FOMC Doesn't See Much Change in Labor Market, Inflation Conditions

Really not much here to go on. The Fed seemed to paint a glass is half-empty outlook, saying that recent growth is not enough to improve labor market. Underlying inflation is in a downtrend. And we had a unanimous decision this time to stay the course in regards to its quantitative easing 2 program.

Overall the release should weaken the USD and help higher yielders as there was no indication that the Fed is thinking about exit strategy or about contemplating tightenign monetary policy.

Until employment and inflation pick up, monetary policy will be loose and the USD should weaken in an environment of risk appetite (higher stocks) and traders and investors seeking higher returns.

US 4th Quarter GDP Misses, but Still a Good Miss

Gross domestic product rose at a 3.2% annualized pace in the 4th quarter. That was lower than expectations of a 3.5% increase, but better than the 2.6% rate we saw in the 3rd quarter.

Gains were led by a 4.4% increase in personal consumption, close to double the rate in the 3rd quarter. Also the trade balance and even non-residential fixed investment (up 4.4% compared to a fall of 10.0% in 3Q as well) added to growth.

The economy less inventories surged a whopping 7.1%, the best since 1984. That means we saw a massive swing in inventories which subtracted from growth.

In other words despite the headline figure missing forecasts, it was a very good miss and shows that the US economy is starting to be propelled by more sustainable activity.

For the first time in 2010, the economy also benefited from a trade surplus in October to December. Net exports, or exports from the U.S. minus imports into the country, contributed 3.44 percentage points to growth. In July through September, the trade gap subtracted 1.7 percentage points from GDP.

Many observers have predicted that GDP growth will run about 4 percent in 2011. If that forecast panned out, it would begin making a substantial dent in the vast rolls of the unemployed Americans, now officially at 14.5 million. Many more millions have given up looking for work, dropped out of the labor force entirely or been forced to take part-time jobs even though they need full-time work.

Even so, we have seen an increase in consumer spending, but what if it falls off? A growth rate of 3.1% in 2011, which is the prediction of the Congressional Budget Office would only bring down unemployment slowly, perhaps leaving rates above 9% by the end of the year.

Therefore, until we see added growth knocking down unemployment rolls the Fed will be staying pat.

ECB Jaw Bones Against Inflation, Ready to Act

In Europe, comments and messages being sent from the ECB are much more hawkish - a result of inflation moving above the 2% target in December. Investors are speculating on the probability that inflationary pressured would cause the European Central Bank to raise rates soon from 1%.

The ECB would do what is necessary to keep inflation in check, a nod towards the prospect of higher rates.

The main concern for the ECB is that inflationary pressure that is being fed by higher commodity and import prices seeps through to second round effects such as workers demanding higher wages in compensation for higher living costs.

BOE Caught in an Environment of High Inflation and Negative Growth

Very interesting mix of vote in the last Bank of England interest rate meeting. We now have2 people calling for interest rate increases on account of the higher risks to inflation. The market had been pricing in a more hawkish Bank of England prior to yesterday's very weak 4th quarter GDP results.

Coming into the overnight release, forecasts had the economy growing 0.5% in the 4th quarter compared to the 3rd quarter. Instead the data showed that the UK economy shrank by 0.5% on the quarter, and grew by 1.7% growth on a year-on-year basis, against expectations of 2.6%

While the GBP rose a bit following the news, the minutes are a bit behind the most recent macroeconomic data and therefore may not be acted upon by market participants in the same way we would have if GDP had come in on target.

The inflation concern is very real. On January 18th, we saw inflation for December register a 3.7% annual rate, higher than expected. The Bank of England thinks the inflation rate may rise to an annual rate of 4-5%, but blames it on temporary factors.

Even if the economy is weak, the BOE will have to act to maintain price stability, meaning higher rates would come just when Britons are least likely to be able to afford it. It seems that is the reason the BOE has not moved to reign in inflation yet. The Bank's Governor Mervyn King gave a speech yesterday saying that the recent elevated inflation will go away as its mainly driven by outside or transitional forces like higher commodity prices and higher VAT taxes and not by underlying measure like domestic wage inflation.

Japan Sees Long-Term Credit Rating Downgraded

The main fundamental story today was a drop in the Yen as we had Standard and Poor's cut Japan's long-term credit rating to AA- from AA, citing concerns over the country's debt. It was the first time that credit rating has been cut in 9 years and puts it three levels below the US.

The Euro and Dollar jumped in the aftermath of the news, but it might not be such a big deal, as much of Japan's debt is owned domestically. That means there's less of a chance that foreign creditors can push around Japanese yields.

Therefore, while its a warning shot for the Japanese economy, it may not have as major of an impact if more of Japan's debt was owned abroad.

On the other hand, the situation in Japan does raise some eyebrows. Japan has an $11 trillion debt burden, which is about 200% of GDP.

Egypt's Protests Fuel Safe Haven Flows

The story to end the week was the escalating unrest and political instability in Egypt, with large protests and violence between demonstrators and activists and police and security forces.

This became a focal story in financial markets as traders squared positions and reduced risk exposure heading into the weekend. Equities turned around in Europe, falling into negative territory and the US indexes sliding as well. There was some classic safe-haven flows as the US Dollar, Japanese Yen, Swiss Franc and gold gained on risk-sensitive higher yielding currencies. Oil was also stronger on fear that access to Suez Canal could be disturbed.