New Year, Same Old Problems

Happy New Year, and good riddance 2008. The year was one of the worst ever for equity markets (the worst on record for the Nasdaq), while a flight to safety has created a potential new bubble in the US Treasury market. 2008 also saw the beginning of a global recession, pummeling commodities, and spawning record volatility in currency markets. In financial markets, January tends to set the tone for the rest of the year, so economic events and data this month may be of particular importance, especially in light of major political changes afoot.

Equities Grope for a Bottom

With some economic recovery projections starting to move out to 2010, January may be too early to predict a rebound, but it does warrant looking at historical trends. If the first week of January and then the full month both show gains on the major equity indices, there has been a more than 90% correlation with the indices ending higher for the year. This could be helped by the so-called "January effect", early buying of small cap stocks after year-end tax loss selling, which may lift equities for the first few days of the month.

A couple of key gatherings will also affect equities this month. The influential annual JP Morgan healthcare conference convenes January 12-15. Last year drug companies were bought up ahead of the conference on anticipation of new drug announcements, and this pattern may repeat itself. Retail technology manufacturers may try to offset shaky holiday sales with a look at their latest products at the Consumer Electronics Show (CES) running from January 7 to 11. The Macworld Expo will also convene in early January (Jan 5-9). Apple already raised a flag of caution when it announced CEO Steve Jobs would not attend the Expo, creating renewed speculation about his health and Apple's ability to roll out new inventive products this year.

The fourth quarter earnings season begins in mid-January, officially signaled by Alcoa's report on January 12. With the NBER recently slapping the official 'recession' label on the US economy, Q4 results are expected to be grim. A bevy of US companies will paint the picture of just how painful Q4 was across the board as consumers and corporate customers pulled into their shells. Commentary on guidance will likely be rare as lack of visibility is leading more and more companies to decline to provide a quantitative outlook.

Commodities Diverge

As companies brace for the recession, commodities continue to suffer from ever shrinking global demand for inputs. Hedge fund deleveraging may be over, but new demand and speculative zeal are nowhere to be found. Gold has found new footing, rising 25% in the last few months and is approaching $900 again. With treasuries oversaturated with investors, gold may continue to attract a flight to safety trade in early 2009.

In contrast, the price of crude oil continues to wallow around $40 per barrel despite OPEC announcing substantial production cuts and the flare up of the Israel-Hamas conflict. An escalation of the Middle East conflict could create some impetus for crude to rebound, but a more likely scenario is that energy futures will get a boost from OPEC members declaring better compliance over the next few months with the previously announced cuts. Absent such conditions however, energy and other commercial commodities may find a hard time gaining ground as the global economy limps along in a deflationary cycle.

Foreign Exchange Free-for-all

The outlook for currencies in 2009 will depend on which economy can best withstand the Tsunami of global credit turmoil and maintain its finances on the federal, state and local levels. Deflation fighting may demand increasing government cash and credit infusions this year, which will continue to provoke commentary about the inefficiency of government spending and tinkering. With diminished global growth prospects and central banks seemingly unable to prompt the commercial banks to stop hoarding their capital, more corporate failures may be in store across the globe.

Safe haven flows will be a dominant force in forex markets as the New Year commences. Most speculators on the street suspect that the worst of the hedge fund deleveraging and redemptions are over, but some murmurs suggest that this process has only been delayed as some redemption periods have been extended up to 90 days. That may spur safe haven flows into the greenback in the coming weeks.

All eyes will be on the Euro Zone in 2009. As the tenth anniversary of the euro is observed, recession will test the cornerstone of monetary union, the Maastrict stability pact. Enduring these tough times will test the mettle of the monetary marriage and whether the growing roster of EU countries can maintain the façade of a 'happy family.' Should the union pass this tough trial, it may ultimately prove the value of the euro as a competitor to the dollar as the world's premier reserve currency.

The EUR/USD is ending the year around the 1.40 area. Interestingly, the so-called German wisemen, senior economic advisors to the government, suggested that the ECB should intervene if the EUR/USD moved back above the 1.50 level and labeled euro appreciation a "problem" for the German economy. Technically, a break above the 1.47 December highs sets up a measured move objective of 1.70 in EUR/USD. Thus the wisemen's level is indeed a potential line-in-the-sand.

The possibility for unorthodox central bank action is always possible, especially with the significant weakness experienced by the British Pound and its related pairs. With the pound sterling approaching parity with the euro, the BOE may feel pressure to take new extraordinary actions (it may even spark new rumors about the UK contemplating finally joining the continentals in monetary union). Meanwhile the BOJ has been somewhat vocal about the appreciation of the Yen seen in late 2008, and appears to be probing the waters for possible currency intervention. Japanese corporations have become quite vocal in their requests for Japanese finance officials to take action in curbing JPY appreciation as it has adversely impacted their earnings and production outlook. The BOJ next meets on January 22.

Historically Central Bank intervention among the G7 nations has been rare. There are varied intervention techniques, depending on the circumstances and goals of the operation ranging from verbal intervention (already underway by the Japanese officials), solo intervention and the effective (but rare) G7 coordinated intervention. Central banks have learned from past ineffective interventions that the appropriate technical background in a currency pair is an important aspect in achieving the required momentum necessary to assure an effective operation. 2009 begins with a ripe technical picturing unfolding in various JPY-related pairs that could spur the BOJ and other G7 members to act. The instrument of any coordinated intervention might not be the obvious USD/JPY pair - instead the Sterling/Yen cross could be the preferred vehicle for intervention.

Central Banks Keep Cutting

On January 15th, the ECB will convene its next policy meeting, and current expectations are for a 50 basis point interest rate cut to 2.00%. This might not be enough to satisfy the German wisemen, who recently called for the ECB to cut rates "significantly."

The Bank of England is also expected to cut rates again this month. Expectations are that the January 8th MPC meeting will result in a 50 basis point cut to 1.50%, bringing the BOE rate to its lowest level since the bank was chartered in 1694.

In the US, the FOMC has now slashed rates to an historically low 0.25%, after cutting 75 basis points at its December meeting in a unanimous vote. At the time of that rate decision, the Fed also stated that it expects exceptionally low levels of the federal funds rate for some time, while completely absent was any rhetoric about withdrawing easing when the economic situation improves. In its rate statement, the FOMC hinted about using "all available tools," code language for quantitative easing, and it may feel pressure to elaborate on new policy initiatives at its January 28th meeting.

On January 6th, the minutes of the December FOMC meeting will shed light on how solid the unanimity is at the Fed. The record of the Committee's discussion may show what other tools the Fed is thinking about deploying and how sober their view on the financial environment has become, in the face of slowing economic activity and deteriorating labor markets.

Data Still Discouraging

The difficulties in the labor market will be further illustrated by December Payrolls and Unemployment data to be released on January 9th. Expectations are for nearly half a million more job losses, while unemployment is forecast to hit seven percent. December has been laden with news of companies announcing restructuring plans, plant closures and layoff, so it won't be surprising if this data is even worse than expected.

The most anticipated economic data of the month may be the Q4 US Advance GDP, to be released on the 30th. Though a recession has already been formally declared, the depths of the downturn are still to be measured, and this early Q4 GDP reading will be emblematic of just how bad the economy got in the latter months of 2008.

Treasury Market Raises Questions

Treasuries are likely to be driven by macroeconomic and political events this month. With Inauguration Day on January 20th, the Obama Administration is expected to immediately begin wrangling with Congress over the conditions for the release of the second half of the TARP fund. The incoming administration will also be tasked with laying out new regulations to combat the excesses that triggered the unprecedented market turmoil.

US Treasury markets will likely be forced to confront certain stark realities heading into the New Year. Many prognosticators are predicting the flight to quality bid that has sent US government bond yields to all time lows, has created a genuine bubble scenario in government paper. Will the prospects of ballooning US deficits, miniscule yields, and steadily ratcheted up supply bring an end to the insatiable demand that has been seen for US government securities? Will foreign governments and central banks curtail their US treasury purchases in a effort to diversify reserves away from the greenback? Will the prospect of higher inflation down the road induced by the endless stream of reflationary government programs eventually pressure bond prices?

It is crucial to remember these questions will be asked in the context of a changing administration. Will President Obama and incoming Treasury Secretary Timothy Geithner continue the policies of Paulson by successfully negotiating the release of the second installment of TARP funds? Will they aggressively expand purchases of GSE and MBS debt? Will they consider buying longer dated US Treasuries as Paulson and company have hinted? And will new regulation restore confidence or stifle risk taking? The answers to some these questions will start to emerge post inauguration and their effect on government bond markets could be substantial.

Asian Economies Struggle On

Back in 2007, the incoming Treasury Secretary Tim Geithner has remarked that "Asia needs to prepare for a future in which it relies more on strength of growth at home rather than strength of growth in the rest of the world." That sentiment proved to be remarkably forward looking when, in October, China reported a 5-year low GDP for Q3 of 2008 at 9.0%, attributing relative underperformance primarily to the overexposure of China's economy to global demand of its cheaply manufactured goods. The centerpiece of economic data emanating out of Asia in January - China's Q4 GDP - is widely expected to show a much lower figure. Estimates range widely, from the official China State Information Center estimate of 8% to more downbeat economist forecasts, and should result in formidable event risk while reinforcing the need to generate a more sustainable internal demand.

As a deeper than previously anticipated recession enveloped Japan and interest rates declined ever closer to the familiar ZIRP (zero-interest rate policy) territory in December, the need for a fiscal stimulus beyond monetary accommodation has become increasingly more evident. While the administration has finally made a formal announcement of a more encompassing ¥23B stimulus plan, getting the measure through the politically charged waters of opposition upon the return of Japan's legislative Diet in January becomes a more pressing concern for the beleaguered Prime Minister Aso. Critics from the PM's own party contend that the plan is either too populist or too expensive in light of Japan's mushrooming budget deficit, which will likely require plenty of maneuvering on Aso's part. With his recent approval ratings declining to fresh lows ahead of the general elections required to take place before September 2009, January is likely to become the make or break period for the administration to move the stimulus forward.

New Year, But No Resolution?

As we seek the promise of a New Year, we face the same old problems - mounting unemployment and job losses, shrinking GDP, unstable currencies, and a seemingly bottomless housing market. The old Wall Street adage says, "as January goes, so goes the year." It is possible that the easing of energy prices, more government activism, and the air of optimism around the new president could lead to a short term recovery in January. Yet the overhang of economic problems is so pronounced, the period of optimism may be short lived indeed, as the resolution of the financial crisis remains out of sight.

Notable Events in January 2009

Jan 6: Dec FOMC meeting minutes
Jan 9: Dec US Payrolls and Unemployment
Jan 15: ECB Rate Decision
Jan 20: Inauguration Day
Jan 28: FOMC rate decision
Jan 30: Q4 US Advance GDP

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