Daily Note – Caught in two minds



Euro/dollar rate clearly mispriced 

United States: Ain’t noting going on but the FOMC

The more talk of tapering, the less enthusiasm for stocks

China:HSBC Flash Manufacturing PMI comes in weaker

Australia: Fiscal situation dodgy.New target for the Aussie dollar?

Japan: Key Tankan survey comes in better than expected, but concerns remain

Euro: Asmussen quits the ECB


We are just recovering from Leinster’s mauling here in Dublin on Saturday at the hands of Northampton. All is not right in the world when the most stylish club rugby team on the planet end up flatfooted in front of 40,000 of their home support.

What it tells us is that we always should be aware of consensus.

On the train into the game on Saturday the hoards of local fans, having seen Leinster thrash Northampton in England the previous weekend, were assured of victory.

When the whole world expects something, make sure you leave at least one option open, for something different.

This week, consensus from the investment banks is around no taper at the FOMC, are you 100% with consensus?

I am always wary of the big banks because they are in the selling business and tend to come up with all sorts of convoluted reasons to forecast a move where the outcome is always good for the seller.

The other thing the game taught us is the danger of being in two minds.

Jamie Heaslip, Ireland’s captain and normally stellar performer, was caught in two minds at the very end with the line at his mercy, he knocked the ball forward and low, the English picked it up and headed up the pitch unchallenged to seal victory.

Financial markets are similarly in two minds. Up to two weeks back, it was a case of no tapering on Wednesday but hard data, stronger than expected, has changed all that.

More talk of taper less appetite for stocks

The poor old equity side took a battering towards the end of the week.

The equity market came into the week hot on the heels of the non-farm payrolls report and tried to maintain the momentum of a strong close from the previous Friday.

The thinking was that low inflation would keep the Fed printing – even if employment data was improving. That sentiment was blown away by a strong retail sales report on Thursday and the US budget deal.

The big jump in initial claims – which should have kept the market focused on weakness in the labour markets – was discounted due to the Thanksgiving holiday.

Taking the two-week average, the trend in equities is still very much down.

The only data point of note on Friday was November PPI, which came in marginally weaker than expected.

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Tomorrow’s Inflation

We get the far more closely watched CPI number tomorrow. We will talk more about the FOMC meeting tomorrow but the only other real data point that has the potential to swing the decision one way or the other is the CPI.

My central case is that the Fed will be dovish on Wednesday and may even initiate a new QE unemployment target of 6% for 2014.

The market is still mixed on whether the Fed will taper this week, with a small majority believing the Fed will wait.

The “taper before Christmas” camp is made up mostly of market participants and portfolio managers. In contrast, the “nothing till 2014” camp” is mostly made up of Investment Bank economists.

There was some talk early last week that the market wasn’t afraid of a taper but that has dissipated. The S&P 500 had its worst week since August, a gold breakout flopped and Treasury yields are set to close at the highest since the September Fed decision.

In short, tapering matters.

The US 10 year closed on Friday at 2.86%.

Euro-Dollar rate clearly mispriced

Dollar Euro Misprced

The US dollar has gained across the board but there is one exception against our own currency here, the Euro.

The resilience of the Euro is the lesson I learned last week, once again.

As you can see from the chart below, the Euro is significantly mispriced versus interest rate differentials.

Why when the dollar is yielding you a full 100 bps more than the Euro and deflation threatens most major economies in Europe, is the Euro strong against the greenback?

It seems to me that there is something else going on.

Now this is where Mr Draghi’s bank stress test comes in. Could it be that the flows into the Euro stem from the large European banks liquidating their foreign positions to repatriate capital ahead of the stress test?

While the Euro was down for the second day in a row on Friday, it had gained for seven days straight before that. In the bigger picture, it’s up for the fifth week in a row as it dabbles with the highs of the year.

What does it mean for this week?

It’s still too early to say. If the Fed tapers, we might have a top but until Wednesday, it’s all a game of wait-and-see.

United States – Is it all about the Federal Reserve? Afraid so.

Scanning this week’s data releases in the US, it’s hard to escape the fact that the Federal Reserve meeting is the only game in town. From a more medium term point of view, the housing data will also be interesting. More on the Federal Reserve meeting tomorrow.

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China – HSBC Flash Manufacturing PMI comes in weaker than expected.

The December HSBC Flash China Manufacturing PMI reading slowed marginally from November’s final reading. But it still stands above the average reading for Q3, implying that the recovering trend of the manufacturing sector starting from July still holds up.

As a result, I expect China’s GDP growth to stabilize at around 7.8% yoy in Q4. The market had been looking for continued improvement and this, combined with continued concerns around the Federal Reserve meeting later this week, has asset prices under pressure this morning.

Australia: Fiscal situation continues to worsen

We are more than a bit concerned about Australia these days, not least because reports in the Irish papers today are blaming the outbreak of the “12 pubs of Christmas” pub crawls in Dublin on returned migrants laden down with Aussie dollars after a year working in the mines of the Pilbarra.

The other reason for our concern about events in the Lucky Country is we are short Aussie dollars.

Down in Australia the Abbott government abandoned its target of returning the budget to surplus in four years. Prime Minister Tony Abbott has indicated a 2016-17 surplus is unrealistic.

This week’s Mid-Year Economic and Fiscal Outlook (MYEFO), for release tomorrow, is expected to disclose a budget deficit for this financial year of about $50 billion and debt to exceed $500 billion beyond the four-year budget forecasts.

New Target for Aussie Dollar?

In the Australian press today, the Australian Financial Review asks Where the RBA’s US85¢ came from?

It is very rare for central bank officials to mention specific numerical currency targets, but the RBA has become increasingly forthright in trying to talk down the price of the AUD in recent months.

Published RBA research suggests one of its preferred currency valuation models is based on the currency trading in the past at given levels of the terms of trade, and at given levels of inflation and real (in other words, after inflation) interest differentials for Australia compared to other major economies.

An attempt to replicate the model, suggests the nominal Australian dollar has tended to fall over time to offset the fact local inflation has been higher than that in the United States.

Allowing for other factors at work, history suggests the exchange rate adjusts to offset differences in cost competitiveness. The model also suggests that every one percentage point increase in the real interest rate differential between Australia and the United States increases the bilateral exchange rate by 1 per cent, and every 10 per cent rise in the terms of trade increases the exchange rate by 7.5 per cent.

Sure enough, the model suggests that “fair value” for the Australian dollar is currently around US.85¢.

Gotta say as a former central bank economist, I still love my former colleagues’ weaknesses for GIGO models – garbage in, garbage out.  While this is not absolutely the case, modeling exchange rates has proven to be highly problematic even before Krugman published his seminal papers on this stuff in the 1980s.

Japan: Key Tankan survey comes in better than expected, but concerns remain

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At first glance, conditions and confidence are on the improve with indices coming in a little ahead of forecasts; but the outlook for March is not quite so rosy, and Capex falls short of expectations.

With the Yen at yearly lows against the majors, this report doesn’t do enough to suggest further imminent easing by the BOJ. While I very much like USDYEN higher in 2014, I sit on my hands with my current small allocation for better levels to add.

Asmussen quits the ECB to take a job in Germany’s new government

Announced yesterday as part of Germany’s “Grand Coalition” government, SPD party member and ECB governing council’s  Joerg Asmussen has been appointed as deputy to labour minister.

Along with Bundesbank head Weidmann, Asmussen has at times criticized the ECB’s accommodative policies but defended the interest cut in November. Germany will propose a successor on the ECB governing council and the favorites,will  all be women: BUBA vice president Sabrine Lautenschtlager, BaFin head Eliki Koenig, and Halle Institute’s head of economic research Claudia Buch.

It will be interesting to see if this development further isolates BUBA head Weidmann. If Lautenschtlager is not appointed it certainly has the potential to do so but I don’t see this as having much significance in future ECB decision making.


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