My Diary 702 --- Not All the News is Grim; To Fix the Italy’s 7%

My Diary 702 --- Not All the News is Grim; To Fix the Italy’s 7% Beacon; The Soft Landing China is Marked; Euro watches ECB +QE

Sunday, November 13, 2011

“It’s all about Euro zone: risk, rebound, reshuffle and recession” --- The week was quite volatile but risk assets are net up, and safe bonds are down, helped by optimism from political changes in Greece and Italy. Excessive pessimism and bearish positions among investors continue to create an asymmetric outlook for equity markets, with bearish news creating limited downside and positive news more pronounced rebounds. Most fund flows data suggest that positions remain low, supporting further equity rallies in the absence of big negative news. The reporting season is adding to positive momentum. More importantly, profit margins appear to have expanded over the past year. SP500 EPS grew 16% yoy in 3Q, vs. 11% for Sales-per-Share. The size of EPS surprise is also higher in Europe with +4% for DJStoxx600 vs. 3% for SP500.

It is counter-intuition to see risk markets to gain in a world with so much risk, unknowns, volatility, disequilibria, and pure political ineptitude?  But as an investor, the ultimate question we have is -- where do you get a return? Yields on cash and USTs remain near all-time lows (0-2%) and after tax and inflation, these yields are negative. Equity yields (earnings yields plus inflation) are, in contrast, high by historical standards (8-10%), but obviously require one to buy a very volatile asset. As a result, last month I saw very significant inflows into equity and HY funds, much of which I believe is driven by the dire returns on safe assets. Macro wise, the fear of US economy (2H11= est. 2.5% vs. 1H =1%) stalling has receded, but not gone away. This week alone, trade, claims, and confidence all surprised on the upside. That said, there remains no sign of compromise in Washington on deficit reduction for next year (nor for the next decade). In China, the continued fall in inflation and move to monetary easing is greatly reducing fears of a hard landing. On the negative side, the massive floods in Thailand will have a similar supply-chain effect (40% of scale) as the Japanese tsunami in March. The floods should take 2.25% off global IP growth this quarter, translating into a 0.5% cut in global GDP growth.

That said, Euro area remains at the core of investor concerns, and rightly so. Last month’s EU summit saw the right commitments --- fiscal solidarity (funding) and fiscal discipline (austerity), but a lot blanks need to be filled in. This week saw some progress in the “Carrot & Stick” policy as Greece now has a new PM and Italy seems set to get one next week. Both should give the EMU creditor nations better confidence that austerity conditions of financial support will actually be implemented. But debtor nations cannot live on austerity alone, as their economies are entering recession, depressing tax revenues even as tax rates are being raised. It is partially why market is turning its attention to Italy, especially after LCH Clearnet demanded for higher repo margins in the Italian bond. This had resulted in a massive surge in Italian bond yields. Fortunately the successful sales of EUR5bn Italian bonds, the passing of Italy’s austerity package by the upper house and the changes in Italian PM helped to restore confidence. 10yr BTPs dipped back below 7%. But the T-bill auction deal came at a yield of 6.087% which is the highest since Sep1997 and was also sharply above the 3.57% it paid at a similar auction last month, and the spread over comparable German bunds held at 16-year highs of ~494bp (per Reuters). These are hardly sustainable levels for Italy and the market will wonder what the rating agencies will have to say if BTPs’ yields stay here long enough. Indeed Moody's last comment on the A2 (Neg outlook) rating was that it could be downgraded, should evidence of ongoing economic weakness, non-achievement of fiscal consolidation targets and/or increasing funding costs translate into significant delays of the reversal of its public debt trajectory. In addition, if Italy's access to the public debt markets were to be constrained and the LT availability of external sources of liquidity support were to remain uncertain, the sovereign rating could transition to substantially lower rating levels. So net net, there is still plenty to be concerned about. Italy has some big redemption months ahead of us and this will remain a key market focus.

Fairly to say, in the Euro area, the political process dealing with the debt/banking crisis is moving quickly by the historical standards, but is still too slow for investors, and too chaotic to reach a resolution. The region’s politics are so much like soap opera. Berlusconi finally agreed to resign but not until Parliament approves the first set of structural reforms which will likely be by late Nov/early Dec. Moreover, it looks like Berlusconi's party is still divided as to whether it prefers to hold an early election after his resignation or not. Meanwhile in Greece, a new government will be sworn and an election is now tentatively set for February 19th. So the politicians leave us potentially with a further few weeks where we'll try to second guess the various scenarios. On the other hand, the overall effect of raising the stakes in weak countries is not comforting for financial markets, especially because very large debtors (Italy) will quickly learn that they also hold a strong hand.  Italy has a massive amount of government debt outstanding. More importantly, the Euro area had no contingency plans for such a crisis, and thus has been unable to come to an agreement. The timid nature of ECB, in contrast with the more aggressive Fed in 2008, is another source of concern, and investors are still worried that a decisive ring fencing of the major banks is not in place. Adding to the gloom, there are now rumors that a partial breakup/overhaul of EUR is being discussed. Bloomberg reported that Merkel's own CDU party is starting to build a contingency plan that would allow a Euro member to exit if it doesn't want to or is unable to comply with the common currency rules. Merkel basically said that the situation in Europe is so unpleasant now that the EU will not survive without a change in the EU treaty. She said "Because the world is changing so much, we must be prepared to answer the challenges. That will mean more Europe, not less Europe".

While market attention remains fixated on European politics, the real economy is the driver of increasingly worrying debt dynamics. Indeed, the lack of a LT growth strategy in the Euro area in the face of increasingly desperate attempts at fiscal austerity is the key driver of investor flight. Economists expect a recession in 4Q11 and 1Q12. As a result, ECB may have another 25bps rate cut in December. The October Euro area composite PMI fell firmly into recession territory last month with large declines in both the output (46.5) and new orders components (44.7). Based on data extending back to 1998, the October PMI is consistent with GDP declining at a nearly 2% annual rate. Consistent with this message, German manufacturing orders from other Euro area economies are now contracting sharply. The rapid deterioration in the larger economies in the region is particularly troubling as the composite output survey places Spain (41.7) and Italy (43.1) at the bottom of the regional growth table and suggests that France (45.6) has entered recession as well.  In short, growth remains at the heart of the European crisis and there is no quick fix to this.

For the European leaders, it is unclear whether any political evolution will be sufficient to satisfy the markets at this point. Thus, ECB is once again being forced to intervene and is reportedly buying Italian bonds in the secondary market. Unfortunately, the impact on yields is muted since there are now few other buyers for the debt. Two major clearinghouses have announced increased margin requirements for Italian debt as the spread over bunds crossed the 450 basis point “line in the sand” that previously had prompted similar moves on Irish and Portuguese debt. This is important since the decision to raise margin requirements decreases the bonds’ liquidity, leading to a further spike in yields. The further danger is that Italian banks begin to come under pressure as markets discount the effect of sovereign debt markdowns on their balance sheets. Given that there is not enough firepower in the EFSF to support Italian banks, the ECB may soon find itself dealing with a bigger and bigger problem. A further deterioration in Italian sovereign debt prices might prompt the ECB to follow the Fed and BoE and expand its B/S through more aggressive purchases, possibly unsterilized, of government debt.

In US, The most recent Fed statement (02 Nov FOMC meeting) revealed a dovish stance. Fed members lowered their 2012 GDP growth forecasts to 2.5-2.9% (from 3.3-3.7%) and increased their 2012 UNE forecasts to 8.5-8.7% (from 7.8-8.2%). Most interestingly, core PCE for 2014 is now projected at 1.5-2.0%. Given the benign growth and inflation outlook, I expect FFTR to remain low until at least mid-2013. Moreover, as long as inflation continues to show signs of topping out, it are likely QE3 to be introduced in 1Q2012. In Europe, ECB already cut the refin rate by 25bps to 1.25% at its 03 Nov meeting. New ECB President Draghi made no specific references to future bond purchase plans through SMP, and maintained that ECB does not target bond yields. However, the recent 100bps surge in 10Y Italian bond yields to 7.25% illustrates that the risk of contagion from the Euro-area crisis has increased considerably. The dovish monetary policy outlook in DMs and the continued concerns over the European sovereign debt crisis have prompted investors to focus on the possibility of monetary policy easing in Asia. So far, it seems Indonesia, China and India has dovish stance on a six-month outlook.

X-asset market thoughts

On the weekly basis, Italian sovereign bonds yields ended +21bps (2yr @5.55%), +27bps (5yr @6.41%) and =9bps (10yr @6.42%) after breaking 7% on Wednesday.  The 10yr Spanish was basically stable at 5.8%. The 3M Euribor-OIS spread rose 3bp to 89.4. In comparison, global stocks was largely flat +0.2%, with +0.75% in US, +0.53% in EU, -3.15% in Japan and -0.37% in EMs. In Asia, MXASJ closed down -3.5%, MSCI China -3.1% and CSI300 -2.5%. Elsewhere, 2yr USTs yields added 1bp to 0.23% while 10yr +2bp to 2.06%. 1MWTI rallied 5% to $98.99/bbl, while 1M Brent climbed 1.1% to 113.76/bbl. The USD weakened 0.3% to 1.3750EUR and 1.33% to 77.2 JPY. CRB flats at 320, while Gold price was up 1.67% to $1787/oz.

Overall, risk-taking remains in short supply due to deep worries that European debt crisis is not going to end until a Lehman-type disaster occurs. This week’s farces in Greece and Italy were the latest episodes fuelling these worries. Although Euro area has been tracking the 2008 disaster in US, global markets are not responding in a similar manner to trends in Euro area risk assets, with modest divergences in recent months. Moreover, global economic activity is far less weak than in 2008. Gold prices are still above their rising 200D MAVG, as inflation expectations have not melted like they did in 2008. While having lagged UST returns, corporate bonds and EM USD-denominated sovereign debt are still showing healthy absolute total returns, a remarkable accomplishment given increasing concerns about global growth. The correction in SP500 has been much less severe than in 2008. Thus, a quick observation is that many risk assets didn’t suffer the worst of their losses as they were on September 15th, the date Lehman declared bankruptcy. Such a jolt was needed to shock US authorities into becoming fully committed to ending the crisis. Euro area politicians and ECB have not yet reached such a juncture, underscoring that one cannot yet rule out a final crunch that could trigger a sizable shakeout in global risk asset prices.

Looking ahead, asset managers are defensively positioned, with cash on the sidelines. However, banks will dominate price action at least into year-end. With the specter of recapitalization requirements and tight funding markets, I expect little room for upside in risky assets. The outlook is now focused on Italy, the too-big-to-fail country on whose fate Europe hangs. Macro outlook is mixed. I expect a mild recession in Euro area over the winter, but US appears unaffected so far, with activity picking up following 1H weakness. Asian export slowdown is evident, but domestic demand is holding up better. The European recession and pullbacks by European banks overseas will be a drag on world growth, but lower food and energy inflation everywhere should help prevent a world recession. The focus is shifting towards monetary policy expectations and which central banks will cut rates in the coming months and quarters, in particular the ECB and some major Asian central banks. As a result, investors should maintain healthy cash reserves as risks will remain elevated until the Euro area crisis reaches an endpoint. While there has not been a lot of global banking contagion and trends in the US and EM economies are mostly encouraging, one could argue that neither did things look too bad in the summer of 2008, before all hell broke loose that autumn. Moreover, another political roadblock approaches as the budget debate in the US is set to move to center stage.

Not All the News is Grim

US economic data continues to improve. In 1H11, higher oil prices were a major factor slowing US growth. Oil prices are still high, but as long as they do not rise to an even higher level, Americans will have more to spend. Add rising payrolls (397K) and slowly increasing wages (+1.8%) to this, and incomes are higher. The latest UoM Consumer Sentiment (64.2) came in BTE. The gain was broad based, but more so in FWD UNE expectations, which is a significant move because it helps confirm the better news on jobless claims – not just this month, but in coming months as well. However, despite record profitability, businesses remain cautious on concerns about the outlook for the economy and fiscal policy. Major decisions on the budget are due in the coming weeks, including the stance for 2012 and long-term plans to cut the deficit. The 2011 social security tax cut will likely be extended, but other stimulatory measures proposed by President Obama are unlikely to be taken up by Congress. Overall, then, US fiscal policy is set to be contractionary in 2012, perhaps by around 1% of GDP.

In China, the soft landing scenario is on track, as indicated October data. Factory output expanded 0.7% last month, lifting the 3M change to 12% annualized. External demand continues to weigh on exports (15.9%). Domestic demand (28.7%) were somewhat encouraging, however, with both FAI and retail sales posting steady gains. A near 10% jump in imports, fueled by strong increases in commodity imports from Brazil and Australia, is another encouraging signal about Chinese demand, including for business inventories. Despite the recent data, economic growth in China appears to be running near a modest 8% pace and policymakers are beginning to take their foot off the brake. Banks have been green-lighted to pick up the pace of lending while a cut in the required reserve ratio looks likely by 1Q12.

Looking into 2012, global growth forecast depends on two important policy decisions. First and foremost, Euro area needs to decide how to open the doors of its liquidity hospital to Italy and signal how funding would be made available for other large sovereigns threatened with a loss of market access. The provision of liquidity to Italy will not prevent a regional contraction nor will it ensure that the new Italian government places its public finances on firmer ground. But a region-wide sovereign lender of last resort is a necessary feature of a monetary union vulnerable to a dynamic whereby a loss of liquidity can quickly feed self-fulfilling fears of insolvency. The second pending policy decision relates to next year’s US fiscal policy stance. The super committee is unlikely to deliver mid-term deficit reduction, and market expect significant fiscal tightening next year as two high-profile economic support programs expire— the one-year 2%  payroll tax holiday and the emergency UNE benefits. Under this scenario, they would combine with the tapering off of the pace of spending from the 2009 Recovery Act, delivering a fiscal headwind that could subtract 1.5% from GDP growth next year.

Good news is global inflation also decline in October, likely to 3.7%. This week China reported a sizeable step down in its over-year-ago rate from 6.1% to 5.5%. Next week US is forecast to follow suit with a reduction from 3.9% to 3.6%. Inflation is falling because of the sea change in commodity markets. Oil and agricultural commodity prices skyrocketed roughly 50% each from mid-2010 through early 2011, delivering a sharp escalation in consumer energy and food prices. With commodity prices in retreat since that time, the inflation surge has begun to unwind. By mid-2012, economists’ project global inflation will fall about 1.5 to 2.4% yoy. The downward slide in inflation will also provide additional maneuvering room for global central bankers. This relief will be particularly important in the emerging markets, where policymakers have felt constrained by the widespread breach of their inflation targets. In Asia, policymakers remain somewhat more cautious. With a concerned eye on robust domestic credit conditions, both Korea and Malaysia kept their rates on hold this week. By contrast, Bank of Indonesia cut rates 50bp this week reflecting the positive inflation picture and to take out extra insurance against a softening global backdrop that has delivered a tightening in local financial conditions. In addition, the primary contagion channel for Asia remains the funding market, although portfolio capital is an additional source of concern. On that it was interesting to read HSBC's CEO's comments that he was concerned Asia could suffer in the event of a sharp withdrawal of credit by European banks as a result of events at home. European banks have been big lenders to Asia and the latest BIS data for 2Q11 showed a small reduction in French and German bank lending to Asia.

To Fix the Italy’s 7% Beacon

The past 10 days saw Italy's situation is deteriorating rapidly as a vicious circle of recession, domestic political uncertainty, and Eurozone institutional paralysis interact with Italy's weak growth potential to destabilize its debt dynamics. From the big picture, while the crisis spreading to Italy, dynamics have changed materially. First, core European policy makers are emphasizing what will not be done, in particular that fiscal union is not an option. This risks pushing the market towards the other extreme of pricing in a Euro-area break-up. Second, Italy is too big to fail. Given that the impact of an Italian default would be severely negative for the rest of Europe, it appears highly unlikely that conditionality will be credibly enforced.

Market wise, 7% has become a psychological beacon due to the fact that Greece, Portugal and Ireland each sought bailouts soon after their debt reached these levels. While analysts said it is too simplistic to say that Italy will be forced to ask for support if its 10-year debt yields 7%, they said the recent selloff is taking the country to the tipping point. And with EUR1.9trn in debt (USD2.62trn) and EUR200bn of debt coming due next year, Italy can ill afford to see rates remain at these high levels. Currently, Italy is paying about 3.42% on bonds coming due next year. if that debt was all rolled over into new 10-year debt at 7%, it would create an extra EUR43bn of interest costs over the life of the debt. Meanwhile, Italy has delivered a mere 0.6% annual average growth since EMU began and needs to grow at more than twice this pace to lower its debt/GDP ratio. With a forecast GDP contraction of 1.5% in 2012, it will be hard to convince markets that Italy is moving onto a sustainable fiscal path. All these highlight the fragility of debt sustainability, and the lack of credibility of the current political class, suggests that market pressure will remain intense.

Bursting the walls of the liquidity hospital Europe’s crisis response tools were not designed to deal with the potential liquidity needs of a nation as large and indebted as Italy. Some EUR469bn of Italian sovereign bonds will mature over 2012-14. Indeed Bloomberg's DDIS shows that Italy's total redemptions (P+I) between now and the end of 1Q12 currently stands at around EU171bn with the monthly breakdown as follows: November (EU14.9bn), December (EU24.8bn), January (EU16.6bn), February (EU63.0bn), March (EU51.4bn). For some perspective this is nearly 3 times of the total redemptions of Greece, Ireland and Portugal combined. February and March's funding humps are the real hurdle for markets. Moreover, that schedule of redemptions is heavily concentrated in 2012, when EUR197bn is to mature. In addition to the need to roll over existing term debt, the budget deficit creates a need for further funding at EUR69bn over 2012-14, with EUR36n of that in 2012. Furthermore, Italian banks will need to raise their capital levels by EUR15bn as part of the region-wide recapitalization effort, with that capital-raising backstopped by official funding. Combining these three, Italian sovereign funding needs cumulate to a total of EUR553bn over 2012-14, with EUR248bn in 2012 alone. Even this assumes nearly EUR150 billion of T-bills can continue to be rolled over.

Clearly, there is a need to stabilize conditions in the broader secondary market for Italian debt. The ECB also clearly understands the importance of the 450bp spread.  But ECB is getting frustrated with this and starting to make noises that it might stop buying Italian bonds. On the other hand China and Brazil are fading from view as potential white knights. CIC Chairman remains skeptical about the European bailout and over the weekend criticized European labor laws as inducing sloth, and indolence, rather than hard work. Interesting comments! Brazil's President Rousseff said "I have not the slightest intention of contributing directly to the EFSF; if they are not willing to do it, why should I?".

As a result, the liquidity providers are left among EFSF, ECB and IMF. EFSF has EUR220bn of unleveraged capacity available. Euro area finance ministers have been set the task of working out the details of two leveraging schemes by the end of November. But neither looks likely to be ready to successfully underpin conditions in primary and secondary markets for challenged sovereigns in the near term, and there are doubts whether they will work over time. Meanwhile, there are serious constraints in the way of expanding EFSF capacity before leverage: not least German political resistance and France’s desire to retain a triple-A rating. Another two further potential sources of liquidity support: IMF and ECB. IMF has EUR280bn it can deploy in the very near term, which could plausibly increase toward EUR650bn in late 2012. IMF will always keep a significant buffer of spare capacity available to retain operational flexibility. IMF appears unlikely to devote its own funds to the EFSF sponsored SPV, but could assist in managing such funds or encouraging investment in them. Thus, the ECB is the only viable option left. I have been discussed in the previous diary that ECB might eventually have to have a balance sheet of trillions of EURs to avoid Euro Sovereign haircuts/defaults and even to keep the Euro from breaking up in the years to come. Days like Wednesday bring forward the point where Europe will have to decide what it ultimately wants. If its the status quo in terms of members and debt, then they might have to find a way to change the remit of ECB. If ECB is sacrosanct, then everybody might have to eventually shake hands and go their separate ways or at least accept that haircuts are here to stay. This isn't necessarily a near-term likelihood but the problem is getting ever more serious.

The Soft Landing China is Marked

Based on the October data, it is comfortable to forecast China’s real GDP to grow a steady 8.0% in 4Q. For 2011, full-year GDP is expected to grow 9.0% yoy. Going into 2012, headline GDP growth is likely to slow further to around 8% yoy in 1H12, followed by a slight pickup in 2H. The full-year 2012 GDP growth forecast now stands at 8.3% yoy. Regarding the major components of growth, the weakness in the export sector will continue to be a drag, especially during Jan-Jun. On the domestic front, consumption should remain supported by solid employment growth and broad-based wage gains, while FAI growth will likely moderate but remain solid next year. Meanwhile, October CPI rose 5.5% yoy, compared to 6.1% in Sep, as base effects (-0.7%) played the main role in the reduction in headline CPI. Even more pronounced was the substantial deceleration of PPI to 5 % yoy (6.8 % in Sep), with the raw material and manufacturing prices both decelerating to the lowest reading in one-year. The substantial drop in metal prices, including those of steel, was one of the main drivers of the PPI inflation. However, inflation is still high by China's own record (with real returns on bank deposits deeply negative), and non-food inflation has been on the rise. In fact, non-food CPI rose by 0.2% MoM, resulting in a gain of 2.7% yoy. This has made a sharp change in monetary stance highly unlikely.  A cut in the RRR is more likely to occur in 1Q next year. In addition, the government will continue with its selective easing strategy to mitigate funding difficulties in certain sectors and to facilitate restructuring of economic growth.

M2 growth slowed a bit further to 12.9% yoy in October, down from 13% in September. RMB new lending rose to RMB587bn in October, up from around RMB500bn per month in the past months. Market has been rumoring about the relaxing of loan quota for the past two weeks, assuming a total new loans could reach RMB7.5trn and RMB1.2trn new loans could be extended in Nov and Oct. In fact, because of over-controlled monetary policy, shadow banking and SMEs had run into rampage. Lately, MSB obtained CBRC approval to issue no more than RMB50bn of SME dedicated financial bonds. What rings the bell to me is that bank deposits fell by about RMB200bn in October, driven by a sharp (RMB727bn) fall in household deposits. It partly reflects the seasonality, but also suggests that, given negative real rates, households continue to take deposits out of the banking system, in part to participate in informal lending and other off-balance sheet investments to gain higher returns. The rise in the cash-deposit ratio leads to a fall in the money multiplier. In the mean time, the rise in the effective RRR (due to expansion of the deposit base on which the RRR is calculated) also reduces the multiplier. This creates a challenging environment for the banking system and the PBOC in the near-term.

Sector wise, property FAI, which accounts for 26% of total FAI, grew 31.1% yoy in Jan-Oct, down from to 32.0% in Jan-Sep. GFA Start in Oct alone (125.9 sqm, down 21% MoM while 2.2% yearly growth) also decelerates from 8.9% yoy growth in Sep. The GFA commencement of construction, a key supply indicator, soared 21.7% yoy to 1603.6mn sqm GFA in Jan-Oct. Overall sales momentum is slowing down too - According to NBS, national property sales in Oct alone decreased by 11.1% yoy or 25.3% MoM. Sales growth in Jan-Oct11 is 18.5% Yoy, which is lower than the 23.2% Yoy growth in Jan-Sep. All these data continues to paint the downside risk for property prices and transaction volume in China. Moreover, retail sales growth also fell to 17.2% yoy from 17.7% in September. In real terms, growth weakened to 11.4% yoy from 11.7%, much lower than the average of 14.6% over the past five years. Based on the latest data, I saw significant slowdown in department stores’ SSSG in Oct. The slowdown in economy and the tight credit finally put pressure on retail sales, especially on high-end goods. And that is not only seen in Zhejiang province, but nationwide. In terms of the significance of slowing down sales: Gold/watch > clothes (men’s wear > women’s wear)> footwear. I think consumer discretionary could see an inflection point in 1Q12….Lastly valuation wise, MSCI China is now traded at 9.7XPE11 and 17% EG11, CSI 300 at 12.7XPE11 and 20.2% EG11, and Hang Seng at 9.8XPE11 and 206% EG11, while MXASJ region is traded at 11.6XPE11 and +5.3% EG11.

Euro watches ECB +QE

By now almost everyone outside of ECB and German government contends that massive debt monetization will be required to manage Europe’s sovereign funding crisis. Most would also argue that this process will be hugely EUR negative. At this stage in the inflation and global rate cycle, however, it isn’t clear that large-scale asset purchases would be so destructive. If QE undermines currencies through higher inflation or inflation expectations, the 2012 recession is a much more auspicious time for debt monetization currency-wise than Fed and BOE’s first attempts at QE in 2009.

The evidence around QE’s currency effect is mixed. The US’s QE experience ran from March 2009 to June 2011 and was text book across all variables. Inflation expectations oscillated around 2.25%, nominal rate expectations declined versus the rest of the world, real yields fell to zero, and the dollar declined trade-weighted. The UK’s experience was less consistent. Inflation expectations averaged 3%, nominal rate expectations trended lower, real rates fell to zero, but TW GBP traced a range. Perhaps GBP’s stability simply reflected Europe’s disarray: Were it not for recurring sovereign stress, GBP might have responded to the declining level of real yields. The implication for ECB is that QE shouldn’t undermine currency stability unless real yields fall relative to other countries. That could happen in 2012 only if Euro area inflation outpaces other countries’ and if bond purchases push nominal rates much lower than elsewhere. Both will be hard to achieve next year when commodity inflation is muted and other central banks are pursuing QE (UK) or considering it (US). For the next year, even a doubling of ECB purchases is probably consistent with Euro stability. The more material question is what amount is consistent with European political harmony, since the governments of most of Europe’s AAA countries share the ECB’s anti-monetization philosophy. These countries sound resolutely opposed to further QE now, but their stance may soften if the revamped EFSF fails to launch. With European sovereigns still without a clear source of guaranteed funding, we retain hedges against another financing squeeze through shorts in EUR/JPY, USD/JPY, and GBP/JPY.

Against the current backdrop of downside European growth risks, the outlook for commodities is somewhat mixed. Commodities are up around 1% helped by oil markets which offset declines in base metals and agriculture. The recent rotation of the WTI futures curve into backwardation (downward sloping) coupled with drawdown in crude oil product inventories show markets are tight. Positioning risk is highest for WTI, where net long positioning among managed money accounts is at its 70th percentile based on the last two years history. In contrast to crude markets, base metals still give some cause for concern that downside risks to the global economy have not gone away. Both copper and steel prices have fallen sharply and remain depressed. I expect copper to continue tracking growth expectations, and hence to remain volatile.

Good night, my dear friends!