Tuesday, January 11, 2011

The Week Ahead: Medium-term fiscal situation as the key-driver of financial markets

The general environment of the markets has not changed dramatically
from the end of last year. However, the weights assigned to various
components are changing. This is especially the case in the US where
short-term growth prospects take the lead over concerns about the
medium-term fiscal situation as the key-driver of financial markets.

The recently positive signals coming from labour data tend to
"limit" the risk of any unpleasant surprises on the household
confidence and spending front.

The first week of the new year ended with somewhat of a 'shock'!
December payrolls rose 103,00, well below the consensus, 150 000 and
my initial 'guesstimate of 160,000, and far short of the 297,000 ADP
number. The net revision was +70,000, though. Unemployment fell
unexpectedly to 9.4% from 9.8%, and hourly earnings rose 0.1%;
consensus was 0.2%. This is a cold(ish) shower after the excitement
generated by ADP; private payrolls rose 113,000, below the 128,000
average for the previous 3 months. And 44,000 of the jobs were in
education, while temp job growth slowed sharply. The underlying trend
is accelerating, but progress is quite slow. With jobless claims now
dropping more quickly I expect better payrolls over the next few
months. The drop in unemployment reflects a 297,000 rise in household
employment and a 260,000 drop in the labour force; both are hugely
volatile. The unemployment trend is about flat.

The December US labour report is an utter mess, and it is becoming
increasingly hard to see why markets focus so much on these numbers.
The non-farm payrolls total rose by a disappointing 103,000, with some
positive net revisions, failing to dispel the sense that this was a
soft figure relative to what was seen more likely in the 180,000
region by consensus, following the recent strong ADP report. But the
household survey of employment reversed a 175,000 fall last month to
register a 297,000 rise - bang in line with the ADP numbers. As a
result of this, and a 260,000 decline in the size of the civilian
labour force (if things were as good as the household survey suggests,
why are so many people giving up the search for work?) the
unemployment rate has declined from 9.8% to 9.4% - the lowest since
May 2009. In spite of this good news, the median duration of
unemployment continues to rise, and now stands at 22.4 weeks, up from
21.7. So those getting jobs have typically not been unemployed for
very long.

Treasuries ended the past week sharply mixed – little change at the
front end, modest further gains in the intermediate part of the curve
on top of the prior week's outperformance, and substantial losses at
the long end – after a BIG rally Friday in response to the
disappointing employment report reversed significant losses across the
curve seen through Thursday on better economic news through the first
part of the week and pressures from record corporate issuance. The
December employment report wasn't terrible, but after the surge in
the ADP employment report added to widespread signs of accelerating
labour market improvement, including claims, the Challenger and
Manpower surveys, and strong recent individual tax receipt growth,
seeing payrolls at +103,000 come in below the October/November average
and other details of the establishment survey (flat average workweek,
only minor gains in aggregate hours worked and average earnings, small
rise in aggregate earnings that will be negative in real terms) show
little improvement was certainly a letdown. And the much more positive
0.4% drop in the unemployment rate to 9.4% was discounted since it
came to a significant extent from a sharp decrease in the labour force
that is unlikely to be sustained. On top of the boost from the
softer-than-expected employment results, a significant renewed
deterioration in sentiment towards peripheral EMU sovereign credit and
increasing signs of contagion into core Euroland, which flowed through
into significant worsening in US municipal bond CDS, and associated
pressure on European bank debt, provided a flight to safety boost to
Treasuries late in the week. Prior to the employment report, economic
data released during the week were more positive but, setting aside
the misleading ADP report, also mixed. Both ISM surveys posted strong
results, with the nonmanufacturing index exceeding the manufacturing
index for the first time in the recovery, a positive indication of a
broadening expansion. Motor vehicle sales rose more than expected to
extend the best three-month run since 2008, but chain store sales
growth significantly decelerated in December and a very strong start
to holiday shopping in November, pointing to a slowing in underlying
retail sales. As a result I have 'trimmed' my Q4 consumption
forecast to +3.8% from +4.1% and GDP to +4.3% from +4.5% Earnings data
were on the stronger side, with the hourly wages number rising to 1.8%
y/y from 1.6%, its highest since July. This would be more in keeping
with the strong household figure than the 'mediocre' payrolls
report. This data is a mess. My best guess is that the labour market
is recovering more in line with what the household survey is telling
us than the payrolls figures. But the market still tends to focus on
the non-farm payrolls numbers. Consequently, the market response to
this figure will be one of disappointment – despite the genuine
elements of good news it contains.

Barring any Eurozone sovereign debt shocks, the improving news flow on
the US labour market will continue to drive risk appetite over the
next couple of weeks. With growing evidence that jobs growth is
picking up, as highlighted in the ADP payrolls numbers and initial
jobless claims data, Friday's US December labour report showed
non-farm payrolls jumping by over 100,000. This should boost consumer
sentiment and in an environment of improving credit conditions,
loooooow interest rates with the added bonus of a mini fiscal
stimulus, I am increasingly optimistic on the prospects for consumer
spending. However, those looking for a swift decline in the
unemployment rate are likely to be disappointed given that more jobs
will encourage previously disillusioned workers who withdrew from the
labour force to return. Consequently, we are likely to see rising
employment and a rising workforce, which I believe will keep the
unemployment rate close to 10% through this year (my initial call is
for a year-end rate close to 8.8%). Other US data includes retail
sales, which should be strong based on evidence from the retailers
themselves post the Thanksgiving holiday. Meanwhile, headline CPI will
be boosted by gasoline prices, but underlying inflation should remain
very benign at just 0.8% y/y. Given the Federal Reserve has suggested
it wants to see the unemployment rate in a 5.0-6.0% range and the core
personal consumer deflation nearer to 2.0%, there is little prospect
of monetary policy tightening in the near term. Indeed, I doubt rates
will be raised before 1Q 2012 at the earliest especially after the
Bernanke headlines from late Friday afternoon before the Senate Budget

* May take 4 to 5 years for job market to "normalize"
* Recovery likely to be moderately stronger in 2011
* Inflation "likely to be subdued for some time"
* Persistent high unemployment could threaten recovery
* Progress is likely to be slow in meeting Fed's dual mandate
* Fed is committed to price stability and says the Fed has "tools
it needs" to smoothly" exit QE
* Labour market "improved only modestly at best"
* Housing sector remains "depressed"
* Failing to curb deficits could lead to higher rates

In Europe, ECB and Bank of England policy meetings will be in focus
although no change to policy is likely. Both Eurozone and UK inflation
are above target and in an environment of strengthening global demand
the hawks on the respective committees are becoming more vocal.

However, given spare capacity, fiscal austerity measures and high
unemployment, I still favour 2012 as the starting point for policy
tightening. German annual GDP growth data and the first estimate for
the fiscal deficit should confirm an excellent growth performance in
2010. With a fiscal deficit close to the Maastricht-threshold of 3.0%
of GDP, Germany remains the showcase of the Eurozone, not only in
terms of growth but also in terms of public finances.

The lagged effects of a strong JPY, moderation of foreign demand and
the withdrawal of government stimulus continue to weigh on the
Japanese economy. Machinery orders have been unusually weak in recent
months though should recover in the coming months. With food inflation
pressures finally abating in Brazil, the monthly IPCA inflation index
should drop in December but that should not stop the index from
printing a high 5.9% rate for 2010 as a whole, markedly higher than
the 4.5% target. As a result, the central bank has signalled in its
latest inflation report that policy rate hikes are likely later this
month. A 50 bps hike is likely, which will probably be followed by two
additional hikes of the same magnitude, bringing the SELIC to 12.25%
by April. In Poland, with CPI likely to have climbed above 3.0% y/y in
December even dovish MPC members are openly talking about rate hikes.

The vote is next week. With no deterioration seen in new orders the
y/y growth of exports may have returned above 20% in the last 2 months
of 2010, and the 1Q11 outlook is also positive. In the Czech Republic,
I assume IP again reached saw double-digit growth, driven by strong
export performance, while retail sales returned to positive growth in
the same month. CPI likely broke the 2.0% target of the central bank
in December, driven by higher food and fuel prices, but demand-pull
inflation remains weak, supporting the wait-and-see stance of the CNB

However, the return to macro fundamentals does not draw a completely
rosy picture. First of all in Europe, all the economic surveys show
further divergence across countries, with confidence going up in core
ones and down at the peripheral. Whatever the current relative calm in
sovereign debt markets, the lack of growth at the South of the
continent suggests that problems can resurface at any time as long as
the EU partners have not proposed an effective resolution of State'
solvency crises. With further optimism about growth expectations,
mostly in the US, inflation is increasingly becoming a key theme and
recent events call for vigilance. Commodity prices are still on the
rise; in the UK the hike in VAT and fuel excise have contributed to
growing inflation expectations; within the Eurozone, the y/y increase
of consumer prices was 2.2% last December, so over the 2.0% ECB
threshold for the first time in 2 years. Even if the importance of
unused capacities in both the US and Europe (a still large negative
output gap) and the low levels of core measures of inflation send a
clear message about the current limited risk of any inflation
acceleration, markets may remain vigilant and could even overreact

The data flow for next week will mainly focus on the US. The general
message would likely confirm a gradual improvement in the economic
situation. December retail sales likely posted a solid broad based
0.8% gain, while the preliminary University of Michigan consumer
sentiment index for January should continue to improve. This more
optimistic tone would be confirmed by the Fed's Beige book. December
CPI is expected to have moved up 0.4% m/m, in relation with energy
prices. The core index would have edged up only 0.1% on the month and
0.8% over the year. This is much lower than the FOMC's preferred
range of 1.6-2.0% and highlights the Fed's concerns regarding
subdued inflation.

For its first Governing Council meeting of the year, the ECB looks set
to remain firmly 'on hold' for now despite early signs of a
pick-up in various inflation gauges. The statement should mention
these recent developments, while further highlighting the downside
risks to growth in the medium-term, despite a recent run of positive
data. For now, the ECB has plenty of arguments left to justify the
status quo. Core inflation remains much lower than the headline (I
look for a modest increase to 1.2% y/y in December). Constraints on
bank lending remain both on the supply and the demand side. And the
improvement in any measure of "Eurozone average" in terms of GDP,
CPI and thus of an appropriate policy rate, has been accompanied by a
strong and rising divergence across countries. In the near-term, the
ECB will likely carry on with its very cautious and gradual approach,
avoiding any disturbing signal for the weakest Eurozone countries
while keeping the Securities Market Programme "ongoing". That
said, JC Trichet is also set to make clear once again that it is up to
the national governments to solve the fiscal crisis, not to the ECB.

Regarding non-standard policy measures, any exit decision will be
announced at the March meeting. Finally, the ECB is likely to welcome
the December EU summit decisions in general, and the announcement that
new bank stress tests will be re-conducted in the coming months in

BoE also would not alter its policy and I do not expect a change in
the key policy rate and the APF programme next week. Although
inflation is above target and is likely to even edge higher in the
near term, an interest rate hike would be premature given the
headwinds, both internal and external which the economy is facing
(budgetary spending cuts, uncertain prospects for consumer spending,
euro-area tensions). Recent macroeconomic data points towards
reasonably strong growth in the Q4 and makes another APF extension

The Eurozone government bond markets for the core markets would be
confronted to opposite factors in the next few days. On the one hand,
the trend for long-term rates would stay upward in the US in relation
with a friendly growth data flow. On the other hand, the persistence
of doubts about the peripheral sovereigns' financial situation and
the importance next week of the issuances from Portugal, Spain and
Italy should plead in favour of enlarged spreads and so of downward
pressures on core rates. At the end, I expect no major shift in rates
for core markets. As mentioned earlier, the US muni bond market also
came under significant renewed pressure as the sovereign credit
worries in Europe intensified. 5-year CDS spreads for Ireland (+35 bps
on the week to 650 bps) and Portugal (+45 bps to 545 bps) ended the
week at new closing highs, though Spain (+8 bps to 358 bps) held
'steady'. Peripheral worries continued to spread into the softer
Euroland core, with Belgium (+35 bps to 252 bps) hitting a new wide as
its political crisis showed no signs of resolution and Italy (+17 bps
to 255 bps) weakening notably. Contagion is even starting to become
more evident in the harder core, with France (+9 bps to 110 bps) also
moving to a new wide. Spillover from European sovereign credit
concerns drove the 5-year muni bond MCDX index 20 bps wider to 237
bps, its worst level since July.

With the growing optimism about the US economy, the USD must stay on
the 'front foot'. However, a likely asymmetric behaviour of the
market should be kept in mind. A shortfall is likely to have a more
pronounced impact than any upside surprise. The difficulty is that, at
least in the next few days, any pull-back in the USD is likely to lack
conviction and could be even perceived as an opportunity to increase
the long positions.
Source: Fxstreet.com

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