Bottom falling out of the US bond market - risk appetite surprisingly unaffected thus far.


MAJOR HEADLINES – PREVIOUS SESSION

  • Japan Nov. Industrial Production rose 2.6% MoM and fell -3.9% YoY vs. +2.5%/-4.3% expected, respectively

  • Japan Nov. Retail Trade fell -1.0% YoY vs. -1.1% expected and vs. -1.0% in Oct.

  • Japan Nov. Labor Cash Earnings fell -2.8% YoY vs. -1.8% expected and -1.7% in Oct.

  • US Dec. Dallas Fed Manufacturing Activity


THEMES TO WATCH – UPCOMING SESSION

Market comments
Risk appetite is having quite a run into the end of the year, with only three days of trading left in 2009 after today's session. It is interesting to note the combination of rallying equity prices and bond yields also vaulting close to highs for the year. While this kind of combination can certainly happen in the short run (since bond yields rising from depressed levels can suggest the market is looking for better opportunities in other asset markets), at some point, higher yields have to become a significant worry for the strength of the recovery. Bloomberg quotes Morgan Stanley's analysis team predicting 5.5% 10-year rates by the end of 2010, a level that could put 30-year mortgage rates at 7.5% to 8.0%.

Sharply higher yields in the months ahead would certainly be an ugly development for those residential and commercial mortgage structures that must refinance in the coming year. We'll take the markets moves here into year end with a hefty grain of salt for the moment, until we get into more liquid trading conditions in the New Year. Calendar year turnovers can be shockers for all markets, above all for FX. Another development at risk of popping up on the market's radar is the sharp rise in oil prices. If this is more than an ephemeral uptick on Iran news and the calendar effect, then the market will need to take significant note if oil can sustain new prices above the 2009 highs of 83 dollars a barrel.

Regardless of the accuracy of Morgan Stanley's prognosis, the higher US yields to provide a fundamental prop for the USD rally, even if the market seems to have ignored this over the last few days, as the USD continues to consolidate to the weak side. Today's chart shows the example of the 2-year (white line) and 10-year (yellow line) German vs. US rate spreads vs. EURUSD (red line). The advantage of US yields, at almost 50 bps, is now the highest since mid-2007.

Forex Trading

China continues weak yuan policy
The Chinese premier was out with rather bellicose rhetoric that again underlined the Chinese intention to keep the yuan pegged to the USD for now and not yield to outside pressures for a revaluation. This is actually somewhat USD negative as it supports the idea of further reserve diversification pressures, which tend to boost the Euro. In an article published by the Xinhua news agency, Wen was quoted saying "We will not yield to any pressure of any form forcing us to appreciate. As I have told my foreign friends, on one hand, you are asking for the renminbi to appreciate, and on the other hand, you are taking all kinds of protectionist measures". The debate on whether China is the world's great hope for economic growth or a giant bubble waiting for a spectacular implosion continues to rage.


Looking ahead

The rest of this week features a few data points of interest out of the US:

Tuesday

  • US Oct. S&P Home Price Data - will likely show another slight uptick from the previous month. More importantly, though, the November New Home Sales shocker (355k vs. 438k expected and -30k downward revision for Oct. This was released on the 23rd) shows the degree to which the tax incentives were driving home sales activity. So all bets are off on whether any home price gains will hold for much longer, particularly as mortgage rates have been on a sharp rise of late.

  • US Dec. Consumer Confidence - a number which may show US confidence continuing to improve, especially after we have seen a healthy uptick in the weekly numbers.

Wednesday

  • US Dec. Chicago PMI - the last major regional manufacturing ahead of the ISM next Monday. The Empire survey for December was very disappointing, but the Philly Fed saw a considerable upside surprise.

Thursday

  • US Weekly Initial Jobless Claims - last weeks claims number was the lowest for the cycle, but claims need to fall another -100k or more for us to look for an improvement in the overall unemployment rate