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Date:

29th May 2009

The latest Nationwide house price numbers reported that UK house prices increased for the second time in three months. In May, prices rose by 1.2%. The Nationwide says that while the short-term trend has improved, "it is still too early to say that the market is turning definitively" (click here for their report). UK house prices are 19% down from their peak in October 2007 though, again, it is premature to claim that house prices are bottoming. I think I am right in stating that there has never been a sustainable rise in house prices when the unemployment rate is going up and that applies to the US market as well. Indeed, this week's latest batch of data on the US housing market still does not make for great reading and signs of a bottom in the US housing market still remain tentative. It is worth noting when looking at the data on new and existing home sales that ‘distressed’ properties accounted for 45% of all sales in April. It is also worth noting that 12% of US homeowners with a mortgage are behind in their payments or in foreclosure.

Recent developments in the US Treasury bond market, where the 10-year yield has been rising and where the 2-10 yield spread is at its historically widest, have put upward pressure on mortgage rates. A 10-year Treasury yield at 3.7% equates with a 30-year mortgage rate at 5.6%. Rising Treasury yields have pushed yields on mortgage bonds higher, prompting holders of these securities to sell government debt used as a hedge to protect portfolios against rising rates. In the bond world this is known as convexity selling. Some see the rise in bond yields as simply a ‘normalisation’ as the US economy recovers. Others see rising yields (and a weaker dollar) as the price to be paid for rising budget deficits and debt levels. So far, the Fed has not stepped in to mop up US Treasuries and put a cap on yields but has plenty of ammunition to do so if required. This might be sensible as it is so important for the Fed and the US Treasury to retain the confidence of foreign investors. Recent bond auctions have not proved to be a problem which is a good sign. However, investors will continue to try and figure out whether inflation or deflation is the biggest issue for the bond markets and in that regard I think we are seeing a new trading range for government bond yields.

In the FX market, sterling is holding up reasonably well as it tries to reclaim lost ground from a very ‘oversold’ and ‘undervalued’ basis. As I have said many times before in my blogs, sterling is a barometer of global investor risk. When risk appetite improves, sterling goes up and vice versa. Much of this has to do with the significant role of financials (and the housing sector) in the UK economy. This is why sterling tends to track the equity market more than the fixed income/interest rate markets. There are good chart relationships between sterling and mortgage approvals and sterling and the FTSE350 bank index that I have also previously highlighted.

Finally, commodities continue to benefit from improving risk appetite though it is worth noting that non-commercial net speculative long positions are the highest in 10 months. Oil keeps edging higher (tracking the EURUSD exchange rate) and at some stage the oil price has to be a concern for global growth (again). Gold looks technically bullish for a break above $1000 and a new high. The gold/silver ratio is also very bullish for the silver price.

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Date:

28th May 2009

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Neil Mackinnon is away today. Today's blog entry has been written by Philip Manduca, ECU's Head of Investment

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Date:

27th May 2009

It felt quiet yesterday, but as has now become normal there was a lot going on in the FX, equity and interest rate markets. The USD, which tried to correct the previous four or five days of straight decline in the morning (using North Korea as an excuse), failed to do so, leading many to conclude that further weakness lies dead ahead. Tests of 1.60 versus GBP, 1.40 versus EUR and 1.10 versus CAD appear imminent.

I would prefer to be a contrarian buyer of USD against 1.61 versus GBP as I feel that the UK and its currency are currently running on too much speculative optimism and investor denial. I can’t find anyone who truly believes that there are not more problems ahead in the UK. Increasing government debt can only lead to higher taxes and a subdued economy for years to come, which does not make for a prosperous future. How is the UK Government going to finance itself? I see no other way than through monetisation by the Bank of England as global investors take fright at our balance sheet. The UK lacks the economic dynamics and scale of the US and I see no reason to prefer GBP to USD at this point. I am cautiously bearish of cable (GBPUSD) because GBP is still shrugging off the bad news but there is much more to come. I am also failing to grasp how the US can tolerate significant USD weakness at a time when they need global investor confidence to finance their deficits. Yesterday witnessed a successful $40bn 2-year US Treasury auction. This may not be the same outcome today or tomorrow (5 and 7-year auctions) but bond holders live one day at a time as the US tries to borrow $2 trillion over the next year or so.

In equities, the S&P500 tried to break below the 978 level and failed to do so yet again. Then we got the release of the May US Consumer Confidence Index and just as one would expect – given that this index tends to follow the major stock market indices – consumer confidence rose to 54.9 from 40.8 which was the biggest one-month gain in six years. The Richmond Fed manufacturing survey is the first regional manufacturing survey to get back into positive territory as the headline composite rose to 4 in May from -9 in April and a low of -55 in December. Volume in this equity rally has been suspiciously low and I continue to feel that the 870 to 950 range (currently at 910) in the S&P500 will hold for the short term. Wealth managers inform me that the ‘smart’ money is ignoring equities and focusing on credit for which read blue chip corporate bonds with high yields.

Elsewhere, Bank of Japan Governor Masaaki Shirakawa said in a speech, "The sharp deterioration in economic and financial conditions in Japan and abroad since last autumn is starting to level out and there is the prospect of a mild recovery ahead." But, adjustments of various excesses that had accumulated worldwide over the past several years could take "considerable time," he said, adding, "It is very likely that the severe economic conditions will continue for some time. The recovery therefore will inevitably be mild and accompanied by high uncertainty. The key to the prospect for the global economy is how much strength that final demand can restore. With regard to this, we are not exactly optimistic. We are rather cautious." I am bearish of Japan and JPY and will continue to focus on levels to sell it.

The Baltic Dry Index jumped six percent to a new eight-month high, while the Dry Ships Index rose two percent – ship owners inform me that the Baltic Dry is no longer as relevant an index as it used to be in reflecting demand for cargo space with many pointing to a vast surplus of ships sitting idle. Cargo, commodities and China – they are all strongly connected. China is without question switching USD into commodities and building stockpiles. But until domestic demand starts to compensate for a sustained collapse in export demand, I feel that China’s economy will require continued massive fiscal injections from the Government to stave off rising unemployment and social unrest.

In the Gold market, COMEX open interest rose over a percent to 396,763 contracts and a new eight-month high. Even more noteworthy was the fact that the GLD ETF’s bullion holdings rose by over 13 tonnes to just shy of 1119 tonnes on Friday. This 13 tonne increase was the ETF’s first 10+ tonne increase since March 24th when its holdings rose 10.7 tonnes. That’s an encouraging sign for the bulls since investment demand (rather than jewellery demand) is going to have to do the heavy lifting over the next several months if the gold price is to punch through $1,000 and trade significantly higher. I believe that it will.

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Neil Mackinnon is away today. Today's blog entry has been written by Philip Manduca, ECU's Head of Investment

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Date:

26th May 2009

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Neil Mackinnon is away today. Today's blog entry has been written by Philip Manduca, ECU's Head of Investment

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Date:

22nd May 2009

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Neil Mackinnon is away today. Today's blog entry has been written by Philip Manduca, ECU's Head of Investment

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Date:

21st May 2009

Yesterday, the USD depreciated on a fear that the US economy would require further Central Bank monetisation of its debt. In simpler language, it’s called printing more money (USD). This fear arose out of the release of the minutes of the latest Federal Reserve meeting where the economic prognosis for growth and unemployment appeared pessimistic, much like the viewpoint of the Bank of England last week. Yet whilst GBP shrugged off its own central bank’s bleak economic viewpoint, the USD couldn’t. Speculators are behind this USD move with lots of talk of range breaks, 200-day moving averages being surmounted, and a search for profit in a barren world. As the USD sells off so do more people sell it. It’s called momentum in market jargon. It was particularly noticeable yesterday that certain market correlations also broke down as the equity market first attempted a rally, which further fuelled the USD down move, then failed and closed on its lows even though the USD continued its sell off into the Asian session overnight. The last 12 months have seen a correlation between weaker equities and stronger dollars and vice versa. No longer, it seems. Equities got the message, FX didn’t.

At our trading desk late last week I concluded that this same correlation was on the point of a break down. Why? Because the fear factor in markets had significantly diminished and the concerns for investors were no longer about systemic failure but about growth and greed once again. “It’s all about the economy….”, and what life will be like in the future. The TV trumpeters are declaring that there will be a life even a good one – and this is a different primary emotion than was witnessed subsequent to the collapse of Lehman Brothers up until the last few weeks. The safety of the entire financial system had been the key debate. No longer.

So I find it odd that the most pro-growth economy with the boldest re-structuring programme (USA), supported by the most dynamic monetary and fiscal policies, is now getting its currency punished. This reflects the same degree of newfound optimism that all of the world will now be okay and that the economy with the loosest monetary policies will suffer the greatest currency debasement.

I disagree. This is not about a euphoric future. It is going to be a bleak one relative to the last thirty years. Unemployment is a structural problem and will exceed all current forecasts, even the upwardly revised estimates of the Federal Reserve yesterday. Incomes will not rise by much if at all. Life changing bonuses are a thing of the past. Bank lending will not return any time soon. Consumer spending will remain weak as job fears and savings dominate consumer minds. In this environment, money will seek growth and capital return wherever it can; in emerging economies, for sure. But in G7, don’t doubt that the US will offer the best opportunities. Growth in the US will not result in widening trade deficits as we have witnessed for the last few decades as it will not be consumer led and imports will not accelerate beyond exports as both remain suppressed. Growth in the US will exceed growth in Europe and the USD will strengthen soon as the US outperforms.

Is this difficult to imagine after yesterday’s price action? Indeed, but yesterday was more about short-term speculators than heavy money and the FX rally can reverse just as quickly. For me to become a USD bear, the case needs to be made: in whose interest is a weakening USD? Not China’s nor Japan’s; not the US’s either as it needs global investors to fund its widening budget deficit in a world where all nations need to compete to tap surplus country savings. It’s not in the global interest either as the corollary will be – indeed already is – higher commodity prices representing a consumer tax on their incomes. Oil yesterday sustained a rally back above $60.    

I have underestimated the degree of USD weakness this week and in particular the strength of GBP. The key point however is to determine if this is the real thing for the USD or just a speculative and momentum driven aberration to flush stops outside of recognised ranges. The failure of the US equity rally yesterday – when the FTSE spent most of the day in negative territory, closing there and the weakening of one of my key indicators, the 2-Year US Treasury note from 0.88% to 0.82% (suggesting that the bond market is more worried about deflation and recession than the FX market) – suggests that before long it will all be about the poor health of the world economy once again….and how weak growth is everywhere else in G7 compared to the US. I am not chasing this USD depreciation train and will be looking to buy my ticket for the next train in the other direction within the next few days.

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Neil Mackinnon is away today. Today's blog entry has been written by Philip Manduca, ECU's Head of Investment

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Date:

20th May 2009

The equity and currency markets are playing a high-wire game of disconnect with future economic reality, threatening the economic sceptics with underperformance in their investment portfolios. This is forcing those who are bearish to have to participate as their underperformance threatens their asset base, which forces prices even higher, and further forces more bears to capitulate. I have commented on this ‘pain trade’ previously, and expect it to continue for a while longer. Why? Because many want to believe that all the bad economic news has been discounted and wish to ignore anything that does not support higher prices and the view of a better tomorrow; because one of my key indicators, the 2-Year US Treasury yield remains below 1% (actually at 0.88%) suggesting that a lot of investable cash has not yet been invested; and because higher equity prices now cause the most pain to the most investors. It’s noticeable that any corrections are shallow and short lived, suggesting that buyers of dips are plentiful.

In truth, the S&P500 overshot to the downside at its 663 low and I believe is about to overshoot to the upside in its correction from those lows. I expect a break of the 950 level before the summer ends as euphoria accentuates and the TV channels trumpet a new bull market. Fair value for the S&P500 is probably closer to 750 to 850 and that is where I expect the year end level to be. But not before all the bears get heavily squeezed into taking a loss and the new bulls get caught at the top.

Elsewhere, oil yesterday pushed above $60 per barrel in New York despite all the industry experts that I talk to remaining bearish. I do believe that China is diversifying cash dollars into hard assets (oil, gold, copper etc.) which are also priced in dollars, fearful of a sustained US currency debasement. In truth, before this is all over all G4 (Japan, USA, Europe and the UK) currencies will suffer a debasement and my prediction that we will see gold reach $2000 prior to the end of 2010 remains more compelling to me each month. It’s been noticeable that despite a 40% rally from the lows in equities, gold, which is deemed as the ultimate safe haven, has not broken down in price.

In the short term, GBP remains the currency of choice to momentum traders – but I am struggling to join them as UK ‘drivers’ fail to support a recovery story. I am concerned that there is political risk looming in the UK with the potential for the Labour Party to remove their leader fearful that the banking sector is not making money other than through proprietary trading (a ‘dirty’ earnings contributor) and that the housing market cannot recover without higher earnings and lending levels, neither of which are likely; yet as I look around I see that GBP remains ‘cheap’ against JPY, EUR and CHF; that European banks have potentially bigger problems ahead of them than the UK ones, that the unemployment problem in Europe – with its risks for social disruption – is worsening, and that Japan’s economy continues to melt down amidst a collapse in world trade. So the question is: where to buy GBP in a market full of bearish fundamentals? The answer is on a bad news day. One of those was when Bank of England Governor King gave his bleak prognosis last week on the UK economy, implying that a weak GBP was an important prop to the economic story. GBP did not weaken much and not for long, suggesting that, like equities, too many shorts exist and not enough GBP bulls have the position on yet. For my part, I believe that we are closer to the end of this rally than the beginning, making a bullish GBP argument a high risk bet. I shall be talking on the ECU mid-month client conference call tomorrow about why I prefer to be bearish of JPY than USD for GBP investors.

Lastly, and one for those of you that think long term, it is generally accepted that G4 government budget deficits will be with us on a grand scale for a long period of time. In the absence of sufficient public investment central banks will need to be sustained buyers of government debt issuance, exacerbating the currency debasement process. In addition, high and rising levels of unemployment, which will likely prove structural and not just cyclical, could prohibit central banks from raising interest rates when economic growth does rebound modestly in the medium term, creating negative real interest rates and inflationary pressures. I would focus on buying hard assets (e.g. tangible goods not paper money). It’s the one view I am absolutely confident of at a time of uncertainty all around. The Chinese Government seems to agree.

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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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Date:

19th May 2009

The “risk on” trade remains firmly in focus this morning after the Dow Jones and S&P rallied 2.85% and 3% respectively, fuelled by speculation that three US banks are looking to repay their TARP loans at the earliest possible opportunity. The main beneficiary of this within the G7 currencies has been sterling which has seen cable rally to the year’s highs at 1.5495. It is clear that most of this move has been missed by investors caught in a bearish stocks and bearish risk view. As the S&P approaches the 950 level (last night saw the index close at 909.71) investors are going to feel less and less comfortable being underweight, both stocks and carry. However, we still feel this is a bear market rally and that money is chasing performance at these levels. Fear of missing the “big picture move” is driving sentiment and ignoring value.

In turn it feels as though the FX market is being squeezed out of its short sterling positions, and if cable bursts through 1.5570 more fear-driven buying will probably ensue. With short-dated Relative Strength Indexes looking stretched however (9-day RSI currently just below 77), this position is looking more and more like a higher risk, lower return trade. On the crosses, both GBPYEN and GBPCHF are approaching important levels at 150.00 and 1.7250 respectively, a break of which would bring the year’s highs of 151.50 and 1.7500 sharply into focus. For those who have not already got the trade, current levels look too elevated to get any meaningful risk vs reward.

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Date:

18th May 2009

I titled my blog last Friday "It's not much better elsewhere" and highlighted the record declines in German and Spanish GDP. Anatole Kaletsky in this morning's Times picks up that theme (click here for the article) and makes the point that Germany is suffering "the steepest economic collapse ever recorded in a major industrialised country" and that several of the countries in Central Europe "are now in a state of economic and financial meltdown". He also notes that Germany's economic decline is "almost three times the rate of decline in the United States and Britain". Germany, as one of the world's leading exporters, has been hit by the collapse in world trade and the high level of the euro. In addition, many European banks have been massive lenders to businesses and homeowners in many of the peripheral eurozone economies in foreign currencies like the Swiss franc. This is a massive debt timebomb ready to explode which has serious fiscal implications for many European governments where debt/GDP is already astronomically high and who are unable (on an individual basis) to print money to bail themselves out. The currency winner might actually be the US dollar where the US authorities have already implemented a wide range of policy measures to stabilise the financial system and kick-start the economy. Importantly, it is the flexibility in comparison to all things European that gives America the edge.

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Date:

15th May 2009

This morning's GDP data published for Germany showed a further decline in economic growth of 3.8% in the first quarter. The German Finance Minister now expects the German budget deficit to reach its highest level since WW2. In Spain, data published yesterday reported that economic growth fell at its fastest rate on record in the first quarter. All of this has to be a major concern for the ECB which will have to loosen monetary policy further. In addition, the appreciation in the euro exchange rate (trade-weighted) in the last month or so will do little to sponsor any recovery in economic activity which is why I believe pronounced weakness in the US dollar is not in the interests of the global economy.

As far as the UK economy is concerned, we have already seen what Mervyn King thinks this week and his caution is understandable in my view as far as the economic recovery is concerned. I think he should also be concerned about his quantitative easing (QE) programme. The evidence is scant that QE is actually working (click here for more on this) and anecdotal evidence suggests that lending between banks in the wholesale money markets is still very limited. In addition, gilt yields are rising which indirectly pushes up borrowing costs for companies. In these circumstances, constraints on lending (regardless of the price of credit) will hamper economic recovery over the medium term.

Otherwise, there is plenty of US economic data out today which will provide fresh evidence on the recession/recovery debate, in particular the latest data on US industrial production. Today’s chart (click here) shows industrial production against the ISM index and you can see just how sharp the decline in industrial production has been. It also provides some perspective as to how great any gains in production have to be just to return to ‘normal’.

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Date:

14th May 2009

Mervyn King, the Bank of England Governor, gave a more cautious and downbeat view of the prospects for UK economic recovery when he presented his quarterly Inflation Report yesterday (click here for an analysis).

This was in contrast to the prevailing optimistic market consenus which uses a variety of gardening metaphors ranging from green shoots, daffodils to saplings (click here for more definitions). While Mr King does not envisage a wasteland (there is plenty of fertilizer about), the fact that he upped the scale of the Bank's quantitative easing (QE) programme last week suggests he is still worried that UK banks do not have enough capital and that the process of balance sheet restructuring still has further to go. The fact is that lending to companies and households is still in a downtrend and lending between banks is still fairly limited.

I think Mr King is more in the camp that believes that the process of deleveraging and restructuring of debt will be a protracted process. I have highlighted before the academic findings of Reinhart and Rogoff (click here) who have investigated what happens in the aftermath of financial crises and the findings don't make for pretty reading. Just to remind you what those findings were:

1. Real house prices decline on average by 35% over a six year period
2. Equity prices decline by an average 55% over a downturn lasting three and a half years
3. The unemployment rate rises by an average seven percentage points over the downphase of the cycle which lasts on average over four years
4. Output falls from peak to trough by an average of over 9%
5. The real value of government debt explodes, rising by an average of 86% in the major post-WW2 episodes

Of course, the credit/financial/economic crisis has been (and is) epic and severe and I understand that not every financial crisis has been the same in terms of scope, duration, severity etc. However, global policymakers have taken interest rates down towards zero in most cases and resorted to QE measures as well as fiscal measures. These measures, I think it is fair to say, have largely stabilised the financial and economic system but not necessarily guaranteed immediate economic recovery.

Mr King's caution, along with disappointing data earlier this week on Chinese exports (down nearly 23% in the 12 months to April) and a dip in US retail sales for the same month (click here for the detail), has poured cold water on the ‘green shoots’ story. Not surprisingly, the rally in equities seems to have come to a halt for now. However, I am aware that it is not all doom and gloom and I am alert to reports of increasing activity in commercial real estate and improving turnover in the UK housing market (from a low level). The RICS house price survey against UK retail sales puts recent ‘recoveries’ in perspective (click here for the chart).

Consumers in work will have higher disposable income(as mortgage rates have fallen) and life goes on. People still spend though I think consumers are wary of buying ‘big ticket’ items. Consumers will save more and spend less generally and the ability to use your house as a glorified ATM (mortage equity withdrawal) will be curtailed for some time (click here for an interesting paper on this topic). Demographics also suggest that the ‘baby-boomers’ will have to save more as retirement is deferred and/or your pension pot shrinks.

I think Mr King, if his caution is right, will likely keep UK interest rates low for some time. Mr King didn't really say anything positive on sterling yesterday. Indeed, he noted that the lower exchange rate will help net exports and that rather than passing any higher imported costs on the consumer, it is likely that wages will be cut. The prospect of higher taxes in the medium term also won't help economic growth move much above trend either.

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Date:

13th May 2009

Recently, the US dollar has come under pressure against the major currencies. This is a function of worries that the Fed has been one of the more aggressive proponents of quantitative easing (QE) as well as market concerns that the Federal Reserve might be amongst the last of the major central banks to abandon QE and raise interest rates. In addition, with all the talk of ‘green shoots’, investors have been moving out of cash into more riskier assets like equities, emerging markets and commodities (the oil price is now back to $60 and the gold price above $900). During the worst of the financial crisis, the dollar benefited from ‘safe-haven’ status as fund managers withdrew investments from emerging markets and parked them back in the US. Now that risk appetite is improving, the dollar has unwound the gains arising from those investment flows.

In this morning's FT, an article questions America's triple A credit rating and clearly any downgrade of that rating would have adverse consequences for the dollar in the longer term – especially in its role as the world's leading reserve currency. My view is that there have been plenty of occasions in history when the US trade and budget deficits were much worse than they are now and no-one questioned the triple A rating. For sure, the credit crisis undermined the credt rating agencies' credibility, particularly in the misleading ratings assigned to mortgage-backed securities which ended up collapsing the credit ‘pack of cards’ in 2007 and through 2008. However, the value of the dollar is set in a free market where $2 trillion is traded EVERY business day. There is no hiding place for opaque ‘mark-to-model’ pricing or, indeed anything else that distorts the real value of the dollar.

All kinds of factors determine the value of the dollar from macro fundamentals, investor expectations of relative returns, and short-term factors like sentiment and positioning. The fact is that the dollar remains the leading reserve currency and is likely to remain so for as long as the US retains its military and technological supremacy. The US trade deficit has already contracted sharply and Americans are spending less and saving more. This implies that America is becoming less dependent on foreign financing of its deficit. China plays an important role in all of this and while China is concerned that it might have too many of its investment eggs in America's basket, there are no serious indications that China is about to exit its American investments. To do so would be to shoot itself in both feet, i.e. by suffering a currency loss and a capital loss.

So I am sceptical of the consensus view that the dollar is in decline. A weaker dollar would only capsize hopes of economic recovery especially in Europe and Japan. In addition, a weaker dollar would push commodity prices – especially oil – a lot higher which would act as a tax on consumption (and economic growth). And from the American point of view, a much weaker dollar might be seen as suggesting a loss of confidence in US policy. I can't see the Fed and the US Treasury wanting that message to become common currency.

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Date:

12th May 2009

Headline:
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George Soros says the worst of the freefall in the global economy is over. The OECD is more upbeat about the prospects for the UK economy and overnight data published on house prices and retail store sales were better than expected. The ECB President, Mr Trichet, says we are at the "inflection point" in the economic cycle. Certainly compared to last summer when the US and UK economies looked as though they were sliding off a cliff, activity does seem to have stabilised even if it is at comparatively low levels. Of course, the massive monetary and fiscal stimulus in combination with a wide range of unorthodox monetary policy measures has helped to stabilise the banking and financial system. Equities are higher, money market rates and spreads are narrower as are corporate spreads. Many companies are now able to implement rights issues.

A lot of these themes have been discounted by investors and underpin the significant rally that we have seen in a variety of risk assets since the beginning of March. Much of the rally in equities has been down to a short squeeze in financials together with a recovery from extremes of sentiment and positioning. It may be that many real money investors are still "underweight" equities and are worried about missing any further gains. Cash levels are still plentiful so liquidity can be a key equity driver. So I guess that any profit taking in equities at the moment that causes a retracement (towards technical support at 850 in the S&P index) will be used as an opportunity to rebuild positions in the equity market (and reduce cash positions further). In fact, the "pain trade" for investors during the summer period might be a grind higher in equities with the S&P breaking up through the 950-1000 level.

Elsewhere, Jim Rogers is predicting a dollar crisis in the autumn. Last time Jim Rogers was predicting a currency crisis was back in January when he was calling time on sterling (sell everything he said). As it happened, his comments actually marked the low point in sterling. I have a feeling Jim Rogers might be doing the same for the dollar. In my opinion, a weaker dollar or dollar crisis is in no one’s interest. I also believe that more importantly it is not in China's interest to see a weaker dollar given that they are a major creditor and holder of US Treasury bonds. Indeed, I wouldn't be surprised to see the dollar recover from its recent slippage. Today's release of the monthly US trade deficit is likely to confirm the underlying contraction in the deficit that has taken place over the last year or so. That has to be good news for the currency.

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Date:

11th May 2009

Headline:
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Green shoots or weeds?

The consensus economic view in the financial markets is that the major economies are turning the corner. The worst is over, the data is "better-than-expected and the bears simply don't get it. The rally in equities, commodities and "risk" currencies that we are seeing reflects the consensus view.

Is the consensus wrong? I have previously noted in my blogs that a turnaround in the inventory cycle in the US and UK would likely lead to "better" data in the manufacturing sector during the second quarter and to some degree this view has been correct. However, I do not believe that we are seeing a V-shaped recovery in the economy because consumer spending which accounts for 60-70% of the US and UK economies just doesn't have the legs to sustain a durable recovery. Consumers are saving more, repaying debt and still face rising unemployment despite massive monetary and fiscal stimulus. The housing market might be stabilising but at a low level in my view. House prices have never gone up while the unemployment rate is still rising (for an interactive map of UK house prices see here).

Goldman's economics team point out that if the UK recession ended now, it would be shorter than either of the last two recessions. They also point out that credit market conditions, which are at the heart of the current downturn, are still far from normal. Note though that Jim O'Neill (the head of Goldman's research) is very bullish generally.

UK business leaders are not convinced that the "green shoots" have "strong roots" (see here). In addition, the Bank of England might still be worried about a fresh phase of the credit crunch after stepping up QE last week (see here). Wednesday's Inflation Report that is published by the Bank will be closely monitored for fresh clues as will a whole host of global economic data scheduled for release this week.

As far as the equity market is concerned, some sentiment indicators like the CBOE equity put call ratio are back at the May 2008 lows (just before the decline to the November lows) and is perhaps a warning signal in the current bullish euphoria (see here). Also bond yields are edging higher which might upset equity bulls. A decisive break of 950 on the S&P index is something to keep an eye on this week. So, we are reaching an interesting juncture in the bullish-bearish debate. Myself, I am cautious about wholeheartedly buying into the "bullish” story. Past experience covering recession/recovery cycles always shows that the "consensus" view does get challenged by the data. I expect it to be no different this time around.

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Date:

8th May 2009

The main event for financial markets today is the release of the monthly US jobs report. The consensus expects a decline in nonfarm employment of 600k in April compared to a loss of 663k in the previous month. The US unemployment rate is expected to rise to 8.9% from 8.5%. The jobs data is regarded as a 'lagging indicator' in terms of the recession/recovery debate and therefore could easily be ignored by investors/traders who want to stick with the 'risk rally' theme which has dominated markets in the last two months. This is especially so if the jobs data turns out to be ‘worse-than-expected’. However, recent auxiliary jobs indicators for the US like the ADP index, initial claims and ISM surveys do not suggest such an outcome and points to at least a deceleration in the rate of job losses. My interpretation is that, while the readings on these indicators are welcome, the US jobs market is still weak and any recovery in economic activity is likely to be a 'jobless' recovery for a while yet. Nobody is doing much hiring as far as I can tell.

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Date:

7th May 2009

The Bank of England (BoE) and European Central Bank (ECB) announce their latest monetary policy decisions today. The BoE is expected to keep UK interest rates unchanged at 0.50% though the focus of the markets will be on quantitative easing (QE) policy (click here for an explanation of QE). The BoE has previously announced an initial £75 billion fund (maximum £150 billion) for buying gilt -edged securities with the theory being that the exchange of gilts for cash will then encourage banks to lend more to the rest of the economy.

However, many commentators – including myself – have criticised the scheme as being too narrow in its remit. Foreign banks and institutions are large holders of gilts and so when they sell gilts to the BoE, the cash leaks abroad thus having no impact on the UK economy. Businesses and consumers still face tight lending conditions and what the BoE should do is to buy corporate debt (as it can do through its Asset Purchase Facility) and other private sector assets. In addition, banks who sell gilts and receive cash are parking that cash with the BoE which simply inflates the level of excess reserves and the monetary base rather than bank lending. As it happens, the level of 10-year gilt yields is actually higher compared to the date when the BoE formally announced QE on 5th March (click here for the Bloomberg chart of 10-year gilt yield). There is a good case for the BoE to expand and extend the scope of its QE programme.

Separately, I note that China is expressing fears that QE could spark inflation, trigger currency depreciation and capsize the major bond markets (click here for more on this).

The bad news for the Treasury and the Debt Management Office is that the increase in gilt yields increases the cost of borrowing. The Treasury already reckons that the cost of interest payments will reach £42.9 billion for the year 2010-11. The Times reports that the Treasury will need to cough up an extra £16 billion to cover the increase in borrowing costs as it turns out that the Treasury did not factor in the possibility of higher gilt yields in the last Budget (!!!). The Treasury has to sell £815 billion of gilts over the next five years to cover its borrowing needs. Already, the City is worried about the ability of the UK government to fund all of this (see yesterday's critical Treasury Committee Report which noted that the Chancellor's forecasts for public borrowing and national debt represent "the worst fiscal outlook since the Second World War" (click here for the report)). No prizes for thinking that this all adds up to higher taxes and cuts in public spending and working longer before you get to retire or die (click here for retirement age analysis).

The ECB also meets today. The main refinancing rate stands at 1.25% and the deposit rate at 0.25%. It's really the deposit rate that matters for market rates of interest. As a result, the ECB can cut the main refinancing rate to whatever it likes today but the deposit rate is likely to stay put at 0.25%.I think the ECB will likely say that it will keep interest rates low for as long as it is required. There is more focus as to what the ECB might announce on QE and Mr Trichet hinted at some proposals in this regard at the ECB's April meeting. The ECB's options include providing unlimited liquidity for longer terms (up to 12 months), loosening collateral requirements, buying corporate debt and buying government bonds. The latter two options are tricky given the absence of a unified eurozone bond market (whose bonds do you buy: Greece or Germany?) and whose corporate debt? The ECB has been notorious for disappointing market expectations in the past and I have to say that it is not clear that the ECB will quickly adopt full-blown QE today.

As far as the currency markets are concerned, there have been some mighty gains in the Brazilian real, the South African rand and the Korean won. All of these have been the beneficiaries of the recent rally in risk assets and an investor preference for yield/carry. This stands in stark contrast to activity in the major currency pairs where price action can best be described as ‘range-bound’. Sterling has held up well as risk appetite improves (click here for the Bloomberg chart showing the sterling trade-weighted exchange rate versus a measure of risk – the junk bond-US treasury spread) as well as signs of ‘stabilisation’ in the UK housing and banking sectors.

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Date:

6th May 2009

Stockmarkets have had a good run and the consensus view in financial markets generally is that the major economies are stabilising and that the worst of the financial/banking shocks is behind us. The latest news is that the upcoming ‘stress tests’ for US banks will likely reveal a widespread need for yet more capital with Bank of America reported to need $35 billion. I think this is not a surprise really as the losses and write-downs were always going to be greater than initially estimated. However, regulators need to be careful about demanding ‘too tight’ capital adequacy at this point in the cycle as it will simply prevent banks from stepping-up lending to the real economy. But who said that the regulators ever knew what was going on anyway?

As far as this rally in the stockmarket is concerned, the ‘economic stabilisation’ theme has seen cyclical stocks advance quite significantly as you might expect but now the advance looks as thought it might stall (click here for the Bloomberg chart of the Morgan Stanley Cyclical Index as a ratio of the S&P index which makes my point). In front of the ECB meeting tomorrow and the US jobs report on Friday, there is a risk that the market is forced to rethink the stabilisation story for now. The European Central Bank might not play ball in terms of cutting rates and/or adopt full-blown quantitative easing. The US unemployment rate (admittedly a lagging indicator) could disappoint. In which case, high-yielding emerging market currencies and commodities may weaken in the short term as would everything else that rallied on the stabilisation story. So don't be surprised if equities pause for breath.

Elsewhere, the US three-month LIBOR rate dipped below 1% for the first time indicating that the price of credit is easing. The Fed's Bernanke said yesterday that there were "signs of bottoming" in the US housing market and was generally upbeat on economic prospects. However, I think that we are likely to see higher foreclosures in the months ahead and with the stock of unsold houses still high, it will be difficult to see a sharp recovery in the US housing market. The same applies over here to the UK market I think. The National Institute of Economic and Social Research (NIESR) say that the plunge in UK output will require the Treasury to raise an extra £42 billion which is the equivalent of a 9-10p increase in the basic income tax rate. Not good news. And the BBC economics editor, Stephanie Flanders, has a chart which shows that the pace of downturn in the UK economy to date has been on par with 1930-31 (click here for the chart). That was when another Scotsman, Ramsay MacDonald, was Prime Minister who fell victim to the economic crisis and who ended up being part of a national government. Could history repeat itself? The FT has an interactive chart of global recessions dating back to WW1 (click here). Finally, in this morning's FT, Hugh Hendry argues that deflation not inflation is the main risk and is critical of Fed monetrary policy in not doing enough, worth a read: "Conservative Fed is good reason to be a bull on bonds" (click here).

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Date:

5th May 2009

The Bank of England's (BoE) Monetary Policy Committee is expected to keep policy unchanged this week. Recent UK economic data has tended to indicate that activity in the UK housing market is stabilising though at low levels. Other data has been mixed but there are market hopes that the worst of the economic decline is behind us. This does not mean that a rip-roaring recovery is immediately in front of us. We should remember that the forces of deleveraging and the pay-down of debt can take some considerable time to put right. In addition, financial and banking stability is still patchy and many US and UK banks will need more capital as they continue to correct their balance sheets. In the interim, bank lending is expected to remain fairly tight.

The European Central Bank (ECB) also meets this week. A rate cut looks likely and the ECB could announce measures geared to some form of quantitative easing. Eurozone economic activity is generally poor and there has hardly been any relief from the exchange rate or fiscal policy.

The financial markets will continue to hope that the rally in risk assets (equities etc.) can continue. The S&P index needs to break technical resistance around the 890 level and trading volumes need to expand so as to signal a durable recovery.

In FX, the majors are still in trading ranges. USDJPY has a chance of breaking through the 100 level into a new 100-110 trading range. GBPUSD is holding up reasonably well and is piercing through the 1.50 level.

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Date:

1st May 2009

The equity market continues to edge higher as risk assets maintain their upturn. Clearly, the market is hoping that the US economy is set to recover (even if it is just a ‘mini-cyclical’ recovery that owes much to the inventory cycle). This chart (click here for the Bloomberg chart) shows the gap between the ISM's new orders and inventory level for US manufacturing and shows that the gap has already turned round sharply, suggesting that manufacturing data should be positive in the months ahead.

The US GDP data that I covered in yesterday's blog shows that the current US recession has just tied the 1973-75 and 1981-82 recessions for post-war longevity. If next week's US jobs report for April continues to highlight more job losses then the postwar recession record of 16 months will be beaten and you would have to go back to 1929-33 to find a longer recession (click here for more details).

As far as US jobs are concerned, the weekly initial claims data is important in predicting turning points in the US economy (by three months on average). In yesterday's data, the four week moving average is at 637,250 from the peak three weeks ago and some think there is a reasonable chance that the peak in weekly claims has happened for this cycle. See this chart (click here for the Bloomberg chart) for the relationship between peaks in initial claims and low points in US industrial production.

The S&P index is now trading around important technical resistance in the 890-900 area with technical channel support around 850. The consumer discretionary and technology sectors in the S&P index are the first two sectors to break their 200-day moving averages (click here for more details).

In the FX market, we are bearish Japanese yen (refer to the chart in yesterday's blog) and Swiss franc. The rally in risk assets diminishes the attractions of holding these currencies. Both Japan and Switzerland are in severe recession (click here for the Bloomberg chart of the Swiss KOF leading indicator versus Swiss industrial production orders) and both the Swiss National Bank and the Bank of Japan have made it clear that they will intervene, if necessary, to prevent significant appreciation in their currencies. In addition, Japanese capital flows will likely seek overseas investment as risk appetite improves, thus weakening the yen.

Likewise, sterling can benefit if you think sterling is a barometer of global risk. UK housing and financials are stabilising (at low levels) which also helps. At the moment, sterling is shrugging off a deteriorating fiscal position. Going forward, I think bond markets will soon start to focus on which central banks will implement credible exit strategies from existing policies of quantitative easing and start to raise interest rates. Sterling might fall into this camp as I believe Mervyn King is really a closet hawk.

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