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

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

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31st March 2009

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Mr Trichet's comments yesterday send a clear signal that the European Central Bank (ECB) is ready to cut interest rates and move closer to quantitative easing at its scheduled policy meeting on Thursday. As I said in my blog yesterday, I think the ECB can cut the main refinancing rate by a full percentage point and announce that they will purchase private debt directly. There is certainly a strong case for decisive action as yesterday's eurozone data reported a record low in consumer confidence, just adding to the already dire news on the state of the eurozone economies. S&P, the credit rating agency, downgraded Ireland yesterday making it the second eurozone country after Spain (third if you include Hungary) to be downgraded this year. S&P reckons that Ireland's budget deficit will rise to 10% of GDP even after government measures.

The equity market rally that dominated most of March is running out of steam. The S&P500 is back below the 800 level (and testing its 50-day moving average) having peaked at 833 and the VIX index is moving back up. Sentiment has been dented by the potential bankruptcy of GM, further bank worries (the Dunfermline bail-out, Fortis’s €28 billion loss, GMAC and CIT unable to issue government backed debt, UBS shares down 11% yesterday on reports of fresh writedowns) and what looks like a disappointing G20 meeting with Mr Sarkozy threatening to walk out. Any fresh fiscal stimulus over and above what has already been announced looks unlikely and the US looks as though it has little left of TARP money. G20 is unlikely to say anything about FX and in particular the dollar's role as a reserve currency which Mr Trichet made positive noises about yesterday. The IMF will likely get extra funding but to no more than $500-600 billion which is not enough to address potential emerging market crises.

Where does this leave the dollar? If you believe the ECB will take aggressive action then the euro declines I think and I am looking at key technical trendline support at 1.3095 being broken which then opens up a 1.2500-1.3000 trading range. The 1.3095 level provided technical support yesterday and I think the euro ‘recovery’ to a retracement at 1.3350 is probably the best of it, with the month's highs of around 1.3750 unlikely to be broken. I think Mr Trichet would like a weaker euro.

Elsewhere, news of Japanese government stimulus measures and talk of ‘price-keeping operations’ did little to help the Nikkei which closed down 1.54%. The latest economic data published overnight reported an increase in the unemployment rate to a three-year high, a sharp drop in housing starts and a further year-on-year decline in household spending. Japan has moved into a mini-depression and tomorrow's Tankan report will not make for pretty reading. Next week's Bank of Japan (BoJ) policy meeting may have no other option but to shift policy towards quantitative easing and an expansion of the BoJ's balance sheet, all of which opens up further weakness in the yen and a break above the 100 level in USDJPY.

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30th March 2009

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The equity markets are starting the week on a fragile note. Overnight, the Nikkei dropped 4.5% and the Hang Seng fell 4.2% (click here for more detail from The Telegraph). Japanese industrial production numbers were terrible, down 9.4% in February and down a massive 38.4% on the previous year. That is what you call a collapse in output. Wednesday's tankan survey will likely be one of the worst in a long time and will highlight the weakness in Japanese business confidence.

Equity market sentiment was also dented by President Obama telling GM and Chrysler that more aid from the taxpayer will not be forthcoming until they step up restructuring plans. In addition, the G20 meeting this week is not expected to feature new fiscal stimulus plans and differences of opinion between the US and Europe still persist (click here for more analysis). Germany's Finance Minister said last Friday that the euro could end up with credibilty problems if budget guidelines are broken.

On top of that, the banking sector is not out of the woods with UBS reported to ditch 8,000 jobs and Spain mounting its first bank rescue in 16 years. US Treasury Secretary Geithner told ABC news that, "some banks are going to need some large amounts of assistance." Roger Bootle in this morning's Telegraph (click here) argues that if the G20 summit shows that "international co-operation is dead", then "we really would be on the road to repeating the 1930s". A mite exaggerated maybe but I have to say that I think Roger has a point. Global trade volume has shrunk 20% since October and is in a sharp downward trend (click here for January’s data, the latest available).

Apart from G20, the market will be watching the European Central Bank's (ECB) policy meeting on Thursday. The market expects a 50bps cut in the main financing rate to 1.00%. I think the ECB should be more aggressive and cut 100 points. The situation in the eurozone economy is severe and the ECB has noted a sharp slowdown in private sector credit demand. After all, (eonia) money market rates are actually closer to the deposit rate which is at 0.50%. Last year, the ECB decided to supply unlimited finance under the repo mechanism which reduces the importance of the marginal rate (the marginal rate was the upper limit and the deposit rate was the lower rate for money markets). Now, the ECB's interest rate corridor is between the deposit rate and the repo rate (0.50-1.50% as of now). So a 1.00% point cut in the repo rate would simply be a ‘catch-up’ with the current level of money market rates. I also expect the ECB to announce that quantitative easing is being considered. If they do what I would like them to do, you might see a sharp sell-off in the euro.

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27th March 2009

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Stockmarkets are on course for the their best monthly gain since 1987. Year-to-date, the best performing market is China (up 30%) with some of the South American markets (Peru and Venezuela for example) up 25-30%. The FTSE100 is 11% DOWN year-to-date with the S&P down nearly 8%. But why am I worried? Well, the yield on the one month US Treasury bill has just dipped back below zero for the first time this year. In other words, investors are paying the US Treasury to look after their money! I'm not sure why to be honest, though it might be something to do with month-end and Japanese fiscal year-end. If it is, then bill yields should go back above zero once year-end is out of the way. Also, the TED spread has been widening again in recent weeks. However, other money market/credit indicators have eased, so it would be misleading to conclude that credit/money markets are freezing up again. Not that credit problems are absent. Moody's, the rating agency, points out that it expects a sharp increase in leveraged loan defaults and predicts that 11.1% of US leveraged loan issuers will default by the end of this year compared to 3.5% at the end of 2008 (click here for the full report). That, together with problems in other areas of securitised credit (like credit cards), may lead to mounting problems.

Nevertheless, John Authers in this morning's FT looks at why credit markets are not joining in the equity market rally and says that credit markets “are still working on the assumption of absolute disaster,"i.e. a ‘re-run of the Depression’. Well, someone has got to be right. The optimists would argue that there is a high degree of illiquidity in credit markets and the prices of various credit indicators simply do not reflect the current ‘reality’. Equity and commodity markets on the other hand are more liquid and much more sensitive to expectations of global economic activity. Hope of economic stabilisation and belief that bank rescue plans/fiscal stimulus will work is crucial in terms of current investor sentiment.For what it's worth, I am still in the bearish camp as far as the prospects for the global economy are concerned and I am not sure that the current equity market rally will extend much further, i.e. S&P faces tough tehnical resistance at 880…833 as at last night's close.

For your weekend reading, I recommend "The Quiet Coup" by Simon Johnson who is a former chief economist of the IMF (click here) who takes a gloomy view of economic and financial developments.

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26th March 2009

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Gardeners' question time: looking for ‘green shoots’

The financial markets currently are taking heart from what seems to be ‘better than expected’ economic data coming out of the US. For example, yesterday reported a 4.7% gain in February's new home sales and a 3.4% gain in the same month's durable goods orders (caveats: this was the ‘worst’ February for new home sales since the data was first recorded in 1963 and the second worst month ever on a seasonally adjusted annual basis, unsold housing inventory is close to a record high and much of the strength in existing home sales has come from foreclosure re-sales, house prices are still falling, commercial real-estate delinquency rates on loans have doubled since September and the durable goods orders increase follows six consecutive monthly decreases).

So, is the worst behind us and is the US economy close to bottoming out? That's the current debate, but I am hesitant to join the recovery camp at the moment and would caution into reading too much into one month’s data. The most I would acknowledge is that the worst of the declines in a number of key activity indicators in the US might have taken place late last year.

Nevertheless, the markets (and some economists) are undoubtedly looking for ‘green shoots’ and some think that tomorrow's US GDP data could mark the ‘cyclical trough’. The Fed's Yellen noted that just a stabilisation in residential construction even at very low levels could arithmetically boost GDP growth, and a reduction in the pace of inventory liquidation which has been very severe in the past few months could also arithmetically raise the GDP growth rate. But as Yellen also noted, this does not necessarily mean that the economy is genuinely posting a durable recovery and she was at pains to highlight that she thinks the US unemployment rate will still be above its natural rate by the end of 2011.

The equity market has had a decent recovery during March partly reflecting previously ‘oversold’ technical indicators and a recovery from extremes in bearish sentiment and short positions (click here for more detail). Hopes of a G20 stimulus package and the Geithner rescue plan for banks (despite the fact that two Nobel Prize winners – Krugman and Stiglitz – have said it's a bad plan) have also bolstered sentiment. Rallies in commodities (Chinese infrastructure spending?) have also helped with the CRB index which is up 13% since the beginning of the month and copper is up 22% over the same period.

Since the beginning of March, the S&P is up 16% compared to 14% in the German DAX and 19% in the Nikkei. Like the debate over the US economy, there is a similar debate over the direction of the US equity market. Some think the market can climb a ‘wall of worry’ and test key technical resistance at 880 in the S&P. Others see the current rally as a bear market rally that is starting to look exhausted. Bespoke Investment note that 62% of the stocks in the S&P are currently trading above their 50-day moving averages and that this is close to the 75-80% level seen at prior market peaks during this bear market. They have presented a variety of charts which show the sectoral composition within the S&P (financials, industrials, energy etc.) showing the % deviation from the 50 day moving average (click here for the charts).

Differences in opinion between the US and Europe over fiscal stimulus remain a concern. In the UK, there appeared to be a difference of opinion on this matter between the Prime Minister and the Bank of England Governor (though this morning’s FT reports that the Prime Minister is retreating on his call for a fiscal stimulus) which didn't help the 40-year gilt auction yesterday (admittedly not representative of usual auction activity which tends to be shorter-dated). Today's UK retail sales data was pretty poor, registering the weakest annual increase in 13 years. No surprise really and I expect more belt-tightening in the months ahead.

US Treasury Secretary's comments on China's SDR proposals temporarily rocked the FX market yesterday afternoon until ‘clarification’ was received that Mr Geithner did actually favour a strong dollar. ‘Foot in mouth’ has afflicted Mr Geithner before (click here for more), but I am sure he will take advice from Treasury officials and be more careful on talking about FX in the future. As far as I am concerned, I think there is no chance that the SDR will replace the US dollar as the leading reserve currency. In the short term, the technical picture suggests there is scope for some outperformance of the dollar against the euro as long as recent highs of around 1.3750 are not taken out.

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25th March 2009

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Mervyn King, the Bank of England (BoE) Governor, has finally got the message on the exchange rate. Maybe it was his visit to Her Majesty which did it. As I have highlighted in my previous blogs, the BoE's preference for a weaker pound to aid exports looked daft at a time when world trade (and exports) are slumping. Looking for a weaker pound when you are a deficit economy is even more daft as it only scares away (much-needed) foreign investors. And presumably, the BoE's search for a ‘rebalancing’ of the UK economy has happened in spades. So, at long last, Mr King's comments in his Treasury testimony yesterday said there was now no reason for the pound to go lower. This is an important signal for FX traders and investors in my view and is similar to Mr Bernanke's ‘Damascene’ moment on the dollar last year (3rd June) when he recognised that a weaker dollar – rather than helping US competitiveness – was pushing commodity prices higher and hurting world economic prospects. He might have also been reacting to calls from the Chinese Prime Minister to stabilise the dollar which were made public at the end of June last year (note that the EURUSD exchange rate peaked at 1.6040 on 14th July last year!).

So, Mr King's comments are important and while the very short-term technical picture suggests that the sterling crosses are set to fall back temporarily, I think we have to recognise that his comments are positive for the longer-term picture for sterling. Mr King also argued against any further fiscal stimulus given worries over the UK budget deficit. In addition, he thinks the downward trend in UK inflation will resume and that yesterday's upward move in CPI inflation to 3.2% was a ‘blip’. I tend to agree with him, as I believe the UK (and global) economy is still in the grip of deflationary pressures. Mr King also emphasised that he takes seriously the possibility that the BoE would have to raise interest rates ‘quickly and sharply’ if and when the UK economy recovers.

After reflecting on my blog yesterday which featured the debate on the future of the dollar, it occurred to me how sensitive the US authorities are to Chinese concerns, which is not surprising in that China is America's main creditor (click here for more detail). I mentioned the change of tune on the dollar last year but I also recall China expressing concern over its investments in US agency debt where China was the largest foreign holder amounting to 29% of the total. Shortly after those comments, Freddie and Fannie was nationalised (13th July) prompting an immediate 16% rally in Freddie Mac stock.

Likewise, recent Chinese concerns over its holdings of US Treasuries (13th March 2009) – which amounted to $740 billion on the latest count – was shortly followed by the Fed announcing that it was making direct purchases of US Treasuries (18th March 2009) prompting a sharp rally in US Treasury prices. The aftermath of a weaker dollar then resulted in China's ‘proposal’ this week to ditch the dollar in favour of a new global reserve system. I don't really believe that this is anything more than a sharp reminder to the US authorities to do their bit on the dollar and it would be no surprise to see the dollar strengthening in response (I actually think that we are seeing a ‘top’ in EURUSD at 1.3735 as of Monday this week and I would not be surprised to see an interim move towards 1.3000 in the next week or so). We shall see.

Much might depend here on the European Central Bank (ECB) at its regular policy meeting next Thursday and the market is now discounting a cut in interest rates of 50bps. Personally, I think they should be more aggressive as the eurozone economy is sliding off a cliff but the ECB's thought process on interest rates mystifies me at times. I accept that the ECB might not be so far behind the curve as some might think as the futures market is predicting that ECB rates will be down below 1.00% in three months time. Goldman's economists think the main refinancing rate will trough at 0.50% in the summer.

As far as ‘quantitative easing’ is concerned, Goldman's economics team expect the ECB to announce next week a lengthening of the maturities to 12 months in their repo auctions from a maximum of six months at present. Professor Willem Buiter argues that the ECB should engage in quantitative easing and claims that there is no treaty based obstacle to the ECB buying eurozone government securities in the SECONDARY market (click here to see his thoughts which are worth reading).

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24th March 2009

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The debate over the longer-term future of the US dollar (quantitative easing aside) is taking another twist with China yesterday proposing to replace the dollar as the world's main reserve currency with a new global system under the control of the International Monetary Fund (IMF) (click here for more details). China says the dollar's role could be taken over by the Special Drawing Right (SDR), a quasi-currency that was created in 1969 to address a key problem of international liquidity that featured during the Bretton Woods system of fixed exchange rates and capital controls.

All this coincides with a report from the United Nations Commission on Financial Reforms (CFR) on which my old friend Avinash Persaud is a sitting member (click here for the report). The CFR proposes to double cumulative SDR allocations to SDR 42.8 billion to help provide more funding for developing countries. More importantly, it proposes a new Global Reserve System through a significant expansion in SDRs as a way of reducing dependence on the dollar as the leading reserve currency as well as alleviating the problems caused by global imbalances which have been a feature of the international monetary system – Bretton Woods 2 – in recent years.

However, the creation of the SDR in 1969 did not replace the dollar and the SDR ended up being a central bank unit of account that now accounts for 1% of global liquidity. Bretton Woods 1 broke down, capital flows were liberalised and exchange rates floated thus liberalising the US (and other reserve centres) from concern about the magnitude of claims on their economies held by one category of foreign holders, namely foreign central banks.

Of course, the Bretton Woods 2 system (click here for a history of international monetary systems) had as its centre-piece the financial relationship between the US and China. China fixed its exchange rate against the US dollar (as did some other Asian economies) and pursued a policy of export-led currency ‘undervaluation’. Consequently, China (and Asia) accumulated large trade surpluses which were mainly the counter-party of America's trade deficit. Those trade surpluses in turn resulted in the accumulation of trillions of dollars in the foreign exchange reserves of Asia's central banks. Where to put those dollar reserves? China (and other Asian central banks) recycled those reserves into US financial assets – mainly the treasury and agency-fixed income markets. In effect, China kept US bond yields (and mortgage rates) lower than they would otherwise be. The Chinese taxpayer inadvertently subsidised the American home-owner. In addition,China supported the dollar (and probably prevented a dollar crash during a period of worsening US trade deficits).

Fed Chairman Bernanke believed that the rapid increase back then in the US current account deficit was due to the emergence of a global savings glut (see his speech on this here). He thought in the longer term that this pattern of international capital flows could prove ‘counterproductive’ with developing countries lending large sums to the mature industrial economies. Given longer-term demographic projections (developing economies have younger and more rapidly growing workforces compared to Western Europe and Japan as well as relatively low ratios of capital to labour implying potentialy higher rates of return to capital), he thought industrial economies should be running current account surpluses and lend to the developing economies, not the other way round.

Obviously, China has become concerned about having all its eggs in one basket and the obvious concentration of investment risk in one currency and one asset class. But there is also the obvious danger of China ‘shooting itself in both feet’ if it did decide to switch out of the dollar and US fixed income markets possibly precipitating a crash in the dollar and a crash in bond prices.

More immediately, US capital flows are already changing quite significantly. Brad Setser notes that in the latest US balance of payments data (click here for more detail) the US government is now a net lender rather than a net borrower. Foreign central banks withdrew $13.6 billion in credit from the US in the fourth quarter but the US – through the Fed's swap lines – provided $268 billion to the rest of the world. For all of 2008, the data shows that the US government lent $534 billion to the rest of the world while foreign governments lent only $421 billion to the US. US private investors are deleveraging and have pulled funds from foreign markets faster than foreigners have pulled funds from the US market. Cross-border flows have effectively collapsed courtesy of the financial and economic crisis. The Federal Reserve and the US Treasury have taken over the role as the main provider of international liquidity and dollar liquidity from China. In addition, the US current account deficit is already starting to shrink and the US household savings rate is starting to increase. All necessary conditions for a readjustment of global imbalances.

This doesn't mean that the debate over the dollar's future is not relevant. Clearly it is, as there is market concern that the US authorities might resort to an eventual explicit policy of dollar devaluation if current policies of stabilising the banking and financial system fail to work. Mr Bernanke's other famous speech on the dangers of deflation highlights currency devaluation as a way of lifting price levels in the last resort. He said, "it's worth noting that there have been times when exchange rate policy has been an effective weapon aginst deflation" and his speech is the template that the markets have been working off in their assessment of Fed policy actions (click here for the full speech).

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23rd March 2009

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Tim Geithner, the US Treasury Secretary, is set to unveil today (at 12.45GMT) details of a plan to take toxic assets off banks' balance sheets (click here for more detail). The plan aims to put $150 billion of troubled asset relief funds into a public-private investment programme (PPIP) with $820 billion from the FDIC and $30 billion from private equity and hedge funds. The plan is designed to persuade private investors to buy as much as $1 trillion in troubled mortgages and related assets from banks with government help.

The government will offer subsidies, in the form of low-interest loans to encourage private funds to form partnerships with the government to buy troubled assets from banks. The government (the Treasury and FDIC) will lend nearly 95% of the money for any investment.The FDIC will auction off pools of mortgage loans that a bank wants to sell and will become a co-owner by forming a partnership with the highest bidder. The partnership will then raise FDIC-guaranteed debt to finance a portion of the purchase price with the Treasury willing to kick in between 50% and 80% of the equity needed to buy the assets.  

Christina Romer, the White House chief economist says, "What we're talking about now are private firms that are kind of doing us a favour...coming into this market to help us buy these toxic assets off banks' balance sheets". Mr Geithner says, "Over time, by providing a market for these assets that does not now exist, this program will help improve asset values, increase lending capacity by banks, and reduce uncertainty about the scale of losses on banks' balance sheets".

The New York Times reports that executives at private equity funds and hedge funds told White House officials over the weekend that they would only participate if the government guaranteed that it would not set compensation limits on their firms (click here for more detail). The executives also expressed concern whether disclosure and governance rules could be added retroactively to the programme by Congress.

One of the key stumbling blocks is how to place a value on mortgage-related assets that have not been traded for months and where, for all intents and purposes, the market for these securities is either moribund or non-existent. In these circumstances, there is clearly a difference of opinion between what the banks want to sell the assets for and what investors are willing to pay for them. The government hopes that the subsidies it provides to investors are generous enough that they will be willing to ‘overpay’ for the toxic assets. Of course, investors will only buy these assets if the investments in toxic assets ultimately proves profitable but it looks a decent bet to put up $30 billion which is then leveraged up to $1 trillion with government money. Banks which hold these toxic assets, on the other hand, will be reluctant to sell if a high enough bid is not forthcoming for fear of having to take a huge write-down on their balance sheets.

Economic commentators like Brad DeLong support Mr Geithner's plan but note that more support will be required, maybe up to $4 trillion (click here to read about this). Professor Krugman is more critical in his NY Times blog (click here).

The equity markets are starting the week on a positive note largely in response to news of the Geithner plan and market hopes that the plan will work. I think that slowly but surely banks’ balance sheets will be purged of toxic assets. The cost to the taxpayer will be huge though, and it is not clear that banks will immediately start lending again to households, businesses or other banks so I'm not expecting a quick turnround in the economy. For a good description and pictorial representation of how it is all likely to work, click here.

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20th March 2009

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Equities are failing to make new highs after this week's moves by the Fed on quantitative easing (QE) initially bolstered investor sentiment. Now, the dollar is weaker, oil prices higher and financials are struggling again (click here to see why non-performing assets are still accelerating and why there will be significant equity issuance). AIG remains in the news over its scandalous bonus payouts, Barclays faces new whistleblower claims over £1 billion tax avoidance deals (click here for more from the Guardian), the collapse of Germany's HRE shows that the crisis is not a US/UK problem, Weavering Capital goes bust, the IMF criticises the US stability plan and Europe is split on the need for a fiscal stimulus (click here for the IMF's latest report which details G-20 fiscal stimulus numbers). There are also doubts in some quarters that QE might not work or at least not prompt an early recovery in the real economy.

Spencer Dale, the Bank of England's (BoE) chief economist, claims in this morning's FT that the UK is already a long way through the recession but does not rule out a more prolonged downturn (click here for the article). He also notes that sterling's weakness can encourage a ‘Buy British’ mentality. The CBI reported yesterday that demand for UK exports has slid to a new low despite the slump in sterling. Unfortunately, the BoE still doesn't understand that a preference for a weak pound will scare away foreign investors which can't help a deficit country like the UK. Some commentators now think the UK budget deficit could rise to almost £100 billion which is £20 billion more than was predicted by the Chancellor in last November’s pre-budget report. The IMF thinks the UK deficit could reach a record 11% of GDP (£200 billion) compared to 9% in the US.

My guess is that the equity markets still remain vulnerable. Hope of an early economic recovery looks ambitious in my view. European policymakers looking for a ‘free-ride’ off the US fiscal stimulus are likely to be disappointed. The dire economic situation in the eurozone demands early fiscal action by the Europeans, otherwise the economic situation can only get worse. The ‘bad news’ story has still to play out.

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19th March 2009

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Last night's announcement from the FOMC is important. They embarked on full-blown quantitative easing by announcing a massive expansion in their balance sheet and, in particular, announcing a $350 billion purchase of US Treasuries. This is testimony not just to the severity of the economic and financial crisis but also reflects official concern that the heavy load of financing and issuance could have capsized the economy through increases in longer-term interest rates (bond yields). Effectively, I think this puts a cap on the US Treasury yield at 3.00% which in turn puts down pressure on US mortgage rates. In addition, the purchase of agency securities will go a long way to freeing up financing in the housing market.

The immediate market reaction was positive for equities as it shows that the authorities are willing to resort to any measures to stabilise the system. Also, the desire to prevent upward pressure on bond yields helps to improve equity market valuations as well as reducing borrowing costs for companies and households. The fixed income trade is to be long bonds and look for yield curve flatteners. 

The immediate FX negative is that it weakens the US dollar. On a comparative basis, the Fed's balance sheet has been aggressively expanded and, given that the currency market is all about relative valuation, it is likely to be to the dollar's disadvantage. In the short term, the EURUSD exchange rate has found technical support around the 1.25 level in the past few weeks and the Fed's decision is likely to push EURUSD up through the 1.35 area maybe to 1.40 in the interim. The likely increase in risk appetite also benefits sterling (if you believe that sterling is a proxy for global financial risk appetite). ‘Carry’ currencies like the Japanese yen and Swiss franc are likely to weaken.

Equity markets have enjoyed a rally over the past week or so. I have previously highlighted a number of mainly technical indicators for the S&P index that pointed to a high probability of a rally. The Fed's measures help, as does a likely decision today by the EU council which gives support for the central and eastern European economies. In addition, Treasury Secretary Geithner is expected to flesh out bank rescue plans ahead of the G20 London Summit at the beginning of April. All of this helps to bolster equity market sentiment.

The main risk for equity markets is that none of this works, thus severely disappointing investor expectations. That risk cannot be ruled out in my view but for the time being investors won't ‘fight the tape’. As a result, the current bear market rally may persist for a while yet (see my blog yesterday on the Credit Suisse data on the duration and extent of bear market rallies).

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18th March 2009

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Last night, Mervyn King warned that mass unemployment is a risk for the global economy (click here for more information). For a comparison with unemployment in the 1930s which was truly awful and a lot worse than what we are seeing now, have a look at these charts for the US economy (click here).

This morning's UK unemployment data is expected to reveal that there are now two million unemployed for the first time in over a decade. Further increases in unemployment can be expected I think which could reach three million. In addition, the IMF believes that the UK will be the last major economy to come out of recession in 2010. The IMF expects the UK economy to shrink by 0.2% that year with the US economy expanding by 0.2%. All economic forecasters would recognize the large margins of error attached to these forecasts and I wouldn't put too much weight on them. My view is that the major economies will struggle to stage a convincing recovery next year.

Elsewhere, yesterday's US housing data is being seen by some as showing that the US housing market might be bottoming. Housing starts jumped by 22% in February (the fifth highest monthly increase in the indicator's history). However, the past four months rank as the worst housing starts figures since the data was collected. Most of the increase in February's housing starts came from the volatile multi-family sector but single-family building permits (an indicator of future housing starts) also rose by 11%. Milder weather in February might have helped but Goldman's economists note that in recessions since 1960 (with the exception of the 1974 recession) an increase of over 5% in permits has always marked the bottom in permits. There is always the possibilty with just one month's data that it could be revised away. Note that the homeowner vacancy rate (a measure of excess supply) is still at a record high and suggests that there will continue to be downward pressure on US house prices. Indeed, Goldman's economists believe that there will be another 15-20% decline in prices from the end of 2008 so don't confuse a bottom in the housing market when looking just at housing starts. House prices are important too especially in terms of household's net wealth.

As far as the stockmarket is concerned, the S&P500 index closed up 3% last night and is at the technical resistance levels I mentioned yesterday. It will be interesting to see whether the rally can continue above the 800 level (from 792 to 812). For interesting stats on the extent and duration of bear market rallies in the equity market, look at this data from Credit Suisse (click here). Asian stocks were somewhat mixed overnight and there was little response to the Bank of Japan's announcement yesterday that it would provide subordinated capital (admittedly modest at $10 billion) to help banks replenish capital. The main focus today will be the Federal Open Market Committee’s (FOMC) announcement on monetary policy this evening especially if the Fed details proposals to purchase US Treasuries.

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17th March 2009

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Fed Chairman Bernanke says that he is hopeful for economic recovery in 2010 (see his interview here). The last time a sitting chairman of the Fed did a TV interview was Alan Greenspan's 1987 appearance on NBC's ‘Meet The Press’. The following week, the US stockmarket had its largest single-day drop in history.

Mr Bernanke thinks that once the financial system is stabilised then the conditions for a recovery in the real economy will follow. However, I think the process of consumer deleveraging and the reduction in the household debt mountain will be painful…a look at some of these charts from the New York Times will tell you why (click here).

Yesterday's US data was poor and points to further deterioration rather than any imminent turnaround. US industrial production dropped 1.4% in February and is now 11% lower than a year ago. Industrial capacity utilisation matched the record low set in December 1982 and points to little need for fresh industrial investment over the medium term.The New York Fed index slumped to minus 38.2 in March from minus 34.6 in the previous month. The Fed survey reported that "conditions deteriorated significantly" for New York manufacturers in March. New orders and shipment indices dropped to record lows and the six-month outlook continued to be subdued with the capital spending index falling to a record low. The National Association of Home Builders Index in March was near its record low and sales expectations for the next six months remained at a record low. I can understand why Mr Bernanke is trying to talk up the economy but unfortunately there seem to be no signs of recovery in the manufacturing sector, housing market and labour market.

In addition, the TIC capital flow data reported yesterday a massive $149 billion capital outflow from the US in January. This was largely the result of foreign private investors reducing their Treasury bill holdings and banks reducing their net dollar deposits. Both reflected an improving appetite for risk as perceptions of an Obama ‘rally’ encouraged investors. Interestingly though, the foreign demand for US equities has largely disappeared according to the TIC data. The only ‘bright’ spot was that China bought $12 billion of US Treasuries. It may well be that the January capital flow data just highlights an unwind of investor ‘flight to quality’ inflows during the worst of the financial crisis rather than an investor ‘thumbs down’ to the dollar. Nevertheless, the capital flow data is crucial going forward for the US dollar as the US authorities are dependent on foreign capital to finance their deficits.

The poor economic data puts the recent rally in equities in perspective. The S&P500 index is now running into technical resistance and could easily fizzle out. The rally is nothing more than a ‘bear market rally’ in my view and was based on a short covering rally characterised by previous trader exhaustion and investor hope that ‘good news’ is around the corner. My blogs in recent weeks also highlighted some technical indicators that suggested the S&P was due a ‘rally’. But don't be surprised if equities take another knock with 750-775 on the S&P proving a tough barrier.The economic fundamentals don't justify a continuation of the rally in equities from here in my view. I also thought the G20 meeting at the weekend was a disappointment as it highlighted the absence of a coherent unified approach to a global fiscal stimulus.

All eyes on the Fed's policy meeting today and tomorrow. The Fed has basically used up a lot of its monetary ammunition, though they could announce measures to start buying US Treasuries thus effectively capping the yield on US Treasuries at 3.00%. The Bank of Japan also meet, but with interest rates at 0.10% there is little that they can do in terms of fresh policy measures.

Finally, just to cheer everyone up today, watch Sesame Street explain the Madoff Scandal (click here).

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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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16th March 2009

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Generally positive and upbeat comments from the G20 Finance Ministers over the weekend seem to have been met with positive enthusiasm this morning, with risk being put back on in the shape of higher stock markets (and in particular bank stocks), higher GBPCHF and higher GBPJPY.

GBPCHF had started this move last week when the Swiss National Bank dropped their target 3-month rate ever closer to zero, and intimated that a weaker currency was desirable. At 1.6800 this morning, there seems little to halt its path in front of 1.7000. It is also interesting to note that GBPCHF option risk reversals (the currency options market-directional bias), whilst still in favour of GBP puts, have opened today at their lowest 1-month levels for a whole year. With a much less heavily directional slant to options, short-term traders should also feel less inhibited about being long the currency pair. 

Elsewhere USDJPY is steady at current levels above 98.00. The obvious target here will be 100.00 and higher. However, with the Japanese year-end looming (end of March), this currency pair could be susceptible to a spike lower at some stage over the next few weeks, although it seems likely that such a move would be met with plenty of buying interest.

EUR continues to enjoy mixed success across the board, struggling against sterling but enjoying real strength against the ‘dogs’ of the currency world, JPY and CHF. Watch out for 1.5500 and 130.00 respectively here.

Finally OPEC resisted calls for a cut in production over the weekend and this morning crude has plummeted by over 4%. This is proving to be a more volatile commodity than most currency pairs, but one can't help thinking that below $40 might begin to look like medium-term value.

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13th March 2009

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As I intimated in yesterday's blog, the Swiss National Bank (SNB) cut its main interest rate by 25bps. The target band is now 0.0% to 0.75%. More importantly, the SNB says it will start buying Swiss franc bonds issued by private sector borrowers i.e., quantitative easing. As Paul Meggyesi at JP Morgan has pointed out, the SNB has a larger central bank balance sheet (as a percentage of GDP) than any other country and has grown it faster than any other country. The Swiss monetary base has also expanded by more than in any other country. All currency negatives in my view, though that is tempered by the fact that Switzerland has a large current account surplus and is a large creditor (net foreign assets stand at 140% of GDP) and therefore is not too dependent on capital inflows.

In addition, the SNB intervened in the FX markets "to prevent any further appreciation of the Swiss franc against the euro". All of this is not surprising given that the SNB now expect real GDP growth to be between minus 2.5% and minus 3.0% for 2009. This is a major revision to its previous growth forecast which did not see the decline in growth anything greater than minus 0.5%.

All in all, I view this as an important policy change by the SNB that can have wider implications for other central banks as well as FX policy. Cynics will say that the Swiss action is designed to prevent Swiss franc appreciation rather than force currency weakness. Nit-picking. If they don't want the currency up, there is only one way it will go and that's down and that's where it is heading in my view. One lesson I have learnt in the past 20 odd years of being in the markets is that you don't fight governments or central banks. Indeed, if the currency markets are a casino then the central banks are the ‘house’ and the ‘house’ does not lose.

Other cynics will say that the FX intervention was only unilateral and FX intervention only ‘works’ if it includes the US. Well, maybe and there are previous examples (like the European Central Bank (ECB) and the euro) where unilateral intervention was insufficient to turn the euro round off its lows and needed co-ordinated intervention with the US to establish a floor in the euro. It is entirely possible that the SNB will have to intervene again to prove a point if needs be and it looks as though 1.45-1.47 in the euro/swiss exchange rate are the intervention levels that the SNB will defend. Note that back in 1978, the SNB successfully put a floor in the deutschemark/swiss rate at 0.80. Note that Switzerland is not a member of the G20 and the Swiss move on FX intervention is likely to trigger worries of ‘competitive devaluations’ and ‘beggar-thy-neighbour’ policies. But in the light of the downturn in world trade, this should not be a surprise and a return to protectionism is quite likely.

This chart (click here) shows a previous correlation between euro/swiss and the German DAX stockmarket index but SNB FX intervention suggests that this relationship might break down. The intervention in the Swiss franc will also help take the heat off central and eastern European currencies where a substantial amount of foreign currency debt (mainly mortgages) is denominated in Swiss francs.

Of course, there are implications elsewhere. The immediate focus is on the ECB who now look increasingly behind the curve in terms of interest rate policy. Germany, a key trading partner for Switzerland, is collapsing as all the recent German economic data on industrial production, factory goods orders and exports make very clear. The ECB has to act aggressively soon by cutting interest rates. However, quantitative easing and FX intervention seems a long way off here though note the euro trade-weighted exchange rate is starting to rise again (click here for the Bloomberg chart).

Of course, SNB FX intervention invites speculation that the Bank of Japan (BoJ) might do the same. I think the BoJ was actually ‘smoothing’ dollar/yen when it was down in the 88-90 area a few weeks ago. In spite of worries about yen repatriation ahead of the March fiscal year-end, the economic news out of Japan has been so bad that the market has sold the yen anyway without the assistance of the BoJ. I don't think the Americans will mind a weaker yen somehow as the Americans need Japanese (and Chinese) money to finance a rising US budget deficit and one way to make that attractive in terms of total investment returns is to allow dollar/yen to go up. So don't be surprised to see dollar/yen move into a 100-120 trading range. Also, with euro/swiss going up (1.60-1.70?), euro/yen (130-140?) is likely to go up as well.

Finally, if you would like to see an entertaining and original view of the how the credit crisis started, check out Jonathan Jarvis with his "The Crisis of Credit Visualised" (click here for the study). Also, DeAnne Julius, ex-Bank of England MPC member, has an article in this morning’s Guardian where she is warning of a sterling crisis (click here for the article). However, I think sterling is starting to consolidate and if you believe sterling is a barometer of global risk as I do and that equity markets look as though they might be recovering, then sterling could surprise on the upside.

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12th March 2009

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The financial markets expect the Swiss National Bank (SNB) to cut interest rates by 25bps from the existing targeted mid-point of 0.50% early this afternoon. The markets will also be looking closely at any proposals for quantitative easing and references to any further official concern over the strength of the exchange rate (click here to see the Bloomberg chart showing the Swiss trade-weighted exchange rate) and the possibility of FX intervention. The Swiss economy is closely entwined with the German economy via exports and the economic collapse in Germany is having adverse effects on Switzerland (click here for the Bloomberg chart showing the sharp fall in Swiss industrial production and the decline in the KOF leading indicator).

Back in the 1970s, Switzerland imposed a variety of controls to tackle strength in the Swiss franc which was attractive during a period of very high inflation and weakness (and loss of confidence) in the US dollar after a move way from gold convertibilty by President Nixon. Some of the Swiss measures included negative interest rates on Swiss franc deposits of non-residents and a prohibition on non-residents investing foreign funds in fixed interest securities denominated in Swiss francs (from 1972-74). I would not be surprised to see the SNB thinking about re-intoducing some of the measures imposed back then.

Elsewhere, equity markets hung on to some of this week's gains though sentiment is still fragile. The G20 meeting remains a key focus with the markets looking for substantive policies rather than platitudes from policymakers. Professor Willem Buiter in his FT blog is scathing in his criticism of the US Treasury (click here "To the victor go the spoils: who answers the phone in the US Treasury?”). OPEC meet on Sunday but any production cuts are likely to be ignored and the impact of the global downturn (especially from commodity demand economies like China) is likely to be more of an issue (click here for the Bloomberg chart showing the oil price versus the Shanghai Composite stockmarket index).

As far as the UK economy is concerned, the Bank of England started quantitaive easing yesterday in its purchases of gilts mainly from banks. Whether the money that goes into banks' coffers from the sales of gilts finds its way into new lending is up for debate; it may have leaked abroad if foreign holders of gilts are the main sellers. The Chancellor, Alistair Darling, if press reports are to be believed, is unlikely to come up with any significant stimulative measures in next month's Budget. The UK economy is in no better shape though and this week's trade data highlighted the fact that UK exports fell at a record pace in the three months to January. We are not out of the woods by any stretch.

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11th March 2009

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Citi prompts equity rally: One-day wonder or a turning point?

An internal memo from Citigroup's CEO which purported to show that Citi had its best quarter since 2007 (click here to read the memo) prompted a sharp rally in equities with the S&P500 recovering from technical support around the ‘beastly’ 666 area (click here for the Bloomberg chart).

In this morning's FT, Lex questions the underlying financial strength of Citi in terms of revenue and capital strength (click here for the article). The WSJ reports that Citigroup is still in the sights of federal regulators who are worried about further losses especially from derivatives and credit default swaps exposure (click here for more). Also helping the rally was an unwillingness of investors to be short going into this weekend's G20 meeting of finance ministers (the FT has more on the G20 here) where the IMF is expected to be given more resources and funding to help alleviate any emerging market crises. Economies with sizeable FX reserves are likely to be asked to come up with the funding (this might also explain why the gold price retreated yesterday).

Jeremy Grantham, a well-kown bear who manages a US$85 billion fund, is now urging investors to move money from cash to stocks. See his report, "Reinvesting When Terrified" which is worth reading here. For an opposing view, read David Kauders of Kauders Portfolio Management who says "Sell every asset except gilts" (click here for the article in The Telegraph).

Is this rally durable? Ben Bernanke, the Fed Chairman, is considering modifying mark-to-market accounting which helps ease the pain for investors and the SEC is considering reviving the ‘uptick’ restriction (abolished in 2007 and adopted after the 1929 Crash) on short-sellers of stocks (Reuters has more detail here). All of this is helpful for equities though it is worth noting that the cost of borrowing (three-month dollar LIBOR) continues to tighten and LIBOR-OIS spreads have not narrowed which introduces a note of caution. UBS, the Swiss bank, this morning revised its 2008 losses higher than previously reported (more detail from the Guardian here).

Meredith Whitney, the star banking analyst, says credit cards are the next credit crunch (more from the WSJ here), so I think this equity rally needs to be treated with caution as this might not be the final stage of the Kubler-Ross model of the five stages of grief (click here for more detail on this model).

Finally, I commend Christine Romer of the President's Council of Economic Advisers and a leading academic macro-economist. Her report entitled "Lessons from the Great Depression for Economic Recovery in 2009" (click here) draws on the policies of President Roosevelt and looks at what needs to be done now. She concludes that, "the more that countries throughout the world can move toward monetary and fiscal expansion, the better off we all will be". She also notes that, "a key feature of the Great Depression is that it did eventually end".

Hurrah!

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10th March 2009

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I should have stayed on the Isle of Tiree (click here for more information) after my trip there over the weekend. At least, only the weather was bad rather than the unremitting newsflow of bad news on the economy and on the markets that I am reading about this morning. Legendary US investor, Warren Buffett, says the US economy has "fallen off a cliff". He notes a renewed tightening in credit conditions and indeed some credit spreads are tightening (like the TED spread and some corporate spreads but not to the same degree that took place in late 2008). He told CNBC television that economic developments were close to the worst case he had imagined and that there would be no quick recovery. When recovery eventually comes, he predicts that inflation will be worse than the late 1970s. He did say, though, that investors will do better owning equities...over a 10-year period. For a rebuttal of Mr Buffet's views, click here.

Professor Roubini (‘Dr Doom’) at NYU says the US ‘recession’ could last up to 36 months with growth at zero and unemployment at 10% (click here for more). The Asian Development Bank reckons that $50 trillion was wiped off the value of global financial assets last year (see their latest report here).

Elsewhere, in the credit markets, banks and insurance companies face more losses as a key measure of distress (the Markit iTraxx crossover index which measures the possibility of default among 50 European junk-rated borrowers) rose to a record 1169 basis points yesterday (click here for a detailed analysis in the Guardian). In the past fortnight, the UK taxpayer has swallowed contingent liabilities of almost £600 billion – 45% of UK GDP. The HSBC share price is at a 13-year low. Barclays has been warned yesterday that its balance sheet would be subject to forensic Treasury examination if it decided to dump toxic assets on the taxpayer. In my opinion, valuing banks' toxic assets is central to the whole problem. The real value of these assets (which are not traded or valued on public exchanges) is probably close to zero rather than the inflated value the banks are telling the Government. These toxic assets are worthless but it means that some of these banks are technically insolvent – not just in the UK but also the US. The longer this all drags on, the closer we get to ‘financial Armageddon’. The FT starts a series on the Future of Capitalism this week...worth reading I'm sure (click here).

The size of the pension deficits facing some of Britain's biggest companies has jumped by around £100 billion to a record £390 billion – the equivalent of over £150,000 for every member of a final salary scheme. The ballooning deficits sharply increase the chance that companies shut down their pension schemes and/or members end up with a much lower annuity (click here for the Telegraph article). It's not just the UK that has a pension crisis. In the US, the $4 trillion assets of pension plans for government workers had fallen by $1 trillion as at the end of October. Pension plans of the S&P1500 companies have lost $0.5 trillion in 2008 of which 80% was lost in the last quarter of the year. The IMF in its latest study sees the fiscal balances of the G20 advanced countries weakening by 6% on average in 2008-2009 alongside a sharp increase in debt/GDP ratios (click here for more).

Finally, the latest UK industrial production data published this morning put the icing on the cake by reporting a drop in output of 2.9% in January and posted the biggest quarterly drop in four decades. Sterling is weaker on the foreign exchanges as I write (0.92 against the euro and 1.38 against the US dollar) as currency traders take a dim view of the prospects for the UK economy and give the ‘thumbs down’ to the effectiveness of the Bank of England's policy of ‘printing money’. Read what Roger Bootle has to say on this here. I pretty much agree with him.

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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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9th March 2009

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The weekend finally saw Lloyd's go the same way as RBS and take shelter under the wings of the UK govt. While the bank's insurance scheme demands Lloyd's to increase their lending by £28 billion, the market this morning is not taking this as a particularly positive step. This may not have come as a huge surprise to anyone, but there remains huge scepticism as to exactly how the Government is going to be able to enforce these loan quotas.

Stocks around the world continue to struggle (the Hang Seng dropped by nearly 5% and the Nikkei 225 by 1.2% last night), and UK financials are leading FTSE lower on the open market this morning.

On currencies, sterling is under pressure against most currencies. GBPUSD is probing the important 1.40 area. A sustained break below this level, and an implicit acceptance of a 1.30 handle could see 1.38 followed by 1.35 in a very short space of time. Against the euro it is now heading back to the pivotal 0.9080 level. Last time we saw this level, the market aggressively faded the move and the pair was soon back below 0.9000. However, a note of caution this time, particularly if GBPUSD is still below 1.40 at the time: This could be the occasion when 0.9080 breaks and sends the Euro bears scrabbling to cover positions. 0.9300 - 0.9500 would then be firmly on the agenda.

Against the Swiss franc we have just seen Friday's low of 1.6236 go, and if it breaks below 1.6150 then the psychological 1.6000 level looms large. Until we see a reason why this should not happen (the SNB make their rate announcement on Thursday, and we are all aware that Swiss strength is explicitly what they do not want), the market will want to test resolve at these sort of levels.

Elsewhere, the dollar remains strong against the Japanese yen, which seems to be being held up as the prime example of what is coming the UK's way in the not too distant future, and so thus far the market has used any retracements (as we saw on Friday) to buy more dollars. The obvious targets here are 100 and above.

Last but by no means least, it is worth mentioning volatility. Over the past week implied volatility levels have been coming down in the near end, which in the past could have been used as an argument for putting on risk. However, these moves need to be seen in their relative context. While they are indeed lower than they have been for some time, they are still much higher than they had been in the three or four years before mid-2007. Volatilities have a long way to fall before one could say that relative calm has returned. Remember, volatility is a measure of two-way movement, and therefore short sharp spikes cannot be ruled out…nothing is ever a cast iron one-way bet!

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6th March 2009

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The main focus in the financial markets today is the release of the monthly US jobs report (1.30pm London time). Given the deterioration in the US economy, it should be no surprise that the report features further sizeable job losses (the market is expecting non-farm payroll employment to have declined by 650k, the 14th consecutive month of jobs lost in the US economy) and a further increase in the unemployment rate (from 7.6% up to 7.9%).

Other labour market indicators published this week didn't make for pretty reading. The ADP private sector index reported a 697k job loss in the month and January was revised down by 92k (click here for more detail). The majority of job losses continue to be at small and medium sized businesses. This was the third consecutive month which showed job losses in the private sector exceeding 600k and was the biggest job loss since the report's launch in 2001. The ISM employment component for the manufacturing sector dropped to 26.1 in February compared to 29.9 in the previous month and the weekly initial claims data continues to highlight a sharp increase in jobless claims to a 27-year high and is up 95% on a year ago. The Challenger layoffs report did highlight that planned layoffs at US firms fell 23% in February but that was from January's seven-year peak and well above long-term averages. The Fed's Beige Book (an important input into Fed interest rate decisions) that was published on Wednesday noted that "...with rising layoffs and hiring freezes, unemployment has risen in all areas, reducing or eliminating upward wage pressures".

The jobs outlook remains bleak and I think that the US unemployment rate can easily hit 10%. Rising unemployment will be a feature of all the major economies this year and probably next. Looking at post-WW2 job recoveries in the US, it is typically some 13-18 months from the previous peak in employment before job losses peak out. In the past three recessions, it seems that it is actually taking longer to return to pre-recession employment levels than previous recessions (click here for more on this). The most serious concern is that the downturn will become something worse than the largest recession in the post-WW2 period: 1982 when the US unemployment rate peaked at 11%. Professor Robert Barro of Harvard University has looked at stockmarkets and depressions using long-term data (click here for the full story). He has looked at 251 stockmarket crashes and 97 depressions globally and finds that in 71 cases, the timing of a stockmarket crash matched up to a depression. He also found that there were 30 cases where both crashes and depressions were also associated with wars.

Looking at the history of non-war events of which Professor Barro's data contains 209 stockmarket crashes and 59 depressions, there were 41 matched in timing.Professor Barro estimates that the odds are about one-in-five that the US economy will end up with a depressionary decline of 10% or more. The average duration of the 59 non-war depressions in his data sample is four years, so maybe we cannot expect an economic recovery until 2012.

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5th March 2009

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The financial markets expect the Bank of England (BoE) and European Central Bank (ECB) to cut official short-term interest rates by 50 bps to day (announcements at 12 noon and 12.45 respectively, London time). The markets also expect the BoE to detail its ‘quantitative easing’ programme designed to free the logjam in credit markets (click here for a definition and explanation of quantitative easing). It is possible, in my opinion, that the ECB could surprise the markets by cutting rates by 100bps given the sharp deterioration in the eurozone economies as well as the growing fiscal and debt problems in central and eastern Europe. This could create considerable volatility in the EURUSD exchange rate (to the downside) and Commerzbank Dresdner Kleinwort note that there has been a 2.6 big figure trading range on average in EURUSD at the last four ECB meetings.

Following on from yesterday's blog in which I looked at the possibility of a stockmarket rally, JP Morgan's equity strategist notes that "retracing 12 year lows for the Dow is an incredibly rare event. Besides the retest of 1997 lows seen on Monday, this has only happened two other times, on 18th April 1932, and 16th December 1974" (click here for more). The Dow closed up 2.23% last night. Is there scope for this rally to continue? Tomorrow's US jobs report which is expected to be poor with the US unemployment rate expected to jump to nearly 8% will be an important test of market sentiment and market direction in the short term.

Otherwise, FX markets are taking note of an article in the latest BIS Quarterly Bulletin (click here for the article) which explains why the US dollar has been appreciating in response to funding risk. European and British banks have relied on an ‘unstable’ source of funding, borrowing in local currencies to finance long positions in dollars. The problems in the money markets have meant these positions have had to be unwound as banks scramble for dollars (The Telegraph runs an interesting article on this here). The dollar also benefits from repatriation of funds as the financial crisis persists and the dollar also derives a ‘safe-haven’ benefit as the world's leading reserve currency.

For those with an interest in the legal and regulatory aspects of securitised credit (and the financial crisis generally), I recommend my old friend Avinash Persaud’s article "Look for onshore, not offshore scapegoats" in this morning's FT (click here to read it). Also, it is worth investigating the Commodity Futures Modernization Act 2000 that was passed by Congress but never debated in the House or Senate. It effectively exempted credit default swaps from regulation and some commentators believe the so-called ‘Enron loophole’ which resulted in Enron manipulating electricity prices (causing blackouts in California) has a lot to answer for in terms of how we got into this mess (especially the speculative price action in commodities last year). To read more about this on Wikipedia, click here and you can read further comment here.

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4th March 2009

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Worth reading in this morning's FT is Martin Wolf's article on bank nationalisation (click here). I think much of the market's negative reaction is largely due to the dilution of private shareholder value as government's effectively partially ‘nationalise’ the leading banks in both the US and UK. In addition, I think there is ‘investor fatigue’ at what seems the endless list of policy initiatives (TARP, TALF etc.) which fail to resolve what seems the endless newsflow of bank losses, dividend cuts and the need for more capital. The reality is that many of the ‘toxic assets’ held on banks' balance sheets actually have a mark-to-market value of zero. Unwillingness to acknowledge this together with the absence of early action to remove these toxic assets off balance sheets is at the root of the problems.

The mood in equity markets is still bleak but we need to be aware that sentiment/emotion is looking rather extreme, not that ‘fundamentals’ look in any way supportive. This is the second worst US bear market in 100 years (click here for market comparisons). Now, the S&P 500 index is about 35% below its 200 day moving average which is not too far away from the one-day gap of 39.65% seen on 20 November last year which was just before the market staged a five-day 19% rally (click here for more information).

Lombard Street Research point out that there have been only 26 months in the past 140 years when the S&P 500 was further below its long-term trend than it is now. All bar six, three each in 1932 and 1982, were caused by world wars. Also, it is worth noting that stockmarket rallies in these sort of extreme circumstances can be quite significant. Looking back at how the Dow Jones performed in the 1930s depression shows that the Dow finally bottomed in July 1932 and then rallied by almost 100% in the following two months. However, the Dow did not reach the prior high set in 1929 until November 1954, 25 years later. For an interesting set of charts go click here.

The collapse in world exports has been well documented. All the leading exporters such as China, Japan and Germany are experiencing a sharp reduction in export growth, as much as 50% down on the previous year. Countries with trade surpluses that didn't have credit/housing booms are suffering equally as those deficit countries that did have credit/housing booms. Clearly, the threat in this environment is an outbreak of protectionism. A key feature of the international economic and monetary system over the past ten years or so is the relationship between the US and China. Chinese overcapacity was matched with American over-consumption. Chinese trade surpluses were matched with America's trade deficit. Chinese official lending was matched with US household borrowing. China's FX reserves (the biggest in the world) financed America's twin deficits (keeping bond yields and mortgage rates lower than they would otherwise be). The Chinese government effectively subsidised the American homeowner. All of this was described as the Bretton Woods 2 system.

In the 1920s, it was the US that played the role that China is playing today and the US ran large annual trade surpluses ranging from 1 to 3% of GDP. Rising unemployment after the 1929 crash and a collapse in world trade prompted some US senators to implement the Smoot-Hawley Tariff Act in 1930 to protect domestic production. But tariff retaliation by America's trading partners triggered a further 70% decline in international trade and trade surplus countries suffered more than trade deficit countries. Michael Pettis (Professor of Finance at Peking University) warns that we need to avoid protectionism and that China needs a multi-year plan to expand domestic demand. His testimony before the US-China Economic and Security Review Commission in February is worth reading on all of this (click here).

Finally, I recommend Professor Willem Buiter's latest blog on the failures of macro-economic theory (click here to read it). Some of the commentary is slightly esoteric for non-economists but I think what he has to say is important. I think that for many laymen (and laywomen), they will recognise that a lot of conventional macro-economic theory is some distance from the real world. As an economist, that was a product of the monetarist and rational expecation school of thought (I was a student of Professor Minford's at Liverpool University in the late 1970s). I have a keen interest in the evolution of macro-economic theory. To some degree, I always felt that theory had been hijacked by the mathematicians and econometricians making any academic paper on these subjects largely unintelligible except to a handful of people. If economics is the ‘dismal science’, then econometrics is the ‘mathematics of misery’. I should know: I have an MSc in econometrics!

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3rd March 2009

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The S&P closed down 4.66% last night with AIG announcing the world's biggest corporate loss and Asian markets extended their losses on the close early morning. The S&P index is now down 22% year-to-date. US investors face the worst year for dividend cuts since 1938 according to Standard & Poors. HSBC shares dropped 19% after announcing a record UK cash call and a sharp cut in dividends taking the Hang Seng index down just over 2%.The FTSE 100 index is below the 3700 level for the first time since 2003 (click here to see where leading UK fund managers think the FTSE is heading).

In the FX market, the Korean won and Mexico peso are at fresh lows with Eastern European currencies facing severe pressure (Fitch has downgraded Hungary's credit rating).

According to the IMF, Western European banks account for 90% of all cross-border loans to Eastern Europe where foreign debt/GDP levels are very high (e.g. 65% in Hungary and 131% in Estonia)and current account/GDP ratios are also high (e.g. 25% in Bulgaria and 15% in Latvia). Eastern European economies have borrowed US$1.7 trillion from abroad, mostly in foreign currencies, with estimates that the ‘impaired assets’ of EU banks' balance sheets may amount to 44%. Eastern Europe has many financial and economic indicators that resemble many Asian economies during the 1997 crisis and it is looking very likely that Eastern Europe will suffer a similar crisis very soon.

All of this is looking very bleak and puts increasing pressure on world leaders at the G20 meeting in London on 2nd April to come up with something substantive. If they don't, then things are likely to get really bad. Professor James Hamilton ("Stock prices and Fundamentals, how low can stock prices go and how worried should you be?”…click here)notes that since 1946, stocks in the S&P 500 in an average year offered a 3.5% dividend and went up in price 2% faster than inflation for a combined real yield of 5.5%. He estimates what might happen to stocks if we repeat what happened to dividends during the 1930s Depression. In this scenario he reckons that the S&P could fall another 19% taking the S&P to just above 600 (the level at which investors could anticipate a 5.5% real rate of return). A study from the IMF finds that an equity price bust lasts some 10 quarters and when it is over, the real value of equities has dropped by half (click here for the study).

In the FX market, the US dollar is still supported by repatriation flows as market uncertainty persists. EURUSD is at a critical juncture technically and 1.2490 needs to hold trendline support, otherwise it looks like a quick move to 1.2000. Sterling is being pressured by the weakness in banking stocks (click here for the Bloomberg chart which shows the relationship between HSBC's share price and sterling/yen) as well as the likely move to quantitative easing by the Bank of England on Thursday.

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Date:

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2nd March 2009

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No respite for share prices as the economic newsflow remains grim and efforts to stem the bloodletting in the banking sector fail to convince. The Nikkei was down nearly 4% overnight and European markets are opening on the downside. The FTSE Bank Index is down a whopping 10% this morning.

The end-game for the banking sector has to be nationalisation but policymakers it seems for whatever reason are reluctant to go down this route. In these circumstances there will inevitably be more write-downs, losses and a need for capital (HSBC are looking for £12.5 billion in a record UK cash call). Anatole Kaletsky in this morning's Times has an interesting article that is worth reading on all of this where he warns of the risk of bureaucratic delays in tackling the banks' problems (click here for the article). Also take a look at James Baker's article in the FT on what America should do to prevent zombie banks (click here).

The main focus for the markets this week will be the meetings of the Bank of England (BoE) and the European Central Bank (ECB). The BoE can (and should) cut interest rates again and they will likely announce that ‘quantitative easing’ is starting. The ECB could also cut interest rates more aggressively than usual simply to catch up with what the other major central banks have done. There are plenty of good reasons why the ECB should cut interest rates by a full percentage point given the fact that the latest data is showing that the eurozone economies are deteriorating fast. Indeed, this chart of eurozone industrial production shows that production is actually collapsing (click here for the Bloomberg chart).

As far as FX markets are concerned, repatriation flows and flows related to a reduction in bank lending as US and UK banks withdraw from international lending, works to the dollar's advantage and to a lesser degree sterling (where the authorities are still pursuing a weak currency policy). If sterling/dollar pierces technical support around 1.4120, there is a chance of a move towards 1.3500. The yen is likely to go up in the short term. Emerging markets (EM) are under pressure with EM currencies still weak...there is a real risk of a crisis here with the absence of EU aid to Central and Eastern Europe (CEE) over the weekend not helping investor sentiment. The financing gaps and requisite current account and exchange rate adjustments in the CEE area could be enormous.

Finally, look here for a summary of economic charts for February. I think you will agree that the economic outlook is gloomy (click for the charts).

For a really gloomy view, read Professor Niall Ferguson (my favourite economic historian) in his latest interview "There will be blood" (click here for the interview).

For those who are fed up of bad news, there are websites devoted to highlighting ‘good’ economic news (click here) but don't get too carried away.

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