3 Top Themes This Week: Bernanke Green Lights "Risk On", AUD at Record Highs, ...

The historic FOMC decision and press conference came and went this week, for the most part we got the same statement as we had in March, with a slight more emphasis on inflation.

Fed Chairman's performance came through "dovish" as he reiterated the need to keep rates low. We did see

PIMCO Disposes of Its Government Debt Portfolio while Bernanke Speaks of an Exit Plan

On the back of some weak data today on the employment and housing markets, and following some disappointing figures from China, stocks and commodities including gold and oil are performing very poorly. Ben Bernanke seems to have contributed his own part to the sudden shift by reassuring us confidently that he and his team of responsible people at the Fed are actually thinking of an exit plan as the economy improves. Expectably he did not make any commitments, but markets apparently don`t enjoy the hints being given so pompously and loudly. 

In Asia, the fact that China has ended up with a small yearly trade deficit instead of an expected sizable surplus is one of the top news items of today. Some have gone so far as to say that this event signals the end of the so-called currency war as the deficit removes the urgency of the need to appreciate the CNY, while others tie it to the government`s conscious efforts to boost domestic spending in order to rebalance the economy. The currency has been slowly appreciating since around June of last year, and a shrinking surplus is natural at this point. However one month`s negative number doesn`t mean much in the long sequence of positive sums stretching back to a long time ago, and if we also keep in mind that the deficit is almost entirely due to the huge jump in commodity prices that followed the Middle East unrest, it becomes clear that the reversal is not a consequence of Chinese actions, but rather of market fluctuations which do not mean much in terms of the USDCNY exchange rate debate. If the worst happens and oil prices skyrocket in consequence of chaos in producing nations, it is obvious that China would be just another victim with exports falling (as demand evaporates in the rest of the world with rising inflation) while imports rise with commodity prices. This is not a China specific event however, and for now its effect must be regarded as temporary because one doesn`t build a base case on a doomsday scenario.

What the Chinese numbers really signify to us is the euphoria that has overtaken the markets on the back of Fed-induced overspending in the U.S., as all the colossal events taking place in the critical Arab World and the chronic problems of European sovereigns were ignored on the basis of momentum trades.

Meanwhile, Bill Gross is preparing his fund for the previous version of the doomsday case, prudently in our view, by getting it rid of its entire government debt portfolio, completing a process that was known to be underway for some time. Mr. Gross apparently wants to play safe for although it is undeniable that any bullishness in the government debt market can last for a while (because it is a bubble), it is also safe to say that the higher it goes the deeper it will plunge, and it will be painful for those who tarry too much in quitting before the masses. We still believe that the U.S. will outperform most developed market economies when the crisis strikes, but that doesn`t mean U.S. paper will do well, only that it will burn with less severity than its less-favored peers in the rest of the world, due to a combination of safety and superpower effects. 

Will Ben Bernanke Launch a QE3?

The question of what Ben Bernanke will do once the bond purchase program expires in June is regarded as the most important determinant of long-term market direction by those who believe that the recovery phase is illusory. If the U.S. economy can gather its own momentum in the meantime and begin to charge forward without such a great dependence financial markets trends, the role of the central bank would also be relegated to secondary rank. With little sign of such a development, one can expect the trading community to remain under the spell of Fed for some time to come. As the Fed`s largest active intervention in the markets, it is clear that the bond purchase program is of crucial role in setting trends.

In order to understand what the Fed will do, we need to adopt a more rigorous approach in our assessment of the Chairman`s policies. We know a lot about his character, ideological outlook, his teachers, and his roadmap for an exit from the economic downturn. But perhaps more importantly than these, we know that his freedom of movement, great as it is, is in fact limited by the legally-defined mandate of the institution he leads - he must keep inflation low, while striving towards a practical goal of full employment. In this aspect at least we have a fairly good idea on what drives his actions and words. Since nobody questions the integrity of the Chairman, we are safe in the basic assumption that we know what his ultimate goal in setting policy is, even though this goal frequently becomes obscured by his effort to reconcile various conflicting interests (administration vs. Congress, public vs. corporations, etc.)

The pivotal point in the debate surrounding another possible leg of liquidity pumping must then focus on what aspect of his mission the Chairman has achieved during this governorate term. Although inflation has generally been higher than the declared target of the Fed, it has remained stable and tolerable, with hints that it is not going to increase dramatically anytime soon. In spite of the worries and concerns that this is temporary, neither inflation expectations nor actual price movements show any risk of runaway price rises at the moment. This means that the Fed has succeeded in achieving its mission with respect to this side of its dual mandate. The other side of the governor`s mission, however, focusing on growth and especially employment, have not been so successful. The unemployment rate remains high, credit for small businesses is improving but still difficult to obtain, and the general outlook for economic activity is  better but not particularly encouraging, judging from the tone and tenor of the chairman`s comments in recent weeks.

As a consequence, we believe that the odds are tilted toward a resumption of purchases before the end of the year. Apart from the problems faced by the U.S. economy itself, the problems of international finance and the global economy in general should keep unemployment at elevated levels for some time, discouraging risk taking and heavy hiring activity, and this will prove unpalatable to the Fed sooner or later. Assuming that the Chinese must increase interest rates, the Europeans must resolve their domestic problems, and that the Middle East turmoil has a long time to go, it is but a matter of time that the Fed, encouraged by persistently low inflation, will move to yet another leg of QE3. The timing itself will depend only on when and how the market panics, with the Chairman having little role in the decision process, although he always gets to have the final say as the unwilling mouthpiece of speculators.  

U.S. Urges China to Appreciate the Currency; Bernanke Expects 3% Growth for 2011

Gold stabilized by the end of last week and is appreciating a little, but the main theme of the market remains the indecision that we typically observe in this part of the year. For the past few years, markets have been tending to rally towards the year end, and sometimes this momentum reverses in the ensuing period. This year seems to follow a similar pattern. As such, we believe that gold will remain at around the level that it presently is, barring a sharp appreciation of global equity prices.

Meawnwhile, just a week before the Chinese President`s crucial visit to Washington, Gary Locke, the Commerce Secretary of the U.S. was reported as speaking of a turning point in the U.S.-China relationship. “Last year, China became the second largest economy in the world. And the policies and practices that have shaped our relations over the past few decades will not suffice”, he is reported as saying. This comes, of course, after yesterday`s comments by Tim Geithner that China must strengthen its currency. Other issues that relate to trademark and copyright theft, Korea, and and the trade surplus,  will be some of the top issues in the presidential meeting this week.

Should we expect the Chinese to submit to American pressure? Our pessimism about any substantial improvement in the bilateral situation is well-known to our readers, but with inflation running so high at home, the Chinese will be more amenable to somewhat faster appreciation of the currency, and the announcement of such an agreement could be regarded as a kind of public relations achievement for the Chinese too. In other words, we suspect that if nothing significant would come out of the meeting, the likelihood is that not mch should be expected to happen for the first half  of this year on the USDCNY issue. All these imply that this week`s Chinese visit will be a very important event for us to watch.

The reason for our pessimism is that the Chinese system is not the kind that the Americans are used to working with. The country is huge, with ubiquitous corruption and a highly immature, and complicated legal system greatly hardening the task of those who would like to see strong improvements in a short time. The same is the case with the Chinese, who, for example, threatened to degrade relations with Norway in response to the Nobel Prize awarded to the dissident Liu Xiaobo. Neither side understands the other very well, both are highly suspicious of their partners behind the smiles, and have a tendency to usually expect the first step from the opponent before making any moves themselves.

In other events, the Fed Chairman is preventing is interpretation of the recent rise in interest rates as a sign that the economy is doing better. He says that it is not an indication that the Fed`s bond buying program is failing. But isnt`t there a chance that it is both? Still, we would like to give him the benefit of the doubt and perhaps attribute the rate rise to the recent improvement in outlook, which is, one should grant, not at all insignificant. This doesn`t mean that the economy is doing any better, but it means that the market buys the idea that the Fed is capable of inflating asset prices by pumping money. Higher asset prices implies an illusion of higher net worth for individuals, which should bring higher consumption, and a stronger growth outlook. It is not clear, nonetheless, that the recent boost to the outlook will be last as long as some people seem to believe.

He expect a growth rate of 3-4% for 2011, and along with his team at the Fed, he is looking at ways to improve the flow of credit to smaller companies. The funny thing is that he is the one responsible for the reduction in credit volumes to smaller, innovative companies. If you were the loan officer, would you extend credit to the government backed behemoth, or the promising upstart from somewhere with only an innovative, but untested to back his claims and pledges. The answer is obvious. It is not for no reason that the Soviet Union stagnated and collapsed in the 80s, in spite of its great advances in technology, science, and international prestige and power. The cycle must move on, and in our universe, destruction is a necessary part of the creative process. Perhaps there was a way out of the 2007-2008 that could have averted the worst results of the crisis, but apparently the one that the Fed and the Bush adminsitration chose, in which all the failing firms were saved in the name of too "big to fail", was not the best possible decision.

These debates, of course, will go on. All that we know is that the buildup of imbalances will not go on forever, and further, that the longer the cycle of bubbles lasts, the more times it is restarted, the more destructive it will be when the edifice of cards finally comes down.

 

U.S. Urges China to Appreciate the Currency; Bernanke Expects 3% Growth for 2011

Gold stabilized by the end of last week and is appreciating a little, but the main theme of the market remains the indecision that we typically observe in this part of the year. For the past few years, markets have been tending to rally towards the year end, and sometimes this momentum reverses in the ensuing period. This year seems to follow a similar pattern. As such, we believe that gold will remain at around the level that it presently is, barring a sharp appreciation of global equity prices.

Meawnwhile, just a week before the Chinese President`s crucial visit to Washington, Gary Locke, the Commerce Secretary of the U.S. was reported as speaking of a turning point in the U.S.-China relationship. “Last year, China became the second largest economy in the world. And the policies and practices that have shaped our relations over the past few decades will not suffice”, he is reported as saying. This comes, of course, after yesterday`s comments by Tim Geithner that China must strengthen its currency. Other issues that relate to trademark and copyright theft, Korea, and and the trade surplus,  will be some of the top issues in the presidential meeting this week.

Should we expect the Chinese to submit to American pressure? Our pessimism about any substantial improvement in the bilateral situation is well-known to our readers, but with inflation running so high at home, the Chinese will be more amenable to somewhat faster appreciation of the currency, and the announcement of such an agreement could be regarded as a kind of public relations achievement for the Chinese too. In other words, we suspect that if nothing significant would come out of the meeting, the likelihood is that not mch should be expected to happen for the first half  of this year on the USDCNY issue. All these imply that this week`s Chinese visit will be a very important event for us to watch.

The reason for our pessimism is that the Chinese system is not the kind that the Americans are used to working with. The country is huge, with ubiquitous corruption and a highly immature, and complicated legal system greatly hardening the task of those who would like to see strong improvements in a short time. The same is the case with the Chinese, who, for example, threatened to degrade relations with Norway in response to the Nobel Prize awarded to the dissident Liu Xiaobo. Neither side understands the other very well, both are highly suspicious of their partners behind the smiles, and have a tendency to usually expect the first step from the opponent before making any moves themselves.

In other events, the Fed Chairman is preventing is interpretation of the recent rise in interest rates as a sign that the economy is doing better. He says that it is not an indication that the Fed`s bond buying program is failing. But isnt`t there a chance that it is both? Still, we would like to give him the benefit of the doubt and perhaps attribute the rate rise to the recent improvement in outlook, which is, one should grant, not at all insignificant. This doesn`t mean that the economy is doing any better, but it means that the market buys the idea that the Fed is capable of inflating asset prices by pumping money. Higher asset prices implies an illusion of higher net worth for individuals, which should bring higher consumption, and a stronger growth outlook. It is not clear, nonetheless, that the recent boost to the outlook will be last as long as some people seem to believe.

He expect a growth rate of 3-4% for 2011, and along with his team at the Fed, he is looking at ways to improve the flow of credit to smaller companies. The funny thing is that he is the one responsible for the reduction in credit volumes to smaller, innovative companies. If you were the loan officer, would you extend credit to the government backed behemoth, or the promising upstart from somewhere with only an innovative, but untested to back his claims and pledges. The answer is obvious. It is not for no reason that the Soviet Union stagnated and collapsed in the 80s, in spite of its great advances in technology, science, and international prestige and power. The cycle must move on, and in our universe, destruction is a necessary part of the creative process. Perhaps there was a way out of the 2007-2008 that could have averted the worst results of the crisis, but apparently the one that the Fed and the Bush adminsitration chose, in which all the failing firms were saved in the name of too "big to fail", was not the best possible decision.

These debates, of course, will go on. All that we know is that the buildup of imbalances will not go on forever, and further, that the longer the cycle of bubbles lasts, the more times it is restarted, the more destructive it will be when the edifice of cards finally comes down.