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

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30th June 2009

Yesterday's UK money supply data highlighted continuing weak credit growth and suggests that the Bank of England (BoE) will have to increase its purchases of gilt-edged securities as part of its quantitative easing (QE) programme. Mervyn King's fears that the banking sector could be an obstacle to sustained economic recovery looks well-founded as the process of balance sheet restructuring looks as it still has some way to go. Against this background, bank lending is likely to remain tight for some time.

The objective of QE is to try and increase non-financial sector deposits and thus trigger an increase in money supply growth and credit demand. Such deposits only increased by £0.4 billion in May and were only up 2% year-on-year compared to growth rates of 9% seen prior to the recession.M4 lending growth is up a meagre 0.3% year-on-year. Yesterday's data on mortgage approvals for May reported little change on April and it seems that the overall level of mortgage activity is stabilising at very low levels. Anecdotally, I am told that 40% of transactions in the housing market at the moment are cash-related and likely relate to cash-rich buyers picking up ‘bargain’ properties. Buyers looking to finance deals with mortgages are having a harder job getting the banks to lend (unless it is on very onerous conditions including LTV ratios of 60-70%).

UK banks' ‘funding gap’ stands at £800 billion which represents the difference between customer loans and deposits. The size of this gap constrains the banking sector in expanding credit and the BoE will have to do more with the banks to help loosen credit conditions. For an in-depth assessment of the UK banking sector I recommend you glance through the BoE's latest Financial Stability Report (click here).

Elsewhere, in a low volume week, investors are sticking with the ‘risk-on’ theme. Bearing in mind that we are coming up for month-end, quarter-end and half year end (which can create unusual volatility as investors put on fresh portfolio positions or change hedging positions), the S&P increased by 0.9% to 927 yesterday. I have previously highlighted the 925 level as an important pivot point for price action as well as indicating that the ‘pain trade’ for investors over the summer period was a move up in the equity markets. Most of June saw equity markets retreat from their highs at the beginning of the month as investors fretted about higher bond yields, mixed economic data and the impact of higher oil prices (up 3% yesterday). Now, the equity markets have a chance of retesting the ground that we saw at the beginning of the month.

The US dollar is back on the defensive with sterling posting impressive gains this morning. The sterling-dollar exchange rate broke out of its recent 1.62-1.66 range and posted a fresh high for the year-to-date at 1.6746. This move has not been triggered by any ‘fundamental’ news as such, but the technical picture looks positive as I have highlighted in previous blogs (higher moving averages with the 50- and 100-day moving averages pushing up through the longer-term moving average). Looking at my weekly chart, the 50% retracement from the November 2007 highs comes in at just above 1.73.

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29th June 2009

Equity markets are starting the week fairly mixed as the summer doldrums take hold of investor sentiment. The latest Japanese industrial production numbers released overnight were strong, largely buoyed by gains in car production but nevertheless giving hope that inventory corrections may have run their course. The important Tankan survey is released on Wednesday and we might see some improvement in levels of Japanese business confidence.

Oil prices have been a bit softer which is encouraging and further slippage would be welcome in helping to stabilise the economy. This is also likely to help the bond markets where longer-term interest rates have started to decline over the past week. In the currency world, China continues to blow hot and cold on the future of the US dollar but looking at my charts this morning, the majors look pretty range-bound and price action looks unexciting for now.

As far as the UK economy is concerned, there was plenty of press comment over the weekend over the sustainability or otherwise of UK government borrowing and government debt. I detect that the Treasury and Bank of England (BoE) are on a collision course as to how these problems might be resolved. There is a risk that the political problems facing the UK government may simply delay the day of reckoning in terms of the tough decisions that are needed on tax increases and/or cuts in government spending. In terms of data releases this week, the latset PMI readings will be monitored for signs of recovery as well as what is happening with mortgage approvals where there have been signs of stabilisation recently from very low levels. The BoE publish their credit conditions survey on Friday but my guess is that bank lending is still tight.

Elsewhere, the ECB meet on Thursday and the expectation is for no change in interest rates especially after the injection of 1-year money at 1% by the ECB last week. The liquidity injection is likely to be similar to a cut of 0.5% in interest rates. The ECB seems to prefer the liquidity route of easing monetary policy rather than following the Fed in taking rates down to zero. However, it wont be plain sailing for the ECB as most forecasts of eurozone GDP for Q2 and Q3 are still negative. I can’t see any argument for the ECB wanting to raise interest rates at any time over the next 12 months.

Perhaps the most important data release of the week will be Thursday's US nonfarm payroll data. The unemployment rate currently stands at 9.4% and President Obama has warned the rate could top 10% in the months ahead. The market is looking for the unemployment rate in this week's report to move up to 9.7%.

Otherwise, The Bank of International Settlements (BIS) publishes its annual report today (click here) and press reports indicate that the BIS is still worried about toxic assets. The BIS view is worth reading as they were prescient in warning about the credit bubble. At the end of last week, there were also worries over systemic risk and credit downgrades in the commercial mortgage-backed securities sector (CMBS) as well as in the municipal bond market where there seems no resolution to tackling California's $24 billion budget deficit.

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26th June 2009

It's been an interesting week in the financial markets. The US Treasury has sold a record $104 billion of debt this week yet US bond yields are lower. Appetite from foreign central banks for US debt has increased which has helped underpin the US dollar. Mixed economic data, downgrades to economic growth forecasts from the World Bank and a gloomy assessment from the OECD on unemployment trends has not damaged the equity markets. And Mr Bernanke, the Fed Chairman, survives a congressional grilling on his handling of the BoA/Merrill deal while the Fed itself left policy broadly unchanged at this week's policy meeting but started to tidy up many of the liquidity injection programmes as a prelude to future ‘normalisation’.

Outside the normal day-to-day stuff in the financial markets, I am very much interested in the debate on regulatory reform. The outcome will have a large bearing on the shape of markets in years to come. The challenge is for policymakers to find the right balance that does not completely strangle the markets but at the same time corrects some of the most glaring issues related to price transparency and investor fairness.

In this regard, I recommend that you read the various testimonies at the recent hearings on this subject at the Senate Banking Committee (click here) and in particular the regulation of over-the-counter (OTC) derivatives which are at the heart of the credit crisis. Experts like Christopher Whalen claim OTC derivatives are a fraud and call for heavy regulation and control of these products. There is also criticism of dealer banks who dominate these products and there is a lot of interest in a recent article by Matt Taibi which is very critical of one such well known institution (click here).

Finally, the latest data on prices out of Japan highlights the severe deflationary pressures facing the economy. The core national CPI rate in May was the sharpest fall on record (minus 1.1%) and forecasters expect a steeper decline in May to minus 1.6%. The last thing Japan needs right now is a stronger yen which would only worsen the deflation outlook. Maybe the Bank of Japan should follow the Swiss National Bank which has been intervening in the currency market throughout the week to stem appreciation in their own currency.

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25th June 2009

...so says Mervyn King, the Bank of England Governor, in recent comments about the prospects for the UK economy. The OECD yesterday in their latest economic assessment believe the UK economy is in a ‘sharp recession’ and looks for real GDP growth to drop 4.3% this year compared to its previous forecast of minus 3.7%. The OECD sees zero growth for the UK economy in 2010. Alarmingly, the OECD sees the UK budget deficit reaching 14% of GDP which is higher than most of the other major economies.

I think Mervyn King's views are more nearer the mark than the ‘green shoot’ believers who think recovery is just around the corner. Yesterday's latest economic data from across the pond reported new home sales at a record low in May. Previous months’ data which had excited the green-shooters was revised DOWN. Interestingly, distressed properties accounted for one-third of all sales in May. Also, recent stats on US cargo traffic movement reported a 22% decline in April. Today's data on weekly chainstore sales will likely confirm continuing sluggishness in spending despite an increase in tax credits (Making Work Pay) and an increase in unemployment insurance payments in April as part of the stimulus package (the American Recovery and Reinvestment Act).

Against this background, it is no surprise that the Federal Reserve kept policy unchanged last night (click here for the detail). There were minor changes of emphasis in the FOMC statement from the previous statement, mainly fewer worries about deflation and fewer worries about weakness in the economy but the bottom line is that it looks like the Fed will keep interest rates low for a prolonged period of time. There were also no changes to the Fed's quantitative easing program, though the Fed will certainly keep its options open (especially if the US 10-year Treasury yield sailed past the 4.00% level).

The ECB did their bit as well yesterday by injecting €442 billion of 1-year money into the banking system. This will help alleviate funding pressures though one of the side effects might be some slippage in the euro which is no bad thing and would certainly be welcomed by German exporters. Indeed, the US dollar is holding up reasonably well and I note that the Federal Reserve's custodial holdings of foreign central purchases of US debt (mainly Treasuries) has gone up sharply in recent months. I have already mentioned in my blogs that there has been healthy demand for US debt at various debt auctions and this goes a long way to allevaiting potential funding pressures as well as supporting the dollar. Emerging market countries also tend to add to their dollar FX reserves when the euro goes up against the dollar and the previous gains in the euro over recent months have been associated with a sharp increase in their FX reserves. So I am encouraged about the short-term prospects for the dollar despite all the talk about reserve diversification and loss of reserve currency status.

As far as stockmarkets are concerned, I highlighted 925 on the S&P index as a pivot point to look out for. Since the 2 June high, only China has reported gains (6%) with Russia one of the worst dropping over 20% (click here for an analysis). For a longer-term perspective, the stockmarket needs a 60% gain from here to break even for the decade (which finishes in 6 months time). So far, the market is down an annualised 5.12% compared to minus 5.26% for the 1930s – the lost decade (click here for more on this).

If you want to read what the newspapers were saying about the markets this day in 1930 you should click here. They had their ‘green-shooters’ back then too!

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24th June 2009

This evening's announcement on US monetary policy from the Federal Reserve at its regularly scheduled policy meeting is the main focus of the financial markets. At its last meeting in April, the statement said "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period" (click here). My guess is that the Fed will continue to use the same language as the jury is still out as to the state of the economy.

Clearly, the financial markets had bought into the story of "green shoots" and all of that but the pullback in the stockmarket recently has mainly come about because the market is less sure that recovery is around the corner. In recent weeks I have warned that the stockmarket was due a pullback based on a number of indicators that I monitor (volumes etc.). I also warned that the evidence of economic recovery was patchy at best. What we are going through is not a "normal" recession and the powerful dynamics of balance sheet restructuring for consumers and banks points to a prolonged recession and weak recovery. Even the bulls at BoA Merrill Lynch who are declaring that the recession in the US is over say that "a durable economic expansion remains elusive" (see report here). Well, you can say that again.

Apart from keeping officially targeted interest rates lower for longer, will the Fed announce much else? Probably not is my view. The markets are watching for any tweaks to the Fed's quantitative easing program but bond yields have moved lower in recent days and in my view the case for a further expansion in the Fed's purchases of treasuries and mortgage backed securities is not yet warranted. If anything, as this week's US bond auctions are proving. There is healthy demand for US debt which will help alleviate any funding worries which in turn helps underpin the dollar.

As far as "exit strategies" are concerned, I'm sure Mr Bernanke will want to reassure markets that the Fed is on the case should inflation start to rise and/or the economy recovers but I think we are a long way from that scenario. Mr Bernanke's term of office expires at the end of January next year and there has been recent speculation over his successor (Larry Summers or Janet Yellen?). Mr Bernanke could easily be reappointed but President Obama will have a big say in the composition of the Fed next year given the large number of appointments needed to replace retiring board governors.

The President will clearly want a "doveish" Fed but he has already put a lot of faith in fiscal policy to do the job. Recent research (click here) shows that you get more "bang per buck" from tax cuts rather than increased government spending but in a balance sheet recession, tax cuts might just end up as higher savings rates. In my previous blogs I have already noted that next year the Bush tax cuts expire if Congress does not vote to make them permanent and this adds uncertainty too. I see no evidence in the weekly chain store sales data that US consumers are displaying any signs of spending and I think we are in for economic disappointment not just in the US but also in the UK for the second half of this year.

Otherwise, we get the latest economic forecasts from the OECD today (see www.oecd.org for details). The OECD have already said that they see unemployment in the OECD area rising to 57 million this year compared to 37 million actual unemployed at the end of last year. Not a pretty picture and unemployment is becoming a massive problem.

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Neil MacKinnon is away today. Today's blog entry has been written by Mike Hughes, ECU's Head of Risk Management

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23rd June 2009

Overnight, the markets have continued the theme of this week, and have sold the JPY cross rates, mainly against the Aussie dollar, the euro and the Canadian dollar. This has also led to a general “risk off” theme for early Europe with cable and EUR/USD both losing ground.

It will be worth keeping an eye on this morning’s gilt auction results (£4bn 4% 2022). Any disappointment will only add to this morning’s sterling insecurity. Thereafter, tomorrow we have the FOMC meeting which could also be a market mover depending on the accompanying statement.

However, in the absence of any directional bias from the above, we will continue to watch stocks and try to answer the interminable question of whether we are in a range, about to break back down (880 S&P is an important level), or are seeing real signs of “green shoots”. It is difficult to get too excited about the latter, and so in terms of currencies, we are still looking for “relative” out-performance. Which currency will come out of recession quickest and be able to manage their QE exit strategy most effectively. To date it has been sterling that has sat at the top of this pile. However, with clear differences of opinion between the BoE and the government on most things fiscal, becoming more apparent (since the Mansion House Dinner), sterling has lost some of its shine over the past few trading sessions.

We now sit on or near some very interesting levels for sterling, namely 1.6170 for cable, 1.7500 GBP/CHF, 0.8575 EUR/GBP & 154.00 GBP/JPY. If sterling is not breaking down and we are either entering the summer doldrums (i.e. range trading), or indeed “green shoots” are appearing, then these could be good levels to start building long sterling positions.

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22nd June 2009

Last week, all the major equity markets were down with the exception of the Chinese market which was up 5%. Over the week, the S&P fell 2.6% and the FTSE100 was down 2.2% (UK companies have raised $50 billion in rights issues year to date compared to $74 billion for all of 2008). The main factors unsettling investor sentiment were uncertainty over financial sector regulation, lowered credit ratings on US banks and Moody's threatening California with junk status. California is the 8th biggest economy in the world accounting for 13% of US GDP and the most populous US state. However, California's unemployment rate is just above 11% and it has the 6th highest tax burden of any US state. Its budget deficit is exploding and remedial action is proving politically difficult.

Elsewhere, the ECB warned that eurozone banks face considerable loan losses with a large part arising from pressures in the central and eastern European area. This week's auction of one year funding by the ECB is likely to be heavily subscribed and with banks likely to convert funding into other currencies, it is likely that the euro will remain under pressure after making a low of 1.3748 against the dollar last week. The Swiss National Bank (SNB) was reported to have intervened again in the FX market during the week. Watch the euro/swiss exchange rate after last week's low of 1.5004. I suspect we will continue to see a game of "cat and mouse" between FX traders and the SNB which wants to prevent further appreciation in the Swiss franc. The SNB will likely to continue adding sufficient funds to keep the overnight repo rate close to zero percent but with interest rates at this level, the SNB will have to stay persistently active to prevent the 1.5000 level in euro/swiss from crumbling.

Elsewhere in FX, my technical chart for euro/dollar reveals there is interim resistance at 1.4011. The US dollar generally shrugged off worries arising at last week's BRIC conference from the dollar's role as the leading reserve currency. The sterling/dollar chart shows that there is good technical support at 1.6246 in the short term with bullish signals for the medium term highlighted by the 50 and 100 day moving averages moving up through the 200 day moving average.

In the US bond markets, the US Treasury is set to sell a record $104 billion of US debt. Foreign central banks have been buyers of debt especially at the short end but the US household sector has started to become a large buyer through bond funds. While corporate bond spreads have narrow from their crisis highs the current level of spreads is still a long way above the long run average of 200bps and there is an interesting chart (click here) which shows a comparison of corporate spreads at various crisis points.

The oil price hit an 8 month high of $73 last week with Goldman targeting $85 for year end. The World Bank raised its forecast for Chinese economic growth last week (see www.worldbank.org for the latest China Quarterly Update) and it is really China's infrastructure spending plans that have largely underpinned the recent recovery in commodity prices. However, I think that should oil prices keep moving higher it presents a real risk to the notion of a sustained recovery in the global economy. Indeed, at this juncture, further increases in the oil price threaten a period of prolonged stagnation in economic activity. The increase in the oil price is a tax on the consumer and businesses rather than an uplift to the inflation rate.

This week's FOMC meeting will be monitored for any changes to the quantitative easing programme. The fact is that US bond yields and mortgage rates are higher than when the program came into being. More importantly, excess reserves stand at $800 billion which is two-thirds of the Fed's expansion of its balance sheet. Excess reserves are still stuck at the Fed rather than being recycled into new lending and hence into the real economy. In these circumstances, the Fed's monetary actions in recent months are hardly inflationary. I think that with the real economy stabilising at best and with the consumer still cautious, the best line for the Fed to take this week is simply to say that it will keep interest rates low for as long as it takes.

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19th June 2009

Yesterday's UK retail sales data were unexciting but that should not be surprising. Consumers still face tough times with unemployment still some way from peaking and stabilising. In addition, consumers have experienced a difficult time in the last 2 years having had to suffer a painful reduction in net wealth as house prices (for the latest data on global property prices click here) and equity prices have declined sharply. Markit, the research agency, have developed a new index of household finances and the latest reading continues to show that UK household finances are deteriorating (click here for the article).

It's the same story in the US economy and similar fundamental factors apply given that both sets of consumers leveraged up to the hilt and created a massive debt mountain on the back of ‘bubble’ type increases in house prices. The bubbles in housing and credit have now burst and both American and British consumers will have to save more to repay debt. Hardly a recipe for a rip-roaring recovery in consumer spending.

Elsewhere, I notice that the latest recruit to the Bank of England's Monetary Policy Committee, Adam Posen, has just penned a very interesting study on the state of the eurozone's banking system. His study shows that the European banking industry ‘remains very fragile’. We know that the ECB are alert to the possibility of a European banking crisis but all of this does not engender confidence in any robust economic revery in the eurozone area anytime soon (click here to see Adam Posen's study).

As far as the stockmarket is concerned, readers will know that over the last week or so I have warned of a temporary setback. While I am a bull longer term I think the rally since March looks overcooked and vulnerable to higher oil prices, upward pressure on bond yields and a reassessment that ‘recovery is around the corner’. I have noted that trading volumes are fading which is a bearish signal and Trimtabs now note that May saw the highest level of monthly stock issuance in May at $64 billion compared to the previous record of $38 billion. Corporate new offerings are five times greater than corporate purchases and Trimtabs show that historically the average 90 day return following such periods was a loss in the S&P of 7% (click here for the report). In addition, the Investment Company Institute reports the 13th straight week of mutual fund inflows into equities. Heavy retail buying is usually a good contrarian indicator. So equity investors beware. Sell in May and go away might be good advice.

Next, I bring to your attention the thoughts of Christina Romer who is head of the President's Council of Economic Advisors. In the Economist magazine she draws an interesting parallel with the experience of 1937 in the US economy where President Roosevelt actually tightened up monetary and fiscal policy after a sharp period of recovery from the Depression. This proved to be a mistake and Ms Romer says that we should not repeat that mistake and in the current circumstances that means not jumping to tighten monetary and fiscal policy (click here for the article). I tend to agree with her and recent talk of so-called “exit strategies" that have been doing the rounds recently looks premature to me.

Finally, I came across this extraordinary graphic of the costs of the US financial bailouts and what it  shows is that the cost of $15 TRILLION for the period of March 2008-March 2009 dwarfs every one time major American expenditure combined including the costs of WW1 and 2, the New Deal, the moonshot, Korea, Vietnam and Iraq (click here for the graphic).

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18th June 2009

Overnight, Asian equity markets put in a mixed performance with equities generally unsettled by higher oil prices and upward pressure on long-term interest rates. S&P cut the credit ratings on 22 banks even though many US banks are repaying TARP money.

In the UK, Professor Buiter in his latest musings thinks any UK recovery will be ‘slow and meek’. His main worry is that government spending will have to be cut to avoid a ‘public finance Armageddon’ and that ‘tax increases are also all but unavoidable’ (click here for the article). I tend to agree and the sharp deterioration in public sector finances (which we know is a global not just a UK phenomenon) will present some difficult fiscal challenges in the years ahead.

Former MPC member Prof David Blanchflower also weighs in and says the UK is faced with a ‘toxic cocktail’ of sliding house prices, negative equity, rising unemployment and zero/negative wage growth (click here for his article). Prof Blanchflower was the only member of the MPC who foresaw the economic crisis and called for lower UK interest rates at a time when some of his colleagues last summer were still harping on about the threat of inflation, oblivious to the growing economic and financial crisis.

Mervyn King is also telling it the way it is and is urging the Chancellor to get fiscal policy back on track. Mervyn King also wants a distinction to be made between investment and commercial banks in his latest comments on the shape of financial regulation (click here for his speech). There have already emerged some interesting responses (click here).

Elsewhere, I note the latest CPI inflation numbers out of the US reported the sharpest decline since April 1950. The latest research from the Federal Reserve sees "a significant decline in core inflation" arising from the sheer size of the output gap (click here for the research). I guess the same applies here in the UK and I think it’s the state of the economy rather than any worries about inflation or even hyper-inflation (see here) that is the main concern.

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17th June 2009

Yesterday's UK inflation numbers revealed slow progress in reducing inflation despite excess capacity and rising unemployment. To some degree, this might reflect the impact of the previous sharp decline in sterling which acted to raise import costs. Sterling's recent resilience should go some way towards counteracting these pressures in the months ahead, though it is still worrying that oil prices (and petrol prices) are creeping up. However, I don't see yesterday's inflation numbers in any way altering the Bank of England's monetary stance and I think the main focus will be in continuing to stabilise the financial system as well as putting in place the conditions for economic recovery. The good news is that so far the Debt Management Office is finding good investor demand for its debt sales and yesterday saw the banks sell £7 billion 25-year gilts with a coupon of 4.5%.

In the annual Mansion House speech, the Chancellor of the Exchequer is expected to focus mainly on financial regulatory reform. Coincidentally, President Obama is unveiling his proposals (click here for the detail) in tackling financial regulation (click here for Simon Johnson’s, the ex chief economist at the IMF, comment).

This is a controversial area as you might expect as it goes to the heart of the causes of the global financial crisis (for a very good exposition of what caused the crisis I recommend "Globalised Finance and Its Collapse" by Anton Brender and Florence Pisani – click here).

It's not just the existence of regulatory legislation that is key but it is also important that policymakers implement and enforce the legislation. This was, in some cases, absent during the 1990s and lack of regulatory oversight allowed financial institutions to increase leverage to unusually high levels. I sympathise with the view of George Soros who believes that regulators must accept responsibility in preventing ‘bubbles’ as well as controlling margin requirements and capital adequacy. He also believes that derivatives should be controlled as strictly as stocks (click here for more details).

Finally, President Obama's comment that he sees the US unemployment rate at 10% is unsettling stockmarkets. Yesterday's data saw US industrial production fall 1.1% in May against a downward revision to the previous month of minus 0.7%. Capacity utilisation is now at a record low (since the series began in 1967). For investment to stage a recovery you need to see capacity utilisation at much higher levels. If anything, the existing degree of excess capacity points to investment cutbacks and a lack of pricing power in the manufacturing sector. 

Some commentators think equities are ‘modestly overvalued’ (click here) and note that the amount of new stock issuance rivals the market peaks of 2006 and 2007. The S&P is not cheap at 16 times normalised earnings and the 925 level on the S&P which I highlighted yesterday is starting to falter.

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16th June 2009

Equity markets have been on the defensive so far this week and my worries that the short-term picture was looking less supportive for equities looks reasonably well founded. This morning's Wall Street Journal carries an interesting article on cyclical and secular bull markets (click here) and quotes a leading equity market historian who thinks that we are in the fourth secular bear market since 1900. Keep an eye on the S&P index in the short term as a decisive break through the 925 level opens up a new trading range on the downside for the rest of the summer.

The economic bulls are being challenged by the latest assessment from the IMF that the worst of the crisis may lie ahead (click here for the detail). I think there is certainly some credence in all of this as there is little supporting evidence of a turnround in consumer spending. Consumers have to save more and repay debt. As a result, I think the economic bulls will have to review their case. In my mind, it certainly will take the steam out of the recent increase in bond yields and some commodity prices too.

The latest data out of the US economy highlights that US credit card defaults hit a record level in May while the Empire Fed index reported that "conditions continued to deteriorate". Goldman's economics team – in its latest note on the US economy – pours cold water on the notion that the Federal Reserve can tighten monetary policy in this environment. Indeed, it notes that since the late 1950s a definitive increase in interest rates has never taken place before a cyclical peak in unemployment and, as we know, unemployment is still going up.

Elsewhere, the ECB in its latest financial stability report highlighted the problems facing European banks, something that I have highlighted many times in my blog. The ECB expects total losses to amount to $650 billion (click here to read Lex in this morning's FT). In addition, Moody's has downgraded 30 Spanish banks. It is no surprise that the euro has weakened in response to this news from 1.43 against the US dollar in early June to just above 1.37 this morning.

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15th June 2009

The G8 meeting did not produce anything of note for the financial markets (click here for the G8 statement). Predictably, the G8 finance ministers felt that the there are signs of stabilisation in the global economy and there was plenty of talk about ‘exit strategies’ from current policies in the event of any economic recovery (click here for more on this and for further analysis, click here). The markets are already sensitive to talk of higher interest rates and in the UK I note that the CBI this morning is reported as urging the Bank of England to raise interest rates later in the year.

I believe that it is too early to talk about exit strategies as I think signs of recovery are tentative. In the real world, I come across plenty of anecdotal evidence of people having to work longer for less pay. Unemployment is still going up. Some commentators are too eager to declare the recession is over when in fact the actual evidence for any recovery in consumer spending in the major economies is thin on the ground. Consumer spending typically accounts for at least 60% of GDP and if you don't get a recovery here then you are relying on exports, investment or government spending to get you out of a hole. As I have mentioned before, a rebuilding of inventories in the US, UK and eurozone probably accounts for the ‘better than expected’ readings in many of the monthly manufacturing surveys that we have seen in the past month or so. A rebuilding of inventories (from an extremely low level) is, in my opinion, no reason to think that a durable economic recovery is imminent.

Indeed, I think the real danger is that we slump back into deep recession rather than quickly return back to normal. As a result, all this talk of higher interest rates and a swift end to quantitative easing is not just misplaced but also dangerous. Policymakers need to be careful not to make things worse by talking about (or actually implementing) tighter monetary and fiscal policies. There are plenty of historical instances of policymakers prematurely tightening policy with disastrous results (remember Japan in the 1990s for a start).

Also at the weekend we heard the Russian finance minister contradict the Russian President's comments on the dollar last week. Apparently, the dollar is safe for now as the leading reserve currency. I think it is as well and I think the dollar can surprise by making a recovery on the exchanges. The euro looks weak to me and the likelihood of Argentina type problems with Latvia could create domino effects elsewhere in Central and Eastern Europe as well as severe problems for many European banks (click here to see why).

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12th June 2009

G8 finance ministers meet in Rome today and tomorrow for their regular get-together. Nice work if you can get it and lots of photo opportunities (Mr Berlusconi excepting) but don't expect too much in the way of substantive policy action (click here for a brief guide). Europe (especially Germany) seems at odds with American policymakers over the best way to tackle the recession and Germany has little enthusiasm for quantitative easing (or ‘printing money’). The Americans believe that the Europeans are ‘free riding’ on the back of American monetary and fiscal stimulus. So stalemate is the likely outcome. Whether the Europeans express concern over a weaker dollar (and stronger euro) remains to be seen.

The oil price is likely to be on the G8 agenda and at $73 is at an eight-month high. The International Energy Agency has just raised its forecast for global demand by 120 million barrels a day and BP says that oil reserves fell for the first time in ten years with consumption falling by 0.6% in 2008. You can access BP's informative annual outlook for energy and oil by clicking here. 

In the financial markets, bond yields keep edging higher. In the UK, the 10-year gilt yield is now above 4% for the first time since last November. Some think higher yields are either proof that policy measures are working or simply a reflection of market worries over the prospect of higher inflation and a sharp rise in bond issuance to fund a massive increase in budget deficits.

However, there may be another explanation that the implicit guarantee of financial corporate debt by the authorities is resulting in a shift between different classes of risk free assets. So, declining yields on privately issued bonds alongside higher Treasury yields as well as rising equity prices is just an asset allocation shift from an asset with no credit risk (government bonds) to assets with credit risk (corporate bonds) (click here for more on this).

Of course, real yields on 10-year US Treasuries are at 5% which is attractive when money market rates are at 1% and equities look a bit pricey at 20 times earnings. I noted yesterday that stockmarket volumes are fading (potentially bearish) but I also note that retail investors have been big buyers of stocks and retail investors are notorious for getting their market timing wrong (click here for an analysis) so watch out. 

Yesterday's US retail sales reported a rise of 0.5% in May but this was largely down to the impact of rising petrol prices on receipts at petrol stores. Looking at the underlying picture and at the number which is used by the government statisticians in computing the consumer spending component in the GDP data, retail sales were flat in May and for Q2 they are tracking at a minus 2% annual rate according to Goldman's economics team. The Fed's flow of funds data revealed that US household net worth fell by $1.3 trillion in Q1 and US household equity fell to a record low of 41.4% (click here for more on this).

In the UK, the Bank of England in their latest Quarterly Bulletin report said that negative equity for UK households is back to the peaks seen in the early 1990s recession. I would recommend the Quarterly Bulletin as it has lots of interesting charts and analysis. It also gives plenty of information on negative equity together with a primer on quantitative easing (click here). Enjoy the weekend!

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11th June 2009

"The UK recession is over", claims the influential forecasting body, the National Institute for Economic and Social Research (NIESR) (click here for the detail). It thinks that March was the trough in economic activity and expect GDP in Q2 to be positive. Yesterday's gain of 0.2% in manufacturing output for April is said to be supportive. Well I hope NIESR is right but I have a nagging doubt about all of this and while output may have bottomed and stabilised I am not convinced that consumer spending is in any way robust. Nevertheless, it chimes with the current mood of optimism in the financial markets which also worries me.

The US 10-year yield is at its highest this year and while the 10-year auction had its highest foreign purchases since last November, it did require higher yields to ensure that the auction was a success. Higher bond yields mean higher mortgage rates and the 30-year fixed rate mortgage now stands at 5.79% compared to 5.00% just two weeks ago (for a calculator of the relationship between bond yields and mortgage rates click here).

Yesterday evening's release of the Beige Book by the Federal Reserve (click here) painted an altogether downbeat picture of what is happening on the other side of the Atlantic:

• "do not see a substantial increase in economic activity through the end of the year"
• "retail spending remains soft "
• "credit conditions remain stringent"
• "prices at all stages of production were generally flat or falling"
• "labour market conditions continued to be weak".

Against this background, it is difficult to see how anyone can be a raging optimist. In addition, oil prices (and petrol prices) keep rising. Rather than being inflationary this is simply a tax on the consumer. The rally in the oil price has been huge, up 108% in the last 118 days compared to an average bull market rally of 66% over an average 217 days. The current rally in the oil price is twice the average bull market gain in half the time (click here for more on this). Most oil price forecasters see an extension to $85 but I think we are getting to a stage where the rise in the oil price could damage the prospects for economic recovery. Of course, the oil price is linked with the outlook for the US dollar just because like other commodity prices it is denominated in dollars and many currency strategists are aware of the ‘correlation’ (click here for more detail). If the oil price does make an interim high soon then I would expect the dollar to stage a (further) recovery.

The economics team at Goldman disagree with me on the dollar and their latest publication sees a weaker dollar based on the following factors:

• a large US output gap
• accommodative Fed monetary policy
• rising commodity prices
• improving investor risk sentiment
• further FX reserve diversification by the world's central banks.

You could argue that these factors are already in play and have been discounted by the market. The surprise to what I think is the consensus view would be that the dollar goes up. The theme of reserve diversification was picked up in Russian comments yesterday with a threat that they would sell their US Treasury holdings and buy IMF ‘bonds’ instead. For a start, IMF bonds are dollar denominated anyway and the amount they are talking about ($10 billion) is insignificant when compared to weekly US bond issuance ($50 billion plus) and daily FX turnover ($2 trillion plus). And only 30% of Russia's $400 billion FX reserves are in dollars ($135 billion). So we are talking small amounts here in the scheme of things.

As far as the stockmarket is concerned, my bullish longer-term outlook here is being tempered in the short term by rising oil prices and higher bond yields. Also, I do not believe that the current optimism on the global economy is justified. I also note that stockmarket volumes are fading and this is a bearish sign so beware (click here for more).

Today's US retail sales data is an important economic indicator but the weekly stats on department store sales for the first week of May (down 6.8%) suggest to me that the American consumer is still cautious.

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10th June 2009

Like Goldilocks' porridge, will the prospective economic recovery be ‘too hot’, ‘too cold’ or ‘just right’. Look at these charts which describe all these scenarios (click here). The ‘just right’ scenario is clearly one in which output and asset prices rise and unemployment falls while the ‘too hot’ scenario sees inflation, higher interest rates and a falling dollar. The ‘too cold’ scenario sees unemployment rising, output and asset prices falling, and monetary policy staying loose.

The financial markets are hoping economic recovery is around the corner. Even well-known ‘bears’ like Professor Krugman said earlier this week that the US economy might bottom in the summer. Goldman's economics team is now expecting US GDP to return to positive territory in Q3. Recent news that ten US banks are repaying $68 billion of TARP money is good news for the banking sector and takes the pressure off the US taxpayer (good for the dollar maybe?). In addition, US bond auctions including the latest this week have gone reasonably well with central banks turning out to be important purchasers of US debt (again good for the dollar as it alleviates funding worries).

However, I am worried that any recovery (in the US and UK) will prove weak given that consumers are still over-leveraged and still have lots of debt to repay. US consumer spending still accounts for 68% of GDP compared to a peak level of 71%. The US flow of funds data for Q1 released tomorrow will give fresh clues on the state of the US household sector. It is worth noting that US households had $13.8 trillion of debt at the end of 2008 and owed 130% of disposable income versus a record 133% in Q1 last year (click here for the charts). Bank lending also remains tight as these charts reveal (click here).

I am also worried that any recovery in output will not be matched by an increase in jobs. The US labour market is still weak with hours worked at record lows and declining wage growth. Any pick-up in activity will likely see firms work their existing workforce harder rather than take on fresh hires. The latest research report from the Federal Reserve concludes "...that the level of labor market slack would be higher by the end of 2009 than experienced at any other time in the post World War 2 period" (click here for the full report). This evening's Beige Book published by the Federal Reserve will give the latest assessment of conditions in the regional economies.

In the UK, sterling is holding up well and is shrugging off worries over the UK's credit ratings as well as increased political uncertainty. The sterling trade-weighted exchange rate is up some 13% from the lows at the end of last year aided by improving rate and yield differentials as well as improving investor risk appetite. The UK housing market seems to be stabilising and the RICS index is at its highest since November 2007. In addition, the latest data suggest that a rebuild of inventories is improving conditions in the manufacturing sector as a cross-country comparison of PMI's highlights (click here for more on this).

Goldman's strategy team is bullish on sterling especially against the Swiss franc (as we are). They see a medium/long-term move to 1.95 and note that sterling has made its first daily close above the 200-day moving average which is currently at 1.75(a bullish technical signal). A simple technical retracement of the highs at 2.50 (July 2007) and lows at 1.50 (December 2008) comes in at 1.88 on my weekly chart. Here's hoping.

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9th June 2009

In the financial markets recently, longer-term interest rates (bond yields) have started to move higher. In the US, this has translated into higher mortgage rates. The futures market is now predicting that the Federal Reserve will raise rates by year end. It probably won't be long before some economist in the City is predicting that the Bank of England will do the same. This is all linked into the prevailing market view that economic recovery is either happening now or just around the corner. As you know, I am sceptical about all of this and my guess is that the ‘bulls’ will be disappointed and have to re-assess their view by the time the summer is over.

The rise in bond yields has triggered an interesting academic debate as to whether we are on the brink of an inflationary blow-out and fiscal meltdown or whether the rise in bond yields is a ‘normalisation’ and shows that government policy is working (click here to read Martin Wolf expounding this thesis). The debate (click here) is exemplified by the contributions recently from Professor Niall Ferguson (whose work I have recommended before) and the Nobel Prize Winner Professor Paul Krugman.

In a nutshell, Professor Ferguson claims fiscal expansion is contractionary because it will drive up interest rates. Ferguson says we are not in a 1930s style depression (though I recommend you see the latest findings from Professor Eichengren that has some very interesting charts that show we are following the 1930s depression closely – click here) and that the size of the current fiscal response is therefore inappropriate.

Professor Ferguson says the size of the US budget deficit is the biggest since WW2 and notes that gross federal debt will be 100% of GDP by 2017. He thinks this is unsustainable and raises the question of sovereign financial solvency (click here for more on this). Professor Ferguson says, "this is the end of the age of leverage" and asserts that, "once you end up with public and private debts in excess of three and half times the size of your annual output, you are Argentina." Ferguson believes it is right to use monetary policy rather than fiscal policy to tackle the current crisis. Interestingly, Professor Ferguson's view has been echoed by the German Chancellor Angela Merkel as well as Professor John Taylor who predicts inflation and dollar depreciation as the consequence of an exploding debt/GDP ratio (click here for the article).

Professor Krugman prefers a Keynesian approach and asserts the primacy of fiscal policy in tackling the economic crisis. To summarise, he says the main problem is a global excess of desired savings. Budget deficits won't drive up interest rates unless they also expand the economy. He argues that Professor Ferguson has got his economic theory wrong and argues that interest rates are not determined by the supply and demand for savings. Krugman makes an important point that all economics undergraduates will be aware of and notes that Keynes made the point that savings and investment are dependent on GDP.If GDP rises, some of the increase in income will be saved and so the interest rate will fall. Keynes famous IS curve (again familiar to all economics students) defines the relationship between the interest rate and GDP. If you want a refresher or want to see Professor Krugman's charts on all of this click here and a nice summary of the debate can be found by clicking here.

Currently, the officially targeted short-term interest rate is effectively zero BUT this is clearly (as of now) not enough to achieve full employment. Indeed, the interest rate the Fed would like to have is negative (but you can't in the real world have negative rates). Indeed, the Fed are reported to believe that the ideal interest rate for the US economy is minus 5% (click here for the analysis). Krugman believes that this ‘ideal’ rate actually shows there is an excess supply of saving. He says government borrowing soaks up some of those excess savings and, in the process, expands demand and does not ‘crowd out’ private spending. Krugman also says that the increase in government borrowing offsets the fall in private borrowing that is taking place at the moment (click here for more).

The link between  government and  private sector borrowing is important as it has implications for foreign borrowing (the current account gap) which, in turn, has implications for the currency. Brad Setser notes (click here) that in the early 1980s and the first part of this decade, both the private sector and the government were large borrowers (cheap money and leverage). Borrowing rose faster than domestic saving (which went to zero in the US) and so the gap was filled by borrowing from the rest of the world (mainly Asian central banks and OPEC). Now private borrowing is declining (and debt is being repaid) and even though government borrowing is expanding, domestic savings are going up. This reduces reliance on foreign borrowing and the US trade deficit is shrinking so helping the dollar to stabilise or go up(the repayment of dollar debt is good for the currency).

The main problem in the debate is that Ferguson is focusing on the ‘stock’ of debt and clearly the solvency arithmetic is important here. The history of debt default and financial crises makes that clear. Krugman is focusing on ‘flows’ and makes valid points about excess savings and the need for government borrowing to offset the shrinkage in private sector borrowing. When the economy does get back on track, clearly two things have to happen. One is central banks need to exit quantitative easing first and then raise interest rates (not the other way round) and second, as private borrowing recovers then government borrowing has to decline. It's as simple as that but I don't think the global economy is in such a great state for these policy changes to take place right this minute.

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8th June 2009

The prevailing mood in the financial markets as far as the economy is concerned is that the end of the recession is near. Bullish investors and economists point to recent economic data (US initial caims, last Friday's jobs report, ISM and other survey data, highest US steel utilisation rates since December 2008) that suggests that output and demand is ceasing to fall and is starting to turn the corner. Data also showed UK service sector activity expanding for the first time in a year. Both the Band of England (BoE) and European Central Bank (ECB) left interest rates unchanged and announced no new measures in quantitative easing (QE).

Last week saw equity markets performing well (to their best levels this year) with the MSCI World Index up 1.3% in the week and up 6.7% year-to-date (for a complete list of how global equity markets performed click here). The FTSE continues to lag behind other Western European markets in terms of performance which might reflect the previous rise in sterling as a fifth of the companies in the FTSE pay dividends in dollars. The FTSE also has lower economic cyclical sensitivity with a third of its constituents characterised as ‘defensives’ compared with the German DAX where ‘cyclicals’ make up half the index (click here for more on this).

Even the Latvian stockmarket went up in a week where worries about massive foreign currency borrowing are likely to result in a masive currency devaluation and huge problems for the lending banks (mainly Scandinavian – note the Swedish krona fell 1.4% against the euro last week). For an interesting article on the Latvian economy and the dangers associated with excess borrowing and property speculation read this from Simon Kuper in last Saturday's FT (click here).

Also last week, and consistent with the recovery story, bond yields edged higher (to their highest in six months), the US 2-year yield (a key interest rate indicator) jumped 35bps, the yield curve spread in the US hit a record high, fed futures are now predicting a Fed rate hike (admittedly small) by December and corporate bond spreads narrowed back to levels last seen in October, copper moved above $5,000 and aluminium breached $1,600 for the first time since early January and platinum rose $25, oil reached $70 (with Goldman raising its oil price forecast last Thursday to $85 for year end). In the currency market, the US dollar gained 1% against the euro and 2.3% against the yen after the trade-weighted index actually hit a fresh low for the year last Wednesday. Political worries weighed on sterling which lost 1.2% against the dollar over the week. The political situation remains grim for the Labour Government so expect further volatility in sterling this week.

Investor sentiment remains bullish (click here for more on this) and all major US equity indices are above their 50- and 200-day moving averages. 66% of stocks on the NYSE are above their 200-day moving average still someway short of the 80-90% levels seen in 2007. There also seems to be plenty of buying power with cash in US domestic money market funds approximately equal to 40% of the market value of the Wilshire 5000 index and that the cumulative flow of money into domestic equity mutual funds is $172 billion below the long-term trend line which is the second largest gap since 1998 (click here for charts). Many equity market forecasters are now predicting moves in the S&P index through technical resistance at 960 to 1050 or 1100 (I don't disagree as I think there are many real money investors who are still underweight equities and who may have missed a large part of the rally since March). 

However, what does worry me is the optimism as regards economic recovery. The reaction to last Friday's US jobs report is instructive (click here for the report). Non-farm payroll employment fell by 345k in May compared to market expecations of around 500k. This was the third ‘best’ report in 11 years if you are comparing actual versus forecast.There were favourable revisions to previous months’ data and so the market reacted positively. It is worth noting that the worst non-farm payroll employment number was minus 325k in the 2001 dotcom recession and minus 306k in the 1990-91 recession and so is 345k ‘good’? Also, you should note that the May jobs report highlighted that Americans are working less hours with the private sector work week hitting a new record low. The year-on-year growth in private sector hourly earnings is about 3% (nominal) and still in a downward trend. Falling earnings growth,less hours worked, higher savings and rising unemployment rates don't paint a bright economic picture to me.

The unemployment rate jumped to 9.4%, the highest since 1983. The average for the first five months of this year is 8.5% and compares with the cycle low of 4.4% in March 2007. Since the start of the US recession in December 2007, US unemployment has gone up by 7 million to 14.5 million. The percentage job decline is now one of the worst for all recesions since WW2 (click here for the analysis). If you look at the official broad measure of the unemployment rate (U-6) which includes part-time and ‘marginally attached’ workers then this measure of the US unemployment rate stands at a record 16.4% compared to 13.9% in January. That probably gives you as good an idea as any as to how bad the US jobs market really is. 

The week ahead will have important data on the US twin deficits, the Fed's Beige Book (an important assessment of activity in the US regions) and a 10-year US Treasury auction (all on Wednesday) with US retail sales on Thursday (the US consumer accounts for 70% of the US economy and 20% of the world economy so this is an important release). The G8 finance ministers meet in Rome on 11-12 June. I'm not expecting any fresh or exciting policy initiatives here though I suspect some will welcome last week's recovery in the dollar from its lows. I am looking for the dollar to extend its gains in the short term with sterling on the ropes as the political situation likely worsens.

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5th June 2009

Preliminary results of yesterday's UK local council elections show that Labour has taken a severe drubbing. Another Cabinet Minister (James Purnell) has resigned and, in the process, has urged the Prime Minister to quit. It all looks pretty grim and untenable for the Mr Brown and the Labour Government. Here in the financial markets, equities and the pound have greeted the political turbulence with equanimity (so far). Traditionally, markets always dislike ‘political uncertainty’ but volatility wherever it arises comes with the territory. It's never ‘plain sailing’ in the markets for long.

As far as the UK situation is concerned, the political decline of the Labour Government has been in place for a while so nobody in the markets is surprised which probably explains the limited impact in the pound and in the stockmarket. A Conservative Government? If I recall correctly, it was a Conservative Government that gave us the ERM fiasco in 1992 after jacking up interest rates to 15% at a time when the unemployment rate was 10%. Double-digit interest rates and unemployment rate was unsustainable though Chancellor Lamont declared that unemployment "was a price worth paying". What he didn't realise was that it wasn't long before he became unemployed (that was a price worth paying). So, foreign investors (who have long memories) might not necessarily be enamoured about the prospects of a Conservative Government.

There is always the possibility that we end up with a hung Parliament (I'm sure there are many voters who think those in Parliament should be hung after the expenses saga). A hung Parliament is simply a recipe for policy paralysis (and probably very unwelcome in the currency market) and given the huge increase in government borrowing and government debt, the main focus for any Chancellor is to bring borrowing and debt back to more normal levels. This, in turn, means higher taxes and less public spending over the medium term. I can see no other option.

The financial markets end the week focusing on today's US jobs report which is one of the most-followed indicators in the monthly flow of data. The markets are looking for some signs of ‘stabilisation’ in terms of the heavy job losses that have taken place in the last two years. The US unemployment rate is expected to move up to 9.2% and Fed Chairman Bernanke earlier in the week made relatively pessimistic noises about expecting any significant improvement. A poor number today would dent equities though the impact on the US dollar is unclear. Watchers of the GBPUSD exchange rate are keeping a close eye on the 1.59-1.60 technical support level. There is the possibility that a combination of a worsening UK political situation and the prospect of a dollar recovery that I talked about earlier in the week opens up a test of the 200-day moving average at 1.54.

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4th June 2009

The European Central Bank (ECB) and the Bank of England's (BoE) Monetary Policy Committee hold their regular monthly policy meetings today. The BoE announce their decision at noon and the consensus view in the financial markets is that there will be no change in UK interest rates (0.50%). Of course, now that official rates are close to zero, there is more interest in what further changes the BoE will make in terms of quantitative easing (QE). The BoE has already announced a debt purchase programme of £25 billion per month through July and I think the BoE will stick with that for now.

Mervyn King, the BoE Governor, has said that it might take 6-9 months before the Bank can assess the impact. So far, bank lending to households and non-financial companies remains subdued but some economists see positive signs in the M4 money supply data that QE is showing signs of working (click here for a report on this and for a more cautious view click here). My guess is that the BoE will be encouraged by positive signs in recent surveys of manufacturing and the service sectors which suggests no change in monetary policy at the moment, but Mervyn King is cautious as regards the prospects for UK economic recovery and this implies the BoE will stick with QE certainly until year-end.

The ECB announces its decision at 12.45 London time and the market expects no change in interest rates (the deposit rate is at 0.25%) though the (less important) refi rate can be cut 25bps just to catch up with market rates. So there will be some interest in ECB intentions here. Mr Trichet is likely to come up with further details of the €60 billion programme to buy covered bonds but Germany (or at least Mrs Merkel) is not keen on QE.

The markets will also be interested in what Mr Trichet may or may not say about the euro. Recent strength won't be welcomed by German exporters. Already, the US dollar has embarked on a minor corrective recovery (as I have been predicting in my blogs earlier this week). Mr Trichet can give the move some extra help by expressing either concern about the strength of the euro or by expressing support for a stronger dollar.

Recent developments in Latvia (not always at the forefront of the markets' attention) might weigh on the euro after a move in the Latvian overnight interbank rate to a record 16.4%. Latvia was was unable to sell any securities at a local debt auction this week. With Latvian GDP expected to collapse by 18% this year, a devaluation of the currency by anything up to 20% looks inevitable in my view and this will have knock-on effects elsewhere in the central and eastern European area.

Yesterday's US economic data was less upbeat than expected. The ADP employment data still shows employment is contracting and so tomorrow's US unemployment numbers will likely disappoint and the ISM numbers are unexciting (click here for the detail). Mr Bernanke in testimony yesterday was downbeat on an early turnaround in the US labour market which might also be a pointer to the outcome of Friday's jobs report (click here).

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3rd June 2009

I mentioned in yesterday's blog that at ECU we have believed that the ‘pain trade’ for equity investors is a market that keeps grinding higher. I mentioned a number of technical indicators (the 200-day moving average, the Coppock indicator) that are bullish and opined that a move to 1050 on the S&P index was something to be alert to. My former colleague when I was at Merrill Lynch many years ago, David Rosenberg, who is actually bearish on economic prospects, does not rule out a move to 1200. His latest thoughts on the market and the economy are worth readiing especially his thoughts on consumer spending which he sees as remaining sluggish (click here).

Yesterday's US economic data on auto sales for May reported the best month this year but the worst pace since 1967 (click here for more detail). Pending home sales increased as a result of the $8,000 first time home buyer tax credit and this should bolster sales in the months ahead (more on this here). However, bank lending in the US remains weak and this analysis from Nomura is worth reading (click here) while bank profitability has collapsed (click here for more detail).

Overnight, the Japanese government is set to upgrade its assessment of the Japanese economy – though admittedly from a low base – and the latest data shows that Australia might have avoided a recession in Q1. Copper, nickel, lead and tin prices all hit fresh highs for the year which will help commodity producers like Australia. Gold keeps pushing higher and looks as though it can make a new high.

In the currency market, the Russian Prime Minister questioned the dollar's reserve currency status in a CNBC interview yesterday which keeps the focus on the dollar in the interim. However, as I suggested in my blog yesterday, my technical charts do highlight the ‘oversold’ nature of the dollar at the moment and I wouldn't be surprised to see a short-term recovery. Maybe the Chinese might come to the dollar's rescue after Mr Geithner's trip to China or comments from Mr Trichet tomorrow at the ECB's press conference might also do the trick.

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2nd June 2009

Most US equity indices closed up around 3% yesterday to their highest level since October/November last year. The S&P cash index moved through its 200-day moving average for the first time in 18 months and the Chinese Shanghai index saw its 50-day and 200-day moving averages cross over-technically, a bullish signal. Stockmarket technicians who follow the Coppock Indicator also detect bullish signals (click here for more on this and for further analysis, click here).

However, some equity markets like India, Taiwan, Singapore, Russia and South Africa look very overbought. The oil price moved to its highest level in seven months and the increase in May was the sharpest one-month rise (30%) in the last ten years. Alongside a higher oil price is a weaker dollar and Barcap now reckon that the EURUSD exchange rate is ‘overvalued’ by just over 7%. Bond yields also edged higher.

Where do we go from here? Well, both Philip Manduca and I have long thought that the ‘pain trade’ for investors during the summer would not lead to lower equity indices but rather higher levels such that real money investors were left behind. This translates into the S&P index moving up through 950 to something like 1050. The market mood has been to ignore bad economic data and look for ‘green shoots’ and good news in the economic numbers. Once the summer is over, economic data/expectations have to be strong enough to justify stockmarket levels otherwise stockmarket investors will have to rethink and/or face a sharp correction in markets.

Yesterday's US economic data did admittedly see an increase in ISM new orders but data on consumer spending (click here) was unexciting as was construction spending (click here). Remember that, historically, it is consumer spending and residential investment that traditionally leads the economy out of recession.

In the currency market, the US dollar is on the ropes but sterling is holding up well in front of Thursday's elections, though the results could well dent the pound on Friday morning. I think US Treasury Secretary Geithner's visit to China is important. China and America have been at the heart of the international monetary system in the past few years. China has built up massive FX reserves as it has used its currency to bolster exports (click here for Professor Niall Ferguson's article on Chinese-American relations). Those reserves have been recycled into the US bond markets and China has become the major financier of America's budget deficits. Clearly, China is now worried that its investments are at risk from a weaker dollar and the sharp increase in America's budget deficit.

Over the past year, whenever China has publicly complained about the dollar or its holdings of US debt, the Americans have usually responded positively, e.g., Bernanke and Paulson advocated a strong dollar policy last summer having previously said that a weaker dollar was good for US exports, also the US nationalised Freddie and Fannie when the Chinese expressed concerns over US agency debt and the Fed announced quantitative easing (QE) when the Chinese said they were worried about higher US Treasury yields.

What's the betting that either the Fed step up their QE programme by buying more US Treasuries at their end of June meeting or the dollar stages a comeback from its currently very oversold position against the majors. Looking at my technical chart on the GBPUSD exchange rate this morning tells me that the dollar might just be starting to do that.

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1st June 2009

Asia equity markets overnight were quite strong (ignoring the GM bankruptcy), oil and gold are higher (with oil pushing EURUSD higher) and the Chinese PMI data was above the 50 level. All of this is setting the tone at the start of the trading week and positive investor sentiment can underpin further gains in ‘risky assets’ generally. The S&P futures has broken up through its 200 day moving average. Anatole Kaletsky in The Times this morning is reflective of the current positive mood in the market and he puts forward a bullish thesis on the economic outlook (click here for the article).

While I do not share Mr Kaletsky's point of view, I think there is no doubt that the ‘worst is over’ and I think that the lows in the equity market are in place. The economic data does show that many indicators of activity have suffered a sharp decline in the last 6-9 months or so. The pace of decline is decelerating (click here for some interesting charts on US economic data).

I think the debate is what sort of recovery that we are likely to see (V, W,L, U, etc.). In previous blogs, I have highlighted the weekly US initial claims data as a good indicator of turning points in the US economy and the four-week moving average has certainly turned down. Professor Gordon, who is an expert on business cycle timing thinks that the US economy might bottom out in May/June this year and his analysis is worth reading (click here and for further analysis, click here). At the end of this week, the latest US jobs data is released and will be an important guide to whether we are moving closer to a peak in the US unemployment rate.

My guess is that household deleveraging, higher savings rates, demographic factors and the prospect of higher taxes will make for a fairly weak recovery in the US and UK. Growth will more likely be centered in China, India etc., which is bullish for commodities generally. In addition, I think the dynamics of the housing market crash will act as a drag on the US and UK. Homeowners in the US and UK are probably 75% of the way through the bear market. In the UK, cash transactions currently account for 40% of the total and this week's mortgage approval data (correlated with sterling) should show some sings of picking up. However, in the US it is estimated that two-thirds of households will end up with a debt/equity ratio of 120-125% on average. In addition, tax cuts expire in 2010 and tax increases are more likely (click here for more on this).

This week's European Central Bank and Bank of England policy meetings are unlikely to contain anything exciting. There may be more interest in the results of the UK European and local elections (on the 5th). Labour are set to do badly and, if they finish in fourth place (behind UKIP say), then the Prime Minister could end up being ousted. I think there will be little FX impact, though the markets will not like the prospect of a ‘hung’ Parliament and consequential policy paralysis. Sterling remains strong in the currency markets but looks extremely ‘overbought’ against the US dollar. I think some of the move represents a sharp unwind of short positions though better housing and financials news helps sterling's valuation as well.

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