Sarkar on Taper, Data

The FED announced that it would reduce its asset purchase programme by US$10bn in January, comprising equally of Treasuries and mortgage backed securities. However, Mr Bernanke was overly dovish, emphasising that the FED’s highly accommodative policy would remain in place well after the unemployment rate declined below 6.5%, in particular as inflation was well below its 2.0% long-run goal. He added that further reductions of its asset purchase programme would be data dependent, though suggested that the QE programme could continue through 2014. In effect the FED has substituted a modest taper with a more dovish forward guidance statement. Bernanke’s comments also suggest that the FED will not raise rates until late 2015 (possibly 2016), based on current inflation forecasts.

US November industrial production rose by +1.1% M/M in November, the most in a year and far better than the upwardly revised +0.1% in October and the increase of +0.6% expected. The index of industrial production rose to 101.3, which was the 1st time the index has risen above its pre recessionary high. Capacity utilisation rose to 79%, the highest since June 2008. The leading indicator index rose by +0.8% in November. Inflation remains tame, with headline consumer prices unchanged in November (+1.2% Y/Y), though core inflation rose by +0.2% M/M. The FED’s preferred inflation gauge (the personal consumption expenditure) rose by just +0.7% Y/Y in October. US housing data was mixed, with housing starts increasing by 22.7% to an annualised rate of 1.09mn in November, well above forecasts, though existing home sales fell by -4.3% in November, to an annual rate of 4.9 million.

The preliminary EZ manufacturing PMI came in at 52.7, better than the estimate of 51.9 and Novembers 51.6. However, the data reveals the widening gap between Germany and France. German manufacturing PMI came in higher than expected at 54.2, whilst French PMI declined to 47.1, lower than the 49.0 expected and Novembers 48.4. The data suggests that France may well be in recession this Q, as services PMI was also in contraction territory. The EZ composite PMI came in at 52.1, higher than the 51.7 in November.

The important German IFO index was also positive, rising to the highest level in 20 months. Importantly, the expectations component rose to 107.4, up from a revised 106.4. Inspite of the weak EZ, Germany seems to be recovering from its recent run of sluggish data, with the domestic economy improving, in particular. GDP is forecast to rise by +1.7% in 2014.

Mr Draghi, the President of the ECB, stated that the current rules proposed by the European finance ministers to deal with failed banks are “overly complex and financing arrangements may not be adequate”. He is right on both counts. The current proposals requires the approval of so many authorities that winding up a failed bank will not be achieved as quickly as is so very necessary. A E55bn fund to deal with failed banks, paid for by levies from the banks, is to be built up over a 10 year period. However, the fund can only be fully accessed at the end of the 10 year period. In the interim, access to the fund will be phased in, with national governments responsible to meet their requirements. Countries can request funds from the ESM, which they can use to recapitalise failed banks, though in reality that was already the case. The agreement was heavily influenced by Germany who want to limit their exposure and that of taxpayers. Furthermore, the agreement does not break the link between the sovereign and their national banks, certainly in the interim period. Mr Draghi urged banks to raise capital before the completion of the stress tests in November next year. However, banks are more likely to sell assets and reduce lending, with credit becoming less available – the last thing the EZ needs at this time. Importantly Mr Asmussen, a member of the ECB, will be leaving to become the deputy minister of labour of Germany. He was a key ally of Mr Draghi and, importantly, acted as a bridge between the ECB and Germany.

UK inflation is finally heading lower and towards the 2.0% target. CPI increased by +2.1% Y/Y in November, the least in 4 years. The UK’s current a/c deficit is widening however – it rose to £20.7bn in Q3 (5.1% of GDP) and the highest since 1989. Unemployment is declining, with the unemployment rate declining to 7.4% in the 3 months to October, down from 7.6% in the Q to September. The Bank of England (BoE) had set a target unemployment rate of 7.0%, as a possible trigger before it started to tighten monetary policy – the faster than expected decline in unemployment will force the BoE to reduce the 7.0% target, as the BoE does not want to raise interest rates.

The important Japanese quarterly Tankan survey came in better than expected. However, the forward looking sentiment indicators were weaker, in particular in respect of capex. Furthermore, whilst import prices have risen due to the decline of the Yen, output prices are forecast to forecast to remain stable/decline. Japan’s trade deficit rose to a record US$12.6bn in  November, though was lower than expected as exports rose.

The Chinese Central Bank, the PBoC has been tightening liquidity to reduce lending, contain inflation and limit the rise of property prices. However, the policy seems to have badly affected a number of banks and the PBoC had to provide an emergency cash injection yesterday. So far the cash injection has failed to resolve the credit squeeze, with the 7 day repo rate (which is an indicator of liquidity in the system) rising to 7.6%, over 300 bps higher this week. The fear is that banks will stop lending to each other, triggering a banking crisis. The PBoC will have to act fast and provide further liquidity. The problem is that banks in China are overleveraged with low liquidity levels and sharp increases in interest rates have a material adverse impact. This is certainly an issue which must be watched carefully. Chinese markets declined for the 9th consecutive day today, the longest losing streak in 19 years, according to Bloomberg.

The Chinese HSBC preliminary December manufacturing PMI came in at 50.5, below expectations of 50.9 and Novembers 50.8. It was a 3 month low. However, the more important issue is that the data adds to the suspicion that the recent better than expected export data was inflated. China maintained its forecast for 2014 GDP at 7.5% – there was speculation that it would reduce the forecast to 7.0%.

US markets reacted positively to the overly dovish statement by Mr Bernanke, with the DOW closing at a record high yesterday. Markets globally have also reacted positively to the FED’s dovish stance and should continue to rally for the moment. However, I remain cautious, especially as we progress into 2014. Emerging markets look vulnerable. The US 10 year bond yield has risen to 2.93% and seems to be heading for 3.0%.

The agreement reached by EU finance ministers on the so called Banking Union is fraught with problems. It simply will not work as currently agreed. As a result, banks will try to raise capital (if they can) ahead of the ECB’s stress tests, but more likely will be forced to sell assets and reduce the size of their balance sheets by limiting lending. The ECB will provide liquidity, possibly through a further LTRO and/or a funding for lending scheme as designed by the Bank of England. However, the continued uncertainty makes me particularly cautious of the EZ. S&P downgraded the EU’s credit rating by 1 notch to AA+, from AAA previously, citing worsening creditworthiness amongst the 28 member bloc. The risks in the EZ remain elevated in my opinion.

Minutes from the recent meeting of the Australian Central Bank (RBA) refer to the A$ as “uncomfortably high and a lower level would likely be needed to achieve balanced growth”. However, the RBA is not keen to reduce interest rates, as they are concerned about rising property prices. The governor of the RBA has talked about a rate of US$0.85. The BoE is worried about the rise of Sterling, warning that a further appreciation would hamper the UK’s economic recovery. In Japan, the Bank of Japan (“BoJ”) current asset purchase programme is buying the equivalent of about 70% of new government debt. Inspite of this massive programme, BoJ officials continue to hint that they may increase the rate of purchases to meet their 2.0% inflation target, though kept their bond buying programme unchanged following todays BoJ meeting. I remain bearish on the Yen, in particular against the US$. The Euro having traded around US$1.38, has slipped to around US$1.3660. I remain bearish on the Euro, especially against the US$. The US$ remains my preferred currency into 2014.

May I just take this opportunity to wish you a very merry Christmas and a happy New Year.

Kiron Sarkar
20th December 2013

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