Eurozone Economy Contracts

The big news this morning is that the People’s Bank of China Gov. Zhou Xiaochuan said, “China will help resolve Europe’s debt crisis.” Remember that a couple of weeks ago, the news was that the Chinese “may” help once they figure out to participate in the EFSF… So the markets are correct this morning to key on the word change from “may” to “will”. And the euro (EUR) rallied on the news, pushing the rest of the currencies onto the rally tracks to join the euro.

But… and you knew this was coming, because since when do we talk about a euro rally without a “but” or “however”? Anyway, the “but” here is that the rally was stopped in its tracks by a report out this morning that showed the eurozone economy contracted in the fourth quarter for the first time in 2½  years. The good news was that it didn’t contract as much as was forecast, posting a 0.3% contraction, when the forecast called for a 0.4% contraction.

Now, one-quarter of economic contraction does not make a technical recession. So we’ll have to wait until April or May for confirmation of that, because I don’t see any way the eurozone can sidestep a recession… The second one for the region in the past three years… But then, with a good portion of the eurozone economy undertaking austerity measures, that was bound to happen.

I told two audiences in Orlando last week that it was my opinion — and that it could be wrong — that the eurozone would survive, maybe without a few members, but that the center would hold, and after all the pain the region would suffer in the next couple of years from austerity measures, they would come out on the other side (in five years) looking lean, fit and ready to tackle the world again…

You see… it is my opinion that the eurozone will suffer through some real painstaking austerity measures, but after doing so, they will be able to look back and say they ran through the gauntlet, while here in the US, we will continue to go along, kicking the can down the road, not willing to implement one austerity measure, much less the number of them that would need to be implemented to make a difference!

But as I said, that’s just me… I could be wrong… We’ll just have to wait and see, eh?

I remember telling people at the Orlando MoneyShow in 2001 that the dollar was ready to enter a long multiyear weak trend, and having them look at me like I was loony! The same thing happened in 2004 when I began talking about the housing bubble… And in 2005, when the dollar rallied, that it wasn’t the beginning of a long multiyear strong dollar trend, that it was just a bear market rally… The same thing for 2008, when on the road for the FX University Tours, one of my fellow instructors told the crowd that the dollar was ready for a multiyear rally, and I contradicted him by saying it was merely a bear market rally…

So there’s some history here. Now, to be fair… I did say last year that we would see another round of QE by year-end, and we didn’t, although I would have to say that I’m somewhat correct in that statement, given the stealth QE going on by the Fed…

OK, enough of that! I came across something yesterday that really got me thinking… The Bank of Japan (BOJ) implemented yet another round of Quantitative Easing (QE) in their efforts to weaken the yen (JPY)… The BOJ saw how well it worked for the Fed, in weakening the dollar, so they went back to square one and implemented more QE. And for now, it’s working, for the yen has lost ground from the 76 figure to the 78 figure… two whole figures in two days… I wonder what the US thinks of this?

I hear you saying, “But Chuck, why would the US care that the Japanese have implemented another round of QE?” Let me remind you that when asked if the US QE was successful, St. Louis Fed head James Bullard listed among QE’s success the fact that the dollar had depreciated. So it’s obvious that the Fed is looking for a weak dollar…

Well, if the yen is going to weaken, it will be against the dollar, and other currencies of course, but what we will concentrate on right now is the yen/dollar cross… So the dollar gets stronger versus the yen, and in the past, what that did was cause the dollar to get strong versus most currencies on the crosses. (I’ve explained these crosses and the relationships before, so I won’t go into it here.)

So if this Japanese QE goes on much longer, I would think they would receive a call from Big Ben Bernanke, asking them politely to cease and desist! Don’t forget for one moment that the president called for a doubling of exports… That won’t be accomplished without dollar weakness. So ride this wave out, hang ten and be safe!

Last week, I heard a lot of talk from people that believed the Australian dollar (AUD) had reached the end of its run. Of course, I argued the other side of that thought, with the caveat that as long as China grows, even at moderated levels, the A$ can maintain its edge. And then I would pull a rabbit out of my hat, Bullwinkle style and tell them that bond buyers around the world are looking for yield, and the only market that makes sense to them is the Aussie market. Bond buyers are flocking to Aussie bonds in record amounts, and that alone is enough to underpin the A$. In the past six months, the A$ has been the best-performing currency in G-10, and most of that surge has come from the bond buyers looking for yield. For instance — and this in no way is a solicitation to buy, just a reference — 10-year A$ government bonds yield more than 200 basis points higher than US 10-year Treasuries…

In my days as a foreign bond trader, I would be drooling over a swap in bonds in which I could pick up 200 basis points (2%)! We would do swaps for 50 basis points. But back then, things were different, in that there were more markets to choose from (pre-euro) and rates didn’t jump around like Mexican jumping beans like they do now…

But that brings me to a thought that I’ve been swishing around in my head lately and that I blurted out to The Wall Street Journal interviewer yesterday. With Swiss francs and yen now on the slippery slope down and US Treasuries basically paying nothing, the markets will be looking for a new safe haven. Why not Australia?

Remember a year ago when things in the Nordic countries were looking up and the respective central banks of each country (except Denmark) were raising rates to combat inflation pressures created by strong economies? Both Sweden and Norway saw rates go higher and expected the rate hike cycle to continue for some time in the future. All good things must come to an end, I guess. Norway has already cut rates, as their economy slowed greatly catching the illness from the eurozone. And now Sweden’s Riksbank will most likely cut rates today.

Sweden actually has the largest economy of the Nordic countries. And when they saw their trade surplus (yes, that’s right, I said surplus!) shrank to the narrowest in more than a year, at the end of 2011, the exporters demanded a rate cut. And it looks like they’ll get one today…

But as we all know, the markets have been in a strange state of mind, rewarding currencies from countries that cut rates (debase the currency) to promote growth. So hopefully, this rate cut won’t damage the krona (SEK) too much.

Yesterday, here in the US, January retail sales rose a smaller than expected 0.4%, which while was not as strong as forecast (0.8%) was better than December’s 0.1% gain (during the Christmas shopping season!). Looks like vehicle sales were very weak, falling 1.1% in January. So once again, the BHI (Butler Household Index) was bang-on with its indication that the January retail sales would be better than the average bear.

Today, we’ll get inundated with data here in the US. The TIC flows used to be a big deal, but no longer is it a market mover. And the minutes of the last FOMC meeting will print. The key prints of the day will be industrial production and capacity utilization, both of which really ticked higher in December. Another strong tick higher for both is forecast for January’s print. If that’s so, then I’m going to have to rethink some things about the economy.

I put the finishing touches on the March Review & Focus yesterday (nothing like two weeks ahead, eh?), and I highlighted the moves that gold has made in the past 11 years, with every consecutive year posting a higher price than the previous year. This is the longest run in a bull market I’ve ever seen. And it’s still not even close to being a bubble!

Speaking of gold, one of the best minds in economics and markets is James Grant. I always stop to hear what he’s talking about when he’s interviewed on Bloomberg TV. The Big Boss, Frank Trotter, gets the Grant’s Interest Rate Observer letter, so he’s held in high regard with us here…

In his latest interview, James Grant said that “The US Treasury should begin to issue longer-date bonds backed by gold and that investors should also buy gold, as it is ‘something substantial.’” In addition, James Grant said that the “US has been ‘overmedicated’ by public policy and should consider the government’s 1920 response to recession.”

He was referring the government responding to the 1920-21 recession by having the Federal Reserve increase interest rates and balance the national budget. He believes that “US policymakers are prolonging the pain of the so-called Great Recession by intervening in markets and running unprecedented federal budget deficits.”

Then there was this, from The Washington Post:

“The administration has repeatedly boasted how the historic rescue of Wall Street will cost taxpayers far less than originally expected. But the budget proposal released Monday came with some unwelcome news: The price tag of the bailout is suddenly going up.

“As a result, the administration said it will seek twice as much money from its proposed bank tax compared with last year, $61 billion versus $30 billion.

“A main reason for the increased bailout cost is that the government’s stock holdings of companies rescued by taxpayers has fallen in value.”

That’s a lot to take on, but wasn’t I one of the few back 2½ years ago who said this would happen? Let me remind you that this is the main reason the Fed keeps interest rates low. Otherwise, their holdings of the toxic waste bonds would circle the bowl.

To recap, the Chinese changed from “may help” to “will help” with regard to the eurozone debt problem, and that news has boosted the euro and other currencies that play follow the leader. The euro ran into a roadblock, though, in the form of a contracting economy in the eurozone for the fourth quarter of 2011. Sweden’s Riksbank will most likely cut rates today, bringing an end to their rate hike cycle. And record numbers of bond buyers are flocking to the Aussie bond market.

Chuck Butler
for The Daily Reckoning