Outlook

Last week saw thinned-out conditions as many traders took the whole week for a vacation. With New Year’s Day at mid-week this week, the same thing can happen again. Thin markets mean the opportunity for volatility and spikes, as we saw in the euro and oil last week. Raw animal spirits have more to do with it than reasoned analysis, and we will have to wait for next week (probably) to see new positioning. We do sometimes get a new direction/trend reversal in the first week of January, as in 2005 and again in 2006, but it’s wiser not to count on it.

Today we get pending home sales, the Dallas Fed and income and spending, both probably up about 0.5%, which would alleviate the dread of a crummy Q4 and Q1 after the unsustainable 4.1% quarterly growth rate in Q3. Tomorrow is a short day but packed with good data, including Case-Shiller, the Chicago PMI, and consumer confidence. We also get durables, with the consensus for 1.8% and core up 0.7% but the different variations capable of surprise. Because it’s a short week, we don’t get payrolls until a week later on Dec 10.

As everybody and his brother makes up his “best 10 hopes” and “worst 5 fears” for the coming year, what we see is three big questions—first, will the US economy reach escape velocity or close enough to allow the Fed to taper steadily and not feel it has to increase QE temporarily at some point? The FT calls it “the Fed getting it wrong.” As an aside, the political shenanigans probably will have little or no economic effects. Depriving the poor of food stamps and unemployment insurance benefits is not on the list of factors that influence the big-shots in the corner office when they are making capital investment decisions. They are sitting on $2 trillion in surplus cash, with another $1 trillion stashed overseas. What will get them to spend it?

The second big theme is deflation in Europe and who is in charge of the ECB. The BBK still has the classic knee-jerk obsession with inflation, even though all the harbingers, including money supply growth, do not point to looming inflation in the eurozone. Prices have fallen in the worst hit of the southern tier, like Greece. Maintaining inflation at an acceptable rate is not the same thing as refusing to acknowledge deflation. So far Draghi has been able to defy the BBK (with LTRO, the “whatever it takes” promise of sovereign bond buying, an independent bank bailout fund) and 2014 is shaping up to bring another ECB-BBK battle. Or not. It’s also possible that deflation comes to a halt and a little inflation appears, and the whole thing was a false alarm.

Finally, China. The world is counting on China to keep cranking out cheap manufactured goods, providing demand for raw materials and commodities, and to clean up its act (political corruption, pollution, shadow banking), as promised at the big Party party. China also promised to get progressively rid of setting rates by dictate and let the markets decide. So far we have had one liquidity crisis (two this year) out of that. The real problem is that reporting of prices and any actions taken to adjust prices is so unreliable. We continue to think that an economy growing at 8% pa and in fine fettle should not have a stock index that fails to reflect that. Foreigners are still clamoring to be let in but the domestic market prefers real estate, gold, bitcoins or just about anything other than domestic equities. There’s a basic disconnect here.

Longer run, by which we mean the first quarter, the dollar “should” strengthen across the board (ex-sterling) on the rising yield and steepening yield curve. At of 7 am, the US 10-year is 3% and the Bund is 1.96% (FT), while the euro is firming. Clearly the US needs a bigger yield premium to give the dollar a boost. How much of a premium? Nobody knows, of course, but at a guess, it’s a good 50 bp.

Finally, positioning for non-economic reasons should get special attention. The euro is getting a bit of a year-end boost from a temporary factor—eurozone banks selling off foreign assets to repatriate funds ahead of capital adequacy and stress tests in 2014. According to Reuters, “… many commentators think the euro could weaken early in 2014 once the AQR [Asset Quality Review] is out of the way.” BNP Paribas, for one, says the liquidity squeeze that started in mid-December could be coming to an end. We doubt it’s the “year of the dollar” but it would well be the “quarter of the dollar” if everything lines up. We would not go short the dollar into January 2.