Derivatives: No need to worry about?

Michael Lewis does not think very highly of the worrywarts at the World Economic Forum in Davos last week. From his latest Bloomberg article entitled "Davos Is for Wimps, Ninnies, Pointless Skeptics":

It's become almost obligatory for the world's most important economic people, at the beginning of each year, to travel joylessly to the base of a Swiss ski slope and worry. And to worry not privately, with dignity, but publicly, to anyone who will listen...

Derivatives seem to be this year's case in point. Davos had hardly been up and groaning about the dangers of being alive before Bloomberg News reported what appears to be the general Davosian view: "The surging demand for derivatives is making financial markets more vulnerable to any slowdown in the global economy."

The piece came with supporting quotes from European Central Bank President Jean-Claude Trichet, Bank of China Vice President Zhu Min and the deputy chief of India's planning commission, Montek Singh Ahluwalia -- but not a worrisome fact in sight. None of them seemed to understand that when you create a derivative you don't add to the sum total of risk in the financial world; you merely create a means for redistributing that risk. They have no evidence that financial risk is being redistributed in ways we should all worry about. They're just -- worried.

But the most striking thing about the growing derivatives markets is the stability that has come with them. More than eight years ago, after Long-Term Capital Management blew up and lost a few billion dollars, the Federal Reserve had to be wheeled in to save capitalism as we know it.

Last year Amaranth Advisors blew up, lost more than LTCM, and the financial markets hardly batted an eyelash...

But perhaps Lewis should spend less time insulting Davos attendees and spend more time understanding the true risks involved. Felix Salmon's post at the Economonitor could be a start.

[A]s the number of entities playing in the derivatives market increases, the total counterparty risk in the system surely increases at the same rate.

And finally, when banks use derivatives to move risk off their balance sheets, that generally just frees them up to take on even more risk.

Or this article from FT by Richard Beales and Paul J Davies:

Steven Smith, head of restructuring at UBS, says credit problems can creep up unnoticed. He recalls a character in Hemingway's novel The Sun Also Rises being asked how he had gone bankrupt. "Two ways," came the response. "Gradually and then suddenly."

That sudden turn has not yet happened in the global credit cycle...

In fact, the opposite happened. By the end of 2006, companies could borrow more cheaply than ever before, with those lending them money apparently almost oblivious to the credit risk they were taking on...

Meanwhile, a wave of innovation in debt markets has produced new, often complex products that have brought new investors into the market... On top of that, the use of credit derivatives...has exploded... But some believe such developments have created complacency about risks - leading investors to employ ever-higher levels of leverage and pumping up global liquidity even further.

Now a number of pundits even speak of the end of the credit cycle, arguing that the new breadth and depth of credit markets means future booms and busts will be more muted than in the past. Others fear that the upswing in the cycle has simply been extended artificially by the glut of liquidity and, when the cycle does turn, the impact will be more painful than in the past...

Martin Fridson, publisher of the Leverage World research periodical, believes financial institutions and hedge funds are managing risks better than they did, helped by the new tools available in the market. But he stresses that complex new products only redistribute credit risk, albeit more widely than in the past.

"Financial engineers want you to believe they have reduced the risk," he says. "That's preposterous." Mr Fridson doubts the next credit downturn will by softened much by the apparently changed structure of the market.

In fact, he raises the question of whether the next downturn could even be worse than on previous occasions, driven by the unusually high proportion of failure-prone companies - rated triple-C or lower, just a few notches above default - that have secured financing in recent years. In 1990, that rating category accounted for just 2 per cent of junk-rated debt in the US; today, it makes up nearer 20 per cent, according to Mr Fridson...

With credit markets seemingly priced with no room for surprises, the likelihood of a rocky patch can only grow. Mr Smith warns that markets are likely to overshoot when a downturn comes. "These things tend to move too far in one direction and then revert."

Distressed-debt specialists are hoping that happens. Anecdotal evidence abounds that specialist funds and banks have been staffing up and raising money in anticipation of the next wave of corporate defaults...

US consumer confidence up, data generally cool

Yesterday's economic data would have been encouraging to bond investors.

From the US comes the Conference Board's consumer confidence index for January.

The Conference Board Consumer Confidence Index, which had improved in December, edged up slightly in January. The Index now stands at 110.3 (1985=100), up from 110.0 in December. The Present Situation Index increased to 133.9 from 130.5. The Expectations Index, however, declined to 94.5 from 96.3 last month

European data pointed to some cooling in the economy, with Bloomberg reporting that European retail sales dropped in January.

European retail sales dropped for the first time in 10 months in January as spending in Germany slumped, adding to signs economic growth is slowing, the Bloomberg purchasing managers index showed.

An index measuring retail sales in the 13-nation euro economy fell to a seasonally adjusted 47.9, the lowest since February 2005, from 52.1 in December, a survey of more than 1,000 retail executives compiled for Bloomberg LP by NTC Economics Ltd. showed. A reading below 50 indicates contraction.

Meanwhile, German inflation in January was lower than expected.

German inflation accelerated less than expected in January, suggesting retailers didn't pass on all of a Jan. 1 sales-tax increase to customers.

The inflation rate rose to 1.8 percent from 1.4 percent in December, when calculated using a harmonized European Union method, the Federal Statistics Office in Wiesbaden said today. Economists expected inflation to accelerate to 2.2 percent, according to the median of 25 estimates in a Bloomberg News survey. From a month ago, prices fell 0.2 percent.

It was a similar story in the UK. From Reuters:

The Bank of England said on Tuesday mortgage lending rose by 10.58 billion pounds last month, well above the consensus forecast for a 9.5 billion gain and the strongest monthly rise since records began in April 1993.

But new mortgage approvals, which are often used to predict the future health of the housing market, came in much lower than expected at 113,000 in December, falling more than 12 percent from a three-year high of 129,000 in November...

[F]igures from the Nationwide building society earlier on Tuesday showed house prices rose at a subdued rate of 0.3 percent on the month in January, the weakest rise since May last year...

Elsewhere, consumer demand for debt remained subdued, according to Bank of England data, with consumer credit rising by just over one billion pounds in December, broadly as expected.

M4 broad money supply growth was unrevised to show an annual increase of 12.8 percent in December, still strong but continuing to slow from a 16-year high hit last year.

So the slowdown story isn't over, even if a bit overplayed in the US until recently.

Japanese December data raises doubts on rate hike

Analysts have been waiting for Japanese consumer demand to show some strength. Well, they are still waiting. From Reuters:

Tuesday's data showed that overall household spending in Japan fell 1.9 percent in December from a year earlier, below a median market forecast of a 1.2 percent decline. It was the 12th straight month of year-on-year declines.

Government data also showed that Japan's unemployment rate rose to 4.1 percent in December from 4.0 percent in November.

But on a positive note, industrial production was up in December.

Industrial production rose 0.7 percent in December from a month earlier, higher than a median market forecast of a 0.3 percent rise. The trade ministry said manufacturers' output -- the core component of production -- is expected to fall 2.8 percent in January but to grow 0.1 percent in February.

A report on Monday had shown that retail sales fell 0.2 percent in December.

Importantly for investors, the weak consumer spending figures makes it harder for the Bank of Japan to justify a rate hike even as officials elsewhere worry over the potential impact of an unwinding of the yen carry trade.

Fed pause supports housing market

The rise in new home sales in the US in December was another indication that the housing market could be stabilising. James Hamilton at Econbrowser explains why this could be so.

... On balance, previous unanticipated changes in monetary policy were a factor that would have continued to depress home sales through October 12, 2006, at which point the Fed's autumn decision to stop raising rates should have begun to be a net positive for new home sales.

In other words, the Fed did it. But it's not all clear for the housing market.

... [T]he autumn monetary policy stimulus will have evaporated by February 2, after which the apparent decision of the Fed to hold the rate steady at 5.25% through the first half of 2007 will start to make a net negative contribution.

Indeed, the Bonddad Blog points out that 10-year Treasury yields are back at 5-month highs and says "don't be surprised if housing numbers fail to impress in the next few months".

Amid strong data, ECB asks markets: Are you feeling lucky?

There was more good news for the US economy yesterday. Reuters reports:

New-home sales rose 4.8 percent in December to an annual pace of 1.12 million units. The median sales price rose to $235,000 in December from $232,200 in November, as builders cut the number of homes on the market to avoid inventory buildups.

Orders for U.S.-made durable goods -- items intended to last three years or more -- rose 3.1 percent in December. While much of the gain came from strong demand for Boeing jetliners, other components like machinery and primary metals also posted sharp hikes...

Analysts said recent indicators imply more underlying resilience in the economy than previously realized...

Some worried the next interest-rate move could be up.

If the next interest-rate move by the Fed is up, it would be following in the footsteps of the Bank of England, whose own resumption of monetary tightening last year might finally be making a serious dent on the UK housing market. From Reuters:

Mortgage approvals fell 11.1 percent in December from a year ago to 45,533, the first annual fall since April, a survey showed on Friday, indicating higher borrowing costs may be dampening demand.

The British Bankers' Association left its figure for underlying net mortgage lending reported last week unrevised at an increase of 5.8 billion pounds, a robust figure but well below the record 6.7 billion pounds' rise recorded in November.

Meanwhile, the even-lower interest rates in Japan have not put too much upward pressure on prices, at least not in Japan itself. From AFP/CNA:

Japanese core consumer prices rose by 0.1 percent in December from a year earlier, the government said on Friday as deflationary pressure eases in the country...

The December core consumer price index (CPI) for Tokyo alone – the leading indicator for national price trends – rose 0.2 percent compared with a year earlier.

Many expect the Bank of Japan to raise rates soon anyway.

Even more hawkish is the European Central Bank. And with good reason in view of the latest figures. From AFX/Forbes:

Euro zone M3 money supply in December grew at a rate of 9.7 pct year-on-year, up from the 9.3 pct growth rate in November, the European Central Bank said...

Loans to the private sector grew 10.7 pct year-on-year in December, down from November's 11.2 pct growth rate.

And if further rate hikes from the ECB hurt financial markets, well...too bad. From Bloomberg:

European Central Bank council member Axel Weber said investors shouldn't expect central banks to bail them out in the event of an "abrupt" drop in financial markets.

"If you misprice risk, don't come looking to us for liquidity assistance," Weber said in an interview in Davos, Switzerland at the annual meeting of the World Economic Forum. "The longer this goes on and the more risky positions are built up over time, the more luck you need."

China's rapid growth continues

If China's economy is supposed to be slowing, it is not very apparent. AFP/CNA reports:

China's economy expanded by 10.7 percent in 2006, according to the government, reporting growth not seen for over a decade and putting it on track to become the world's third biggest next year...

The growth rate was also slightly higher than the 10.5 percent that officials had indicated in recent weeks...

Fixed asset investment, the main indicator of state-funded spending on new productive capacity, rose 24 percent last year, fuelled by the ample liquidity available in the Chinese economy.

Industrial output expanded 12.5 percent, boosted by massive investment in new plant and equipment in recent years, and booming exports.

Retail sales, a main gauge of consumer spending and sentiment, increased 13.7 percent in 2006, while consumer price inflation remained moderate at just 1.5 percent.

However, the consumer price index appeared to spike in December, rising 2.8 percent compared with the same month a year earlier.

The National Bureau of Statistics confirmed in its briefing Thursday that China's trade surplus reached a record 177.5 billion dollars in 2006, up 74 percent from 2005.

With its rapid growth, China's economy could overtake Germany's soon, especially if the latest turn in sentiment indicators in the latter are the start of a trend. The Ifo business sentiment index fell to 107.9 in January from 108.7 in December while GfK AG's consumer confidence index for February dropped to a 12-month low of 4.8 from a revised 8.5 this month.

But Germany at least has a trade surplus, helping the overall eurozone current account which, nevertheless, slipped into a deficit of 2 billion euros in November after a revised surplus of 1.8 billion euros in October.

One country that does not have problems with deficits on the trade front is Japan. Bloomberg reports:

Japan's trade surplus widened in December after a drop in oil prices cut the country's import bill and exports rose to a record, supporting growth in the world's second-largest economy.

The trade surplus rose 22.8 percent to 1.11 trillion yen ($9.2 billion), the Ministry of Finance said in Tokyo today. Imports rose 7.6 percent and exports climbed 9.8 percent. The result was in line with economists' expectations.

There was also continuation of recent trends in the US in yesterday's data in the form of a weak housing but a resilient labour market. Reuters reports:

Sales of previously owned U.S. homes slipped 0.8 percent in December and took their biggest tumble in 17 years for all of 2006, leaving in doubt whether the worst of a housing slump has passed...

But the monthly report on sales of so-called existing homes...also contained some encouraging news since inventories of unsold homes were down 7.9 percent to 3.508 million units at the end of December.

In addition, the median price of homes sold in December was up to $222,000 from $217,000 in November...

The Labor Department said new claims for U.S. jobless aid jumped 36,000 last week to 325,000 -- still a relatively modest number of applicants, especially when there are lingering issues with seasonal adjustments stemming from the year-end holiday season...

A third report from the New York-based Conference Board said help-wanted ads in U.S. newspapers rose in December. Its gauge measuring help-wanted ad volume in the United States rose to 33 in December from a revised 29 in November.

Interest rates raised in Norway, unlikely to change soon elsewhere

Another surprise rate hike, this time from Norway, with the Norges Bank announcing that it is raising its key policy rate by 0.25 percentage point to 3.75 per cent with effect from today.

Meanwhile, that other surprise rate hike, from the Bank of England, might not be repeated soon. Reuters reports:

The Bank of England's Monetary Policy Committee voted by the narrowest of margins, 5-4, to raise interest rates to 5.25 percent this month, suggesting rates could be close to their peak.

The pound fell sharply against the dollar while gilts, interest rate futures and equities extended gains after minutes on Wednesday from the January monetary policy meeting confounded forecasts for a more hawkish 7-2 split.

Markets moved to price in only one more rate increase, rather than two, after the minutes and now foresee a 25 basis point increase to 5.5 percent by March, but analysts are less convinced.

A Reuters poll showed less than half of 51 economists polled forecast rates would hit rise by the March meeting, and only six think rates will go up next month.

Not that economic growth in the UK has not been good. Again from Reuters:

The Office for National Statistics said GDP rose by 0.8 percent in the October-December period, the fastest rate of growth since Q2 2004 and beating forecasts for a 0.7 percent reading.

Annual fourth quarter growth came in at 3.0 percent, also the fastest rate of expansion in more than two years.

On the other side of the world, interest rates also look to be on hold for the time being at least.

Bloomberg reports today that the Reserve Bank of New Zealand kept its benchmark interest rate at a record-high 7.25 percent, although Governor Alan Bollard remarked that it remains "concerned about the upside risks to medium-term inflation" and "it is likely that further policy tightening will be required".

Meanwhile, an imminent rate rise in Australia looks unlikely after a benign inflation report yesterday. From The Age:

Australia's consumer prices in the final three months of 2006 were 3.3 per cent higher than a year earlier. On a quarterly basis, they fell 0.1 per cent after rising 0.9 per cent in the previous quarter, the first drop since 1999.

As widely expected, cheaper fuel, down 12.4 per cent, contributed to the lower CPI figure.

But Australia and New Zealand already have high interest rates. Japan, on the other hand, has very low interest rates, and it still might not raise them soon if economic growth continues to look uncertain, as it does after the Ministry of Economy, Trade and Industry reported yesterday that the all-industries index fell 0.2 percent in November from the previous month.

Risks shifting to upside

We are moving further and further away from talks of recession.

Yesterday the Conference Board reported a 0.3 percent increase in the US leading index in December. And while the Richmond Fed's manufacturing index fell to -11 in January from -6 in December, it's survey also found that manufacturers in the region were "generally more optimistic in January" and "anticipated that their shipments, new orders, and capacity utilization would rise sharply by mid-year".

Meanwhile, Reuters reports that the composite leading indicator for Canada also rose 0.3 percent in December. In addition, annual inflation edged up to 1.6 percent in December from 1.4 percent in November but the Bank of Canada-monitored core inflation rate fell unexpectedly to 2.0 percent from 2.2 percent. Retail sales were also relatively soft, inching up 0.2 percent in November.

The data look a bit stronger in the euro zone, with French consumer spending on manufactured goods rising 1.3 percent in December and eurozone industrial orders rising 1.4 percent.

And over in the UK, although the Confederation of British Industry said its monthly manufacturing order books balance fell to -9 in January from -5 in December, manufacturers were upbeat about output in the coming months, with that balance rising to +12 in January from +11. And with the average prices balance rising to +19 from +8, it is probably no wonder that Bank of England Governor Mervyn King said yesterday that the "balance of risks to output growth and inflation has shifted towards the upside".

And even Bank of Japan Governor Toshihiko Fukui says that an interest rate hike is needed in Japan, even if the timing is uncertain.

Optimism rises

US companies appear to be getting more optimistic. Bloomberg reports:

More U.S. companies said they plan to boost hiring through the middle of 2007 even as labor shortages force up wages, a quarterly survey by the National Association for Business Economics showed.

The poll found that a third of executives would boost payrolls in the next six months, up from 29 percent last quarter. Thirty-five percent, the most since April, reported that wages and salaries increased in the last three months...

Twenty-two percent of the executives surveyed said they were more "optimistic" last quarter about the economic outlook than in the previous three months, up from 13 percent in the October survey and 10 percent in July. Some 11 percent said demand declined in the fourth quarter, the fewest since the first three months of 2006...

The NABE survey of 124 companies, taken from Dec. 14 to Jan 10, showed that two-thirds of the respondents predicted the economy will expand at an annual pace of 2 percent to 3 percent in the first half of this year. Just over a quarter forecast growth of 2 percent or less, up from 17 percent in October.

Meanwhile, house buyers in the UK remain as optimistic as ever. Reuters reports:

Asking prices for homes in Britain rose an annual 13.5 percent this month, a survey showed on Monday, picking up from a 13 percent increase in December and suggesting higher interest rates have not dampened demand. Property Web site Rightmove said the average asking price rose to a record 222,859 pounds ($439,700) between Dec. 3 and Jan. 13, when the survey was conducted.

Slower producer price inflation could also boost optimism in Germany. From Bloomberg:

German producer-price inflation, an early indicator for price pressures in an economy, slowed in December as energy costs declined.

Prices for goods from newsprint to plastics rose 4.4 percent from a year earlier in Europe's largest economy, down from 4.7 percent in November, the Federal Statistics Office in Wiesbaden said today. Economists expected a gain of 4.6 percent, according to the median of 30 forecasts in a Bloomberg News survey. Prices were unchanged from a month earlier.

Morgan Stanley's Stephen Roach has more on the optimistic consensus on the macro climate.

MacroVision -- our annual deep dive into the burning issues in the markets and the global economy -- offered nothing but optimism for 2007. Risks were banished to the distant tails of the probability spectrum, with the all-powerful liquidity cycle expected to cushion all but the most wrenching of shocks. Sure, markets will correct from time to time, but the MacroVision crowd felt any such downdrafts should be ignored. Dips were thought to be buying opportunities -- whether for commodities, equities, credit, or emerging markets. The endgame was nowhere in the realm of possibility. Out-of-consensus views were presented with low conviction.

But with optimism comes risk. From Bloomberg:

Lawrence Summers has a message for investors heading to the Swiss mountain resort of Davos this week to toast a year of booming returns and record bonuses.

"It's worth remembering that markets were very upbeat in the early summer of 1914," the former U.S. Treasury secretary observes...

"It's too good to be true," says Vittorio Corbo, head of Chile's central bank, who will speak at a seminar in Davos about the dangers of derivatives. "Tomorrow the mood could change. We have to be prepared."...

"Current risks are ludicrously underpriced," says [Willem] Buiter, a former member of the Bank of England's Monetary Policy Committee. "At some point, someone is going to get an extremely nasty surprise."

Asian stock markets hit record highs

It was another record breaking performance for some of the Asian stock markets today. Bloomberg reports:

Asian stocks rose to the highest in three weeks as benchmarks in Hong Kong, China, Australia and Singapore closed at all-time highs.

BHP Billiton and Nippon Mining Holdings climbed as prices of metals and oil rebounded. Samsung Electronics Co., Asia's biggest maker of mobile phones and flat screens, and Westfield Group, the largest operator of U.S. shopping malls, gained after U.S. consumer confidence rose to the highest since 2004, adding to speculation sales in the region's largest export market will grow.

Is it a sign of irrational exuberance? Or just blind optimism? Especially in China?

China's stock market has become the most expensive in Asia, leading strategists at Citigroup Inc., HSBC Holdings Plc and UBS AG to warn investors to stay away.

Shares traded on mainland Chinese exchanges cost twice as much relative to earnings as they did 18 months ago, and double the average for emerging markets, after extending last year's 121 percent rally in the Shanghai and Shenzhen 300 Index. The surge sent their value above $1 trillion for the first time and prompted the government to caution shareholders that "blind optimism" is driving gains...

The Shanghai and Shenzhen 300, tracking A shares on the mainland's two exchanges, jumped 10 percent last week to 2396.09, its biggest weekly gain in eight months. The index climbed 4 percent today and is up 22 percent this year...

The Shanghai and Shenzhen 300 is valued at 37 times profit, up from a low of 14.4 times in July 2005, and the H-share index at 20 times. The Morgan Stanley Capital International Emerging Markets Index, a global benchmark, is valued at 15 times...

Cheng Siwei, vice chairman of the Standing Committee of the National People's Congress, the Communist Party-controlled parliament, warned investors against "blind optimism" in local capital markets that are relatively underdeveloped, the state- owned China Securities Journal reported Dec. 30.

China's policy makers are trying to stem the boom. Banks were urged to stop lending money for stock investments and to recall outstanding loans, the China Banking Regulatory Commission said in a Dec. 31 document sent to the lenders and obtained by Bloomberg News.

Foreign buying is a major factor in most Asian markets. That may not be a good sign, as foreign investors are often late to the party.

And things could turn bad quickly if authorities in Asia start getting serious about stemming the "massive" capital inflows, as suggested by this Bloomberg report.

All is well with the consumer

Reuters reports that consumer sentiment in the US improved in January.

The preliminary January reading on sentiment by the Reuters/University of Michigan Surveys of Consumers rose to 98.0 from 91.7 at the end of December.

This was the highest since 103.80 in January 2004 and well above the 92.5 median forecast of analysts polled by Reuters.

A robust economy helps.

Meanwhile, the Economic Cycle Research Institute said the outlook for the U.S. economy is growing more positive. The forecast firm said the annualized growth rate of its leading economic indicator rose to 4.4 percent in the week ending January 12 from an upwardly revised 4.1 percent in the previous week.

However, the weekly reading on U.S. economic growth slipped to 140.8 last week from a downwardly revised 141.7 in the previous week, ECRI said.

It is a similar story in the UK, where Christmas sales were strong, reports Reuters.

Retail sales rose twice as fast as expected last month -- sales volumes jumped 1.1 percent, the biggest monthly rise in 18 months and the best December reading in three years.

That took the annual rate up to 3.7 percent and even more impressive was the fact that retailers achieved bumper sales without cutting margins.

Retailers raised prices for a fourth consecutive month -- the longest run of increases since 1999.

There were some signs of moderation in the UK economy though.

Investors also had figures to digest on Friday showing money supply and mortgage lending growth moderated last month, albeit from very high levels.

Annual British broad money supply growth, identified by the Bank as a key contributor to inflation, eased to 12.8 percent from 13.1 percent in November. Underlying net mortgage lending rose 5.8 billion pounds last month, down from November's all-time high of 6.7 billion but still pointing to a robust housing market.

Consumer demand in the UK could also be boosted by accelerating wages. From another Reuters report:

Pay consultants Industrial Relations Services said a snapshot of 22 pay deals settled in January put the median wage settlement at 3.6 percent.

That was up from the 3.0 percent median for the three months to December -- a level that has been maintained for more than 3-1/2 years, IRS said.

Barry Ritholtz injects some caution into the interpretation of the US data, warning about past and potential revisions and the fact that recent months have been warmer than usual.

On the other hand, Felix Salmon at the Economonitor thinks that Ritholtz finds "the cloud in any silver lining" and instead points to the Intrade recession contract showing that the market thinks that the "chances of a recession in 2007 are just 21% and falling".

Incidentally, Barry Ritholtz also thinks that US inflation remains high, pointing out that the Cleveland Fed's median CPI showed a "+3.7% year over year increase" in December. Ironically, if sustained, this suggests that demand is likely to remain robust, since waning demand and price increases usually don't go together in the absence of supply disruptions.

In any case, the UK money supply data, coming in the wake of the BoJ's decision to hold interest rates and continued tight emerging market risk spreads, point to ample global liquidity that could help sustain consumer and asset demand.

Yen carry trade lives on

For a while more at least. Bloomberg reports the Bank of Japan's interest rate decision yesterday:

The Bank of Japan held its benchmark interest rate at 0.25 percent, averting a clash with government officials who say household spending and inflation are too weak to withstand higher borrowing costs.

The decision was split six-to-three, the bank said today in Tokyo, prompting traders to bet on a February increase. Board members were divided over the outlook for consumer spending, Governor Toshihiko Fukui said...

The central bank today said in a report that the economy has "so far deviated slightly downward from the outlook" made in October. The economy and prices are still expected to "develop broadly in line" with expectations, it said.

Indeed, the recent economic data have not been too encouraging. Exports were up 11.8 percent in November from a year earlier, boosting the trade and current account surpluses, but consumer confidence fell in December. Demand for services, as measured by the tertiary index, fell 0.3 percent in November, while the leading index for November has been revised down to 18.2 from 20.0.

But perhaps the yen carry trade is diverting the impact on demand elsewhere.

Like the US for example. Reuters reports that inflation in the US picked up again in December.

... [T]he Labor Department said core consumer prices, which exclude food and energy costs, rose by a relatively tame 0.2 percent in December after being flat in November. The overall Consumer Price Index was up 0.5 percent after also being unchanged in the prior month.

But that came with signs of strength in the economy.

An index prepared by the Philadelphia regional Federal Reserve bank showed business activity at its highest level since August, when concern about a slowdown was growing.

The index, which is taken as an early indicator of the health of U.S. manufacturing -- hit 8.3 in January, compared with a revised -2.3 in December...

A Commerce Department report said housing starts unexpectedly climbed 4.5 percent in December to a seasonally adjusted annual rate of 1.642 million units from November's 1.572 million...

The Labor Department said the number of Americans filing new claims for jobless benefits dropped by a surprisingly large 8,000 last week to 290,000, lowest since last January.

US data show inflation pressures remain

There were plenty of economic data from the US yesterday. Reuters summarises:

The Labor Department's Producer Price Index increased 0.9 percent in December. Excluding volatile food and energy prices, the index advanced a smaller 0.2 percent.

The Fed reported industrial output that was stronger than expected in December, rising 0.4 percent on robust gains in manufacturing and mining. For all of 2006, industrial output grew 4 percent, the biggest annual gain in six years...

The...Beige Book report...pointed to modest economic growth at the end of last year.

While many companies were looking for employees with special skills, the Fed report said housing markets continued to soften and that bulging inventories of unsold homes were slowing construction.

However, other data on Wednesday showed U.S. home-builder sentiment has improved in January to its strongest since last summer amid price cuts and other incentives. But mortgage applications fell last week.

The rise in the PPI and the relative resilience of the economy indicate that some inflation risks remain. Now where have we heard that before?

Perhaps in the UK. But the latest employment data provide a mixed picture. Reuters reports:

The Office for National Statistics said average earnings including bonuses rose 4.1 percent, below forecasts for an increase of 4.2 percent.

Claimant count unemployment fell by 5,500 in December, nearly double the 3,000 decline forecast by analysts and the third straight month of decline...

The internationally-comparable ILO jobless rate came in at 5.5 percent in the three months to November, as expected. The number of people unemployed fell 29,000 to 1.674 million.

Meanwhile, inflation in the euro zone in December has been confirmed at 1.9 percent, unchanged from November.

UK inflation at decade high, BoC holds rates, BoJ contemplates next move

We now have a better idea why the Bank of England raised interest rates last week. From Reuters:

British inflation accelerated to 3.0 percent last month, its highest since comparable records began a decade ago, handing the Bank of England a narrow escape from having to explain itself publicly to the government...

Retail price inflation rose to 4.4 percent, the highest since December 1991. Policymakers are worried that the rising cost of living will encourage inflationary pay demands in the crucial New Year bargaining round, triggering a wage-price spiral.

Meanwhile eurozone data continue to point to another rate hike in the not-too-distant future. From Bloomberg:

German investor confidence rose more than forecast to a six-month high in January as Europe's biggest economy overcomes a higher sales tax and a slowdown in export markets.

The ZEW Center for European Economic Research index of investor and analyst expectations for economic growth in six months rose to minus 3.6 from minus 19 in December. Economists forecast a gain to minus 10, according to the median forecast of 43 economists in a Bloomberg survey...

"At the moment, monetary policy is still accommodative," ZEW economist Matthias Koehler said at a briefing in Mannheim, Germany, today. "Interest rates are low, there is plenty of liquidity and the euro-area economies are in good shape."

The Bank of Canada, though, was content to leave interest rates unchanged yesterday. From CBC News:

As expected, the Bank of Canada left its key interest rate unchanged at 4.25 per cent Tuesday...

The central bank said it doesn't need to tinker with the rate because inflation is running largely as expected and economic growth should pick up in the first half of this year.

The Federal Reserve is also not likely to hike rates anytime soon, especially with the weakness in manufacturing as reflected in the latest Empire State Manufacturing Survey, which showed the general business conditions index falling sharply to 9.1 in January from 22.2 in December.

But the big debate on the direction of monetary policy remains on Japan, where industrial production for November has been revised to a 0.8 percent increase from a preliminary 0.7 percent but inflation pressures remain subdued. Reuters reports the latest data on wholesale prices in Japan:

Japanese wholesale prices rose 2.5 percent in December from a year earlier, matching the consensus forecast and doing little to change the view that the Bank of Japan (BOJ) could raise interest rates this week.

Growth in the corporate goods price index (CGPI), which tracks trends in wholesale prices of goods, slowed for the third straight month after a 2.7 percent increase in November, BOJ data showed on Tuesday...

Compared with a month earlier, the CGPI was flat in December, matching economists' consensus forecast.

This kind of data only add fuel to the debate on whether the BoJ should hike rates. From AFP/CNA:

"Pretty much everybody expects them to do it. Very few people think they should," said Robert Feldman, chief economist for Japan at Morgan Stanley.

"The issue for the BoJ is how they explain themselves and can they justify a rate hike when you have such low inflation? If they don't explain themselves clearly, then there will be some fireworks," he said...

"The BoJ has repeatedly said it will adjust policy rates gradually but if it fails to raise rates a full six months after last July's decision to end the zero interest rate policy, it will need to offer a convincing explanation to the markets," argued Barclays Capital strategist Masuhisa Kobayashi.

"If the economy continues its gradual recovery, the BoJ is likely to raise rates once every six months. But if the recovery's pace picks up even a little, we believe capital spending would strengthen and inflationary pressures would build, hastening the pace of rate hikes," he predicted.

Economic and Fiscal Policy Minister Hiroko Ota urged the BoJ this week to hold steady its super-low interest rates so as to stimulate the economy and decisively beat deflation.

"Japan is facing an extremely critical moment as it is finally getting out of deflation," she told a news conference...

Markets, meanwhile, are nervous that the central bank could repeat its blunder of August 2000, when it raised interest rates too soon and helped snuff out a nascent economic recovery.

"Things aren't as bad as they were in August 2000 but if consumer price inflation goes negative again, which it probably will in the spring, it's going to be very difficult for the BoJ to justify itself," said Feldman.

But perhaps BoJ officials have even longer memories and remember that the CPI was also pretty flat for much of the mid- and late-1980s. Was the BoJ right in keeping interest rates low then?

Japanese interest rates may rise with machinery orders

Japan readies itself for a possible rate hike later this week with the following news provided by Bloomberg:

Japan's machinery orders climbed more than economists forecast, fueling speculation the central bank will raise interest rates this week.

Non-government orders, excluding shipping and utilities, climbed 3.8 percent in November to 1.06 trillion yen ($8.8 billion) from October, the first back-to-back gains since 2005, the Cabinet Office said today in Tokyo. The median estimate of 28 economists surveyed by Bloomberg News was for 3.5 percent.

Policy makers will decide on Jan. 18 whether to raise the key overnight lending rate from 0.25 percent to prevent excessive business investment and asset-price bubbles. Investors see a 76 percent chance the central bank will increase borrowing costs this week, up from 66 percent on Jan. 12, according to Credit Suisse Group calculations.

But despite the Bank of England's rate hike last week, the inflation picture in the UK painted by the latest data looks mixed. From FT:

Manufacturers’ raw material costs are rising at the slowest pace for more than 2½ years, suggesting inflationary pressure may be easing at the start of the supply chain.

However, prices at the factory gate climbed by slightly more than expected last month, as producers enjoyed more pricing power, a report released on Monday showed.

The Office for National Statistics said its seasonally adjusted index of input prices rose by 0.1 per cent between November and December...

Meanwhile, output prices climbed by 0.2 per cent month-on-month, for an annual gain of 2.2 per cent.

And from Bloomberg:

An index of U.K. house prices fell to a four-month low in December as two interest-rate increases by the Bank of England last year began to subdue the property market, the Royal Institution of Chartered Surveyors said.

The number of real-estate agents and land surveyors reporting higher home values outnumbered those showing declines by 37 percentage points, down from a revised 46.9 percent in November, the organization said today in London.

Perhaps the European Central Bank was more correct in cautiously holding rates last week, with eurozone industrial production remaining somewhat weak. Eurostat reports:

Seasonally adjusted industrial production increased by 0.2% in the euro area (EA12) in November 2006 compared to October 2006. Production fell by 0.1% in October and by 1.0% in September. In the EU25 output rose by 0.3% in November, after remaining unchanged in October and decreasing by 0.5% in September.

In November 2006 compared to November 2005, industrial production grew by 2.5% in the euro area and by 2.8% in the EU25.

Hawks circling over Europe

The Bank of England and the European Central Bank had been widely expected to raise interest rates in 2007, but markets were still taken by surprise last week by a decision by the BoE to raise interest rates.

On 11 January, the Bank of England's Monetary Policy Committee raised its official bank rate by 0.25 percentage points to 5.25 percent. In the statement accompanying its decision, the BoE cited steady growth in domestic demand and rapid growth in credit and broad money. With the margin of spare capacity in the economy appearing limited, it wrote that it is likely that inflation will rise further above the BoE target of 2 percent in the near term before falling back as energy and import price inflation abate.

With the latest hike, the BoE's benchmark rate is now on par with the Federal Reserve's federal funds rate, after having allowed the latter to overtake it as a result of the BoE's pause in 2004 followed by a rate cut in 2005 amid fears of a collapse in the housing market. It also keeps the yield curve well inverted, with the 10-2-year spread on UK government bonds currently at about minus 50 basis points.

However, the inverted yield curve seems to have had little adverse consequence so far, and the feared collapse in the housing market did not happen. Indeed, the housing market has roared back to life, surely a factor behind the BoE's latest decision to raise rates again.

In addition, the inflation rate had hit 2.7 percent in November, a rate not seen in a decade. Indeed, many analysts speculate that the inflation rate for December, not yet officially released but already known to BoE members, could have breached the 3-percent threshold that would force the BoE to write a letter of explanation to the government.


Whatever it was that prompted the rate hike, it must have been something substantial enough to have spooked the BoE into springing a surprise on markets. And that in turn raises the probability of yet more rate hikes to come.

In contrast to the BoE's rate hike, the ECB's policy decision on the same day proved less of a thrill. No change was announced on interest rates, but ECB president Jean-Claude Trichet did drop a strong hint at a briefing in Frankfurt: "I would not say anything here that would change expectations in the market that we could do something at the end of the first quarter."

Indeed, the surprise would be if the ECB did nothing by then. Although the inflation rate in the euro zone was relatively subdued at 1.9 percent in December, Trichet noted that money and credit growth remains "very strong". In fact, Trichet pointed out that the November M3 growth rate of 9.3 percent was "its highest annual rate of growth since the introduction of the euro and, indeed, its strongest aggregate growth in the euro area group of countries since 1990". The 11.2 percent growth rate of loans to the private sector in November, unchanged from the previous month, was further evidence of the rapid rate of monetary and credit expansion.

Trichet concluded that "annual inflation rates are projected to hover around 2% this year and next, with risks to this outlook remaining on the upside".

In an answer to a question at the session, Trichet also commented that the ECB remains "very attached to the monetary pillar", saying that it "had served us very well". He said: "You remember that the OECD was advising us not to move, that the IMF was advising us not to move, that a number of market participants were giving us the same advice. We decided to move, we are now fully vindicated."

And such confident words can only mean one thing: More rate hikes to come from the ECB.

US retail sales up, Chinese GDP growth down

Despite earlier fears, US retail sales proved surprisingly healthy in December. Reuters reports:

Retail sales rose by a larger-than-expected 0.9 percent in December and were even stronger than anticipated when autos were stripped out, suggesting consumers were willing to open their wallets despite slowing housing markets, a Commerce Department report showed on Friday.

The seasonally adjusted December gain in retail sales, which covers the crucial holiday shopping season, was the largest since July. Analysts polled by Reuters were expecting a 0.6 percent rise.

A 1 percent jump in sales aside from autos, considered a more reliable indicator of core household spending, was well ahead of the 0.5 percent gain analysts were expecting. It was the sharpest climb since January of last year...

However, November's sales data were revised down to a 0.6 percent gain overall from a previously reported 1 percent increase, and excluded autos to a 0.7 gain from an earlier reported 1.1 percent rise...

Another report emphasized some inflation risks remain. Prices of imported goods jumped a stronger-than-expected 1.1 percent in December, with much of the increase from higher petroleum costs. When oil was excluded, import prices rose a strong 0.4 percent...

A separate Commerce Department report showed that business inventories rose a higher-than-expected 0.4 percent in November and business sales were up 0.5 percent.

So much for hopes for a Fed rate cut.

U.S. Treasury debt prices tumbled, sending yields to their highest since late October, as the data supported the view that the Federal Reserve will not cut interest rates soon. The dollar gained after the data but fell later in the day on profit taking...

"It seems that everything we heard about flat screen television sets is certainly true. The possibility of a Fed rate cut in the first quarter has melted away along with everything else on the East Coast," said Mark Vitner, a senior economist at Wachovia Securities in Charlotte, North Carolina.

A resilient US consumer must be good news for China's exporters, although the authorities there probably would not mind slower growth. From Bloomberg:

Gross domestic product expanded 10.5 percent in 2006 from a year earlier, National Development and Reform Commission head Ma Kai said today in a statement on the organization's Web site. That is down from 10.7 percent over the first three quarters...

The slowdown in investment and loans is "not stable," according to Ma. "The pace of economic growth is still fast," the planner said, adding China's government will continue to strengthen and improve macro-economic controls.

BoE raises interest rates, others may follow

The Bank of England sprang a little surprise on markets yesterday by raising interest rates. Reuters reports:

Interest rates hit their highest level in nearly six years on Thursday after the Bank of England stunned markets by raising interest rates to 5.25 percent, the third quarter-point hike since August...

Economists said further interest rate increases could lie ahead and futures markets quickly moved to reflect the possibility of two more hikes before the year was out.

A resilient UK economy was surely a factor. Again from Reuters:

The Office for National Statistics said factory output rose 0.3 percent on the month, in line with forecasts and leaving it 2.4 percent higher than a year ago.

Overall industrial output, which includes the energy sector, rose 0.5 percent in November, 0.8 percent higher on last year. That was the strongest monthly rate since March 2006 and above the 0.3 percent increase predicted by analysts.

And the Conference Board's leading index for the UK also showed a rise in November:

With the 0.1 percent increase in November, the leading index now stands at 138.6 (1990=100). Based on revised data, this index remained unchanged in October and increased 0.3 percent in September. During the six-month span through November, the leading index increased 1.5 percent, with six of the eight components advancing (diffusion index, six-month span equals 75.0 percent).

The European Central Bank, on the other hand, left interest rates unchanged, but according to Bloomberg, European Central Bank President Jean-Claude Trichet said at a briefing in Frankfurt: "I would say nothing here that would change the expectation by markets that we could do something at the end of the first quarter."

The eurozone economy would probably be able to take another rate hike, if the latest forecast is anything to go by. From Reuters:

Quarterly economic growth in the euro zone is expected to accelerate slightly in the first half of this year from rates at the end of 2006, the European Commission said on Thursday as it tweaked its forecasts higher.

The Commission raised its forecast for growth in the first and second quarters of 2007 to a range of 0.4-0.8 percent and 0.4-0.9 percent quarter-on-quarter respectively, from 0.3-0.8 and 0.3-0.9 percent seen at the end of November.

Next to raise rates, though, could be Japan. Today's data on bank lending and liquidity probably did not discourage such a view. From Bloomberg:

Japan's bank lending gained for an 11th month in December as companies and consumer borrowed more, confident that expansion in the world's second-largest economy will be sustained.

Loans rose 1.7 percent from a year earlier, the biggest increase in four months, the Bank of Japan said in a report today in Tokyo, after climbing 1.2 percent in November. The median forecast of three economists was for a 1.3 percent gain...

Lending adjusted for factors including currency fluctuations, securitizations and bad loan write-offs advanced 2.8 percent.

Japan's money supply, or M2 plus notes in circulation, rose 0.8 percent in December, the central bank said in a separate report. Broad liquidity, which includes bonds and investment trusts, gained 2.7 percent.

But yesterday's report of a fall in the leading index leaves doubts. From Reuters:

Japan's diffusion index of leading indicators, a key barometer of the economy, dipped below a key threshold in November, signalling that recovery may stall in the months ahead.

The leading index, which gauges economic conditions several months ahead, fell to a preliminary 20.0 in November from a revised 54.5 in October, government data showed on Thursday.

US trade deficit falls with oil prices

Oil prices continued to fall yesterday. Reuters reports:

U.S. crude settled $1.62 lower at $54.02 a barrel after falling as low as $53.80, the lowest since June 2005. London Brent crude fell $1.49 at $53.69 a barrel.

News that oil flows had resumed along the Druzhba crude pipeline from Russia after a dispute with Belarus helped push U.S. oil down to $53.49 in electronic trading after hours.

Data from the U.S. Energy Information Administration showed a bigger-than-expected rise last week in distillate stocks, which include heating oil, in the world's biggest oil market.

The fall in oil prices should help reduce the US trade deficit further, after having fallen in November. From Reuters:

The trade deficit narrowed 1 percent in November to $58.2 billion, the smallest since July 2005, surprising many Wall Street analysts who had expected a wider trade gap...

U.S. exports of goods and services grew nearly 1 percent in November to a record $124.8 billion...

Lower oil prices, after a sharp run-up earlier in the year, also helped trim the trade gap.

Other economic news from the Reuters report:

A separate survey of top forecasters released on Wednesday pegged U.S. economic growth at 2.3 percent and 2.5 percent, respectively, in the first and second quarters of this year...

In a separate report, the Mortgage Bankers Association said its seasonally adjusted index of mortgage application activity, which includes both refinancing and purchasing loans, jumped 16.6 percent to 671.1 for the week ended January 5...

A second Commerce Department report showed inventories at U.S. wholesalers climbed a much-stronger-than-expected 1.3 percent in November as stocks rose in most industries, including a 0.6 percent gain in the auto sector.

The fall in oil prices was not enough to reduce Britain's goods trade deficit in November, which grew to 7.193 billion pounds from a revised 6.601 billion pounds in October. British appetite for goods is also being reflected in rising shop prices, which rose at an annual rate of 2.28 percent in December, the fastest since March 2004.

It was a similar trade story across the English Channel, France reporting that its provisional seasonally-adjusted trade deficit widened to 2.834 billion euros in November from 2.794 billion in October. This came as French industrial production fell 0.2 percent in November.

Of course, if some countries are reporting trade deficits, others must be reporting surplus.

One such country is Canada. Reuters reports:

Canada's trade surplus widened more than expected in November to C$4.67 billion ($3.96 billion) from a revised C$3.76 billion in October as exports grew sharply after two straight months of declines, Statistics Canada said on Wednesday...

Exports rose 2.8 percent in November to C$38.14 billion, led by a rebound in automotive products shipments...

Imports, on the other hand, gained only 0.4 percent to C$33.48 billion as gains in energy and automotive imports offset a large drop in industrial goods and materials, Statscan said.

But when most people think of trade surplus, they think of China. Understandably so. From Xinhua Online:

China's trade surplus reached 177.47 billion US dollars in 2006, the General Administration of Customs said Wednesday.

Exports rose 27.2 percent from the previous year to 969.08 billion dollars, while imports were up 20 percent to 791.61 billion dollars.

The December surplus stood at 21 billion US dollars, a slight decline from November's 22.9 billion dollars.

Monthly imports for December were 73.1 billion US dollars, up 13.5 percent on the same month of 2005 while exports stood at 94.1billion US dollars, up 24.8 percent.

Weather turns cold but not economies

A blast of polar air may be coming down the United States but the economies of the rest of the world show few signs of cooling.

The German economy approached the end of 2006 on a reasonably strong note. From Bloomberg:

[Industrial production] rose 1.8 percent from October, when it fell 0.8 percent, the Economy and Technology Ministry said today in Berlin. The seasonally adjusted trade surplus rose to 19.3 billion euros ($25.2 billion) from 17.3 billion euros in October, the Federal Statistics Office in Wiesbaden said...

Economists expected industrial production to rise 1 percent, according to the median of 37 estimates in a Bloomberg News survey. Exports had a smaller-than-expected drop in November, declining 0.5 percent from the previous month...

"The figures bode really well for the German economy going into this year," said Jacques Cailloux, chief euro-area economist at Royal Bank of Scotland in London. "The only thing we see is that the German economy remains somewhat split, the corporate and industrial side are powering ahead, while German consumers still fret about their incomes and won't spend."

But consumer spending did not turn out too badly in the UK in December. The British Retail Consortium reports that UK retail sales were up 2.5 percent on a like-for-like basis compared with December 2005. The three-month trend rate of growth was unchanged from November at 1.9 percent for like-for-like sales but slowed to 4.0 percent from 4.3 percent for total sales.

And while Australian retail sales slowed in November, the latest consumer confidence survey from Westpac released today showed that consumer confidence has jumped to a 17-month high in January. And in another piece of news released today, Australia reported a narrower trade deficit as exports rose one percent and imports fell three percent.

Meanwhile, tortillas are frustrating hopes for a rate cut in Mexico. Bloomberg reports:

Mexico's annual inflation exceeded the central bank's target range in 2006 as a surge in prices for fresh food retreated more slowly than expected in December.

Consumer prices rose 4.05 percent in the 12 months through December after rising 3.33 percent in 2005, the central bank said on its Web site.

Previously expected rate cuts in the first quarter of 2007 are no longer likely, said analysts such as Gray Newman, chief Latin America economist with Morgan Stanley...

Core inflation, which excludes fresh food and energy, was 0.43 percent in December, the [central] bank said...

The rising price of tortillas, spurred by global demand for corn, is sustaining core inflation, [Barclays Capital's chief economist for Latin America Michael] Hood said.

US inflation may not ease, global growth remains encouraging

Yet another Fed official warns us not to count on an interest rate cut. Reuters reports:

The U.S. economy is poised for moderate growth and lower inflation, but there is no guarantee core inflation will continue to ease, Federal Reserve Vice Chairman Donald Kohn said on Monday.

"A very gradual decline in the trend rate of inflation continues to be the most likely outcome, but that path is still by no means assured," he said in remarks to the Atlanta Rotary Club...

Not assured, indeed. Not with consumer credit rising again. From Reuters:

U.S. consumer credit rose $12.33 billion in November as Americans loaded up on credit-card debt, while closed-end loans for items such as cars, educations and holidays recovered from an October decline, the Federal Reserve reported on Monday.

Consumer credit rose by a 6.23 percent annual rate to $2.390 trillion in November, compared to a revised October fall of $1.25 billion. October's 0.63 annual percentage rate fall was the biggest since a 0.96 percent drop in October 1992.

Sustained growth in US consumer spending will certainly help keep the global economy afloat though, even as German consumer spending appears to be faltering. From Bloomberg:

German retail sales unexpectedly fell for a third month in November as concern that tax increases will reduce households' disposable income restrained consumer spending.

Sales, adjusted for inflation and seasonal swings, declined 0.3 percent from October, the Federal Statistics Office in Wiesbaden said today. Economists forecast a gain of 1 percent, the median of 25 estimates in a Bloomberg News survey showed, with none predicting a decline.

But German manufacturing appears to be more resilient. Bloomberg reports:

German manufacturing orders rose for the first time in three months in November, led by an increase in demand for trucks and cars.

Orders, adjusted for seasonal swings and inflation, rose 1.5 percent from October, when they declined 0.7 percent, the Economy and Technology Ministry in Berlin said today. The report was in line with the median of 37 estimates in a Bloomberg News survey. From a year earlier, orders increased 6.1 percent.

So there appears justification for some optimism -- and a rate hike.

In Germany and across Europe the economy may still expand fast enough to allow the European Central Bank to keep raising interest rates in 2007.

ECB President Jean-Claude Trichet speaking as chairman of the Group of 10 nations in Basel, Switzerland, today said he's "reasonably confident" Europe and Asia will withstand a U.S. slowdown. Global growth is "encouraging," he said.

Lower interest rates may take some time to come

Hopes for a cut in interest rates by the Federal Reserve receded further last week. And to add insult to injury to bond investors, China and Japan appear to be resuming their monetary tightening campaigns.

While most of the world's economists were focussed on developments in the United States, the world's largest economy, developments on monetary policy on the other side of the world also shared the limelight last week.

One development was the announcement by the People's Bank of China (PBC) on Friday that the required reserve ratio for financial institutions engaged in the deposit business in the country would increase by 0.5 percentage points from January 15. This was the fourth such move by the PBC in a year and will bring the reserve requirement to 9.5 percent.

Then there were various news reports in Japan speculating that the Bank of Japan might be preparing to raise interest rates this month. As a result, the yield on the 10-year JGB rose 3.5 basis points last week to 1.71 percent after touching a 1-1/2-month peak of 1.715 percent on Thursday.

Finally, we have developments in the United States suggesting that the Federal Reserve is likely to keep the target federal funds rate unchanged for an extended period.

A healthy labour market will be a major factor. While much of the US economic data released during the week had been mixed -- indeed, even on employment, the ADP National Employment Report had indicated that the private sector lost 40,000 jobs in December -- the employment report from the Bureau of Labor Statistics on Friday indicated that nonfarm employment increased by 167,000 in December while average hourly earnings rose 0.5 percent. It was a surprisingly strong report for an economy that is supposed to be well into a slowdown.

Other employment-related data released during the week -- specifically those on claims for initial jobless benefits, planned job cuts surveyed by Challenger, Gray & Christmas Inc and the employment readings from the Institute for Supply Management surveys -- tend, on the whole, to support the picture of a healthy labour market.

The employment report on Friday caused expectations for a rate cut in the first quarter of the year to be lowered.

There were also signs from the Federal Reserve itself last week that reinforced the view that a first quarter rate cut is unlikely.

On Wednesday, the minutes of the Federal Open Market Committee (FOMC) meeting in December were released. The minutes showed that the committee thought that "the economy seemed likely to expand at a moderate pace" and that "inflation risks remained of greatest concern and that additional policy firming was possible".

On Friday, in a speech to the Connecticut Business and Industry Association, Boston Fed President Cathy Minehan said that "2007 will bring continued moderate growth, with GDP at or a bit below potential". On the other hand, inflation "has been and remains a challenge", with core inflation over the 12-month period to November remaining "close to its third-quarter high, suggesting inflation may be slow to taper off".

On the same day, in a speech to the Labor and Employment Relations Association, Chicago Fed President Michael Moskow said that "recent changes in population growth and labor force participation imply that we need to change our benchmark for employment growth to something more like 100,000 per month". This means that the recent rate of job growth can be viewed as "quite solid".

Then, after noting the difficulty in boosting worker productivity recently, he said: "The slower growth of available workers and the rate at which trends in educational attainment and labor market experience add to those workers' productivity both...suggest that the contribution of labor to potential output growth may have declined by a bit more than half a percentage point since the late 1990s."

In a nutshell, what Minehan and Moskow are saying is that the US economy probably cannot grow much faster than it recently has been without pushing up inflation, which is already near a high. Hence the FOMC's continuing concern with inflation risks. This in turn means that the Federal Reserve is unlikely to entertain suggestions of a rate cut anytime soon.

So with the world's most important central bank likely to remain on the sidelines for a while more as far as explicit action is concerned, the fate of global interest rates over the next few months lies mainly in the hands of other central banks. And the latest indications are that these central banks are taking interest rates up.

Labour market strong in US and Europe

The US nonfarm payroll number for December proved to be a shocker. Reuters reports:

The Labor Department said 167,000 jobs were created last month and also revised up hiring for each of the two preceding months. The unemployment rate in December was 4.5 percent, unchanged from November.

Wall Street economists had forecast that only 100,000 new jobs would be created in December, so the report painted a picture of a healthier job market and potentially stronger expansion than anticipated as 2006 ended...

Some parts of the report will trouble Fed policy-makers, who have expressed concern about potential inflation. Average hourly earnings climbed 0.5 percent in December -- the largest monthly increase since a 0.6 percent jump in April -- after a 0.3 percent gain in November...

The average workweek was unchanged at 33.9 hours but overtime ticked up to an average 4.3 hours last month from 4.2 in November.

Economists acknowledged the strength in the economy that the report implies, as well as the inflation implication.

"The manufacturing side of the economy may be weak, but the rest of the economy is strong and that suggests that we're probably going to see continued good economic growth in the months ahead," said Gary Thayer, chief economist for A.G. Edwards and Sons Inc. in St. Louis...

"It's certainly going to go a long way in calming fears that a housing slowdown was taking the economy apart," said Jim Paulsen, chief investment officer for Wells Capital Management in Minneapolis...

"Without a doubt, the wage picture will be regarded as threatening by Fed hawks," said Pierre Ellis, senior economist with Decision Economics in New York.

The news from Europe yesterday was also relatively positive. Reuters reports:

The jobless rate in the 12 countries that share the euro fell last year to 7.6 percent in November, the lowest since 1993 when such measurements started, the European Union statistical agency Eurostat said on Friday. October's level was 7.7 percent...

Separately, the European Commission said its business climate indicator for the euro zone rose in December to 1.60, its highest ever, from 1.55 in November. However, managers' production expectations were less optimistic.

A separate general economic sentiment indicator fell slightly to 110.1 in December, but remained well above its long-term average, the Commission said...

Eurostat said industrial producer prices in the euro zone remained unchanged in November from the previous month, capped by falling energy costs. But they rose 4.3 percent year-on-year, boosted by rises in oil and commodities earlier in 2006, Eurostat said...

In another release on Friday, Eurostat said euro zone retail sales rose 1.3 percent in November from the same month in 2005. The indicator grew by 0.5 percent in month-on-month terms.

In contrast to the previous day's reports, the UK yesterday provided a cooler picture, Reuters reporting that take-home pay rose 2.9 percent in December, up slightly from a low of 2.6 percent in November, while data from Halifax showed that house prices fell by 1.0 percent in December.

More signs of slowdown but BoE might have to look harder

The US data yesterday confirmed the general slowdown picture. From Reuters:

The Institute for Supply Management said its services index dipped to 57.1 in December from 58.9 in November. This was broadly in line with market expectations for a 57.0 reading...

Supporting the view of a slowing economy was news that factory orders rose 0.9 percent in November, below the market's consensus outlook for a 1.4 percent gain.

In October, new orders declined by a revised 4.5 percent, the Commerce Department said, versus a previous estimate of 4.7 percent. Excluding transportation, November factory orders fell 0.5 percent.

Orders for non-defense capital goods excluding aircraft, seen as a good gauge of business spending, fell 1.1 percent, following a 4.0 percent fall the previous month. The last time this measure fell for two consecutive months was in February and March 2005...

Consumers also appear to be showing signs of fatigue. Retailers posted disappointing December sales, marking the third consecutive month of disappointing growth, according to research firm Retail Metrics. It said 10 retailers lowered their earnings forecasts...

The National Association of Realtors said its Pending Home Sales Index, based on contracts signed in November, fell to 107.0 from 107.5 in October, but held above July's trough. The index had been forecast at 108.0...

The number of workers applying for initial jobless benefits edged up 10,000 to 329,000 in the week ended December 30, beating market expectations. But analysts said the figure had been distorted by the holidays and the job market remained stable...

Backing the view of a stable labor market was an independent report showing that planned layoffs fell 29 percent in December from the previous month.

Planned job cuts for all of 2006 fell below 1 million for the first time since 2000, according to Challenger, Gray & Christmas Inc., an employment consulting firm.

Meanwhile though, the UK economy is still looking relatively hot. Although GfK NOP's monthly consumer confidence index slipped to -8 in December from -7, the Chartered Institute of Purchasing and Supply/Royal Bank of Scotland's services index rose to 60.6 in December, its strongest showing since June 1997 and up from 59.8 in November, while the rate of return for non-financial companies rose to 15.2 percent in the three months to September from an upwardly revised 14.9 percent in the second quarter.

If all this is not enough to suggest another rate hike by the Bank of England, perhaps this Reuters report does:

The Bank of England said lending secured on dwellings rose by 9.830 billion pounds, the biggest jump since September 2003 and up from a downwardly revised 9.705 billion pound rise in October...

Mortgage approvals, an indicator of the future strength of the market, rose to 129,000 in November, the highest since December 2003. Total lending was also strong, up 10.873 billion pounds -- the biggest rise since July 2004.

However...[g]rowth in unsecured lending eased slightly as expected to 1.043 billion pounds from 1.101 billion in October.

...M4 growth slowed to an annual rate of 13.0 percent from 14.0 percent in October. Month on month, M4 grew by 0.5 percent, down from 0.9 percent.

However, the eurozone economy looks somewhat cooler. Bloomberg reports:

Royal Bank of Scotland Group Plc said its services index, which gauges growth in industries from telecommunications to banking, fell to 57.2 from 57.6 in November...

The slowdown in services growth was led by Italy and France, today's report showed. In Germany, Europe's largest economy, the gauge rose...

Euro-region inflation held at 1.9 percent in December, just below the ECB's 2 percent ceiling, Eurostat, the European Union's statistics office in Luxembourg, said today.

Inflation could still fall further after the recent price movements in the oil markets. From AFP/CNA:

A brutal sell-off gripped world oil markets, with London Brent hitting its lowest level in over a year, after data showed rising reserves of US heating fuel during an unusually warm winter.

In London, Brent North Sea crude for February delivery slumped 2.85 dollars to settle at 55.11 dollars a barrel. The contract came off 54.76 dollars, its lowest level since December 1, 2005.

New York's main contract, light sweet crude for delivery in February, sank 2.73 dollars to close at 55.59 dollars a barrel, its lowest level since its 2006 low struck in mid-November.

The Bonddad Blog wonders whether "like the copper sell-off, is this also the markets telegraphing their perception of slower US growth". However, David Gaffen at the MarketBeat Blog says that for most of 2005 and 2006, "it wasn’t the oil industry driving crude higher — it was investors and speculators, who are now selling".

US manufacturing steady, other data mixed

Reuters reports the economic news from the US yesterday.

[T]he Institute for Supply Management said its index of national factory activity climbed to 51.4 from 49.5 in November -- above the 50-threshold that separates growth from contraction. Analysts had forecast a reading of 49.9...

Analysts were also encouraged by the decline in the ISM's prices paid index, which measures inflation pressures at the industrial level. The index fell to 47.5 from 53.5, while a measure of new orders climbed to 52.1 from 48.7...

Construction spending...fell 0.2 percent in November, led by an eighth straight drop in private residential building that more than offset record highs in nonresidential and public construction...

The Mortgage Bankers Association said its seasonally adjusted index of mortgage application activity, which includes both refinance and purchase loans, rose 3.6 percent last week...

The monthly ADP National Employment Report showed private sector employers shed 40,000 jobs after adding 158,000 jobs in November...

Meanwhile, things look more positive elsewhere.

In Germany, unemployment fell in December, reports Bloomberg.

The number of people out of work, adjusted for seasonal swings, fell 108,000 to 4.12 million, the Nuremberg-based Federal Labor Agency said. The jobless rate fell to 9.8 percent, the lowest since August 2002, from 10.1 percent...

Germany's DIW economic institute, the largest of the country's six leading research institutes, today raised its outlook for growth this year to 1.7 percent from 1.4 percent. Gross domestic product may even reach 2.5 percent next year, the Berlin-based DIW said.

In the UK, Reuters reports that construction accelerated in December, the Chartered Institute for Purchasing and Supply's index for construction rising to 57.5 from 54.8 in November.

Manufacturing slowdown spreads

Japan kicked off the reporting on purchasing managers' indices last week. From Reuters:

The NTC Research/Nomura/JMMA Purchasing Managers Index, which gives an early snapshot of the health of manufacturing, slipped to a seasonally adjusted 53.1 to indicate the weakest rate of growth since March 2005. It was 53.7 last month.

Yesterday, we had more reports. AFX/Forbes reports the eurozone PMI.

The euro zone's manufacturing sector saw output grow at its slowest rate in nine months during December, sources said of a key survey.

The purchasing managers' index for the euro zone manufacturing sector slipped to 56.5 in December from an unrevised 56.6 in November, they said.

UK manufacturing slowed as well, the CIPS/RBS Purchasing Managers' Index falling to 51.9 in December, its lowest reading since March.

Even China saw manufacturing slow. AFX/Forbes reports that CLSA's purchasing manager's index for China fell back to 52.4 in December from a four-month high of 53.0 in November.

And in India, the purchasing managers' index compiled by NTC research and sponsored by ABN AMRO Bank fell to 56.6 in December, the slowest pace in five months, from 58.9 in November.

2006 ends on bullish note for stock investors

Stock markets performed spectacularly in 2006, continuing a bull run that has now lasted about four years. Despite an ongoing slowdown in the US economy, the global economy is likely to stay relatively healthy in 2007. However, further gains in stock prices are far from assured.

For stock markets, 2006's performance is hard to beat as it is. It was a year that saw many market indices, including the Dow Jones Industrial Average, make all-time highs. The following are the performances of the major stock markets according to their respective Morgan Stanley Capital International indices:

	Local currency (percent)	US dollars (percent)
USA	13.2	13.2
Japan	6.1	5.1
UK	10.7	26.2
Germany	19.0	33.0
France	17.8	31.7

Gains were even bigger in emerging markets, including the so-called BRIC.

	Local currency (percent)	US dollars (percent)
China	78.7	78.1
Russia	52.1	53.7
India	46.5	49.0
Brazil	28.5	40.5

All these gains were achieved despite a clear slowdown in the US economy, the global growth engine. US real GDP growth slowed from a 5.6-percent annual rate in the first quarter of 2006 to 2.6 percent in the second quarter and 2.0 percent in the third.

Persistently low interest rates helped stocks, especially in a financial world that is seeing increasing use of financial derivatives and leverage. Despite higher official rates from all the major central banks, longer-term bond yields stayed relatively steady. For example, the US 10-year Treasury yield, which started the year at around 4.4 percent, finished the year at around 4.7 percent despite the federal funds rate rising one full percentage point over that period.

In addition, some central banks have hardly moved interest rates up. The Bank of Japan ended its "quantitative easing" policy in March, raised its overnight call rate target to 0.25 percent from zero in July, then did nothing else for the rest of the year.

However, through most of the first half of the year or so, while the Bank of Japan and other central banks were still actively tightening monetary policy, bonds weakened and yields went up as inflation fears rose and investors became increasingly convinced that central banks were bent on beating it. That caused stock markets worldwide to tumble in May and June.

But around the middle of the year, markets began to perceive that inflation had peaked or was about to peak, a perception that was reinforced by the Federal Reserve going into pause mode from August onwards. Bond yields then started to decline. And stock markets took off.

So what are the prospects for 2007?

The consensus among economists appears to be for a soft landing for the US economy and a gradual decline in growth rates for the rest of the global economy. This view is supported by signs of a stabilisation in the US housing market as well as continued gains in various indices of leading indicators for the global economy. At the same time, inflation appears to have peaked in the US and, once slower growth takes hold, is widely expected to slow in the other economies as well.

With such an outlook, the Federal Reserve is widely expected to cut rates, possibly as early as the first quarter of the year, although most of the other major central banks are still expected to continue raising rates, at least in the early part of the year, until slower growth and inflation becomes more apparent.

So the overall economic environment is expected to be benign: Slow growth but accompanied by low interest rates. Such an environment is usually considered good for stocks.

And yet, with stock markets having risen as much as they have in 2006, there is a real possibility that stock investors have already discounted the benign economic environment. Most market forecasters see higher stock prices for 2007 while sentiment indicators also show that investors are generally bullish going into the end of 2006, a picture supported by low implied volatilities for stocks and low spreads in credit markets.

Such bullishness could mean that stocks are currently -- in the words of some analysts -- already "priced for perfection", leaving no room for positive surprises, only negative ones.

For example, if the economy turns out to be weaker than expected, investors are likely to become concerned about earnings growth and sell stocks. A recession could turn what is currently expected to be a mere slowing of corporate earnings growth into outright earnings decline and pull stock prices down as well.

On the other hand, if the economy proves unexpectedly resilient, investors are likely to become concerned that inflation could persist and interest rates could rise, and sell stocks anyway. Indeed, as of today, all of the world's most important central banks -- the Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England -- maintain at least a bias towards higher rates; none have expressed an inclination to cut rates soon. This is in direct contrast with the view of many analysts that at least the Federal Reserve is poised to cut rates.

Stocks that are priced for perfection are also vulnerable to financial shocks -- including those arising from natural disasters and geopolitical events -- especially with the widespread use of leveraged financial instruments.

To sum up, we probably have a benign global economic environment ahead of us which would provide investors in the stock market with more gains over the next year or so. But having finished 2006 on a canter, stock market bulls will have to enter 2007 walking on a tightrope.