year. This is far from the consensus view of the financial markets as GBP has been consistently the weakest link in FX over recent weeks, something I expect to continue, bar one-off flows, in the very short term.

This survey highlights the positive side of the GBP argument and in terms of relative value GBP is very cheap. However, the FT poll also highlighted two key concerns which will weigh heavily on GBP until the market can get comfortable that there is resolution. The two concerns are i) the UK’s stubbornly high inflation (a very important factor going forward, highlighting the potential impact on nascent growth recovery should the MPC be forced into raising interest rates to defend their inflation fighting credibility), and ii) the risk that the eurozone sovereign debt crisis re-ignites. 

These two factors will weigh on GBP sentiment in the short term as the European fiscal, political and debt concerns and the impact of austerity measures create enough uncertainty to prevent GBP from realising its potential amid what I feel will be a very nervous and noisy (volatile) start to 2011.

High frequency macroeconomic data out this morning has been on the strong side with better than expected manufacturing PMIs from the eurozone and the UK, yet this ‘good news’ is likely to add to the potential energy of GBP in the longer term. However, it is unlikely to be the focal point of financial markets in anything but the very short term.

The first week of the year is historically a very ‘noisy’ week for financial markets as participants chase initial moves in fear of missing out on the move of the year. Patience, however, is likely to be a virtue at the start of 2011 as we await the start of Phase 2 of Philip Manduca’s roadmap to returns, detailed in the post below.

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