The Monday Report

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By Greg Peel

Friday's trading session in offshore markets was one that featured surprising magnitudes and a similar theme. With the US dollar index steady on the session, everything else – stocks, bonds, commodities – went into reverse, and significantly so. The Dow fell 90 points or 0.8%, the S&P fell 1.2% to 1199, the US ten-year bond yield was up 14 basis points to 2.79%, gold fell US$41.10 to US$1368.10/oz, silver fell 6%, nickel and zinc fell 6%, aluminium, copper lead and tin fell 3-4%, and oil fell US$2.93 to US$84.88/bbl.

On Saturday morning, the news wires seemed to be struggling for explanations. The common theme was “fear of a Chinese rate rise” but to me this seems a bit hollow. From the moment the Chinese inflation number hit the tape on Thursday, another Chinese rate rise was an absolute lay-down misere. Yet that night metals traders in London took the Chinese data as a reason to buy, and gold held its ground above US$1400. (The US bond market was closed, so that was a factor in Friday's move).

My explanation? Well it all starts with the fact that Friday was the day the Fed actually made its first physical bond purchases as part of its QE2 package. This, in itself, was a signal, albeit the signal needed a bit of background support to be as loud and clear as it was. What we have not seen since the QE2 confirmation a couple of weeks ago was any “sell the fact” going on in a big way. The day after the announcement, the US stock market surged. There has been some weakness on profit-taking since due to European concerns, but no big profit-taking dump following the 17% run-up from August which was all about QE2 speculation. And commodity prices have done nothing but surge further north knowing US dollar weakness, in the form of QE2, was a driver.

The long period of QE2 speculation sucked the oxygen out of every other “story” in the global market at the time. Two of those stories were: Europe continues to struggle through difficulties and potential sovereign debt problems, this time with Ireland in the frame; and the Chinese economy was not at all slowing too sharply, raising threats of further monetary tightening. China actually raised its interest rates for the first time in years during the QE2 speculation period, but the move only received five minutes of attention from elsewhere.

So why, if there is now speculation Beijing will raise again, it is suddenly so much more of a factor this time, particularly given the QE2 “backstop”?

Well, what we now have is a situation which looks very much like early 2010. European sovereign default is very much back on the agenda, but this time it's Ireland in the frame rather than Greece. It is quite likely Ireland will be forced to tap into the EU-IMF emergency fund which was first set up with Greece in mind, and already rumours have circulated with a figure of E80bn. Those rumours have been swiftly denied by Dublin, and Dublin has also moved to quell any fear of sovereign bondholders facing “haircuts”. The soothing words on Friday night stopped the euro falling and allowed the US dollar index to settle about square at 78.11. It was trading higher at the earlier time when commodity markets were closing.

One will always be reminded that on the Friday, Lehman CEO Dick Fuld assured shareholders via a conference call that the firm was not about to go under, and that on the Monday it did.

Earlier in 2010 there was also a grave fear that the Great Saviour of the global market, being China, would exacerbate the tenuous global situation by forcibly slowing its economy as was announced by Beijing. Beijing has indeed been tightening ever since, but it kept a very close watch on Europe. Europe is, after all, China's biggest export customer. The first rate rise came only when it appeared Europe was sufficiently out of the woods.

Or at least it was out of the woods enough to be ignored and attention swung toward soaring commodity prices on the back of QE2 speculation. Beijing knew a big inflation jump was on the way as the US dollar weakened, taking the renminbi down with it. It was time to act.

You'd think the market might have now become used to the pattern – China's monthly economic data come in with strong readings, Beijing tightens. Equilibrium is maintained. But no – every time China posts good numbers global markets rally (salad days) and every time Beijing tightens in response the market crumbles (days of doom).

The importance therefore, as I see it, of the Fed actually making its first physical foray into the US bond market is that earlier in 2010 there was QE2 to speculate about. Now there isn't. There will be no more rescue packages this time, at least in the medium term.

With that in mind, the surge in commodity prices driven by QE2 will force Beijing to raise its interest rate to curb inflation. Across the emerging markets, and those economies which benefit from the emerging markets (eg Australia) rates are being raised to fight inflation. What is a hedge against inflation? Gold. And what has been driven by reflation efforts? Commodities. If now half the world starts tightening, those prices will not necessarily keep rising just because the US dollar might be weak.

And the US dollar won't be weak if the euro is weak in its place.

Then we come to the G20. President Obama went into the G20 with the intention of loudly reprimanding Beijing for its manipulated currency and the assumption the rest of the world would stand behind him in so doing. Instead, the rest of the world turned on the US. Currency manipulation? Pot calling kettle? Perhaps, Mr President, you might pull the mote out of your own eye first?

And he cried mightily with a strong voice saying, Babylon the great is fallen…

One might suggest, that along with all the background developments, this was the clincher. Beijing will almost certainly make an incremental revaluation to the renminbi before the year is out, but it will not be because the US says so. And it will continue to revalue in its own good time. The pendulum of power has swung. The Fed now looks very lonely.

And so positions that were built on QE2 speculation were reversed on Friday night, and profits that have been made were taken. It's not the end of the world. In fact it's a pretty healthy move. It was time this market came down from the clouds and back to reality. It cannot be as simple as “QE2 supporting everything”.

On Friday night the first estimate of eurozone GDP showed a 0.4% increase for the September quarter after a fall of 1.0% in June. Economists had expected 0.5%. Growth over twelve months was 1.9% which is unchanged and was as expected. Nothing too ominous there.

In the US tonight we have retail sales, business inventories and the Empire State manufacturing index. Tuesday it's industrial production, the housing sentiment index, and the PPI. Inflation will be in focus in the US this week, and inflation is QE2's specific target. Wednesday brings the CPI and housing starts.

Thursday wraps it up with the Conference Board leading economic index and the Philadelphia manufacturing index.

Japan will make its first estimate of September quarter GDP today, and tomorrow night the closely watched ZEW sentiment index will be released in Europe.

It's a relatively quiet week for Australia on the economic front. Today is vehicle sales, tomorrow the minutes of the RBA meeting will be released and should make interesting reading, and on Wednesday it's the quarterly wage cost index and Westpac's leading economic index.

It's not a quiet week for AGMs, of which there are plenty. Commonwealth Bank ((CBA)) will provide a quarterly trading update today, Elders ((ELD)) and Incitec Pivot ((IPL)) full year reports, and James Hardie ((JHX)) a quarterly report.

For further global economic release dates and local company events please refer to the FNArena Calendar.

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