Hilsenrath Takeaways: Fed Sets Bar on Tapering

Federal Reserve officials stuck to their plan to reduce the central bank’s bond buying program to $65 billion per month.

Here are five takes on what it means:

VALIDATION OF THE TAPERING PLAN:Ben Bernanke suggested in December that the Federal Reserve would continue reducing the central bank’s monthly bond-buying in $10 billion increments at upcoming meetings, but he didn’t state it directly. He said the Fed would take “further modest steps” to reduce QE in the “general range” of $10 billion. Wednesday’s decision to pull back the bond-buying program to $65 billion per month is a validation of the Fed’s strategy.

MEASURING THE FED’S BAR FOR ALTERING COURSE: The Fed conveyed information today about its threshold for changing course on the bond-buying program. In the last few weeks, a soft jobs report and turbulence in emerging markets have raised investor concerns about the economic outlook and about the outlook for Fed policy. Some investors wondered whether the Fed might keep the bond-buying program at $75 billion per month because of these new worries. By deciding to proceed with a $10 billion reduction in the bond-buying program, the Fed has demonstrated its threshold for inaction. We now know that it will take something worse than a weak jobs report and declining currencies in places like Turkey, Russia and South Africa to convince Fed officials that they should keep the bond-buying program going longer than planned.

GOOD-BYE MR. BERNANKE AND THANKS FOR THE MEMORIES: The Fed chairman got a going away gift from his colleagues … his first unanimous vote on a policy decision since June 2011. Officials voted 10-0 in favor of reducing the bond-buying program again. Mr. Bernanke spent much of his time at the Fed building consensus among officials for controversial new policies. All that work finally paid off just as he gets ready to walk out the door. There’s actually important information in this vote. The Fed appears quite comfortable with the course it set out for unwinding its bond-buying program. This, too, suggests the bar to changing the plan is high.

FIVE DEGREES OF COMMUNICATION: The Fed has five different indicators in its policy statement of when it might start raising interest rates: 1) After the jobless rate gets below 6.5%; 2) If inflation looks like it might breach 2.5%; 3) Not until a “considerable time” after the bond buying program is over; 4) “Well past” the time when the jobless rate reaches the 6.5% threshold; 5) Depending on “other information” about the labor market and inflation. Officials didn’t change any of that “forward guidance” about rates, though they might decide to change it at upcoming meetings, particularly if the jobless rate, at 6.7% in December, keeps falling. Investors believe liftoff is in mid- to late-2015.

A MIXED ASSESSMENT OF THE ECONOMY: Fed officials nodded to the December jobs report, which showed job growth slowed at the end of 2013, but indicated it didn’t change their overall assessment of how the economy is performing. “Labor market indicators were mixed but on balance showed further improvement,” the Fed said in its assessment of how the economy performed since officials last met in December. Put another way, officials aren’t too worried about a slowdown in payroll growth in December, but if it persists their view might change.

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Rout In Emerging Markets May Only Be In Phase One

The flight of investors from the once-booming emerging markets they previously favored with $7 trillion-worth of inflows may have only just begun.

It is mainly retail investors who have packed their bags and moved on to date. If and when big institutional firms join in, there is a risk of wholesale capital flight.

Signs of China slowing down and the global impact of a wind-down in U.S. monetary stimulus - effectively draining money from the system - have been particularly punishing in emerging economies dependent on external financing.

Currencies in Turkey, Argentina and Russia have hit record lows, for example, lifting safe-haven yen, Swiss francs and U.S. Treasuries in a sign of global contagion.

Such moves are crucial factors for foreign investors because exchange rate losses can easily wipe out any gains in stocks bonds in the high-yielding emerging world.

However, data on capital flows shows many long-term investors have either stuck with, or even added to, their emerging holdings. The outflows of over $50 billion seen since 2013 have largely been driven by retail investors.

But fears are that at some point the big investors will be forced to cut losses and run as the effect of falling currencies becomes too painful to bear.

"Every emerging market crisis is first-and-foremost a currency crisis," said Mike Howell, managing director of London-based CrossBorder Capital.

"Emerging economies have very weak private sector cash flow growth. This is both a cyclical but also a structural problem. There is a lot more pain to take out in the emerging markets."

Emerging debt performance of the past year illustrates how currency moves matter. For example, South African government debt was slightly positive in rand terms in 2013. But in dollars terms, it lost more than 18 percent, according to Citi's bond index.

And in the past three months or so, the dollar has risen 2 percent against key developing currencies.

Fund tracker EPFR estimates emerging equity and bond funds have seen outflows of almost $5 billion so far this year, on top of $58 billion of losses seen in 2013. EM equity funds have had 13 consecutive weeks of outflows, the longest run in 11 years.

JP Morgan estimates emerging equity exchange-traded funds have already seen a net redemption of $4.2 billion this year.

And emerging stocks .MSCIEF are the worst performer in global markets this year, having lost 4 percent.

But investor positioning so far seems far from extreme. CrossBorder's emerging market risk appetite index, measured by normalized weightings of investors in equities less bonds, stands at a moderate -3, the lowest only since August and ca far cry from the -40 seen in 2012.

"What we haven't seen in emerging markets is major currency devaluation, a run on government debt or ratings downgrades. Any combination of those would suggest humiliation trade (a complete giving up of the asset class) is taking place," said John Bilton, European investment strategist at Bank of America Merrill Lynch.

SUDDEN STOP

Now investors may need to be braced for further outflows.

The Institute of International Finance expects capital inflows into emerging markets, which include buoyant direct investments, to fall more than 3 percent to $1.029 trillion in 2014 - the lowest since at least 2009. Portfolio equity flows are forecast to be down $17 billion.

World Bank warned earlier this month of the risk of a sudden stop in capital flows for emerging markets, a point which was discussed by the International Monetary Fund as well.

The bank said long-term interest rates are subject to a sudden rise of as much as 200 basis points under a scenario of disorderly adjustment when super-easy Western monetary policy begin normalizing.

This could cut financial inflows to developing countries by as much as 80 percent for several months.

In such a case, nearly a quarter of developing countries could experience sudden stops in their access to global capital, throwing some economies into a balance of payments or financial crisis, the Bank said.

Stephen Jen, managing partner of SLJ Macro Partners, says emerging markets will have seen the worst - which involves currencies falling a further 10-15 percent - when the rising U.S. 10-year yield reached 4 percent.

The yield was 2.7 percent on Friday.

"The worst is ahead of us, not behind us," Jen said.

(Editing by Jeremy Gaunt)

REUTERS

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LARRY FINK: 'The Experience Of The Marketplace This Week Is Going To Be Indicative Of This Entire Year'

Just as they were getting their swagger back, the global elite stumbled last week on an emerging market sell-off that served as a reminder of the risks the global economy still faces.

Veterans of the annual World Economic Forum in Davos seized on the wobble as a warning that expectations for a smooth upswing were misplaced, and that recovery would likely be volatile and uneven.

The euro zone crisis is out of its acute phase and growth is returning across the developed world but a revival fuelled largely by vast amounts of new central bank money is a capricious one.

The prospect of the U.S. Federal Reserve turning off its money taps this year, combined with political troubles in several emerging markets, drove last week's sell-off and exposed some of the unresolved problems in both developing and advanced economies.

"I hear way too much optimism now," Larry Fink, CEO of investment group BlackRock, told the forum.

"I think the experience of the marketplace this week is going to be indicative of this entire year. We are going to be in a world of much greater volatility."

The return of growth in the United States, Japan and Europe masks festering problems from chronic youth unemployment to skills shortages and rising inequality that dampened any hubris in Davos.

Tech executives were exuberant about breakthroughs that are revolutionising production, healthcare and communication but others warned those advances may kill jobs.

CEOs in Davos complained more vociferously than ever about a lack of talent for hire despite sky-high unemployment in rich and poor countries alike.

In the West, too many young people are graduating from expensive colleges with high debts and the wrong skills, while in developing countries a big majority are not achieving their economic potential.

Worldwide unemployment hit nearly 202 million in 2013, an increase of 5 million compared with a year earlier, the International Labour Organization reported last week.

Joe Kaeser, chief executive of German engineering giant Siemens, questioned whether the world was really seeing an economic recovery at all.

"Do we feel good because what we see is good?" he asked. "Or do we feel good because we just have eased the pain? How many jobs have we created? How many of those millions and millions of jobless people in Europe have we put into jobs?"

GLOBAL SHIFT

The year ahead will witness a marked shift in the balance among the world's main growth engines, with the United States and other developed economies contributing more and emerging markets somewhat less than before.

Reduced Fed bond buying will reverse the liquidity that has flooded into higher-yielding emerging markets assets.

"We expected this year to be a volatile year for EM as the Fed tapers," Mexican Finance Minister Luis Videgaray said, adding that volatility "will happen throughout the year as tapering goes on".

Despite particular worries in countries like Argentina and Turkey, CEOs are still determined to tap into the growing middle classes of the new mega-cities of Asia, Latin America and Africa. But they are becoming more selective.

The notion of lumping together diverse economies like Brazil, Russia, India and China has gone.

BlackRock's Fink said the Fed's tapering was just an excuse for turmoil in some emerging markets. The real cause was "bad policy" in the countries affected.

Renault-Nissan chief Carlos Ghosn, whose company has car plants in many emerging markets, said: "You have to be ready when you invest in emerging markets for ups and downs."

In the short term, investors are braced for more downs.

"We are on the cusp of a slowdown in emerging markets," said Scott Gordon of Taconic Capital Advisors. "There is a higher proportion of developed market growth that will drive the global economy."

COMPLACENCY RISK

Yet advanced economies also have work to do to put their houses in order.

"Complacency is both the positive and the negative of Davos this year," said John Studzinski, global head of Blackstone Advisory Partners. "On the one hand, we're not looking at the break-up of the euro zone anymore and people are more relaxed.

"On the other hand, people are not paying attention to things they need to, like the education reform that is needed to resolve mismatches in the workforce, particularly in Europe and the United States."

Even as headline growth numbers improve, few citizens are feeling the recovery. A survey by consulting group Alix Partners of 6,000 adults in six European countries conducted in mid-January showed 71 percent of those questioned saw the economy staying the same or getting worse over the next year.

Christine Lagarde, managing director of the International Monetary Fund, warned policymakers of "some of the old risks that have not yet been completely fixed", added to which is the threat of deflation in Europe.

A case in point is a European Union plan to curb banks' ability to take market bets with their own money, which Germany and France have attacked, warning in a paper seen by Reuters that it could jeopardise a delicate revival.

In some cases, European policymakers cannot even agree on the problems they should be tackling.

German Finance Minister Wolfgang Schaeuble publicly disagreed with EU Economic and Monetary Affairs Commissioner Olli Rehn's view that prolonged low inflation in the euro zone would make necessary economic rebalancing harder.

Schaeuble called that view "nonsense".

Both Rehn and French Finance Minister Pierre Moscovici said the European Parliament could still "improve" a complex system for winding up failed banks agreed by the EU last month. Schaeuble said there was little scope for change without breaching EU treaties.

Joe Jimenez, chief executive of Swiss drugmaker Novartis, said the conversation at Davos had shifted from five years of angst over financial crisis to talk of economic recovery, but companies were still hesitant about the levels of investment which could drive lasting growth.

"If we had the certainty I think you would see more and more companies around the world leaning forward in terms of investment," he said.

(Additional reporting by Alessandra Galloni and Paul Taylor. Editing by Paul Taylor and Mike Peacock)

This post originally appeared at Reuters. Copyright 2014. Follow Reuters on Twitter.

Read more: http://www.businessinsider.com/larry-fink-sees-volatile-year-in-markets-2014-1#ixzz2rWzong46

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A Complete History Of Quantitative Easing In One Chart

This chart illustrates the complete history of the Federal Reserve's quantitative easing program, along with Goldman Sachs chief economist Jan Hatzius's forecast for how "QE3" will be wound down.

"The January FOMC should be fairly uneventful, following significant policy changes made at the prior meeting," writes Hatzius in a preview of next week's monetary policy decision.

"The FOMC will likely continue to taper the pace of its asset purchases by a further $10 billion — split equally between Treasuries and mortgage-backed securities — as hinted at in Chairman Bernanke’s press conference following the December meeting. While the Committee has taken pains to note that the path of asset purchases is 'not on a preset course,' a substantial change in the outlook would likely be required for the Fed to either pause or accelerate the gradual pace of tapering started at the last meeting. We think this relatively high bar has not been met, some weaker recent data notwithstanding. Based on a roughly $10 billion per meeting tapering schedule, the last QE3 purchases should occur in October 2014."

Read more: http://www.businessinsider.com/quantitative-easing-chart-2014-1#ixzz2rRo7c3IC

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These Are Exciting Times For Traders Of The Canadian Dollar

The Canadian dollar is hitting another new 5-year low this morning following the Bank of Canada's decision to maintain its benchmark interest rate at 1%.

"Although the fundamental drivers of growth and future inflation appear to be strengthening, inflation is expected to remain well below target for some time, and therefore the downside risks to inflation have grown in importance," said the Bank in a statement, causing traders to push the loonie lower to reflect greater chances of additional easing ahead.

"Today the BoC has told the market in multiple ways that CAD weakness is desirable and the market should keep pushing on an open door," says Alan Ruskin, global head of G-10 FX strategy at Deutsche Bank.

The move in the U.S. dollar-Canadian dollar exchange rate today is sizable — USD is up 0.8% against CAD — but CAD has lurched lower in several sessions since the turn of the new year on this theme, and USD is already up more than 4% against CAD in the year to date.

Société Générale senior forex strategist Sebastien Galy hints that the environment is similar to that in which the U.S. dollar shot upward against the Japanese yen last year as expectations built for a substantial monetary easing campaign there.

"USD/CAD is one the main trending currencies with TRY technically, and from a modeling perspective in a break of regime, which is the complicated way of saying it no longer trades as it used to for many years," says Galy. "This makes standard regression-based valuation metrics obsolete as they will largely follow spot as happened with USD/JPY under Abenomics."

The chart below shows how much speculators have already piled into the trade. The net position of futures traders at the Chicago Mercantile Exchange is one of the largest shorts in years.

Read more: http://www.businessinsider.com/exciting-times-for-usdcad-traders-2014-1#ixzz2rAbVwNXi

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Here's The Advice UBS Is Giving Its Millionaire Clients

Investors still cowering in fear from their 2008 losses might have missed the stock market rally in 2013. Many chose to sit on the sidelines, and others are worried about a looming stock market bubble.

Cash holdings on the UBS Investor Watch Survey were at 22%. And globally, UBS clients hold 30% of their assets in cash or cash equivalents.

But this isn't the best idea because interest payments on cash deposits don't exceed the prevailing inflation rate.

So what should an investor do?

Here's what UBS is telling it's wealthiest clients to do. UBS' Private Wealth Investment Management division manages money for those with a minimum net worth of $25 million.

Stocks

For those worried about a stock market bubble UBS' Andrea Fisher writes that "there is virtually no evidence that stocks have disconnected from fundamentals." She argues that until pretty recently, the S&P 500 was actually lagging the recovery in earnings. While she is "optimistic [on] the upward march in US equities" she thinks investors need to prepare for more volatility. Some of the best opportunities lie in sectors tied to U.S. economic growth.

Bonds

Investors need to prepare for "several years of unusually low bond returns,"  Brian Nick, a senior portfolio strategist at UBS argues. Investors can lower bond risk by doing one of three things. 1. Lower the duration of the bond portfolio 2. Hold lower quality bonds 3. Try hedge fund strategies because they "traditionally exhibit low or even negative correlation to bond prices." 

"Most hedge fund strategies cannot match bonds’ income or downside protection," Nick writes. "But we believe they will generate better returns over the foreseeable future while adding little to portfolio volatility. This makes them a valuable complement to bond portfolios."

Gold

Investors with large gold holdings (2-3% of their portfolio) should reduce their exposure in 2014, writes UBS' Andrea Fisher.

"Gold tends to do well when real interest rates are either falling or negative as well as when panic pervades the market. Over the past year, real interest rates have begun to increase. This development, along with softer demand from emerging markets, lower central bank purchases, and Fed policy tightening dialogue, help explain the sharp 21% year-over-year drop in global gold demand in 3Q13. Diminished investor appetite for gold in 2014 could result in an additional 300-500 tons (i.e. 7%-11% of yearly demand) of out- flows hitting the market. To balance supply and demand, gold could fall further to its marginal production cost of USD 1,050/oz-1,150/oz; an additional 12% loss from current levels."

Broader strategies

To get more from your portfolio this year, UBS' Michael Crook, head of portfolio and planning research, thinks investors should consider doing three things, that emerge from 2013 Nobel Prize winning research of Robert Shiller and Eugene Fama.

1. Change your liquidity preference (buy illiquid securities). These illiquid assets also help investors avoid market timing risk.

2. Change your time horizon.

3. Invest with managers that have an edge through better market knowledge.

Active management

Nick also suggests that investors reconsider active management as the trend of portfolio managers being bested by the S&P 500 is beginning to reverse. "Regardless of the environment, we believe virtually all investors should invest using a balanced approach between active and passive management," writes Nick. "We find that higher-tracking error managers have greater potential to add value to portfolios, which makes them particularly useful for ful- filling asset classes on which we are neutral or underweight."

2014 is likely to be a challenging year for investors with higher stock market valuations and bond yields that are still low, but UBS thinks these strategies should help.

Read more: http://www.businessinsider.com/what-ubs-is-telling-millionaire-clients-2014-1#ixzz2qVhePoUn

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Seasonality Approaching Its Worst Point

We have entered the Mid-Term cycle in the Quadrennial Presidential Cycle, in which the months April through to September typically represent the worst SP-500 seasonal period for the entire 4 year cycle. The current cycle which commenced in 2012 has performed way above average so far, as shown below with the black dotted line:

However it is plain to see from the chart above that the average gains through the 4-year cycle are composed of cycles that vary quite a bit around the mean. We also note that despite the hugely above-average performance so far in this cycle, we are by no means out of boundaries set in prior cycles.

Due to wide dispersion around the mean since 1956, we find it more illuminating to rather compare the current cycle with all prior cycles that are showing at least a 90% correlation with the current 2-year progress:

Again it is clear we are still running above average (no doubt due to the FED’s stimulus – see “FED in the driving Seat“), but are still very much in tune with the directional cues imparted by the average as shown by the r-squared correlation of 0.97. Regardless if one looks to this chart or the chart depicting all past cycles, the message is clear that we are entering a seasonally weak period through to September 2014.

If we examine all prior stretches running from April through to September in the mid-term election cycle, we get the following distribution of returns:

Whilst it is not impossible for out-sized gains to occur during this period, the odds are clearly stacked against you with the historical record providing a lowly 35% chance of success and losing points outweighing winning points by 2.56 times to one. There are obviously many factors to take into account when deciding what do do during this period of weakness, most importantly the status of the economy, stock market health metrics, your investment horizon and so forth but if you are purely making decisions on statistical odds of past performance then this is the time to be sitting out the market since risks are more than double any likely rewards.

As we showed with our SuperCycle Seasonal Methodology, bear markets and recessions have a surprisingly large seasonal factor surrounding them. If ever this market is going to correct 10-15% off current heady highs it is very likely to occur between now and September. We certainly hope it does follow the playbook, since the 4-6 months pain is more than rewarded with the mother of all rallies that usually commences in the latter part of the mid-term election cycle.

Read more: http://recessionalert.com/seasonality-approaching-its-worst-point/

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HSBC- EUR: Myths Vs Facts

"We are not convinced by a number of suggestions offered for the EUR’s resilience to wider USD strength. One idea is that EUR is gaining on the basis of its improving current account balance. Yet the US deficit has seen an even greater correction in its imbalance. In addition, the swing into surplus for the Eurozone reflects economic weakness or collapsing domestic demand not strength. The second suggestion is that the EUR is being supported by portfolio flows, but the Eurozone is not the only market to see buying of local equity and bond markets. Furthermore, portfolio flows are not the dominant aspect of the Eurozone’s capital account.

So in the end, the EUR continues to be a “carry trade” where currency movements are largely determined by movements in relative rate expectations. Chart 10, for example, shows EUR-USD in black plotted against the expected gap between Eurozone and US 3M interest rates by the end of 2015. The link may not be perfect, but it is strong. The EUR-USD exchange rate will be determined by the policies of the ECB and Fed, a data-determined evolution, and one we continue to believe will see EUR-USD much lower over this year."

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CITI - Here Are The Best 5 FX Trade Ideas For 2014

Citibank expects the USD to rally versus G10 in 2014 - pretty much across the board.

"GBP and NZD are the only currencies we expect to hold their own versus USD. Weakest currencies are likely to be JPY, AUD, CAD and CHF. The surprise in 2014 FX markets will likely be how well risk appetite survives tapering given the low volatility across asset markets," Citi projects.

"Carry is attractive under these conditions. The winning currencies will be the highest carry with the lowest country specific risk, the losers, currencies with low yields and flat yield curves," Citi adds.

In line with this view, Citi picks the following 5 FX trades for 2014:

1. Relative value in majors – Long GBP, USD vs. Short JPY, CHF

60% Buy USDJPY with 102.90 stop

40% Buy GBPCHF with 1.4640 stop

2. Further strength in USDJPY

Buy 6mth USDJPY 1x2x1 fly (strikes 106/109/112, expiry Jul 10) at 0.50% of USD

3. AUDNZD to take out parity

buy 9mth AUDNZD 1.00 European digital (spot ref 1.0760, expiry 10/10/14) at 12% of AUD Policy divergence is likely to drive AUDNZD into a new historic low range close to parity.

4. CAD undermined by disinflation and competitiveness

Sell CADMXN at 12.0840, targeting 11.2610 with a stop/loss 12.551

5. Long NOK on valuation grounds 

Buy EURNOK 7.70 one touch (spot ref. 8.43, expiry 19 Dec 2014) at 19.75% of EUR.

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Citi's Economic Surprise Index Is Now At Nosebleed Levels

Citi's economic surprise index, which measures the actual outcome of economic data releases relative to consensus estimates, is at its highest level in nearly two years after a streak of stronger-than-expected data in the last few months has sent it on a tear.

Now, the index is at levels often associated with a rolling over of this measure, as Chart 1 shows.

If the index does roll over soon — as economists' expectations outpace actual further improvements in the data — it could provide support for U.S. Treasuries, which have been selling off since October, when Citi's surprise index turned upward.

It would also bring to a halt a big theme in interest rate markets that has played out in the wake of the Federal Open Market Committee's December 18 announcement that the Federal Reserve will begin tapering down its quantitative easing program.

Short-term interest rates have been rising as traders test the FOMC's commitment to keep its policy rate pinned between 0 and 0.25%, where it has been since the financial crisis. The idea is that continued improvement in the economic data of the sort we've seen since October will cause the FOMC to renege, normalizing its policy rate sooner than it currently says it will.

"Since they've only started to taper, the idea of repricing the first hike does seem rather premature, but the logic does include the data itself," says David Ader, head of government bond strategy at CRT Capital.

"So when we hear people say things like, 'If the data strengthens…' we can only respond with, 'Indeed!' The issue is: what if the data just continues with the current sort of strength?"

If that's the case, the big sell-off we've seen in interest rate markets may subside.

Read more: http://www.businessinsider.com/citi-economic-surprise-index-surging-2014-1#ixzz2pwXBf0oU

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CITI - Is EUR/USD Resilience Coming To An End?

EUR/USD resilience could come to an end if supportive December flows like corporate yearend earnings repatriation and banks’ euro buying ahead of the AQR do not extend into January, argues Citibank.

"EURUSD remained rather resilient of late consistent with the pattern of euro outperformance in the month of December we had in recent years... Bank inflows into EUR in particular have intensified noticeably in Q4 according to Citi FX flow data," Citi notes.

"As shown in Figure 3, the EURUSD outperformance in December was often followed by underperformance in January suggesting that the pair may look vulnerable again if the supportive December flows do not extend into the New Year," Citi adds. 

"We also note that EURUSD still looks quite overvalued compared to a gauge of relative economic surprises out or the Eurozone and the US Our fair-value model based on EUR-USD rate spread, FX volatility, market positioning and relative bank performance suggests that EURUSD should be trading at 1.3200," Citi projects. 

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GEORGES SOROS: The World Economy’s Shifting Challenges

As 2013 comes to a close, efforts to revive growth in the world’s most influential economies – with the exception of the eurozone – are having a beneficial effect worldwide. All of the looming problems for the global economy are political in character.

After 25 years of stagnation, Japan is attempting to reinvigorate its economy by engaging in quantitative easing on an unprecedented scale. It is a risky experiment: faster growth could drive up interest rates, making debt-servicing costs unsustainable. But Prime Minister Shinzo Abe would rather take that risk than condemn Japan to a slow death. And, judging from the public’s enthusiastic support, so would ordinary Japanese.

By contrast, the European Union is heading toward the type of long-lasting stagnation from which Japan is desperate to escape. The stakes are high: Nation-states can survive a lost decade or more; but the EU, an incomplete association of nation-states, could easily be destroyed by it.

The euro’s design – which was modeled on the Deutsche Mark – has a fatal flaw. Creating a common central bank without a common treasury means that government debts are denominated in a currency that no single member country controls, making them subject to the risk of default. As a consequence of the crash of 2008, several member countries became over indebted, and risk premia made the eurozone’s division into creditor and debtor countries permanent.

This defect could have been corrected by replacing individual countries’ bonds with Eurobonds. Unfortunately, German Chancellor Angela Merkel, reflecting the radical change that Germans’ attitudes toward European integration have undergone, ruled that out. Prior to reunification, Germany was the main motor of integration; now, weighed down by reunification’s costs, German taxpayers are determined to avoid becoming European debtors’ deep pocket.

After the crash of 2008, Merkel insisted that each country should look after its own financial institutions and government debts should be paid in full. Without realizing it, Germany is repeating the tragic error of the French after World War I. Prime Minister Aristide Briand’s insistence on reparations led to the rise of Hitler; Angela Merkel’s policies are giving rise to extremist movements in the rest of Europe.

The current arrangements governing the euro are here to stay, because Germany will always do the bare minimum to preserve the common currency – and because the markets and the European authorities would punish any other country that challenged these arrangements. Nonetheless, the acute phase of the financial crisis is now over. The European financial authorities have tacitly recognized that austerity is counterproductive and have stopped imposing additional fiscal constraints. This has given the debtor countries some breathing room, and, even in the absence of any growth prospects, financial markets have stabilized.

Future crises will be political in origin. Indeed, this is already apparent, because the EU has become so inward-looking that it cannot adequately respond to external threats, be they in Syria or Ukraine. But the outlook is far from hopeless; the revival of a threat from Russia may reverse the prevailing trend toward European disintegration.

As a result, the crisis has transformed the EU from the “fantastic object” that inspired enthusiasm into something radically different. What was meant to be a voluntary association of equal states that sacrificed part of their sovereignty for the common good – the embodiment of the principles of an open society – has now been transformed by the euro crisis into a relationship between creditor and debtor countries that is neither voluntary nor equal. Indeed, the euro could destroy the EU altogether.

In contrast to Europe, the United States is emerging as the developed world’s strongest economy. Shale energy has given the US an important competitive advantage in manufacturing in general and in petrochemicals in particular. The banking and household sectors have made some progress in deleveraging. Quantitative easing has boosted asset values. And the housing market has improved, with construction lowering unemployment. The fiscal drag exerted by sequestration is also about to expire.

More surprising, the polarization of American politics shows signs of reversing. The two-party system worked reasonably well for two centuries, because both parties had to compete for the middle ground in general elections. Then the Republican Party was captured by a coalition of religious and market fundamentalists, later reinforced by neo-conservatives, that moved it to a far-right extreme. The Democrats tried to catch up in order to capture the middle ground, and both parties colluded in gerrymandering Congressional districts. As a consequence, activist-dominated party primaries took precedence over general elections.

That completed the polarization of American politics. Eventually, the Republican Party’s Tea Party wing overplayed its hand. After the recent debacle of the government shutdown, what remains of the Republican establishment has begun fighting back, and this should lead to a revival of the two-party system.

The major uncertainty facing the world today is not the euro but the future direction of China. The growth model responsible for its rapid rise has run out of steam.

That model depended on financial repression of the household sector, in order to drive the growth of exports and investments. As a result, the household sector has now shrunk to 35% of GDP, and its forced savings are no longer sufficient to finance the current growth model. This has led to an exponential rise in the use of various forms of debt financing.

There are some eerie resemblances with the financial conditions that prevailed in the US in the years preceding the crash of 2008. But there is a significant difference, too. In the US, financial markets tend to dominate politics; in China, the state owns the banks and the bulk of the economy, and the Communist Party controls the state-owned enterprises.

Aware of the dangers, the People’s Bank of China took steps starting in 2012 to curb the growth of debt; but when the slowdown started to cause real distress in the economy, the Party asserted its supremacy. In July 2013, the leadership ordered the steel industry to restart the furnaces and the PBOC to ease credit. The economy turned around on a dime. In November, the Third Plenum of the 18th Central Committee announced far-reaching reforms. These developments are largely responsible for the recent improvement in the global outlook.

The Chinese leadership was right to give precedence to economic growth over structural reforms, because structural reforms, when combined with fiscal austerity, push economies into a deflationary tailspin. But there is an unresolved self-contradiction in China’s current policies: restarting the furnaces also reignites exponential debt growth, which cannot be sustained for much longer than a couple of years.

How and when this contradiction will be resolved will have profound consequences for China and the world. A successful transition in China will most likely entail political as well as economic reforms, while failure would undermine still-widespread trust in the country’s political leadership, resulting in repression at home and military confrontation abroad.

The other great unresolved problem is the absence of proper global governance. The lack of agreement among the United Nations Security Council’s five permanent members is exacerbating humanitarian catastrophes in countries like Syria – not to mention allowing global warming to proceed largely unhindered. But, in contrast to the Chinese conundrum, which will come to a head in the next few years, the absence of global governance may continue indefinitely.

Read more at http://www.project-syndicate.org/commentary/george-soros-maps-the-terrain-of-a-global-economy-that-is-increasingly-shaped-by-china#43jfaxD0oUgIPGd2.99

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Expectations: A Market Time Machine

In H. G. Wells’ novel, The Time Machine, a traveler’s desire to find out what will happen to the human race ultimately leads him on a tremendous expedi- tion into a terrifying and perilous future. Metaphorically, the expectations of market participants also function like a time machine, as they allow partici- pants a glimpse into the market’s future. Foreign exchange traders stress that expectations play one, if not the, leading role in the dynamics of the market. ‘‘It is the expectation of the market which is most important,’’ says one trader regarding exchange rates. ‘‘Everything is expectation,’’ another trader concurs. Also market observers (i.e., financial journalists) underscore the vital role of expectations in the foreign exchange market. ‘‘Markets deal on expectations and the future. If you didn’t have news of expectations and expectations of the market then what would traders deal on?’’ one financial journalist asks. ‘‘When a market goes from being golden to being rotten, like Mexico [i.e., the Mexican peso] goes from one day to another, not because anything fundamental has changed, it’s because all of a sudden expectation went one way or the other,’’ another journalist adds in support of this view.

Similar to travel in a time machine, market expectations change not only the views but also the behavior of participants, both among individuals and on the level of the collective market. Indeed, the foreign exchange market may be the most rapid of all financial markets to translate and integrate expectations of the future into the present market behavior. One trader observes lucidly that, ‘‘Especially the currency markets tend to run ahead. We have seen that over the last few years, especially the currency markets tend to focus very much on the future. We often had discussions with our economist in which he said, ‘All the figures currently would point to such and such trend.’ And then all that was already priced in!’’ Thus, in their present evaluations of currencies and trading decisions, market participants include their expectations of future events and discount the probable effects of yet-to-come developments. Conse- quently, on the aggregate level of the market, collective expectations about future events are integrated into the current level of exchange rates. ‘‘The market is always expecting some events ... and the thing is before this event happens, the market moves in that way ... Everyone said, ‘OK, the dollar is coming up because there are interventions, there is some especially good big figure . . . and the market is expecting that and buying dollars, and of course dollar–mark is going higher’,’’ according to one trader. Thus the foreign exchange market creates an anticipatory reality that turns the expected future into the present in advance. ‘‘The market positions itself beforehand,’’ another trader declares. As expectations about future events are built into the market, a trader’s shrewd observation that, ‘‘If the news has come out, it is old for us: it is the past, it is already built into the prices,’’ is hardly surprising.

Like a time machine, market expectations allow individual participants to turn the wheel of time ahead, and the collective market to preempt the likely future of the market. This journey in time, however, transforms the meaning and impact of market news and information. Effective news is the difference between the market’s expectation and the actual published figure. Pointing to his massive, wooden trading desk, one trader explains that, ‘‘Information that comes out that is expected is not really information. It just confirms something you already know. You know, this table is made of wood. I don’t need to know that [news] comes out that this table is made of wood. Because we know that— fantastic. [However, news that] this table is made out of gold, that’s something different. If people don’t know it, it is going to move [the market]!’’ Expecta- tions thus determine the market’s reactions to news by turning news into a check of already acted-on expectations. ‘‘What makes the market move is the delta between the expectations and the news. It’s not the news itself,’’ one trader explains. Thus, news that merely confirms expectations does not change the already created status quo of the market, independent of how positive ornegative the intrinsic content of the news may be. Only unanticipated news, such as economic indicators deviating from what was expected, will move the market. Accordingly, as one trader observes, ‘‘Some figures are coming. If the figures are good or bad does not make any difference. [However], it makes a big difference if you expect a bad number and a good one comes.’’ Another trader echoes this sentiment, saying, ‘‘The final event gives just the conclusion and tells the people if their expectations were right or their positions were right. The expectations move the market, not the event.’’

According to traders, because expectations are already integrated into the market before the corresponding information confirms them, the arrival of anticipated news may even trigger a paradoxical move—in the opposite direction of what identical news would have triggered normally. ‘‘If the market has positioned itself beforehand, then you could get a totally adverse reaction to a certain event. You might get a positive number for the American economy, nevertheless the market reacts to the contrary because people were already long, and they are just going out of it,’’ one trader observes. Another trader explains this shift with a pertinent market example: ‘‘Five percent inflation is a bad figure, and that would under normal circumstances hurt any bond market. But if the market’s perception was the figure should be 5.5%, although 5% is still a bad figure the market could actually react the other way because what is expected is different from what the actual figure is.’’ Thus, traveling in the time machine of expectations, participants not only catch a glimpse of the foreign exchange market’s future; doing so actually changes the future they finally encounter. 

From the book "The Psychology Of The Foreign Exchange Market" by Thomas Oberlechner

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