Key News

* BOJ easing likely if Tokyo intervenes in FX (Reuters)

* U.S. Averts Default as Obama Signs Bill (WSJ)

* Italian bonds under fire on gobal economic worries (Reuters)

* U.S. Sovereign Rating Is Placed Under Review by Fitch (Bloomberg)

The Event Agenda

Afternoon Run-Down

There continues to be a risk-off theme in markets – and for good reason.

And there continues to be a breakdown in the “crisis-era” correlations that we’ve seen in recent years – where risk-on has meant buying everything and selling the dollar and U.S. treasuries … and risk-off has meant the exact opposite.

In recent weeks, given the simultaneous drama surrounding European and U.S. sovereign debt, the favored safe-haven trades have been long Swiss francs, long Japanese yen, long gold and long U.S. Treasuries. The dollar hasn’t participated.

The Swissie is making record highs against both the dollar and the euro. And the Japanese yen breached its March all-time record high against the dollar yesterday, trading at 76.28 before reversing sharply on rumors of official intervention.

Here are the three monster issues facing markets:

1) A continuation of record stress in European government bond markets, even after the most recently “resolution” plan out of Europe.

2) A complete fumbling of policy in Washington from inept and sleazy politicians.

3) A clear threat of recession in the manufacturing data of China, the euro zone, the U.S., and the UK – i.e. the second half of global recession is coming.

There is a heavy slate of central bank meetings this week. But the conversation has changed, away from speculation of reversing emergency policy measures, and back toward speculation that more easy money – for longer – may be needed.

The RBA weighed in last night. They held the line on rates citing an “acute sense of uncertainty in global financial markets.” Though the RBA had a hawkish tone, the markets are beginning to price in cuts in the future.

The ECB and BOE meet on Thursday. Both are expected to make no changes to rates.

On Thursday night, the BOJ will convene. There are rising prospects that they may increase asset purchases (more easing) to combat the effects of the strong yen.

With the debt/deficit bill passed in the U.S., the communications from the ratings agencies should be watched closely. If an indication is made that the AAA rating will be downgraded, it will be important to watch the behavior of the dollar and U.S. Treasuries. Given the global impact of a downgrade, it’s likely the dollar and U.S. treasuries will, again, be safe haven trades. On the other hand, if these two key proxies of global safety do in fact get punished, don’t be surprised if we see concerted G-7 intervention to stem the panic. They may pre-empt chaos by coordinating intervention in USD/JPY … under the guise of helping the Japanese. A stable dollar and U.S. Treasury market will go a long way to manage global confidence and fear.

Here’s a look at the charts …

Key Charts

Euro

The euro made another vicious spike from 1.38 to 1.45 in the middle of July, briefly violating the descending trendline that marks the decline from the May highs. But that trend remains intact. A series of lower highs are in place … and a lower low on this move down brings into play the huge trendline from the June 2010 lows.

If that line gives way, expect the 1.3050 area, the 61.8% retracement of the move from 1.1875 to 1.4939, to be the major long-term technical level the market hones in on. The sustained breach of the 100-day moving average (the red line) has proven to be of significance in this crisis 3-4 year crisis period.

Gold

The continued safe haven favorite is Gold, up 12% since the first of July. The top of the channel comes in around $1,690 to $1,700 area. A pullback to the bottom of the line projects $1,500.

S&P 500

Stocks are looking very ugly. As the key proxy for global risk appetite and global economic health, the S&P 500 is staring down the barrel of 1,100 … then 1020 … then the big level of 937. These levels represent the key Fibonacci retracement zones. Yesterday we got a break of the 200-day moving average. And today we’ve broken below the major ascending trendline, marked by the 2009 bottom at 666.

10-year yields

Yields continue to slide on the heightened global risks, trading at 2.62%. That’s the lowest levels since October of 2010. The post Lehman low was 2.42% marked in December of 2008.

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Key News

* Best Currency Forecasters Say Dollar Slump Coming to an End (Bloomberg)

* EU Stress Test Data May Cause Market Instability (Bloomberg)

* Dutch FinMin: Greek Selective Default Not Ruled Out (iMarketNews)

* China’s Wen Says Inflation Top Priority; Will Watch Growth (iMarketNews)

The Event Agenda

Afternoon Run-Down

As the global markets shifted toward the European time zone this morning, markets were scrambling out of risk. Chinese stocks were down 1.7%, Hong Kong down 3%, India down 1.5%, Australia down 1.9%, the S&P futures were down 1% and commodities were getting nailed … all following the decline in the euro, which was down 1.4% at one point, breaching its May lows and slicing through the 200-day moving average.

But in the face of debacle in Europe, the euro later turned on a dime and the risk environment turned with it. Rumor had it China was buying European sovereign debt, followed by rumors it wasn’t China, but the ECB. As sovereign debt yields turned, so did the euro … so did global markets.

Articles over the weekend on Europe introduced a change in the conversation among euro officials – now to include a Greek default. Though today, the official message is mixed, the Dutch Finmin said it wasn’t ruled out, while others said default (“selective default”) wasn’t going to happen.

Meanwhile, Europe braces for bank stress tests to be published on Friday. The stress tests are said to include scenarios where:

Ø The euro zone contracts ½ percent in 2011,

Ø A 15% drop in European stocks,

Ø As well as “possible trading losses on sovereign debt.”

Germany’s banking associations are apparently warning that the report could be too detailed, exposing weak banks to a speculative attack of their own.

Meanwhile, as if they were oblivious to the above events, the IMF upgraded German growth today – in what appears to be yet another attempt at official sentiment manipulation. Of course, they succinctly hedge themselves by saying there are “risks” to their forecasts from “financial spillovers into Germany.”

Back to reality: A report on the U.S. economy from the Fed Bank of Cleveland says the U.S. economy in 2012 may grow at just 1.1 percent – that’s less than half the 2.7 percent to 2.9 percent range projected by the Fed in its official estimates.

Here’s a look at the charts …

Key Charts

Euro

The euro looks very slippery here … it broke definitively below the 100-day moving average (the red line) yesterday, which has contained it since early this year. And the steep slide this morning took it through the 200-day moving average (the dark line). The next big support comes in at the 1.3710 area – the ascending trendline that describes the retracement from the June 2010 lows of 1.1875.

If that line gives way, expect the 1.3050 area, the 61.8% retracement of the move from 1.1875 to 1.4939, to be the major long-term technical level the market hones in on.

Gold

With the euro leading the risk aversion theme, gold and the dollar are, again, trading in a positive correlation. Gold sits just 8 bucks off of its May highs in dollar terms of $1576 and has already reached new record highs in euro terms.

S&P 500

After posting one of the biggest one week surges on record, the S&P 500 is reversing course. The bearish outside week from May still holds, potentially marking a significant turning point for stocks and global risk appetite. A break of the blue trend line, which coincides with a break of June lows opens up big downside.

Crude Oil

The charts for global risk proxies (the S&P 500, the euro and crude oil) are all near a significant technical breakdown of the uptrend of the past year. Crude is also forming the right shoulder of a bearish head and shoulders pattern that projects a move down to $60.

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Key News

* Papandreou Confidence Vote May Decide Fate of Greece (Bloomberg)

* Reserve Bank Weighs Europe Debt in Holding Rates (Bloomberg)

* Fitch: would cut Greece to default on any voluntary debt rollover (Reuters)

* Why Germany must exit the euro (Telegraph)

The Event Agenda

Afternoon Run-Down

The euro zone crisis faces another stiff test later today, a vote of confidence on the Greek government. If at 5pm EST, the Greek PM Papandreou wins a “vote of confidence,” the clock on the next major hurdle begins to tick. From there the markets will be waiting to see if the PM has done enough in reshuffling parliament to pass new austerity measures next week – that is, to qualify for additional aid from the EU/IMF.

If we get a negative outcome in either of these events the markets will immediately begin pricing in default. And chaos will erupt in financial markets.

But it doesn’t end if the Greek PM can win today. S&P and Fitch are now saying that the new EU/IMF plan for Greece, that includes voluntary debt rollovers, will constitute a credit event (i.e. default).

So expect new, even more desperate plans to bubble up out of Europe in the next few days, in attempt to extend Greece’s walk toward insolvency, without triggering a credit event. That’s IF Greece can get past the confidence vote today.

Markets have been conditioned to believe that politicians can continue pulling rabbits out of the hat. As such, the euro has bounced aggressively, again, this week after an aggressive decline for much of last week. And U.S. stocks are bouncing sharply this week after bouncing in front of major trendline support that describes the bull trend in stocks since the March 2009 low. These relief rallies reflect optimism that “the can” will successfully get kicked down the road.

Assuming, Greece gets past today intact, the Fed will be the key event to hold the attention of traders/investors tomorrow. Remember, QE2 ends this month. In April, in its first post FOMC press conference, Bernanke was clear that risks from inflation pressures were outweighing the benefit that more QE would have on improving the employment picture. He reiterated that position in his June 7 speech at the International Monetary Conference in Atlanta. And he used the word “vigilant” in describing the Fed’s requirements to “preserve its hard-won credibility for maintaining price stability.”

With that, and given some better retail sales data and hotter inflation data since this speech was made, expect the Fed to step up its leaning toward inflation risks – perhaps by including the word “vigilant” (a la the ECB) in its statement – and, at the same time, leaving the door opened to more QE should the euro zone crisis erupt. The “vigilance” language should support the dollar vs. the euro.

With risks of a euro zone unraveling, UK banks have been said to be restricting their lending to euro zone banks. Keep an eye on Libor, Euribor, the Ted spread, etc … the risk proxies of 2008 that demonstrated the credit freeze in the interbank markets — which quickly translated into financial crisis and a global credit freeze.

Here’s a look at the charts …

Key Charts

Euro

In my last post I showed the correlation breakdown between the S&P 500 and the euro (which was lagging). That gap closed with the euro decline of last week. For now, the euro continues to hold the 100-day moving average (the red line).

With the Greek solvency continue to flap in the wind, the chart below shows big support areas for the euro. Support #1 is the trendline that represents the sharp retracement in the euro off of the June 2010 crisis-induced lows (related to the “shock and awe” 750 billion euro bailout announcement from the EU/IMF). Support #2 and #3 are significant Fibonacci areas. And finally, support #4 brings the June 2010 lows back into play, 1.1875 … 18% lower from current levels.

S&P 500

The S&P is down 5.8% from its May 1 high – which took place shortly after the Fed’s last meeting/press conference. Big support comes in just under 1250, the line from the March 2009 lows. A definitive cross under the 200-day moving average and break of this line opens up big downside for stocks.

Credit watch

Below is a chart of the TED spread. This was a key indicator to watch at the height of the financial crisis to gauge the fear in the financial system. It measures short term US gov’t rates against rates on interbank loans. You can see, even as the Fed was slashing rates down to zero, the TED spread was spiking because banks were hoarding dollars – unwilling to lend them to other banks – creating elevated consumer rates, while gov’t rates were moving toward zero.

Expect markets to keep a close eye on this risk proxy for information on how global banks are feeling about the outlook in the euro zone financial system.

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June 8, 2011

Key News

* European Central Bank risks being ‘wiped out’ by bail-outs (Telegraph)

* China official says U.S. could pursue weak dollar policy (Reuters)

* Limited default might clear way for Greek bond swap (Reuters)

* Fitch Warns U.S. on Debt Ceiling (WSJ)

The Event Agenda

Afternoon Run-Down

The broad dollar weakness of recent days began reversing today. Yesterday, Fed Chairman Bernanke stirred global growth concerns, but most importantly didn’t hint toward of another round of QE.

He also made rare comments on the dollar, which sum up his responses to media questions over past months regarding dollar weakness …

He said:

“Some have argued that accommodative U.S. monetary policy has driven down the foreign exchange value of the dollar, thereby boosting the dollar price of commodities. Indeed, since February 2009, the trade-weighted dollar has fallen by about 15 percent.”

“However, since February 2009, oil prices have risen 160 percent and nonfuel commodity prices are up by about 80 percent, implying that the dollar’s decline can explain, at most, only a small part of the rise in oil and other commodity prices; indeed, commodity prices have risen dramatically when measured in terms of any of the world’s major currencies, not just the dollar.

“But even this calculation overstates the role of monetary policy, as many factors other than monetary policy affect the value of the dollar. For example, the decline in the dollar since February 2009 that I just noted followed a comparable increase in the dollar, which largely reflected flight-to-safety flows triggered by the financial crisis in the latter half of 2008; the dollar’s decline since then in substantial part reflects the reversal of those flows as the crisis eased.”

“Slow growth in the United States and a persistent trade deficit are additional, more fundamental sources of recent declines in the dollar’s value; in particular, as the United States is a major oil importer, any geopolitical or other shock that increases the global price of oil will worsen our trade balance and economic outlook, which tends to depress the dollar.

“The best way for the Federal Reserve to support the fundamental value of the dollar in the medium term is to pursue our dual mandate of maximum employment and price stability, and we will certainly do that.”

Beyond Bernanke’s defense of his alleged dollar killing policies, the real area markets were focusing on was QE.

Bernanke reiterated that accommodative policy is still needed but acknowledged a readiness to respond to inflation if needed. And Atlanta Fed President Lockhart said there is a “very high bar” that would have to be breached to prompt another round of QE.

As such, the much loved QE trade (long stocks) is unwinding.

The next Fed decision is June 21-22. QE2 comes to an official end at the month’s end.

As for the crisis in Europe …

The “troika” as it’s called, comprised of the European Commission, European Central Bank and the IMF, have agreed, at least amongst themselves, on pouring more money into the Greece black-hole, if its “under financing is resolved” … and only if Greece steps up sales of its public assets and, in concert with, “voluntary” maturity extensions made on Greek government debt by its creditors in the private sector (i.e. European banks).

Given the prospect for another “kick the can down the road” solution to materialize in Europe, this idea has been the key driver behind a bounce in the euro that has been nearly as dramatic as its fall that transpired throughout much of May … falling 6.5% in 14 days, and then retracting more than 70% of that decline in just 11 days.

But already the dreams of another successful campaign to put off the crisis are falling apart. Moody’s has said that the maturity extension would constitute a credit event, i.e. default. And that’s exactly what European officials had hoped to avoid when crafting the plan.

The next big focus of the week will be on the ECB Thursday morning. After running a rate hiking campaign through the first quarter of the year then following with its first rate hike since the onset of the global financial crisis, last month the ECB paused with a less ambitious message on rates. Look for the same this month.

Here’s a look at the charts …

Key Charts

Euro vs. S&P 500

As two markets that gauge the pulse of risk appetite, the euro and S&P 500 have traded in close relationship throughout much of the crisis period. With the S&P 500 now in decline, the euro catch could mean a quick return to the low 1.40s.

New Zealand dollar

New Zealand cut rates by 50 bps in March to respond to a devastating February earthquake, held the line on rates at its last meeting, and is expected to be on hold again tonight, despite an elevated inflation reading. With the hotter inflation number reported last month, the NZD charged to new all-time highs vs. the dollar. Given the inflation data was driven by higher oil prices and increased excise tax on certain products and given the massive overvaluation of NZD on a purchasing power parity basis … look for the weight of the risk-off trade to take the NZD down with it.

S&P 500

The S&P climbed 105% off of its 2009 lows. With QE coming to an end and global economic growth deteriorating, how low can it go? First big resistance comes in at the trendline from the March 2009 lows .. 1250.

Plunging velocity of money points to lower stocks

This chart from GaveKal shows the plunge in the velocity of money in red…and the corresponding effect it tends to have on global stocks (in gray)…

Key reversal signals still in play

The key risk markets all reversed their trends following the last Fed and ECB meetings, marking key reversal signals across markets … which still hold.

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Key News

* EU Rehn: Voluntary Extension Of Greek Debt Maturities Possible (iMarketNews)

* U.K. Inflation Accelerates, Fastest Pace Since 2008 (Bloomberg)

* As Debt Limit Reached, Agreement Still Far Off (WSJ)

* Aussie Dollar flounders as traders try to decipher RBA tea leaves (Sydney Herald)

The Event Agenda

Afternoon Run-Down

The dollar is in the third week of its bounce. The bottom was marked after two key central banks meetings: the Fed and the ECB. The Fed indicated that the risks of more QE were outweighed by the costs of inflation, which leans the Fed toward the exit doors of ultra easy money (hawkish leaning). On the other hand, the ECB made a noticeable change in its “vigilance” toward inflation (dovish leaning). That began the narrowing of interest rates between Europe (i.e. Germany) and the U.S., which got the euro rolling down hill and the dollar rising sharply.

But the dollar was already being fueled by the breakdown in commodities – the contra-dollar speculative bubble. And that trade continues to unwind.

The risk-switch has been flipped from inflation fearing to growth fearing. The serious threat to global growth is now being acknowledged: Europe. While European officials were hoping to soon execute another step in their “confidence massaging” game, by rolling out a rescue package for Portugal this week, the flare up in Greece has put a wrench in the plan.

Now EU officials are talking about a “re-profiling” … code for restructuring. This likely involves extending maturities on some Greek debt. But it’s said that it wouldn’t entail a write-down of Greek sovereign debt for debt holders (the banks) and it wouldn’t be considered a credit event … which would trigger the sovereign credit default swap contracts on Greece. Huh? When the rulebook doesn’t work to your advantage, make new rules.

While inflated commodity prices had underpinned inflation readings across countries in recent months, that bubble has now burst and is continuing to unwind. Meanwhile, inflation numbers from late April were released from the euro zone and the UK this week, and were, not surprisingly, “hot.” Of course, commodity prices were sitting on highs when this data was compiled. That said, it should be a non-event, but the dollar and the euro have moved a long way in recent weeks, and the inflation data was a good enough excuse for day traders to cover their shorts – fueling some bouts of strength in the euro/ weakness in the dollar.

Many are anxiously awaiting the FOMC minutes tomorrow, which will likely show the Fed’s concern about risks of inflation outweighing the gains of improving the employment picture; we should remember though that the commodity driven inflation pressures have eased since the April 26-27 meeting.

Here’s a look at the charts …

Key Charts

Euro

Since marking the high above 1.60 in June of 2008, the euro has made a series of lower highs and lower lows. The major long term support of the move from the most recent low of June 2010 to the most recent high of May 2011 comes in at 1.3025 – the 61.8% retracement.

Economy Slowing

This chart from Bloomberg shows the sharp decline in Leading Economic Indicators and the close relationship it has with economic output (GDP). This chart portends a fall in GDP to below 2% year over year. When GDP has fallen below 2% historically, the U.S. economy has fallen into recession every time since 1948.

USD/Yen

USD/JPY started to show some life again today after the BOJ governor said that the

economy was in a “very severe” state. After retracing a bit more than 61.8% of the G-7 coordinated intervention spike in USD/JPY, it now looks ready to complete a C-wave which could take it to the 88 area.

Gold

After posted a bearish outside week a few weeks ago (a key reversal signal), gold is now breaking 4-month trendline support.

Crude Oil

In 2008 oil collapsed over six months as carry trades and risk were unwound across the world. Given the mass speculative capital that plowed into commodities, seeking a “carry” of price appreciation from the effects of QE, could this unwinding phase have a similar look? If so we could be looking at oil back to $30 – certainly possible if we see a default in Europe and another wave of global economic crisis.

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Key News

* Greece’s Budget Deficit Wider Than Expected (WSJ)

* ADB: Food, Oil Could Hurt Asia Growth (WSJ)

* Geithner Says U.S. Won’t Pursue Strategy to Weaken Dollar (Bloomberg)

* PBOC Plans Forex-Reserve Investment Funds (WSJ)

The Event Agenda

Afternoon Run-Down

The dollar is sitting on lows going into one of the most anticipated Fed meetings in history. Tomorrow we’ll get a statement from the Fed at 12:30 (according to Market News International) and then, for the first time, Bernanke will sit for a 45 minute Q&A with the press at 2:15.

Last month the Fed recognized that commodity prices had climbed “significantly” and were “putting upward pressure on inflation” but they considered the effects to be “transitory.”

With the ECB already in tightening mode, asset prices continuing a parabolic trajectory and headline inflation in the U.S. moving consistently away from the 2% area, there has been growing division among Fed members on the appropriate monetary policy. So, given that markets are pricing in no change in policy, there’s significant risk to the “asset reflation, weak dollar” trade if there is any hawkish leaning out of the Fed.

If their “transitory” view still holds, look for the Fed to acknowledge that the $600 billion asset purchase program will expire in June as planned. Any changes to that view may prompt the Fed to stop reinvesting principal payments from its current securities holdings and (in a more hawkish response) they may pull the plug on the remainder of their planned asset purchases due to expire in June.

In Europe, the news continues to worsen, yet the euro continues to print higher highs on this 2011 rally. An ECB board member said today "any debt restructuring would imply the breach of legal obligations, which most likely would have a more negative systemic effect than the Lehman [Brothers] catastrophe." The Greek government 2-year yields are now trading at a euro-era record high of 22.48%. And after bailouts and austerity, a Eurostat statement today showed budget deficit numbers in Europe for 2010 remain disappointing — Ireland at 32.4%, Greece at 10.5%, Spain at 9.2% and the UK at 10.4%.

Meanwhile, Geithner made an unusually specific statement on the dollar today saying that “our policy has been and will always be, as long as at least I’m in this job, that a strong dollar is in our interest as a country.”

With the day’s news clearly negative for the euro, it fittingly sits on the highs — maintaining its recent negative correlation with the deteriorating sovereign debt problems (and arguably common sense).

Here’s a look at the charts …

Key Charts

The Fed watch

Going into the Fed tomorrow, these charts from Bloomberg make the case for a tightening campaign to commence.

The Fed has maintained its target for fed funds at near zero as long as there is slack in the economy and inflation expectations are stable. The above chart shows to trending rise in capacity utilization (a closing of the output gap) which has historically led to a rising fed funds rate. Its last hiking cycle began right around this area on the capacity utilization reading.

Fed’s Dual Mandate …

Sticking to the Fed’s dual mandate of price stability and full employment … historically the Fed responds with interest rate hikes when the non farm payroll (the gray line) number begins trending positive (from negative).

Global FX Reserves

Last week China reported its FX reserves had grown to $3 trillion. Now Chinese officials are admitting that their currency reserve accumulation (thanks to their currency manipulation) is driving dangerous inflation. They say $3 trillion is enough. The below charts show the sharp rise in global FX reserves to $9 trillion (a third of which China owns).

In the next chart you can see the gradual decline in the dollar’s composition (from 70% to the low 60s) and the gradual increase in the euro’s composition of global FX reserves.

And because of this consistent build in China’s FX reserves in the past decade, and the gradual diversification into euros, the next chart shows its significant impact on the eur/usd exchange rate …

Fed’s last two statements – Side by Side …

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Key News

* China Banks to Need $131 Billion in Equity Over Six Years (Bloomberg)

* US lacks credibility on debt, says IMF (FT.com)

* BRICs to Seek End to U.S., Western Europe Monopoly of World Bank, IMF (Bloomberg)

* Spain: China Mulling €9.3 Billion Cajas Investment (WSJ)

The Event Agenda

Afternoon Run-Down

This week there continues to be a focus on elevating oil and gold prices and the sliding dollar. And there’s been a constant association of cause and effect between the three … i.e. crude oil and gold are higher because the dollar is weaker, and vice versa.

But the real driver at the moment is rate prospects. And the CPI data out this week will be the key events. We saw rate hikes out of the ECB and China last week and we’ve seen an increasingly divided Fed in recent weeks. This means the price data out of all three countries will be highly scrutinized.

We’ve already seen price data out of the UK. Of course, the Bank of England held the line on rates and its asset purchase program last week. And this week’s tamer than expected consumer price data supports that decision. The markets are pricing in just an 18% chance of a BOE rate hike at its next meeting.

Given China’s pre-emptive rate hike last week – in front of this Thursday mornings CPI release- the expectations are for a reading above 5% again, after two months of slower price increases. We also get a look at a barrage of other Chinese data that should continue to confirm that the central bank has been unable to get a grip on inflation, despite rate hikes in five out of the past seven months … and a number of other tightening measures – and that economic growth is slowing from its double digit levels of last year.

In Europe, a hotter CPI reading on Thursday will underpin more speculation that they will move again next month on interest rates.

The biggie of the week is U.S. inflation data on Friday. The FED doves have maintained that inflation remains low. And that higher commodity prices are temporary and shouldn’t translate into broader inflation. The FED hawks have been more vocal arguing that the Fed risks losing control of inflation. The market expects to see a slight uptick in the core number to 1.2% year-over-year from 1.1% last month. Anything hotter would mean a better probability of the FED on its April 27^th meeting either ending QE2 early or communicating a move away from ultra-easy monetary policy.

Here’s a look at the charts …

Key Charts

The yen

USD/JPY has taken a breather from its 12% post G-7 intervention run. The upgraded nuclear threat in Japan sent traders back into the yen, as a perceived safe have trade. But Japan and its G-7 partners have put a floor under the yen. Expect this pullback to be shallow and short-lived. For now, the 200-day moving average (the blue line) holds as support.

Big data week in China

China has a slew of data out this week. The key data to watch is:

>New yuan loans – key to see if the Bank of China has had any success in discouraging the uber-liberal bank lending practices of recent years.

>GDP- is the liquidity driven growth of recent years falling faster than what the market expects?

>CPI- despite the numerous tightening policies in recent months, prices continue to rise.

Crude Oil

The commodity run has all of the makings of a bubble – hysteria included. This recent surge puts crude in the area of a key technical Fibonacci zone on this long term chart, a move down to 95 this month would mark a bearish outside month that could turn the tide of this sharp retracement off of the crisis-driven lows of 2008.

All eyes on U.S. CPI

Though the Fed is focused on the core CPI number, which is expected to remain low, the headline number is expected to reach 2.6% (chart below). As this number rises away from 2%, expect the external pressures on the Fed to build.

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Key News

* Home Prices in U.S. Declined 3.9% in January (Bloomberg)

* Portugal Says 2011 GDP Will Fall (Bloomberg)

* Japan battles crippled nuclear plant, radiation fears grow (Reuters)

* Portugal austerity vote likely Wed, could topple govt (Reuters)

The Event Agenda

Afternoon Run-Down

Economist Nassim Taleb defines a “Black Swan” event as a high-impact, hard to predict, and rare event that is beyond the realm of normal expectations in history, science, finance and technology. The current crisis environment has been full of events that would, in normal times, be deemed magnificent in isolation, much less in clusters, as we’re seeing now. But despite the onslaught of “Black Swans” thrown at the markets, again, the response is a shrug and back to the forecasts of recovery, rate hikes and optimistic outlooks.

Since the G-7 intervention on Friday to weaken the yen, currencies have bounced back, and the dollar has remained weak, because the intervention was done through the yen crosses … i.e. it hasn’t been a USD/JPY specific event, each major central bank bought its own currency, sold yen. Historical coordinated interventions in the yen have been drawn out events. So expect more to come. And it will be important to pay close attention to which currency/currencies central banks buy in the process — to gauge its ultimate impact on the dollar.

Given that the interest rate markets are pricing in three ¼ point rate hikes from the ECB by year end, the markets are focused on EUR/JPY to take advantage of intervention and a widening rate differential between Europe and Japan.

With rate expectations rising in the euro zone, the hot UK inflation data this morning has turned the focus toward the UK. The minutes from the last Bank of England meeting are due out tomorrow, which should show increasing pressures within the Monetary Policy Committee to hike rates.

Portugal released its stability and growth program that projects contraction in 2011 of 0.9%. But most importantly, it forecasts the average rate of Portugal’s 10-year bonds will be 6.8 percent in 2011, 6.9 percent in 2012, 6.8 percent in 2013 and 6.5 percent in 2014 — slightly lower than current levels but persistently high.

The Portuguese government is due to announce a harsh austerity plan tomorrow. All indications point to a parliament rejection of the plan, which may lead to the fall of the Portuguese government. With the market massively long euros, and with the euro approaching its November highs, a fallout in Portugal could be the catalyst for another sharp swing lower in the euro.

Also on tap for the end of the week, we get GDP, price data and a consumption reading from the U.S. which should increase speculation about a wind-down in QE2.

Here’s a look at the charts …

Key Charts

The yen

USD/JPY broke the 1995 all-time lows last week and recovered 7.4% from the lows following G-7 coordinated intervention. Interestingly, despite the attention given to the widening Europe/Japan rate differentials … the percentage move in USD/JPY and EUR/JPY, from last week’s lows to the post intervention highs, is exactly the same.

Market position

The market continues to lean heavily against the dollar. The market position in the dollar is most short since 2009 … the euro is most long since 2007 … the Aussie dollar is most long since 2010 … the Swiss franc is most long since 2009 … the Canadian dollar is most long since 2007. When markets lean so heavily in one direction, they tend to create big reversals as they all run for the exits at the same time. Below is market position in the euro (above the thick white line is net long, below is net short).

EUR/USD

The euro is nearing its November high of 1.4281, which coincides with the major descending trendline from the July 2008 highs of 1.6037. If this resistance holds, the next leg down in the euro projects 1.10.

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Key News

* S&P Warns on Asian Inflation (WSJ)

* Weber Indicates ECB May Raise Rates Several Times This Year (Bloomberg)

* Fed Presidents Signal No Urgency to Expand Bond Purchases (Reuters)

* Greek Bond Yields Climb to Records Before EU Leaders Discuss Crisis (WSJ)

The Event Agenda

Afternoon Run-Down

The euro reached a new four month high against the dollar Sunday night, but has since given way to broad dollar strength. And with the market position very stretched in the direction of dollar shorts, a short squeeze could be in the cards.

The euro has nearly retraced its entire post-ECB rise from this past Thursday morning. Of course the catalyst for that jump was the ECB talking tougher on inflation, stirring a consensus market opinion that the ECB opened the door for an interest rate hike as early as next month.

Here are the key scrutinized areas from the central banks press conference introductory statement and Q&A from Thursday…

The ECB said … “It is essential that the recent rise in inflation does not give rise to broad-based inflationary pressures over the medium term. Strong vigilance is warranted with a view to containing upside risks to price stability.”

“Strong vigilance” = hawkish.

They also called current monetary policy “very accommodative“ … last month it was just plain “accommodative.”

Then, in response to this question: “In your statement just now you did not include the word “appropriate”. Can we assume from that that you consider the current rate to be inappropriate, and was the Governing Council unanimous in keeping rates where they were today?”

Trichet said … “On your first point, the interest rate decision today was unanimous. We mentioned that we are being very vigilant and my understanding of the position of the Governing Council – fully in line with assessments made in the past – is that an increase in interest rates at the next meeting is possible. As you know, we never pre-commit ourselves. Our decision will – as always – be taken by the Governing Council and will depend on any new information and data we receive. So, it is not certain but it is possible.”

Was it an attempt to manipulate inflation expectations or a true telegraph? Well, we know from recent history the ECB isn’t afraid to ignore all but its mandate of price stability … i.e. its 2008 rate hike as the global financial system was unraveling.

Next on the agenda for Trichet is the EU summit this week, were for some reason market participants are waiting for the reveal of a “comprehensive solution” to the euro zone sovereign debt crisis. Where have I heard that before?

Meanwhile, Greece was downgraded three notched by Moody’s yesterday. Portugal is going to market with a debt sale this Wednesday – faced with a jump in financing costs in the neighborhood of 50% since the last quarter of 2010. And Ireland’s new leadership says it will keep their promise to renegotiate terms of the EU/IMF rescue package – asking for a lower interest rate and for bond holders to absorb some losses, among other things. EU leadership has been rejecting the notion – not budging.

This week we get a slew of Chinese data. We’ll see if the tightening measures taken by the Chinese government have curtailed price pressures and bank lending.

And then we get decisions on monetary policy from the Bank of England and the Reserve Bank of New Zealand. Look for the BOE to hold the line, but the internal debate is getting hot. On the other hand, in New Zealand, we’re looking at a rate CUT. In response to a sluggish economy and the widespread damage from a recent earthquake, New Zealand is going from raising rates in 2010, to cutting inside of eight months.

Here’s a look at the charts …

Key Charts

Market position – U.S. dollar

This chart shows the extreme net short position in the dollar. You can also see how the dollar tends to respond in these overstretched periods.

British pound

The pound traded into this long term descending trendline and failed, even as hawkish speculation continues to build going into this week’s Bank of England meeting.

Sovereign debt crisis – Portuguese Rates

Portugal will be paying 50% more for 2-year debt this week (the yellow line = 2-year Portugal gov’t. bond yields). As German rates have risen with speculation surrounding an ECB rate hike, the yields throughout euro zone countries have floated higher. While the common gauge of risk in the euro zone has been the spread between yields of the weak versus the strong (Germany), the absolute level of yields is important to watch. The higher yields go for these countries that haven’t turned to the EU/IMF for help, the more threatened their solvency becomes. This chart shows why Portugal will likely be forced to ask for help in the coming weeks.

Euro area inflation

The chart below from the ECB’s website demonstrates why the ECB Governing Council is concerned. Anything above the blue line means the ECB is nervous.

ECB rate hawks

It appears that the ECB may repeat their mistake of 2008 … while the rest of the world was cutting rates in the face of an unraveling global crisis, the ECB had tunnel vision on inflation … they raised a quarter point, only to reverse course the following nine months and slash rates by 3.25 points. The euro put in a top the month the ECB hiked.

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