Economic Recovery Continues, but is it Enough?

• Economic indicators this week suggested continued economic growth. Factory orders, the Institute for Supply Management manufacturing index and employment all suggest continued progress.
• Yet the pace of the recovery still presents several fundamental challenges. First, construction spending is disappointing and for a society that has put so much emphasis on housing, there is a disconnect between aspirations and reality. Second, the pace of growth will not likely solve the budget shortfalls in many states or at the national level.

Economic Recovery Continues, but is it Enough?

Three important economic indicators this week suggested continued economic growth. Factory orders, the Institute for Supply Management Index and employment all suggested continued progress on the economic front. Factory orders increased 0.6 percent in February and the gain reported for January was revised higher. Factory orders have gained in 10 of the past 11 months and are now more than a third of the way back to where they were at their peak in July 2008. Specifically, new orders for non-defense capital goods ex-aircraft are up nine percent (annualized) over the last three months, consistent with our expectations for 8 percent or more gains in real equipment & software spending for this year.

Meanwhile, the Institute for Supply Management manufacturing index rose to 59.6 and is consistent with a continued recovery rather than a double-dip recession. Orders, employment and production all suggest a positive growth outlook. Finally, employment rose in March and private sector employment has risen for the past three months. The breadth of the employment gains was also positive in March. There were gains in manufacturing and services with improvement in such cyclical areas as retail trade, leisure & hospitality and temporary help. One downside for jobs is that the mean duration of unemployment remains very high and suggests persistent structural unemployment. With that come concerns about consumer and housing credit.

Yet, the pace of the recovery still represents several fundamental challenges. Moderate economic growth alone does not solve several secular imbalances in the economy. First, construction spending is disappointing and for a society that has put so much emphasis on housing, there is a disconnect between aspirations and reality. Our expectation is that housing purchases will not rebound at a pace that will make many speculative housing starts economically viable. Second, the pace of growth will not solve the budget shortfalls in many states or at the national level. Political promises have outpaced the ability of the economy to deliver. For several years entitlement spending has outpaced the tax base that supports it. Finally, the longer-term budget deficits and our dependence on foreign capital to support them creates a delicate balance of supply and demand that is currently being tested by questions raised about the U.S. commitment to long-term deficit control.

Cyclical Recovery Still Leaves Structural Imbalances

Both public and private decision-makers are left with the reality that a cyclical economic recovery still leaves us with longer-run structural imbalances—many of which have been growing since the 1960s. Economic growth appears insufficient to generate the income needed to meet all the entitlement promises. The latest Congressional Budget Office report on Social Security emphasizes this point. For the private sector, the ability to generate jobs and earnings are being challenged in an economy with slower top-line sales and greater consumer caution. We may be out of the woods but it is still a long journey to Mordor.

U.S. Outlook

ISM Non-Manufacturing • Monday

The ISM Non-Manufacturing Index remained in expansionary territory for the second consecutive month in February increasing by 2.5 points to 53.0. With the exception of employment, all components of the composite index (business activity, new orders and supplier deliveries) contributed to the increase. The recent strength in service sector business activity is consistent with our view that an economic recovery is underway. The forward looking new orders index has been in expansionary territory for seven consecutive months and suggests continued strength in the service sector in the near future. The employment index rose 4.0 points to 48.6, the highest level since April 2008. The employment index will likely push into expansionary territory in March, which is consistent with underlying strength in private sector jobs.

Previous: 53.0 Wells Fargo: 53.5
Consensus: 54.0

Pending Home Sales • Monday

Pending home sales have fallen two out of three months with declines likely due to the weather and a payback from the jump in sales that occurred before the initial expiration of the first-time homebuyer tax credit (initially scheduled to end November 30th). While the extension and modification of the tax credit has yet to spur sales, we expect to see a boost in the months leading up to the second expiration (extended to April 30th for contracts to be signed). All four regions of the country saw declines in January with the West seeing the largest decline. We expect the index to continue to wane in February. The decline in mortgage applications in February supports the notion that pending sales will likely remain weak.

Previous: -7.6%
Consensus: -1.0%

Initial Jobless Claims • Thursday

Initial jobless claims for the week ending March 27th fell by 6,000 to 439,000, the second consecutive weekly decline. On a trend basis, the four-week moving average edged lower to 447,250. Consistent with our view that labor market conditions are stabilizing, we expect claims to continue to decline in coming weeks (especially with improving weather conditions in most parts of the country). While claims are moving in the right direction, the level is still too high to be consistent with sustained underlying strength in payroll growth. We expect temporary census hiring will likely help boost payrolls through May. Thereafter, we should see a retracement in temporary and government employment from June through September. By the fourth quarter, the effects of the census should be behind us and payroll gains should reflect underlying strength in the private sector.

Previous: 439K
Consensus: 433K

Global Review

Signs of Continued Global Recovery in Q1

• The Tankan index of Japanese business sentiment, which is fairly correlated with GDP growth, rose further in the first quarter, and manufacturing PMIs across Asia were strong in March.
• Monthly GDP data suggest that the Canadian economy continued to expand at a strong pace in the first quarter.
• Manufacturing PMIs in Europe also rose further in March. However, strength in “soft” data has yet to translate into robust “hard” data in most European countries.

Signs That Global Growth Strengthened Further in Q1

Data released this week suggest that the global economic recovery, which has been in place over the past few quarters, strengthened further in the first quarter of this year. In Japan, the Tankan index of business sentiment, which is fairly correlated with real GDP growth, rose to its highest level since the near collapse of the global financial system in the autumn of 2008 (see graph on first page). Sentiment among large manufacturers, who tend to be exporters, was the strongest among different sectors. However, the increase in sentiment was broad-based among both manufacturers and non-manufacturers, suggesting that domestic demand also strengthened in the first quarter.

Speaking of Japanese exports, survey evidence indicates that growth in some of Japan’s major trading partners in Asia remained strong in the first quarter. The manufacturing PMI in China rebounded in March after a brief dip during the previous month, suggesting that growth in Chinese industrial production remained strong (top chart). In India and Taiwan, manufacturing PMIs remained well within expansion territory in March.

A marked upturn got underway in Canada in the second half of 2009, and real GDP data for January indicate that the economy is on pace to register another strong quarter of growth in the first quarter (middle chart). In January, real GDP rose 0.6 percent relative to the previous month, which follows the 0.5 percent increase that was chalked up in December. Even if the economy stagnated in February and March, which we do not expect, real GDP in the first quarter will have risen at an annualized rate of about 5 percent. Although exports clearly have played an important role in the Canadian recovery, indicators of domestic demand have been strong as well recently. For example, retail sales in January were up 0.7 percent relative to the previous month, and employment in February stood 0.4 percent above its year-ago level. (By way of comparison, U.S. employment in February was down 2.5 percent on a year-over-year basis.)

Among the major regions of the global economy, recovery thus far has been strongest in Asia and weakest in Europe. However, the manufacturing PMIs for the euro-zone and the United Kingdom strengthened further in March (bottom chart). The PMI in the former jumped to a 40-month high and the index in the latter rose to its highest level since 1994. Service sector PMIs for March will not print until next week, but European and British indices are expected to remain well within expansion territory where they have resided since last summer.

Unfortunately, the apparent strength in the PMIs has not translated into strong economic growth, at least not yet. Real GDP in the United Kingdom rose only 0.4 percent (not annualized) in the fourth quarter, and it was essentially flat in the euro-zone. Although British consumer spending has rebounded somewhat, continental European consumers have no pulse at present. And we fear that the fiscal consolidation that is underway in some of the euro-zone’s former high-flying economies (e.g., Greece, Ireland and Spain) will keep growth in the overall euro area weak for some time.

Global Outlook

German Industrial Production • Thursday

The year-over-year rate of decline in German industrial production (IP) has slowed significantly over recent months due, at least in part, to base effects. German IP has risen 8 percent from its low last April, but remains 17 percent below its peak in early 2008. However, recent increases in survey data (e.g., the Ifo index and the PMI) suggest that German IP rose further in February. Germany also releases data on February factory orders and French IP data will print next week as well.

The European Central Bank holds its monthly policy meeting next week, and there is very little chance of a change in rates at the meeting. Rather, investors will look to the press conference for clues about ECB policy going forward. Due to the sluggish nature of the euro-zone recovery to date (see page 4), we believe that the ECB will keep rates on hold throughout the rest of the year.

Previous: 0.6% (month-on-month change)
Consensus: 0.7%

British Industrial Production• Thursday

As in Germany, the year-over-year rate of decline in British IP has flattened out in recent months. Unlike Germany, however, there has been very little bounce in British industry thus far. British IP is up only 2 percent from its low, and it remains 14 percent below its peak in early 2008. As discussed on page 4, the manufacturing PMI has risen sharply in recent months, so “hard” data should, sooner or later, start to firm as well. Indeed, the consensus forecast looks for a modest rise in IP in February. In addition, a widely followed index of monthly GDP is also slated for release next week.

Like the ECB, there is very little chance that the Bank of England will change rates at its own policy meeting next week. In our view, the upturn in Britain is not quite as tepid as the euro-zone recovery, and we look for a BoE rate hike by the end of 2010.

Previous: -0.4% (month-on-month change)
Consensus: 0.5%

Canadian Employment Report • Friday

Despite the occasional month of contraction, Canadian payrolls have been growing on trend since midsummer 2009. The gain in payrolls reported for February was driven by an increase in manufacturing jobs. Consensus expectations for March payrolls look for an even larger increase. Still, the employment component of the forward-looking Ivey purchasing managers’ index recently slipped to its lowest level since February 2009, suggesting the pace of the recovery in the labor market might slow somewhat in coming months.

Speaking of the Ivey index, we get our next look at that survey on Wednesday of next week. The overall index has been above 50 for eight of the last nine months. However the employment series has been below 50, signaling contraction, for the last several months. An improvement here could lift expectations for future jobs reports.

Previous: 20.9 K
Consensus: 25.0 K

Point of View

Interest Rate Watch

Canary in the Coal Mine

As expressed by Alan Greenspan, rising Treasury interest rates are the canary in the coal mine suggesting danger in the outlook for interest rates. In our December annual outlook for 2010 we posited a pattern of rising interest rates on the benchmark 5- and 10-year Treasury notes. In rebalancing the U.S. economy, we anticipated that both fiscal and monetary policy would have a significant influence on the pattern of interest rates this year. In recent weeks the pattern of fiscal policy has turned negative. First, recent estimates of the future fiscal integrity of Social Security have suggested that the system’s revenues would fall short of spending this year—much sooner than many anticipated. Second, the budget estimates for the healthcare plan do not appear credible to the markets. Future Medicare cuts are unlikely. While mandates have been raised and entitlements broadened, there is likely no reasonable method to pay for these.

Meanwhile for monetary policy, questions have arisen about the ease and extent of the Fed’s exit strategy. Both the composition and the size of the Fed’s balance sheet represent significant issues to the marketplace. Also the Fed’s real commitment to reducing the balance sheet has been in question as several members of the Federal Open Market Committee suggested that the Fed could reenter the market for mortgage-backed securities if problems arose. With the recovery in the first quarter and expectations for further growth, the flight to safety trade that favored U.S. Treasury debt became less attractive. Bond issuance for both high grade and high yield has grown sharply over the last three months. Equity markets have improved. Therefore, the opportunity costs have risen for continued investing in Treasury debt. For the rest of this year our view is that interest rates will continue to rise. We see that investor demand will decline as more attractive alternatives become available. Our concern is that the interplay of policy risks and diminished domestic and foreign demand may create more upside risks to the interest rate outlook than earlier anticipated.

Consumer Credit Insights

Mortgage Rates Still Low… for Now

The Fed’s mortgage-backed securities (MBS) and agency debt purchase programs have helped to keep mortgage rates low for the past year. Even though 10-year Treasury yields have rebounded by about 180 basis points from the December 2008 lows, 30-year conventional fixed mortgage rates have actually declined slightly. The average spread between 30-year fixed mortgage rates and 10-year Treasury yields over the last 15 years has been about 160 basis points, about 40 basis points higher than the current spread, which is still near the lowest in decades. The Fed’s mortgage purchase program however, came to an end this week on schedule and we have already seen some response in the MBS markets where securities declined in value and yields rose on Thursday. Buyers are likely on the sidelines waiting to see how the Fed’s exit affects markets in the coming days. In addition, with signs that the housing market is continuing to struggle and unemployment remaining high, investors are still concerned about mortgage defaults. This will continue to exert upward pressure on rates. Higher mortgage rates will add another headwind, or at least takeaway a tailwind, from a housing market that continues to struggle. In the coming months the housing market is also likely to lose the other major stimulus it has received with the first-time homebuyer tax credit scheduled to expire. The combination will likely hold down sales activity through the summer months.

Topic of the Week

Does Another Debt Crisis Await Argentina?

Argentina has been in the news once again as investors are worried that Argentina may default on its external debt. This speculation is a repeat of what happened during 2008 and 2009, and it seems to be more related to internal political fights than to the current condition of government finances, though government finances have continued to deteriorate. Argentina is still negotiating with holdout bondholders from the 2005 restructuring of its defaulted external debt. Argentina’s access to international financing markets has been closed since the default in 2001, and some investors holding about $20 billion in defaulted debt did not accept the debt renegotiation in 2005.

While we do not expect Argentina to default during the next several years, the seeds of a potential default are being planted today. First, the administration is using stocks to pay for what it owes instead of relying on its cash flow. Second, the government is tampering with inflation numbers to pay less in interest on some part of its current debt. Third, government expenditures are growing too fast for fiscal sustainability, especially if the economy does not make a strong recovery.

The administration has been moving to make a final offer to the 2005 holdouts from the 2001 debt default. According to the Argentine minister of economics, Amado Boudou, the holdouts should expect no more than 35 cents on the dollar. If the holdouts accept this offer from the government, the country will be able to access the international capital markets once again, and will likely be able to find financing rates close to the single digits, much better than today’s rates of 15 to 20 percent. However, if the government runs into trouble obtaining financing in the short- to medium-run, then we should expect a higher inflation tax, devaluation and more confiscatory measures against different productive sectors of the economy. The outcome of these measures will determine how close or how far away another debt default may be.

Wachovia Corporation
http://www.wachovia.com

Disclaimer: The information and opinions herein are for general information use only. Wachovia Corporation and its affiliates, including Wachovia Bank, N.A., do not guarantee their accuracy or completeness, nor does Wachovia Corporation or any of its affiliates, including Wachovia Bank, N.A., assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or any foreign exchange transaction, or as personalized investment advice. Securities and foreign exchange transactions are not FDIC-insured, are not bank-guaranteed, and may lose value.

U.S. Review

Public Policy Grabs Center Stage

• Public policy dominated this week, with the passage of healthcare reform and confirmation the social security system would run into deficit this year contributing to disappointing Treasury auctions and higher bond yields.
• Advance orders for durable goods rose in line with expectations, but a large downward revision to January’s nondefense capital goods orders raises a red flag as to how strong capital spending will be in the first quarter.
• Sales of new and existing homes both declined in February, raising fears the incipient recovery in housing has faltered.

Strange Days in the Credit Markets

The bond market is the ultimate truth detector and its verdict on healthcare reform is the new law will be more costly than the Congressional Budget Office (CBO) estimated and budget deficits will be larger. The bond market was already on edge from the ongoing Greek debt saga and reports that Berkshire Hathaway and a handful of other businesses can now borrow more cheaply than the U.S. Treasury. The CBO confirmed the Social Security system would pay out more in benefits this year than it receives in taxes, something that was not supposed to occur until 2016. The Social Security shortfall means the Treasury will need to redeem the “special issue notes” issued to the Social Security trust fund, which will require the Treasury to sell real bonds, which has become more challenging in recent weeks.

The last few years have seen Treasury yields rise during the spring, triggering a whole new set of challenges. History looks like it will repeat itself this year, with the end of the Fed’s mortgage-backed securities purchases next week adding to the upward drift in yields. The supply of bonds coming to market will remain a challenge, with additional money needed to pay Social Security benefits and recapitalize Fannie Mae and Freddie Mac. Sovereign credit risk and worries about growing supply also extend to municipalities, which saw yields climb sharply recently.

Rising interest rates will make it hard for the housing recovery to gain momentum. The latest numbers are clearly troubling, although anecdotal reports from builders and Realtors are not nearly as pessimistic as February’s home sales were. New home sales fell to a new all-time low in February, falling 2.2 percent to 308,000. Builder sentiment also remains near all-time lows but builders are reporting some improvement in sales and buyer interest. On a net basis, housing is likely modestly stronger this year than last year. Supply remains a big issue, with a 9.2-month supply of new homes currently available for sale.

The harsh weather had less of an impact on existing home sales, which fell 0.6 percent in February. Single-family sales fell 1.4 percent, while condominium prices posted a slight increase. Maybe all that cold weather up North boosted the attractiveness of all those vacant condos in South Florida. The inventory of homes available for sale rose to an 8.6-month supply, as more homes are put up for sale in anticipation of the key spring home buying season and the expiration of the tax incentives.

The unusually prolonged drawdown in inventories has set off a strong cyclical recovery in parts of the factory sector. Advance orders for durable goods posted a 0.5 percent gain in February with January’s numbers being revised higher. Big gains in orders for machinery appear to be driving the overall increase. New orders for nondefense capital goods, excluding aircraft, rose 1.1 percent in February, but the previous month’s decline was a percentage point worse than first reported and now shows a 3.9 percent drop. The downward revision should cause forecasters to pull back their estimates for first quarter economic growth and may also signal a weaker trend for capital spending in general for 2010.

U.S. Outlook

Personal Income and Spending • Monday

Personal income is expected to advance at a moderate 0.2 percent pace in February. Aggregate income data from the February employment report proved disappointing, falling 0.2 percent on the month. This should continue to weigh on the wage and salary growth component of income. Personal consumption expenditures are expected to rise a more tepid 0.2 percent in February, after strong gains of 0.5 percent in January. Unit vehicle sales dropped 2.0 percent in February, which will be an important factor behind the somewhat slower trend in overall consumption spending. The chain PCE price index should continue to point toward slowing consumer inflation. Headline PCE is expected to be unchanged in February, reducing the year-0n-year growth rate to 1.8 percent. Fears of inflation forcing the Fed’s hand on interest rates appear overplayed at the moment.

Previous: 0.1 percent Wells Fargo: 0.2 percent
Consensus: 0.2 percent

ISM Manufacturing • Thursday

Regional manufacturing surveys for March suggest that manufacturing expansion remains firmly in place as we close out the first quarter. The rapid recovery in global trade, combined with the end of aggressive inventory cutting in the United States, is helping to boost manufacturing production at a healthy pace despite still-sluggish final demand growth from consumers and businesses. The March ISM index is expected at 56.7. This is a slight improvement from February’s 56.5 reading, but still below January’s 58.4, which marked the highest level since August 2004. The Chicago Business Barometer and Philadelphia Fed index both improved in March, though the Empire index moderated, suggesting a somewhat mixed picture on production gains in March. These ISM manufacturing levels are consistent with 6 to 7 percent industrial production growth on an annualized basis.

Previous: 56.5 Wells Fargo: 56.7
Consensus: 56.5

Employment • Friday

For March, we are finally expecting to see a positive net non-farm payroll print. The payroll report for February was encouraging in this regard: it revealed only a modest 36,000 net job loss in a month plagued by winter storms, suggesting the U.S. economy is on the verge of positive employment growth. A strong monthly boost from Census Bureau hiring should be the catalyst that finally pushes the payroll change into positive territory. The unemployment rate is expected to hold steady at 9.7 percent, though re-entering job seekers could still push the unemployment rate slightly higher in the months to come. Look for additional gains in working hours and hourly earnings to confirm the firmer labor market tone. Jobless claims remain stubbornly high, pointing to a weak underlying trend in private employment growth, and consumer confidence stumbled in light of labor market uncertainty.

Previous: -36 K Wells Fargo: 177 K
Consensus: 150 K

Global Review

The Argentine Economy Surprises on the Upside

• The Argentine economy grew by 2.6 percent during the last quarter of 2009 compared to the same period a year earlier, and by 0.9 percent for the whole year.
• The most important contributor to last year’s GDP performance for the Argentine economy was the collapse of imports.
• Government consumption increased by 7.7 percent during the last quarter of 2009 compared to the same period a year earlier, and rose 7.2 percent for the year as a whole.

The Argentine Economy Surprises on the Upside

According to the INDEC, Argentina’s statistical institute, the country’s economy grew by 2.6 percent during the last quarter of 2009 compared to the same period a year earlier. This result followed two consecutive negative quarters when the economy dropped by 0.8 percent and 0.3 percent in the second and third quarters, respectively. The fourth quarter growth helped the economy to avoid a negative performance during the whole of 2009 by posting an annual growth rate of 0.9 percent. Interestingly enough, the economy’s performance during the last quarter of the year was boosted by very strong personal consumption expenditures, which increased by 2.9 percent after dropping by 1.8 percent and 0.7 percent during the second and third quarters, respectively. However, personal consumption expenditures increased by only 0.5 percent during the whole of 2009.

The most important contributor to last year’s Argentine GDP performance was the collapse of imports. Imports of goods and services plunged by 19.0 percent in real terms during the year, while exports of goods and services dropped by only 6.4 percent. Thus, the strong drop in imports helped the economy prevent a deeper recession during the year as imports are a subtraction to GDP. On the other hand, the second most affected sector during 2009 was gross fixed investment, which dropped by 10.2 percent during 2009, the worst performance since the 2001-2002 financial crisis when gross fixed investment collapsed by a cumulative 52.1 percent in real terms.

Another contributor to growth during the year was strong government consumption. Government consumption increased by 7.7 percent during the last quarter of 2009 compared to the same period a year earlier, and rose 7.2 percent for the year as a whole. Thus, the Fernández-Kirchner administration continued to support economic growth through very strong fiscal policy at a time when fiscal revenues continued to dwindle due to the effects of the worldwide recession. Government consumption during 2009 was stronger than during the previous year even though the Argentine economy grew by 6.8 percent during 2008.

This is one of the reasons why many analysts are wondering if this policy is sustainable, considering that the Argentine government has been an international “pariah” and has not had access to international capital markets since the country’s default back in 2001. Many are wondering how long will it take for the country to default on its debt again if it cannot continue to finance its increased expenditures.

So far the administration has been able to “find” domestic financing through several measures that have captured increased revenues, but the situation is getting tougher, fundamentally because the government has lost the majority in the Argentine Congress and it is becoming more difficult to bypass the institution to continue the spending spree.

Global Outlook

German Unemployment • Wednesday

Despite the deep German recession – real GDP contracted nearly 7 percent between early 2008 and early 2009 – the unemployment rate in Germany has barely risen. However, the unemployment rate understates the weakness of the German labor market because many workers have been put on “short shifts” (i.e., hours worked have been reduced). The consensus forecast anticipates a small increase in the number of unemployed workers in March when the data print on Wednesday. Preliminary CPI data for March are expected to show few inflationary pressures in Germany at present.

Other data will offer further insights into the current state of the Euro-zone economy. Italy releases unemployment and CPI data as well next week. In addition, the sizeable increases in the Euro-zone PMIs that were reported in March are expected to be confirmed by final data next week.

Previous: 8.2%
Consensus: 8.2%

Canadian GDP • Wednesday

Like its large neighbor on its southern border, the Canadian economy has grown for the past two quarters after enduring a painful recession. Canada is alone among major countries that provide GDP data on a monthly basis, and data that are slated for release on Wednesday are expected to show the economy continued to expand at a strong pace in January. If the consensus forecast is realized, then the Canadian economy would be on pace to register an annualized growth rate in excess of 4 percent in the first quarter of 2010.

Data on raw material and industrial prices are also on the docket next week. Although prices of raw materials have risen significantly over the past year, the Bank of Canada is not likely to raise rates anytime soon because the core rate of CPI inflation remains very benign (i.e., only 1.3 percent in January).

Previous: 0.6% (month-on-month change)
Consensus: 0.5%

Japanese Tankan Index • Thursday

The quarterly Tankan survey that is conducted by the Bank of Japan is widely watched by investors. Not only does it contain a treasure trove of data on the Japanese economy, but the “headline” index, which measures sentiment among large manufacturers, is fairly correlated with real GDP growth. If, as expected, the “headline” index rises further, then investors will infer that the year-over-year growth rate in GDP in the first quarter rose into positive territory for the first time in two years.

Monthly data for February will offer further details about the present state of the Japanese economy. The consensus forecast looks for a small drop in industrial production last month, which, if realized, would be the first decline in IP in a year. Data on retail spending, the labor market and housing starts are also on the docket next week.

Previous: -24
Consensus: -14

Point of View

Interest Rate Watch

Cyclical Rise in Rates Reinforced by Structural Deficits.

Over the last few weeks the typical cyclical pattern of rising interest rates has become more obvious. Improved economic activity tends to be associated with rising credit demand. With each economic recovery, the demand for credit tends to increase as firms raise their expectations for stronger final sales. Meanwhile, on the credit supply side, the opposite pattern starts to emerge as the Federal Reserve begins to withdraw liquidity. For now, many investors appear to anticipate that the Federal Reserve will maintain its accommodative policy for the rest of this year. This may be true for the politically sensitive federal funds rate but behind the scenes the risk is that the cost of funds is likely to rise while longer rates will also rise as the Fed reduces its role in the Treasury and mortgage backed security markets.

Structural Deficits Reinforce the Cycle

In the last two weeks the long-run outlook for U.S. fiscal deficits has deteriorated for two reasons: Social Security and healthcare. Recent estimates suggest that the Social Security fund will experience spending outflows in excess of revenue inflows this year – much earlier than prior estimates. This suggests the entitlement problems that were anticipated with the retirement of the baby boom generation are coming earlier than many expected.

Meanwhile, the budget implications of healthcare have become more visible. First, there is lots of skepticism on the ability of future Congresses to really enforce cuts in Medicare. Second, there are very few elements in the healthcare bill to control costs.
Research done at the Federal Reserve suggests that it is expected future federal deficits that influence interest rates today. Financial markets are forward-looking and the outlook is not good. This outlook is reinforced by the understanding that much of the Federal deficit in the last year has been purchased by the Fed and Asian buyers – two buyers that the markets are less confident about going forward.

Consumer Credit Insights

ABS Slowdown May Hinder Spending

During the credit boom, issuance of asset-backed securities (ABS) soared, peaking at $1.2 trillion in 2006. Since then, ABS issuance has fallen off a cliff, with a mere $177.4 billion being issued in 2009, a whopping 86 percent decline from the peak. While the year-to-date total through March 2010 of $27.9 billion is 42 percent above the same period in 2009, issuance through the rest of the year will have to largely match the last nine months of 2009 in order for 2010 totals to surpass 2009.

Unfortunately, that may not happen. After rebounding from a scant $600 million in October 2008 to $26.4 billion in September 2009 as investors’ risk appetite returned, ABS issuance has slowed to just $9.2 billion in March 2010 as investors have turned cautious again. Following the cash-for-clunkers surge in fall 2009, auto ABS issuance has been cut in half. Credit card issuance has fared even worse as no securities have been issued in two of the last three months, leaving the three-month moving average at just $370 million versus about $8.0 billion last summer. Furthermore, the Fed’s assistance is waning as ABS holdings via the TALF have actually declined since December.

Over the last couple years, consumer spending growth has been closely linked to ABS issuance, lagging it by about six to nine months. Thus, the recent slowing of ABS issuance suggests consumer spending growth could remain sluggish as we head into the summer.

Topic of the Week

A Few Brief Comments on Healthcare Reform

The financial markets appeared to have already priced in passage of the healthcare bill before last weekend. Our early assessment is that, while there is a great deal of cost shifting taking place, the bill that passed was less onerous than many had feared. Unfortunately, the history of massive social spending programs is that they tend to grow larger and larger over time. Moreover, the scoring by the Congressional Budget Office (CBO), which shows the program costing $940 billion and reducing the deficit $138 billion over the 2010 to 2019 period, was based on a strict interpretation of the bill as it was written. The costs will likely be higher than the CBO estimate and the budget deficit will also likely be larger. Savings from Medicare cutbacks will likely be harder to achieve. Moreover, the extended phase-in of the program will likely lead to incessant political pressure to expand benefits and scale back the tax hikes. The healthcare bill will have relatively little impact on economic conditions over the near term as most of the provisions will not take effect for a couple of years.

There is little evidence the new healthcare law will hold down the price of healthcare. Healthcare costs have been rising faster than the overall inflation rate for about as long as can be remembered. The driving force for this increase has been the aging population, which has resulted in increased demand of healthcare services and a lack of market discipline in the healthcare marketplace. Most costs are paid indirectly either by insurance companies or the government. This leads to over-consumption and little to no price sensitivity.

The higher tax rates on investment earnings will draw more investment dollars into tax avoidance projects and lead to modestly lower investment throughout the economy. Likewise, the new tax on medical devices and pharmaceutical companies could lead to reduced profitability and thus less innovation and product development.

Please visit our website for the full report.

Wachovia Corporation
http://www.wachovia.com

Disclaimer: The information and opinions herein are for general information use only. Wachovia Corporation and its affiliates, including Wachovia Bank, N.A., do not guarantee their accuracy or completeness, nor does Wachovia Corporation or any of its affiliates, including Wachovia Bank, N.A., assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or any foreign exchange transaction, or as personalized investment advice. Securities and foreign exchange transactions are not FDIC-insured, are not bank-guaranteed, and may lose value.

Highlights

• Greek denouement looms
• RBI hikes, more coming from others
• SNB pulls the rug out from under EUR/CHF
• March 24 UK budget will be critical in pre-election positioning
• CAD–To parity and beyond
• Key data and events to watch next week

Greek denouement looms

FX markets continue to fluctuate broadly in recent ranges, turning with every twist in the ongoing Greek drama. Risk saw higher in the beginning of the past week as EU leaders appeared to be in agreement on a plan to provide an aid package to Greece. Then the German government indicated it could not legally support such a plan and that Greece should seek aid from the IMF, sending EUR/USD and most other risk assets lower into the end of the week. Then on Friday, EU Commission President Barroso confused matters further by advocating a standby financial aid mechanism of coordinated bilateral loans from Euro-area countries. The immediate Greek drama may be entering the final act, though, as next week’s EU summit is likely to see a definitive resolution one way or the other. If European leaders fail to reach an agreement, it will look very bad for Euro-area cohesion, exposing the fiscal vulnerabilities of other members now seen to be on their own, and likely see the Euro suffer as a result.

In the end, Greece will be bailed out, whether by the EU, the IMF, or some combination of the two, and we think the risk of a Greek debt default remains remote. Even though its last bond auction was well oversubscribed, Greece is facing unsustainably high borrowing rates and a package is needed to lower Greece’s borrowing costs and give the austerity plan time to work, otherwise a high cost debt-spiral would ensue. Once an aid package is resolved, we would expect some of the tempest to subside and for the EUR to stabilize and potentially recover. Given that EUR/USD has moved back to the lower end of the recent range, we would prefer to be buyers of EUR/USD while its holds above the key 1.3430/50 level. A daily close below that level, however, would suggest that the market was not in agreement with us and we would have to reckon with weakness down to 1.3200/50 initially.

From the charts, this past week’s price action mostly highlights downside potential ahead. Attempts to rally in EUR/USD, GBP/USD, XAU/USD and AUD/USD, all look to have been rejected, and the US dollar index has posted a weekly bullish engulfing line. But until the ranges break, fading the ranges (buying dips/selling rallies) still seems the most viable trading strategy.

RBI hikes, more coming from others

The Reserve Bank of India caught markets flat-footed on Friday with an inter-meeting rate hike of 1/4%, its first rate hike since July 2008, and the RBI indicated it would need to do more. The move itself was not unexpected, just the timing. But it should serve as a reminder that central banks globally are in the process of monetary tightening for those doing well (emerging markets mostly, maybe Canada–see below) or removal of extraordinary liquidity measures for those limping along (the G7). The PBOC, China’s central bank is widely expected to raise again its required reserve ratio, further restricting credit in China and potentially undercutting the global recovery. The Fed is also expected to further normalize (raise) the discount rate again before its next meeting. In most cases, such moves should only lead to short-term setbacks for risk appetites, and these may be sharp at times. However, we generally prefer to use such dips as a buying opportunity on risk assets.

SNB pulls the rug out from under EUR/CHF

SNB board member Jean-Pierre Danthine shocked markets by suggesting that the Swiss need to be prepared for higher rates and an eventual exit from accommodative policies. The CHF strengthened sharply on indications that the SNB was stepping back from its efforts to rein in CHF strength, and EUR/CHF plunged to essentially the all time low around 1.4315/20. Danthine later tried to put the cork back in the bottle, saying that the SNB will continue to counter excessive FX gains, but the markets were too busy unloading EUR/CHF to hear. We think the risk of intervention remains and we would not be surprised to see the SNB in the market sometime early next week. The fundamental flows, however, favor the CHF, especially if there is an EU impasse on Greek aid, so we would prefer to be sellers on the approach to 1.4500 should the SNB step in. SNB Chairman Hildebrand will be speaking on Tuesday morning in St. Gallen and he may stir things up. For those who anticipate a positive resolution to the Greek situation or believe the SNB is not done yet, it may be worth trying small longs in EUR/CHF, but with a highly disciplined stop loss below at around 1.4270.
March 24 UK budget will be critical in pre-election positioning

The March 24 budget will provide the incumbent UK government with a make or break opportunity to lay out its stall ahead of the general election. The release of better than expected public finances data for February will have put a small spring back in the step of Chancellor Darling. With just one month to go until fiscal year end the February data suggest that Darling will be able to announce that public sector borrowing this year is likely to be between GBP5 bln and GBP 10 bln less than forecast.

In essence this appears to be good news, but it requires qualification. Firstly, the February numbers may be better than expected but they are a far cry from good data. In the fiscal year to February net borrowing stands at GBP 131.9 bln. At this stage last year the borrowing requirement was around half the size at GBP66.5 bln; meaning that public finances are very much still in a shockingly poor condition. Not only that but there is risk that Chancellor Darling will use the news that the borrowing requirement is set to come in under his (very high) GBP 177.6 bln target to announce some pre-election sweeteners on March 24. The huge UK budget deficit (around 12.9% of GDP) is already a nasty thorn in the side of sterling, additional spending would not be welcomed by investors.

The recent falls in the value of the pound vs the US dollar are correlated with the fear that the general election (expected on May 6) will provide a hung parliament. The optimal outcome from the election as far as the markets are concerned would be a clear majority for the Conservative party insofar as this is more likely to bring a quicker resolution to the worries surrounding the huge UK budget deficit. Recently, there were signs that the Conservative party’s lead in the poll could again be increasing (albeit by probably not enough to win a clear majority) and this brought some support for the pound. Sterling also posted gains on the news that the February borrowing requirement data were better than expected. However, these gains proved to be short-lived. Further losses for the pound would be likely if the Labour party picks up more votes as the result of a pre-election giveaway at the March 24 budget. In the absence of clear evidence on March 24 that the incumbent government is committed to tackling the budget deficit cable could also see lower. The risks surrounding the pound suggest potential for a deeper decline. Below the GBP/USD1.4960/00 level may see towards USD1.4870.

CAD–To parity and beyond

Despite what has been a massive run-up of late, we maintain that the Canadian dollar still has considerable upside in the short/medium term. Rate hike expectations for the Bank of Canada (BOC) continue to increase, economic data in Canada remains robust and market positioning has yet to reach an extreme. These factors should help drive USD/CAD though parity and beyond.

Bank of Canada rate hike expectations continue to be nudged higher and the latest inflation report north of the border only increases the probability of a rate hike occurring sooner rather than later. Core consumer prices (excludes food and energy) jumped to an annual rate of 2.1% in February and this was well above the 1.7% run-rate expected. Remember that in their March statement, the Bank of Canada noted that core inflation had been "slightly firmer than projected" and the fact that it is now above their 2.0% target puts some pressure on the bank to potentially raise interest rates before their "end of 2Q 2010" line in the sand. We will have to see just how much of this pricing power at the retail level was due to the winter Olympics, but regardless, the trend in inflation remains decidedly higher and could force the bank’s hand. We may get an update from BOC Gov. Mark Carney next Wednesday (Mar. 24) when he delivers a speech and holds a press conference.

Canada also continues to outperform compared to the majority of the G-10 when it comes to economic growth. Not only have gross domestic product, international capital flows and housing starts come in better than expectations, but the all-important retail sales report (released just this week) blew away the consensus. Retail sales jumped 1.8% month/month in January and this was significantly better than the 0.5% market projection. The number in February is likely to be even stronger given the aforementioned impact from the winter games. This will continue to put Canada on better relative footing than most of the developed world and should continue to help attract capital to its shores.

Finally, while there has been much talk about the so-called overextended long position in the Canadian dollar, we must keep in mind that it is still well below the recent record. The non-commercial net position currently sits long 62,123 contracts and while this is quite elevated by historical standards, it remains nearly 30% below the 2007 highs when USD/CAD was making its 0.9058 low. In other words, there is plenty of room left to run here. Traders are now watching the 1.0050 level, where ostensibly a major option barrier lurks. Below there should see parity in no time.

While the Canadian dollar has the ability to rally on its own due to exceptional fundamentals, moves in other markets could help drive the move through the 1.00 level and beyond. In terms of what the CAD has been best correlated with since the beginning of the year, oil and stocks jump out. Loonie has moved in tandem with US equities 92% of the time in 2010 thus far and 85% of the time with oil. The relationships suggest that 1180 on the S&P 500 and/or $86 oil would translate to USD/CAD at parity.

Positive top-line 4Q earnings in the US coupled with massive amounts of flows out of money market funds suggests the upside in stocks remains in place. In terms of oil, the commodity is in what we would call a seasonal sweet spot. Looking back at the last 20 years, oil prices have rallied more than 10% on average from March through June – just in time for a Bank of Canada rate hike!

Key data and events to watch next week

The calendar lightens up in the United States in the week ahead. The under-the-radar Chicago Fed National Activity index kicks off the action on Monday. Existing home sales are due Tuesday while durable goods and new home sales are up on Wednesday. Initial jobless claims highlight Thursday while the final cut of 4Q gross domestic product and the University of Michigan sentiment index round out the week on Friday. Look out for a Bernanke testimony on Wednesday as well – these always have the potential to move markets.

It is also not very busy in the Eurozone. Consumer confidence starts off the week on Monday while French business confidence is due Tuesday. PMI indices, industrial new orders and the German IFO surveys are due Wednesday. French consumer spending is up Thursday while Friday has German consumer confidence due up. It will be a busy week in Brussels ahead of the EU summit on Thursday and Friday; expect a lot of headlines.

It is extremely light in the UK. Consumer prices are up on Tuesday, UK budget release on Wednesday, retail sales are due Thursday and business investment is scheduled for Friday.

Ditto for Japan. The BOJ meeting minutes kick things off on Monday, international trade is up on Tuesday while consumer prices are expected Thursday.

Canada is ultra-light, with leading indicators on Tuesday the only noteworthy release.

Don’t look down under for much excitement either. Australia has leading indicators on Thursday while New Zealand sees gross domestic product on Wednesday and trade numbers on Thursday.

Forex.com
http://www.forex.com

DISCLAIMER: The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase of sale of any currency. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness, nor does author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.

Gbp/Usd moved 100 pips higher during the European session after reports from the U.K. labor market hit the newswires that were better than expected. The minutes from the recent Bank of England rate meeting revealed that nothing much had changed from the previous month, and that CPI and inflation reads were as much to do with a weaker pound than instigated by internal growth.

The MPC minutes suggest that interest rate increases are just as far away in the U.K. as any other major region, with the exception of Australia. This news had a positive effect on the major currencies, but the pound is the only pair to make a substantial breakout.The euro had a shy attempt to break the 1.3800 area during the London open, but the move was quickly retraced, and the pair spent the rest of the European session trading in a tight range. Unless the infamous Greek problems are actually solved, rather than jawboned, there seems to be much more upside potential for the Aud, Cad or even the Gbp than the Eur. The two commodity currencies, the Aud and the Cad continued their march against the Usd.

The global market place is once again trading on light momentum, signaling that investors may be reluctant to invest fresh capital, especially around such vital values, and now that global equity markets have moved into deeply overbought territory. It will need a fresh fundamental reason to instigate the next long move if it is to be ahead of a reversal to support.

Every global asset (except the Usd) is currently trading in an overbought state on the 4-hour timeframes, and the same on most Daily chart reads, which raises some questions whether this non-stop buying can continue during the next few sessions. S&P traders have moved 80% of the last 30 sessions into the green, but a point to note is that the vast majority of that buying has been put in place by futures trade; the cash sessions have been weak in comparison.

The major currencies are also overbought, in a move that forced the dollar index lower, to hit the 79.50 area in intra-day trade, which is a price area not seen in a while, and a previous swing point of note that may get the major currencies snagged up on in intraday trade.

Global Risk Impacts Usd Ahead Of PPI

Dollar Index

The Usd is being sold in-line with the move to risk, away from Bonds (read Usd based Treasuries) ahead of the 8.30am ET U.S. PPI read on inflation at the factory gate. Price action around red-flag releases is creating strong volatility. The Fed confirmation of rates on hold for extended periods has impeded long-Usd plays. Momentum is strong. Favor a straddle (Long and Short near term plays).

S&P Futures

Global risk markets are being bought, and stocks are through 2010 highs. Positive news on low interest rates means equities move higher in the near-term, with very little selling now that global expansion is expected through 2011. Market participants are focused on the positives right now, with nothing able to block the upwards view. Equity index numbers are holding at their highest valuations since Sept 08. Momentum is building. 12-month 96% correlation to Aud and Cad moves. Favor a pull-back to support.

Crude Oil

The energy and the entire commodity market saw strong upside action over the last two days of trading. This comes as the Fed continues to maintain its pledge for low interest rates, which reduces the value of the U.S. dollar, but also provides an important prop to the demand side of the economy. Favor a pull-back to support.

Gold Bullion

The gold trading pattern is hard to characterize, as most of the time the precious metal seems to be driven by the market’s aversion to risk. Some view gold as the only asset that is actually worth holding, while other say that gold has no real value in the fiat currency world. Intra-day traders should seal themselves from both camps, and focus on its price action.

Written by TheLFB Trade Team, © 2007-2008 LFB Services, LLC. All rights reserved. http://www.TheLFB-Forex.com

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U.S. Review

Upbeat, Downbeat or Simply No Rhythm

• Economic news continues to come in mixed, with positive reports on retail sales and the trade deficit being offset by disappointing reports on small business optimism and unemployment claims.
• Revised employment data for states show larger job losses during the recession and cast some doubt on January’s drop in the national unemployment rate.
• Stronger retail sales and declines in imports led to surprising drops in inventories at retailer and wholesalers in January. Inventories rose slightly at manufacturers, however.

Still on Pace for a Modest Economic Recovery

February’s retail sales report was easily the best economic news released this week. Overall sales rose 0.3 percent during February, with strong gains reported across nearly every major category. Sales excluding gasoline, building material and automotive dealers, which is a category that tends to track the personal consumption data, rose 0.9 percent in February, following a 0.6 percent gain in January. The strong back-to-back gains suggest consumer spending will rise at a 2.2 percent pace or better during the first quarter, which is in line with our forecast, published earlier this week.

One complicating factor in the retail sales figures is that retailers have done a really good job at bringing inventories in line with sales and are discounting much less than they did in prior years. As a result, the better numbers reported for January and February may not reflect as much volume as they first appear. The lack of discounting is also apparent in the Consumer Price Index, which has shown larger price gains for core good prices. Prices for core goods are currently up 2.9 percent over the past year, which is their largest gain since the early 1990s.

One of the more disappointing reports released this week was the Small Business Optimism survey conducted by the National Federation of Independent Business. The survey fell 1.3 points in February and showed little to no improvement in most of its key components. Small businesses remain pessimistic about the near-term economic outlook and relatively few feel that it is a good time to expand their operations or hire additional staff.

The lack of improvement in small business optimism does not come as much of a surprise to those that follow the sector. Small businesses are often firms that are usually privately owned and the owners are intricately involved in the operations of their business. The owners likely hired the vast majority of the workers they currently employ, work side by side with them, and many had to let some of their workers go over the past couple of years. Most owners also have a great deal of the personal net worth invested in their business and are understandably cautious about putting their life’s work at risk. To further complicate matters, credit is harder to get for many firms, particularly those tied to the housing sector.

There were three key reports on the labor market this past week. One was slightly positive, while the other two pointed to continued trouble. The Job Openings and Labor Turnover Survey reported a sizable increase in job openings during January, with the job openings rate rising to 2.1 percent. The increase brings the number of job openings to 2.7 million. The ratio of unemployed to job openings fell a record 0.6 during the month to 5.5 workers per job opening.

The better unemployment rate data for January, which saw the nation’s jobless rate fall 0.3 percentage points to 9.7 percent, may have overstated the pace of recovery. Newly revised state data show the unemployment rate moving in the other direction, with increases reported in January for every major Census region.

U.S. Outlook

Industrial Production • Monday

Industrial production rose 0.9 percent in January, the seventh consecutive monthly increase. The string of gains dating back to July is consistent with our view that the recession likely ended in June. Both manufacturing and utility output contributed to the gain. Cold weather will likely continue to boost utility output in February. The headline ISM manufacturing index came in at 56.5 in February with new orders and production still solidly in expansionary territory. With inventory levels still relatively lean, the difference between new orders and inventories suggest further gains in production are likely in coming months. Capacity utilization, which peaked in 2006 at 81.2 percent, will likely continue its gradual upward trajectory, but is rising from very depressed levels. Consequently, pricing power will remain minimal.

Previous: 0.9% Wells Fargo: 0.2%
Consensus: 0.0%

FOMC • Tuesday

The Federal Reserve is expected to keep its federal funds target rate at its current level at the March meeting. Economic conditions including “low rates of resource utilization, subdued inflation trends, and stable inflation expectations” that have continued to warrant “exceptionally low levels of the federal funds rate for an extended period” are still in place. Our outlook continues to suggest that resource utilization should remain low through the end of 2010 with the unemployment rate peaking at around 10.1 percent. Moreover, the fed has historically not raised rates while the unemployment rate is rising. Further, inflation trends as measured by the core PCE deflator remain well within the Fed’s comfort zone at 1.4 percent year over year. Finally, one measure of inflation expectations, the TIPS spread, is a little more than 2 percent, suggesting inflation expectations are contained.

Previous: 0.25% Wells Fargo: 0.25%
Consensus: 0.25%

CPI • Thursday

The Consumer Price Index (CPI) rose 0.2 percent in January. The overall CPI is now up 2.6 percent year to year, while the core CPI is up just 1.6 percent. With housing in obvious oversupply, rent and owners’ equivalent rent should continue to moderate in coming months keeping core consumer prices relatively tame. Goods prices, however, are continuing to rise faster than services prices. Goods prices were up 2.9 percent over the past year in January, the largest increase since the early 1990s. Core goods prices are being pulled up by stronger global economic growth, while weak domestic demand continues to restrain core services prices. Higher retail gasoline prices will likely also push the headline higher. We expect headline CPI to increase 2.3 percent year-over-year in February and core CPI will likely register a modest increase of 1.4 percent.

Previous: 2.6% (Year-over-Year) Wells Fargo: 2.3%
Consensus: 2.3%

Global Review

Brazilian Economy Surges on Domestic Consumption

• The Brazilian economy surged during the last quarter of 2009 on the back of personal consumption expenditures and government expenditures. Given the faster-than-expected rate of recovery, we will likely raise our forecast for 2010 GDP growth.
• For the full year, the economy slipped 0.2 percent in real terms during 2009 after growing 5.1 percent in 2008.
• Our primary concern in Brazil going forward is inflation.

Brazilian Economy Surges on Domestic Consumption

The Brazilian economy expanded substantially during the last quarter of 2009 on the back of personal consumption and government expenditures. Personal consumption expenditures jumped 7.7 percent during the fourth quarter of the year compared to the same period a year earlier, while government consumption posted a 4.9 percent growth rate over the same period. The growth in private and public consumption was largely engineered by the administration through very specific fiscal programs as well as a very accommodative monetary policy by the Brazilian central bank.

The economy dropped 0.2 percent in real terms during 2009 after growing 5.1 percent during 2008. It is clear that the Lula administration had to put some type of domestic package together during the year because exports remained very weak even as the world economy recovered. Exports of goods and services dropped by 4.5 percent year over year in the last quarter of 2009 and by 10.2 percent during the whole of 2009 after a decrease of just 0.7 percent during 2008.

After three miserable quarters for gross fixed investment, there was a welcome turnaround in the fourth quarter. This is an important dynamic because fixed investment spending is going to provide some sustainability to the current recovery, especially as the external sector comes back. Gross fixed investment grew by 3.6 percent during the fourth quarter of the year compared to the same quarter a year earlier but dropped by 9.8 percent for the whole of 2009 compared to the previous year.

Our main concern going forward is Brazilian inflation. The Lula administration will have to scale down government programs put in place during the last two years if it does not want to suffer another bout of accelerating inflation, especially during an election year, which is normally a very difficult time for inflation expectations.

Even though the country has advanced considerably in terms of productive infrastructure, it still needs to invest more to reduce productive bottlenecks that occur once the economy is growing at a fast pace. Thus, gross fixed investment will have to keep advancing at a much faster pace than it is today to help relieve some of the pressure on the supply side of the economy.

Given the faster-than-expected rate of recovery, we will likely raise our forecast for 2010 GDP growth. That said, there are still some risks attached to this forecast, and the fundamental risk is renewed inflationary pressures. We have already seen the first signs that inflation is coming back, and if domestic consumption continues to remain as strong as it is today, then the problems will worsen as the external sector continues to recover. Thus, the central bank will have to move sooner rather than later, and this could slow down growth during the second half of the year. For this reason, our forecast is likely to remain below the consensus forecast of almost 6 percent for 2010.

Global Outlook

Japanese Machine Tool Orders • Monday

The Japanese economy surprised markets by posting a very strong 4.6 percent rate of growth during the last quarter of 2009. Early indications point to a very strong number for Japanese machine tool orders next week, which could point to relatively strong growth during the first quarter of this year.

However, these expectations will have to deal with the blow coming from the automobile industry where Toyota has continued to face production slowdowns and stoppages as well as reputation hits that have severely affected the company’s performance. Thus, while the economy seems to be on the mend, it is still too early to gauge how serious Toyota’s problems will be for the overall economy. So far, the news coming form Japan seems to point to a somewhat negligible effect, but we will not be surprised if this changes during the next several months.

Previous: 67.8
Consensus: N/A

U.K. Unemployment Rate • Wednesday

While the U.K.’s unemployment rate remained at 7.8 percent during the last quarter of 2009, there is plenty of evidence that the employment situation has continued to deteriorate during the first quarter of this year. Production measures like the industrial production index have remained in negative territory even as other countries’ indices have rebounded strongly during the last several months.

The weak employment situation is clear when looking at the unemployment claimant count. This measure, which shows those workers seeking unemployment insurance, increased by 23,500 in January to 1.64 million, the highest level in 13 years, and was up by 381,800 compared to January of last year. Thus, while the U.K. economy is recovering from the recession, the pace of this recovery is still very weak.

Previous: 7.8%
Consensus: 7.9%

Canadian Retail Sales • Friday

The rebound in Canadian economic activity has been significant, and next week’s retail sales activity could confirm the recovery in domestic demand, which was also prey to the global economic downturn during the last two years. Retail sales in December of 2009 posted a very strong growth of 6.7 percent, and we should expect that trend continued during the first month of 2010 as the economic recovery gained momentum.

Meanwhile, commodity prices have increased considerably over the last several months, and this is giving the external sector and the economy as a whole some more ammunition to continue its current expansion. Petroleum prices are once again on the way up, and this is very good news for the Canadian petroleum sector and for domestic consumption.

Previous: 0.4% (Month-over-Month)
Consensus: 0.5%

Point of View

Interest Rate Watch

Fed Exit Strategy

We are skeptical. This perfect strategy sounds too much like the British invasion of Gallipoli. Seldom have we had so much policy easing in so many new and untried ways, and now we are looking at getting out with no problems? Effective communication is the way we have heard it expressed but already we have the Treasury SPF program announcement with some confusion about what is the purpose of this rebuild of the program from $5B to $200B over the next two months. The Fed’s announcement of the discount rate hike did catch many observers by surprise. Certainly we do not expect the Fed to have a perfect plan that will be laid out so that everyone will know exactly what to expect at all times and we have already seen two examples where actions that entail credit markets effects have not been perfectly anticipated. Why would we expect future actions to be perfectly anticipated? Instead our expectation is for short-term rates to be more volatile and drift upward over the next six months. There is uncertainty about the commitment of the Fed to drop further intervention in the mortgage backed security (MBS) market. Without the continuation of the Fed’s significant buying over the last six months our expectation is that mortgage rates will drift up as growth and inflation expectations rise with the economic recovery while the Fed drops out as a major buyer of MBS. Much uncertainty remains among investors that the Fed can remain out of the mortgage market due to the political pressures to support the economy and housing. Yet any Fed return to intervention in the MBS market would suggest that the Fed’s balance sheet is not going to be reduced and that growth, not inflation, is the goal. In this case the Fed’s inflation-targeting credentials will be tarnished—especially in an election year.

Our outlook is that both short and long-term interest rates will rise this year as the economy continues to recover. However the rise in rates will limit the gains in housing and consumer durable purchases this year. Rebalancing the consumer balance sheet does require less spending.

Consumer Credit Insights

Rebalancing the U.S. Consumer

One of the key drivers for the pace of the recovery will be the actions of the U.S. consumer. If the consumer does shift toward higher savings and paying down credit/debt obligations we will see a slower pace of growth in the short run. Yet if the consumer returns to old ways then leverage will drive spending again.

This week’s Flow of Funds data from the Fed suggested that households are downshifting on debt and raising that saving rate. Household total liabilities (debt) fell for the fifth straight quarter. Liabilities declined for both home mortgages and consumer credit. Meanwhile, the personal saving rate came in at four percent and is off the sub-two percent range that characterized the 2005-2008 period.

On the asset side, homeowners’ equity as a share of household real estate has begun to recover and we expect this recovery will continue for several years. Household net worth also continues to recover although it remains beneath the 2007 peak.

Our outlook is for consumer spending growth to remain subpar in 2010 and 2011 compared to the 2004-2007 period. Both housing starts and light vehicle sales will therefore remain significantly below the pace of that same period. With more modest consumer spending comes more modest economic growth and thereby continued stress on state and local sales tax revenues.

Topic of the Week

State Finances Face a Tough Road Ahead

Even with the recovery finally taking hold, the outlook for state finances remains bleak. The exceptionally weak labor market, with high and unusually long-term unemployment, continues to restrain personal income tax receipts, while falling home prices and disappointing retail sales are hitting property and sales tax collections. State lawmakers already closed a cumulative budget gap of $158.5 billion earlier in fiscal year 2010, but new gaps have emerged as revenues have failed to keep pace with spending. Midyear budget gaps bring the total shortfall for fiscal 2010 to $196.2 billion.

Revenues are expected to decline further as state tax collections traditionally lag trends in the overall economic recovery. In the previous recession, tax revenues lagged nearly a year following the end of the recession. The extended drag on revenues is due to the weak labor market, which weighs on personal income, consumption and corporate profits growth. State tax revenues were down nearly 11 percent on a sequential basis in the third quarter and are 33 percent below the peak reached in the second quarter of 2008. Preliminary figures for the fourth quarter from The Nelson A. Rockefeller Institute of Government showed continued weakness with total tax revenues declining 4.1 percent. Declines have moderated, however, reflecting fewer layoffs, a slight increase in hours worked, and a slightly better-than-expected holiday shopping season.

Many states have already projected huge budget gaps for fiscal 2011 with estimates of $103.5 billion. Provisions in the proposed federal budget for fiscal 2011, however, will likely not be enough to offset growing budget concerns. With many states having already scaled back many nonessential services and boosted taxes and user fees, there are few easy alternatives left. The drag from state and local government will continue to be a drag on GDP growth, further slowing an already modest economic recovery.

Please visit our website for the full report.

Wachovia Corporation
http://www.wachovia.com

Disclaimer: The information and opinions herein are for general information use only. Wachovia Corporation and its affiliates, including Wachovia Bank, N.A., do not guarantee their accuracy or completeness, nor does Wachovia Corporation or any of its affiliates, including Wachovia Bank, N.A., assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or any foreign exchange transaction, or as personalized investment advice. Securities and foreign exchange transactions are not FDIC-insured, are not bank-guaranteed, and may lose value.

U.S. Review

Making Progress on the Road to Recovery

• December’s employment report was generally disappointing, with a larger than expected 85,000-job decline in nonfarm payrolls and huge declines in household employment and the civilian labor force.
• Most major chain stores reported better-than-expected results for December.
• Manufacturing activity improved toward the end of 2009, with factory orders rising solidly and the ISM manufacturing survey ending the year at 55.9.

Employment Gains Are Not There Yet

December’s employment report was somewhat of a disappointment. Many were expecting a small increase in employment to be reported for December, even though the consensus was calling for a small decline. Our own forecast called for a larger than consensus drop and we had repeatedly noted that the optimism so many were showing was premature. The actual data proved to be weaker than our forecast, with nonfarm payrolls declining by 85,000 in December and the household survey showing substantial drops in both employment and the labor force.

Revisions to the previously published data produced a slight increase in employment during November. The 4,000 job increase was the first since the recession began back in December 2007. Any celebration about November’s increase was tempered by downward revisions to the October data. On net, the employment data were revised down for the two previous months by 1,000 jobs. Moreover, benchmark revisions will be made to the employment data next month dating back March 2008. The BLS has reported the revision would be around 0.6 percent, which would result in an additional 830,000 job losses over the past two years.

The unemployment rate was unchanged at 10.0 percent, but beneath the surface there was a great deal of weakness. Both household employment and the civilian labor force tumbled in December, with the labor force plunging 661,000 and employment declining by 589,000. In addition, both the average and median duration of unemployment increased during the month, reflecting the continued difficulty the unemployed are having finding another job.

While the December employment report was disappointing there were some positive rays of hope in the report. Hiring at temporary staffing companies posted its fifth consecutive increase, with employment rising by 47,000 in December. Aggregate hours worked also held on to their strong 0.6 percent November gain and the percentage of industries adding jobs held above 40 percent for the second month in a row. All these are things that typically improve six to nine months before employment begins to rise. We continue to believe the economy is moving closer to the point where we will see consistent and meaningful gains in nonfarm payrolls, but we are not there yet.

Early reports from the holiday shopping season continue to come in ahead of expectations. Chain store sales for December rose a solid 2.8 percent over their year ago level. The increase is at least partly due to less discounting on the part of retailers, so likely reflects less of an increase in volume. The government figures due out next week will also likely show less strength as they are adjusted for holidays and Thanksgiving came early this year.

Data from the manufacturing sector is another bright spot. Business inventories have been drawn down to the point that orders and output are now rebounding, even with only minor gains in final demand.

U.S. Outlook

Retail Sales • Thursday

Advanced retail sales rose 1.3 percent in November with broad-based gains across most sectors. “Core” retail sales, which exclude gasoline, building materials and autos rose 0.5 percent, the fourth consecutive monthly gain. “Core” retail sales were driven by an increase in electronics which rose 2.8 percent in November. The better-than-expected gain in retail sales kicked off the holiday season above last season’s levels. Due to lean inventories, retailers went into this holiday season in a far stronger position. The large discounting seen during the previous holiday season was far less prevalent. We expect headline retail sales will continue the positive momentum and will likely increase 0.6 percent, driven by increases in gasoline station and motor vehicle sales. Excluding motor vehicle sales, retail sales likely rose 0.4 in December. Chain store sales rose 2.1 on a sequential basis percent in December.

Previous: 1.3% Wells Fargo: 0.6%
Consensus: 0.4%

CPI • Friday

The headline Consumer Price Index (CPI) rose 0.4 percent in November largely due to increases in transportation-related prices like gasoline and motor vehicles. Core CPI, which excludes food and energy, was flat on the month. With housing in obvious oversupply, rent and owners’ equivalent rent should continue to moderate in coming months keeping core consumer prices relatively tame. Goods prices are rising faster than services prices and were up 2.6 percent over the past year. The gain marks the largest increase in goods prices since the early 1990s. Core goods prices are being pulled up by stronger global economic growth, while weak domestic demand continues to restrain core services prices. We expect headline CPI to increase 0.2 percent in December and core CPI will likely register a modest increase of 0.1 percent.

Previous: 0.4% Wells Fargo: 0.2%
Consensus: 0.2%

Industrial Production • Friday

Industrial production rose 0.8 percent in November, the fifth consecutive monthly increase. The recovery in manufacturing remains intact with gains fairly broad-based. The headline ISM manufacturing index came in at 55.9 in December driven by gains in new orders and production suggesting more upside momentum. Forward looking new orders rose to 65.5 and suggests a sixth consecutive monthly gain in industrial production. Record cold weather in December should result in an outsized gain in utility output. We expect headline industrial production rose 0.4 percent in December. Capacity utilization, which peaked in 2006 at 81.2 percent, will likely continue its upward momentum, but is rising from very depressed levels. We expect capacity utilization will likely rise to 71.6 percent in December, but at such historic low levels, pricing power will remain minimal.

Previous: 0.8% Wells Fargo: 0.4%
Consensus: 0.6%

Global Review

Euro-zone: Where Is the Recovery?

• The purchasing managers’ indices in the Euro-zone suggest that real GDP growth likely remained positive in the fourth quarter. However, “hard” data have been less encouraging. Although we expect that economic growth in the euro area will remain positive, we believe that the pace of expansion will remain frustratingly slow over the next few quarters.
• The core rate of inflation continues to trend lower. With benign inflation and a weak recovery, we expect that the European Central Bank will refrain from raising rates well into the second half of the year.

How Strong is the Expansion in the Euro-zone?

The purchasing managers’ indices in the Euro-zone rose further into expansion territory in December, suggesting that real GDP growth in the euro area remained positive in the fourth quarter. Indeed, the service sector PMI rose to its highest level since autumn of 2007 (See graph on front page). Although we concur with the view that the expansion in the euro area remains intact, we believe that the pace of recovery will remain quite modest, at least in the near term. Real GDP rose at an annualized rate of only 1.7 percent in the third quarter relative to the previous quarter, and we project that the economy eked out a similar rate of expansion in the fourth quarter.

Despite solid readings in the PMIs, “hard” data from the Euro-zone have been generally disappointing lately. For example, industrial orders declined 2.2 percent in October, more than reversing the 1.7 percent increase registered during the previous month (top chart). Moreover, orders in the overall euro area have been flat on balance since July. German orders rose 0.2 percent in November relative to the previous month, which holds out hope that orders in the Euro-zone also edged up in November, but the outturn can hardly be characterized as robust.

Flatness in orders over the past few months has translated into softness in industrial production (IP). Indeed, the fourth quarter got off to a weak start as Euro-zone IP dropped 0.6 percent in October relative to the previous month. In Germany, IP in November retraced some of its large decline in October, which suggests that IP in the overall euro area may also have bounced back somewhat during the month. (Official data will be released next week – see page 5). Weakness in the production of consumer goods has helped to weigh on Euro-zone IP recently.

In that regard, retail spending in the Euro-zone remains weak. Indeed, the volume of retail spending (excluding autos) in the overall euro area was nearly 4 percent below its year-ago level in November (middle chart). It is not often that we apply the term “strong” when we refer to consumption expenditures in Germany and Italy, but consumer spending in these two countries is holding up better (in relative terms) than in most other economies in the Euro-zone. Real retail spending in Italy is essentially flat while German consumer spending is down “only” 3 percent. In Spain and Ireland, which are both reeling from the fallout of their burst housing bubbles, real retail sales are down about 6 percent. Greek consumer spending is down an incredible 15 percent on a year-ago basis.

CPI inflation in the Euro-zone recently returned to positive territory due to the rise in energy prices from their lows last year (bottom chart) However, the “core” rate of CPI inflation has declined to its lowest rate in nearly nine years due to economic weakness in the Euro-zone (bottom chart). As we discuss on page 5, the European Central Bank holds a regularly scheduled policy meeting next week, and the probability that the Governing Council hikes rates next week is miniscule. Indeed, we believe that the ECB will be on hold well into the second half of the year.

Global Outlook

Euro-zone IP • Wednesday

From its peak in April 2008 to its nadir a year later, industrial production in the Euro-zone plunged 20 percent. IP has subsequently ground higher, but it remains 18 percent below its peak. Moreover, the fourth quarter got off to a weak start as production declined 0.6 percent in October relative to the previous month. November data for France and Italy as well as the overall euro area will offer further insights into the current state of the economy. In that regard, Germany reported this week that IP rose 0.7 percent in November relative to the previous month.

The European Central Bank (ECB) holds its monthly policy meeting on Thursday, and there is very little chance that the ECB will change its main policy rate from its current setting of 1.00 percent. Not only is the Euro-zone economy weak at present, but the core rate of inflation has dropped to a 9-year low of only 1.0 percent.

Previous: -0.6% (month-on-month change)
Consensus:

U.K. Industrial Production • Wednesday

As in the case of the Euro-zone, industrial production in Great Britain tanked in late 2008/early 2009. Although British IP has stabilized, it has yet to exhibit much of an upward trend. However, the manufacturing PMI has been above the demarcation line that separates expansion from contraction for three consecutive months, suggesting that production should increase sooner or later. Indeed, the consensus forecast anticipates that industrial production rose 0.3 percent in November relative to October.

The widely followed NIESR estimate of GDP growth will also be released on Wednesday. In the September – November period, real GDP was estimated to have increased 0.2 percent (not annualized) relative to the previous three-month period. If December’s outturn is also positive, it would add to the growing body of evidence that the British economy is starting to expand again.

Previous: 0.0% (month-on-month change)
Consensus: 0.3%

Australian Unemployment Rate • Thursday

The downturn in Australia was relatively mild compared to what was experienced in many other foreign economies. Public infrastructure spending is helping to jumpstart the economy and three consecutive months of payroll growth has started to spark domestic demand. Retail sales have posted two straight months of gains, and the 1.4 percent jump in November was much stronger than the 0.3 percent gain that the consensus had expected. Market watchers down-under will have their eyes on the Australian employment report on Thursday of next week as the consensus is expecting a fourth month of job growth.

In mid-December, the deputy governor of the Reserve Bank of Australia (RBA) indicated that monetary policy has moved into a “neutral” range, which has led some investors to question whether the RBA would hike rates again at its next policy meeting on Feb 2.

Previous: 5.7%
Consensus: 5.8%

Point of View

Interest Rate Watch

Into The Fray of Monetary Policy

The latest episode in the current saga of monetary policy in the Unites States happened last week between the Fed Chairman Ben Bernanke and “Taylor’s Rule” proponent John Taylor. The latter argues that monetary policy was at the heart of the causes of the last recession, while Bernanke argues that lack of regulation, not lax monetary policy, was the problem.

This is nothing new. Economists are still arguing about what caused the Great Depression back in the 1930s. The only thing that is clear is that when you generate economic activity by pushing interest rates too low it causes the economy to grow faster than its long-run sustainable rate. At the beginning of the cycle demand outpaces supply and when supply catches up and many times surpasses demand, something unexpected happens. This could be a shock to the economy, like a reversal in capital flows, or a sudden collapse of the financial sector, etc., and the house of cards collapses.

This is what happened to the East Asian countries (the so called Asian Tigers) back in the late 1990s. They put forward a development model that was dependent on exports and very low, subsidized interest rates. This policy of very low interest rates pushed demand over its sustainable limit and supply way over this limit.

Monetary policy exists to support economic activity but if this policy is not also conducive to sustainable growth, the responsible monetary institution or central bank has to adjust its course. And it is very difficult to argue that interest rates were not extremely low during the preceding period in the United States and that housing demand was not growing without bound. True, the Fed was arguing that a “world awash in savings” was the problem, not Fed policy. This gives the impression that the Fed has lost its ability to influence monetary variables. Both Bernanke and Taylor have good arguments, but the question remains, why did the institutions not work to prevent the crisis?

Consumer Credit Insights

Did the Holidays Lead to Credit Use?

Consumers have been cutting their outstanding credit balances at unprecedented rates. Consumer credit balances outside of mortgage loans have been cut in 13 of the 15 months through October 2009—with an aggregate decline of $98.7 billion. At the same time the personal saving rate has remained well above the levels we saw during the last expansion. However, did consumers change their minds about credit use again during the holiday season? Perhaps just as importantly, did banks change their minds on credit standards in the early stages of the recovery?

Holiday sales have come in better than expected than in early reports. November retail sales were considerably better than originally anticipated and reports from retailers have been generally positive on December sales as well. The question about credit providers remains: did consumers use savings, income or credit accounts to finance this year’s holiday buying? We get an early reading late on Friday afternoon with November consumer credit data. The market is looking for another drawdown in outstanding balances of $5 billion.

Strong gains in outstanding credit are unlikely before the labor market shows more meaningful improvement. And while gains are likely on trend within the next few months, December data showed an unexpected setback.

Topic of the Week

Fear Not, the Sun Will Shine Again in Florida

Florida’s economic recovery looks like it will take a little longer to build momentum than much of the rest of the country. The Sunshine State is much more dependent on the continued inflow of new residents from other parts of the country to drive economic growth, and migration trends turned exceptionally negative during this recession. Florida saw its first domestic net out-migration since the immediate aftermath of World War II during 2008 and 2009, with residents increasingly relocating to other Sunbelt states, such as Georgia, the Carolinas, Tennessee and Texas. Population still increased, however, with gains from international immigration and a small natural increase offsetting the net loss of state-to-state migration. The primary reasons Florida is losing residents to other states is the dramatic increase in housing costs, including the price of insurance and property taxes, as well as the state’s greatly diminished employment prospects. Nonfarm employment declined 9.1 percent over the past two and a half years, producing a net loss of more than 736,000 jobs. The unemployment rate has shot up more than 8.0 percentage points from its pre-recession lows, hitting a modern era high of 11.5 percent in November.

Efforts have been made to diversify Florida’s economy away from its historical dependence on tourism and population inflows. Much of Florida’s existing base of industries is tied to servicing Floridians. One notable exception has been international trade, which has been a key growth area. Trade has led to enormous growth at several of the state’s major port facilities and South Florida is home to hundreds of Latin American headquarters for major U.S. and global multinational companies. Efforts have also been made to bolster the healthcare and biomedical industries in South Florida and central Florida. While these efforts hold great long-term promise, the immediate impact has been limited, and the size of these industries is still relatively small compared to the overall Florida economy. Please visit our website for our complete Florida Chartbook.

Wachovia Corporation
http://www.wachovia.com

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Trading volumes and data were light this week as markets wound down ahead of the holidays. In the US, the November housing starts and building permits data bounced back from the softness seen in October. The FOMC kept interest rates on hold and slightly sweetened its economic outlook, although this positive note was somewhat offset by the second consecutive increase in weekly jobless claims. The dollar gained steadily for a second week against the euro and the yen as sovereign debt issues continued to roil the Euro Zone, while gold hit a one month low below $1,100 on Thursday. The Senate Banking Committee voted to move the nomination of Fed Chairman Bernanke to a full Senate vote, but not without another round of Bernanke bashing from the usual quarters (even after Time named Bernanke the Man of the Year). In the background, there were dark rumblings: PIMCO’s Bill Gross raised his cash holdings to the highest level since the failure of Lehman in Sept 2008, while BoA/Merrill Lynch analysts discussed the possibility of a “Valentine’s day massacre” market correction in Q1 that could stem from the end of the Treasury’s MBS buying program or other factors, and Meredith Whitney took another swipe at banks, cutting her 2009-2011 EPS targets on JP Morgan, Goldman and Morgan Stanley. US equity markets closed the week out on high volume due to quadruple witching and the quarterly Q&P rebalancing. Equity indices ended mixed for the week, with the DJIA down 1.3%, the Nasdaq rising 1%, and the S&P 500 slipping 0.4%.

Little was expected from the FOMC this week, although ahead of the decision an FT article prompted speculation that, in a nod to the ECB, the Fed might choose to distinguish between liquidity and monetary policy, specifically by raising the discount rate from the existing 0.50% level and simultaneously keeping the Fed Funds target rate steady at 0-0.25%. The discount rate hike never came to fruition, but the FOMC did alter its policy statement to remind markets that most of its special liquidity facilities are scheduled to wind down in Q1 2010. As expected, the Fed funds rate was kept unchanged and the commitment to keeping rates on hold for an “extended period” was reaffirmed, with the economic outlook paragraph slightly more optimistic.

Citigroup has wasted no time in scaring up the capital it needs to pay back the US Treasury. The bank said on Monday that it would sell more than $20B in debt and equity to repay a portion of its TARP funds, and had priced a 5.4B share offering at $3.15/share by Thursday morning. Wells Fargo was right behind Citi, announcing later on Monday that it would repay its entire TARP stake. It priced an offering of 426M shares at $25/share. Note that a number of regional banks have not disclosed any plans for repaying TARP as of yet and have lost ground this week, including SunTrust and Fifth Third Bank. Meredith Whitney was out this week ripping the more solvent end of the industry, cutting her earnings estimates on Goldman Sachs, Morgan Stanley and JP Morgan well below the consensus.

Exxon made a big vote of confidence in the shale gas industry by announcing a $31B deal to acquire major player XTO Energy. The deal could begin a new rush to own North American natural gas assets by major integrated names and may set off significant consolidation in the energy industry. Exxon will buy the firm for $31B in Exxon common stock and also assume $10B in XTO debt. Other leading natural gas names such as Apache, Devon Energy, Anadarko, EOG, Chesapeake and Nabors gained steadily this week on news of the acquisition. The deal is not a sure thing, however. Congress will certainly hold hearings on the move, while scrutiny of the environmental impact of shale drilling technology has been growing. Note that Congress is mulling restrictions on some of these techniques.

Strong earnings from selected tech names helped the NASDAQ outperform the Dow and S&P500 this week. Adobe, Oracle and Research in Motion reported better than expected quarterly results and offered strong forward-looking guidance. Executives from Adobe said demand improved in the quarter, while over at Oracle management said they expect the EU to clear Oracle’s acquisition of Sun. RIMM’s shipment volume grew more than 20% sequentially and new subscribers were up by more than 12% q/q. Intel took a hit this week when the FTC sued the company for using its dominant market position for a decade to stifle competition and strengthen its monopoly.

Trading in US Treasuries revolved around the FOMC statement this week. The yield curve hit fresh steepening highs post FOMC, with 2 10-year spread getting as wide as 278bps. Yields have traded in a fairly wide range over the course of the week, the benchmark 10y Note ascended though 3.60% for the first time since late summer, only to retreat to more respectable levels holding near 3.5% as the week drew to a close.

The Greek fiscal tragedy took more twists and turns this week. The government announced a number of ambitious debt and deficit reduction targets early on while the finance minister embarked upon a confidence building tour of Europe’s major financial centers. But in the absence of any specifics bond markets and rating agencies remain unconvinced. S&P joined Fitch in downgrading the Hellenic Republic to BBB+ on Wednesday. The downgrade leaves Moody’s flying solo with an A1 rating two notches above its peers. Should Moody’s choose to recalibrate its rating to be closer to the other agencies, Greek government bonds would be ineligible collateral for ECB liquidity operations (if and when it decides to return to pre crisis rules) which would likely set off a chain reaction of issues for Greek banks. With the ECB making tentative steps toward the exit earlier this month, the story is clearly not going away any time soon. Bunds have been the main beneficiary, with safe haven flows sending the yield to within one basis point of the 3.10% level last tested in April. Greece’s 10-year is now a hefty 260bps wider , while 10y UK Gilt yields hit fresh 2009 highs above their German counterpart near +70bps as polls began to point to a hung parliament in next year’s general elections.

In currencies, trading saw more turbulence in the Euro Zone thanks to Greece’s second credit downgrade and a negative call out of Moody’s on the Irish banking system. Safe-haven flows out of peripheral debt weighed on the euro throughout the week, while year-end repatriation flows further aided dollar sentiment. Stresses are starting to filter down to the European financial sector: a Fitch analyst said European banks could face rating actions over commercial property losses and the ECB revised its Euro Zone bank write-down forecast to €553B from €488B prior for the 2007-09 period. The greenback is at its best levels of the last three months against the Euro and Swiss Franc thanks to these stories as well as thinning year-end liquidity conditions. Interest rate differentials have also played a role in helping the dollar, as reflected in notably widening yield spreads between the US and both Europe and Japan.

The technical picture has been constructive for the dollar, with 200-day moving averages were back on the radar, particularly against the European pairs. The FOMC statement only sustained the dollar’s momentum, with the Fed offering a slightly more optimistic economic outlook. An alleged 1.4500 option barrier was breeched mid-week electing some stop loss selling in EUR/USD and triggering a broad adjustment across the G10 currency regime. Dealers said there were decent option flows, with a European name buying two-month EUR/USD puts with strikes between 1.36-1.40 early in the week. EUR/USD tested the 1.4530 level after the German IFO barely registered a 50 reading, demonstrating the fragility of the economic recovery. EUR/USD tested just below 1.4300 on Friday, hovering near its 30-week moving avg.

Sterling benefited the most on the initial news regarding Dubai World debt restructuring as the week began. GBP/USD tested above 1.64 after UK jobless claims declined for the first time since Feb 2008, although GBP was weighed down following the weaker UK retail sales data. UK newspaper The Daily Mail noted that the world was losing faith in the UK’s debt load and concerns about the vast quantity of gov’t bonds that would have to be sold over the coming years.

Commentators discussed the Swiss National Bank’s slow exit from expansionary policy this week, strengthening the Swiss Franc. Although the SNB’s Roth confirmed that the bank would continue to work to avoid franc appreciation, the market had other ideas. The rush to safe havens weighed on EUR/CHF during the latter part of the week, sending the cross below the pivotal 1.5000 level. Recall that this was deemed the “line in the sand” during the initial Swiss currency intervention back in March on rumors of a coup in Pakistan. The cross was off its Asian lows of 1.4910 but has yet to regain a foothold above the 1.50 level.

Expectation for a fourth consecutive interest rate tightening by the Reserve Bank of Australia at its next meeting in February repeatedly came under pressure from disappointing economic data and dovish central bank rhetoric this week. Starting on Tuesday, the minutes from the last meeting revealed a closer than expected decision to raise rates. The Board saw policy at a “less accommodative setting” after the move, offering policymakers “greater flexibility” for adjustment going forward. Despite the recent upside surprise in November jobs growth, RBA was also more cautious in its employment outlook, noting that the jobless rate may not have reached its peak. Then on Wednesday, Australia’s disappointing Q3 GDP further downgraded RBA prospects, pushing February tightening probability below 40%. The Q/Q 0.2% figure – below the 0.4% expected – marked the lowest rate of growth since Q4 of 2008, while also revealing a greater chunk of economic expansion coming from the stimulus-infused public sector. Following that GDP release, Treasurer Swan – an early opponent of RBA tightening – said the data demonstrates that growth momentum is not yet self-sustaining, suggesting that Q3 would have been a contraction without the stimulus.

A Bank of Japan interest rate decision on Friday saw monetary authorities yielding to cabinet pressure with a notable shift to a more dovish tone, helping spark the regional equity rebound going into the weekend. Keeping the economic assessment unchanged after consecutive upgrades, BOJ said it would keep monetary conditions “very easy” amid signs that the economic recovery would slow until mid FY10. On the inflation front, BOJ dropped its prior view that the decline in core consumer prices is likely to keep narrowing, vowing not to tolerate CPI at or below zero and targeting 1% for price stability. BOJ then expressed its deflation fighting resolve by pointing out it would “patiently support the economy” until it comes out of deflation. JGB yields fell across the board on the dovish BOJ comments, with the 5-yr note registering a 4-yr low below 0.45%.

The Asian Development Bank maintained China’s growth forecast at 8.2% in 2009 and 8.9% in 2010, but raised India outlook for 2009 to 7% from 6%. ADB also raised the overall developing economies growth target in the region to 4.5% from 3.9% in 2009 and 6.6% from 6.4% in 2010. The upgrade follows an upward revision as recently as late September.

Trade The News Staff
Trade The News, Inc.

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• USD: Mixed, overseas loses pared by news of Iran/Iraq tension
• JPY: Lower, BOJ won’t tolerate deflation, five-year bond yields hit a four-year low
• EUR: Mixed, German IFO hits 17 month high, trade balance swung to surplus, EUR/CHF declines
• GBP: Higher, mortgage approvals rise, BOE says banking system more stable, PSNCR at record high
• CAD and AUD: AUD & CAD higher, Australia’s business sales rise, Carney says low rate pledge conditional

Overview

USD drifted lower Friday pressured by a slight uptick in risk appetite as US equity markets edged higher. The EUR was supported by report that the German IFO business sentiment hit its highest level in 17 months and the EU trade deficit swung to surplus in October. GBP edged higher in reaction to report that UK mortgage approvals rose for the third month in a row and the BOE says that the UK banking system is more stable. Commodity currencies traded higher supported by improving risk sentiment and rising crude prices. AUD was supported by report of improvement in Australian business sales. CAD traded higher in reaction to a statement from the BOE’s Carney that the BOC has the flexibility to shorten the time frame for its commitment to keep rates low until mid 2010. Carney appeared to be reacting to Wednesday’s report of higher than expected Canadian CPI. JPY traded lower in reaction to a pledge from the BOJ that the central bank would not tolerate deflation. This pledge encourages speculation that the BOJ may ease monetary policy early next year. USD downside was limited by report of tensions between Iran and Iraq as Iraqi troops were reported to have crossed over the border into Iran and temporarily occupied one of Iraq’s oil fields. The Iraqi deputy minister denied the report. EUR/CHF dropped below 1.50 with CHF supported by rumors of a coup in Pakistan. The drop in EUR/CHF may encourage the SNB to intervene as the SNB has defended the 1.5100 level in the past. The Pakistan government denied the coup rumor.

USD traded at a three-month high Thursday supported by improving outlook for the US economy and speculation that the Fed will withdraw stimulus earlier than expected. US LEI and manufacturing data suggests that the US recovery is picking up pace but jobs growth remains elusive. USD is also supported by concern about sovereign debt outlook in Europe. Thursday Greece’s sovereign debt rating was downgraded.

Today’s US data:

No major data was released in today’s trade.

Upcoming US data:

Next week’s US economic calendar includes the December 22nd release of final Q3 GDP expected at 2.7%. Existing home sales for November will also be released on December 22nd expected at 6300k compared to 6100k last month. On December 23rd personal income and consumption for November will be released along with November PCE deflator, final December University of Michigan sentiment and November new home sales. Personal income and consumption are expected to rise by 0.4%. The PCE deflator is expected unchanged at 1.4%. Michigan sentiment is expected at 74 compared to 73.4 last month. Home sales are expected at 440k compared to 430k in October. On December 24th initial jobless claims for week ending 12/19 will be released expected at 476k compared to 480k last week along with November durable goods expected to rise by 0.3% compared to -0.6% last month.

JPY

JPY traded lower pressured by a pledge from the BOJ that the central bank will not tolerate deflation. The BOJ concluded a two-day policy meeting Friday and elected to hold rate policy unchanged. The BOJ said that it would not tolerate CPI at or below zero. The BOJ’s focus on combating deflation encouraged speculation that the BOJ may be forced to ease monetary policy in early 2010. BOJ ease speculation sent Japan’s five-year bond yields to a four-year low. Earlier in the month the BOJ elected to ease monetary policy and provide additional funding to try to weaken the JPY and combat deflation. JPY remains vulnerable to BOJ ease speculation and concern about Japans debt outlook. Japan says that its 2010/11 budget will be at ¥92trln. MOF officials said that Japanese government needs to cut at least 3trln from the budget to keep bond issuance below ¥44trln. The ratings agency Fitch said that Japan’s debt rating may be downgraded if bond issuance rises above this level.

Next week’s Japanese calendar includes the December 21st release of November trade balance expected at ¥395bln compared to ¥807bln last month along with October all industry activity expected to fall by 0.1% compared to -0.6% last month. On December 25th November CPI will be released expected at -0.2% compared to -0.4% last month. November household spending, employment housing starts and construction orders will also be released on December 25th. Household spending is expected to fall by 0.5% compared to 0.7 last month, unemployment is expected to rise to 5.2% from 5.1% last month, housing starts are expected to fall by 4.5% compared to 9% last month and construction orders are expected to fall by 28.9% compared to -40.1% last month.

Key technical levels to watch in USD/JPY include support at 89.35 the December 16th low with resistance at 90.86 the November 6th high.

EUR

EUR rebounded from a three month low supported by report of improving German business sentiment and better than expected EU export sales. German December IFO business climate improved to 94.7 compared to 93.9 last month with current conditions improving to 90.5 compared to 89.1 last month. EU October trade balance swung to surplus of 8.8bln as exports declined less than expected. These reports suggest that the EU economy is recovering. The improvement in today’s economic data from the EU is unlikely to change the outlook for ECB policy as the reports are overshadowed by concerns about sovereign debt risks in Europe. EUR traded at a three-month low versus the USD Thursday pressured by S&P downgrade of Greece’s debt rating and speculation that upbeat assessment of US economic outlook by the Fed sets the stage for the beginning of the Fed’s tightening cycle. Uncertainty about sovereign debt risks in the EU generates concern about the stability of European monetary Union and the credibility of the EUR. The EUR looks much less attractive as an alternative to USD as a reserve currency in light of sovereign debt worries in the EU. There was some interesting price activity in EUR/CHF cross which traded below 150 with the CHF supported by safe haven demand sparked by rumors of a coup in Pakistan and report that Iranian troops had crossed over the border into Iraq. The SNB has defended the 1.5100 level in EUR/CHF and today’s price action in the cross spark SNB intervention. The Pakistan coup rumor has been denied. More information is awaited on the Iranian news.

Next week’s EU economic calendar includes the December 22nd release of German January GFK index expected four compared to 3.7 last month. December 23rd EU October industrial orders will be released expected it 1% compared to 1.5% last month.

The technical outlook for the EUR is negative as the EUR breaks trend line support. Expect EUR support at 1.4304 the December 17th low with resistance at 14535 to December 17th high.

GBP

GBP edged higher supported by report that UK mortgage approvals rose for the third month in a row and in reaction to the release of the BOE financial stability report. The rise in mortgage approvals suggests that the UK housing market has stabilized. GBP was pressured in Thursday trade by report of weaker than expected UK retail sales. The drop in UK retail sales offsets the improvement in the UK housing sector and the outlook for the UK recovery remains uncertain. The BOE Financial Stability report said that the UK banking system is more stable but warned that challenges remain. There was limited reaction to report that the UK public sector borrowing for November rose to a new record high. November sector borrowing rose to 14.67bln which was much better than the anticipated rise of 17.5bln. GBP remains vulnerable to uncertainty about BOE policy outlook and UK budget outlook. Last week the BOE left interest rate policy unchanged and said it will maintain its current level of asset purchases. The BOE left interest rates unchanged at a record low 0.5% and the level of asset purchases at £200bln. The BOE is expected to wait until the release of the February inflation report before it decides to make any adjustments in monetary policy or in the size of its asset purchase plan. The BOE’s Barker said the BOE must be cautious of how much farther to expand its bond purchase plan. Today’s rise to new record high for the UK net public-sector borrowing will likely continue to weigh on the outlook for GBP.

Next week UK economic calendar includes the December 22nd release of final Q3 GDP expected at-0.3% along with the Q3 current-account expected at -11.80bln.

The technical outlook for GBP is negative as GBP trades below 1.6100. Expect near-term support at 1.6020 with resistance at 1.6340 the December 17th high.

CAD

CAD traded higher supported by a rise in crude oil prices, a slight improvement in risk appetite as US equity markets rally and in reaction to comments from the BOC Governor Carney. The BOC Governor Carney said that the BOC’s pledge to keep rates low until mid to 1010 is conditional and the BOC has flexibility to shorten the time frame for the rate commitment. Wednesday Canada reported higher than expected CPI. BOC pledge to maintain low yields is dependent on whether inflation remains in check. Canada’s November CPI rose by 0.5% m/m and 1% y/y with core inflation at 0.4% m/m and 1.5% y/y. Carney’s comments appear to open the door for an earlier BOC rate hike if inflationary pressures continue to mount. Canada’s wholesale sales for October came in below expectation reported up 0.3%, a 0.6% rise was expected. This report suggests that at the wholesale level Canadian price inflation remains in check. Carney went on to say that he doesn’t expect a double dip global recession. Yield differential is emerging as the key short-term driving factor for Forex trade and the CAD.

Next weeks Canadian economic calendar includes the December 23rd release of October GDP expected at 0.5%.

The technical outlook for CAD is negative as USD/CAD consolidates trades above 1.0700. Look for near-term support at 1.0552 the December 15th low with resistance at 1.0780 the November 9th high and 1.0855 November 3rd high.

AUD

AUD rebounded from Thursday’s sharp drop supported by report of improving business sales. Australia’s November business sales rose by 0.6%. AUD traded as low as 8910 and in overseas trade pressured by rumor of a coup in Pakistan. This rumor sparked selling of higher risk currencies. The AUD rebounded after the Pakistan government denied the rumor. AUD traded sharply lower Thursday pressured by weaker global equity market trade and speculation that US and Australian yield gap is set to narrow as the Fed lays the foundation for future rate hikes and the RBA moves towards steady policy. Although the RBA was the first major industrialized central bank to hike interest rates this year recent statements from the RBA suggest that further rate hikes are less certain. Wednesday the RBA’s deputy governor Battelino said that Australian interest rates are back in the normal range and he sees less need for a rate hike if loan rates keep rising. His comments follow Tuesday’s release of the RBA policy minutes for December. The RBA policy minutes were seen as less hawkish and dampen speculation that the RBA will hike rates aggressively at the start of 2010. The minutes for the December RBA policy meeting said that arguments for a rate hike are finely balanced and that the current rate structure is less accommodative. AUD remains vulnerable to diminished RBA rate hike speculation and speculation that Fed is moving closer to the end of its ease cycle.

Next week’s Australian economic calendar includes the December 21st release of November new car sales expected 4% compared to 3.7% last month.

The technical outlook for the AUD is negative as the AUD drops below above 9100. Expect AUD support at 8755 the October 6th low with resistance at 9010 the December 17th high.

By Michael J. Malpede

Easy Forex

Michael J. Malpede is Chief Market Analyst with Easy-Forex® and has previously been featured on Bloomberg TV, Bloomberg radio, Reuters, MarketWatch, Wall Street Journal, Chicago Tribune, Chicago Sun Times, Toronto Star and Nikkei press. In analyzing the markets, he draws from 29 years of Foreign Exchange Research as a Foreign Exchange Analyst.

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