Market Directions

Several factors sent the dollar soaring: end of the year profit taking and position squaring; sovereign debt concerns in the European Monetary Union (EMU); further improvement in the American economy; and perhaps a Federal Reserve contemplating the withdrawal of crisis support for the credit markets. All of these conditions except the first will continue into 2010.

December is the season of market reversals. Not in the sense of establishing a trend for the New Year but in the appreciation by traders that if they do not take their profits someone else will. To put it more succinctly, if the market has moved in one direction in the months prior to December, expect a u-turn in the last month of the calendar. This reversal may happen regardless of economic and rate considerations, which in most cases will not have changed.

Last year was an excellent example. The euro had been falling against the dollar since July. Safe haven flows into the States ruled the currency markets, particularly after the failure of Lehman in September. But beginning in early December the euro suffered a violent reversal, appreciating 17% in two weeks. This shift anticipated nothing in January as the united currency promptly resumed sinking in the first quarter until it bottomed in early March. Clearly the vault higher in December had little to do with fundamental changes in the currency or in the financial markets and everything to do with market conditions and stop loss orders.

The December reversal last year was not an unusual occurrence. In 2008 the euro had been rising since August. It peaked in mid-November, fell through the first part of December, and finished the month just about where it had begun. The years 2005, 2006 and 2007 exhibited similar reversal movements in December. The pattern is not invariable. In 2003 and 2004 the euro continued its uptrend through December and saved the reversal for the start of the New Year. But for traders thinking of profit preservation in the terminal month, defensive plays are essential.

The biggest problem weighing on the euro is the sovereign debt crisis in the European Monetary Union (EMU), which took on a new urgency last week. Greece and to a lesser extent Spain, Ireland and Portugal are facing deficits well in excess of the 3% stabilization treaty limits. But of more concern to ECB monetary authorities, their path to solvency and fiscal reliability is impeded by the severity of the recession, structural economic rigidities and political inertia. Even Great Britain though not a part of the EMU, added its weight to the European gloom.

Greek sovereign debt suffered its biggest one week decline since January after Standard and Poor's lowered its debt rating on Wednesday to BBB+, the third lowest investment grade. Fitch, another agency had already downgraded Greek debt earlier in the month. The yield on Greek 10 year notes rose to their highest level since April at 5.77 %. The spread over German Bunds, the risk equivalent of US Treasuries in Europe, stretched briefly to 265 basis points, also the widest since April. Moody's the third major credit rating agency is expected to cut its standard on Greek debt within a few weeks.

Greece has the highest deficit as percent of GDP in the EMU at 12.7%. The official limit for government debt is 3% as set in the stabilization treaty of the Maastricht Accord which created the conditions for joining the euro. But that limit was already transgressed by Germany and France several years ago so its force has always been in doubt. But it was not only the size of the Greek debt which shocked the markets but the fact that it was almost double what had been previously admitted. The 12.7% figure was revealed by the newly elected Socialist government of George Papandreou. The prior center right New Democracy government had claimed a deficit percentage of 6.7%.

It is now that the weakness of the EMU currency structure is most evident. The EMU is united; each of the countries in the euro zone uses the same currency and is subject to the same interest rate. But the debt rating and the fiscal soundness of the individual countries differ widely. Greece may issue sovereign debt in euros but those notes cannot have the same interest rate as German bunds. Because the fiscal and political conditions in Germany and Greece are not comparable the notes are very different instruments despite the single denominating currency. The EMU countries are united in monetary policy but in nothing else.

In the United States Mr. Bernanke is not yet willing to outline an active plan for reabsorbing the trillions of cash with which the Fed has flooded the US economy. But he is not above reminding the markets that the flow will be seriously diminished by the end of February when a number of the special liquidity programs end. In the FOMC statement on Wednesday the Fed went out of its way to enumerate these programs and remind that the monetary sluice may soon be shut. That these programs will end is not news, nor is the date, but the pointed reminder from the Fed Chairman certainly is.

American PPI and CPI for November both hinted at inflation dangers over the horizon. PPI at 1.8% in the month and CPI at 1.8% for the year are not comfortable figures when trillions of excess liquidity may just be beginning to enter the price equation. Industrial production, capacity utilization, and leading indicators were considerably stronger than predicted. Even moderate economic growth has the potential to incite inflation when it is coupled with unprecedented money creation and a weak dollar which can import commodity inflation. For despite the recent recovery the dollar is still more than 30% below where it was against the euro in the spring of 2003.

The major factors supporting the dollar last week and this month will not abate in the New Year. The EMU sovereign debt situation is likely to ramify instead of subsiding. The US economy will continue on its slow recovery path and Mr. Bernanke's notice that the free monetary lunch is ending will come true. For once the directional taken from end of year profit taking may not be the monthly exception it usually is; the dollar could continue to strengthen in the first quarter of 2010.

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