I am taking a break from blogging for the next 6 weeks, while I move abroad. Once I am settled, I will pick up again.

It has certainly been a very interesting start to the year. Hopefully by the time I return we will know more about Obama’s plans for overhauling the banking system. This remains the critical issue facing the economy 18 months on since Lehman failed.

I hope you have all had an excellent start to the New Year and I thank you for your continued support

Ben

Last week’s Pre-Budget Report (or was that “Pre-Election” Report) gave us the latest warning sign of trouble ahead. Even with an election a mere 6 months away, Alastair Darling was forced to admit the extent to which public spending will be slashed in the coming years. I didn’t see the point in writing about any of this as there wasn’t really anything new here.

However I have taken the time to form a view on Sterling in 2010.

Regular readers will know that I have been bearish on Sterling’s prospects for quite sometime. In fact one of this year’s biggest surprises for me has been our currency’s resilience. While it is certainly true that some of the more dire predictions have failed to materialise (e.g. UK unemployment has hit 2.49 million rather than the 3 million expected by Christmas), there has still been plenty of worse than expected news, not least the uncertainty surrounding the British Quantitative Easing strategy.

By way of comparison there have been two notable news items from the US this week.

The first was the announcement that the TARP programme is ultimately likely to have cost US tax payers $141 billion. While still a very heavy price to have paid for Wall Street’s excesses this is substantially lower than the $700 billion originally budgeted. Although the reduction in cost has largely been driven by bail-out recipients desperately paying money back to avoid restrictions on executive pay, this is still a positive step forward.

The second announcement came from the Federal Reserve yesterday that it plans to withdraw fiscal stimulus measures over the course of the first half of 2010. On the face of it this is another positive step, but any number of caveats remain about the strength of the recovery and how the economy will react to the withdrawal of fiscal support.

So while the the long term-viability of recent fiscal policy is still debatable, for the time being America’s financial sector revival should continue and it is probable this will help the US Dollar rise.

This is all in stark contrast to prospects on this side of the Atlantic.

There is still a great deal of uncertainty over the extent to which the next Government will be forced to cut spending, there is great uncertainty over where spending cuts will fall and, perhaps most worryingly, there is great uncertainty over how the deficit will be repaid i.e. where will the new jobs be created, so vital for increasing the tax base. Where in the US the exposure of taxpayers has reduced, over here we can’t even be sure that Quantitative Easing has finished (for what it is worth I would not be at all surprised to hear of a further increase at February’s Monetary Policy Committee meeting).

I have maintained for a while that 2010 is going to be a very tough year for Britain, so it is about time I put some numbers to this prediction. Recent price movements indicate that the market is about to turn on Sterling. If this happens then I expect to see a 15 - 20% decline in the value of the Pound across the board. I see particular weakness versus the US, Australian, Canadian and New Zealand Dollars, the Norwegian Krone and the Japanese Yen. There should also be a good trading opportunities versus the Euro, but I want to see how events in Greece and Ireland develop first.

Although the announcement did spark a short-term collapse in stocks and other financial asset classes, prices stabilised fairly quickly and have started to return to the previous highs. This can easily be explained by the fact that the “news” from Dubai cannot have come as much of a surprise. Even the most passive observer of Dubai’s growth cannot have failed to have recognised that the situation there was a classic bubble and was bound to cause problems. While the U.A.E. is oil-rich, the extent to which debt was used to drive Dubai’s growth was always likely to make it a victim of the Credit Crisis and ensuing Global downturn. This was just another bubble that had to burst one day.

However this situation does not look like another Icelandic crisis. It is true that Western banks seem to be exposed to yet more losses as a result of this default, but the sustained market reaction has remained localised to the Middle East. This suggests strongly that unless a genuine shock occurs and this event has surprising ramifications elsewhere, the Dubai situation will remain isolated.

However this is not to say that we should not pay attention to warning signals from this latest mini-crisis.

I am reminded of events in February 2007. You may or may not remember that there was a huge sell-off in stocks during this month in response to negative news on Chinese GDP. This sharp decline was followed by a strong rally, driven by expectations of US Federal Reserve Interest Rate reductions. I am sure I don’t need to remind you what happened after October 2007, when the financial World went into meltdown as the Credit Crisis really took hold.

So where do the parallels between then and now lie?

The answer is quite simple. As in February 2007 we have now witnessed an extreme, short-term sell-off in stocks belying genuine confidence in the economic soundness of the current rally. As with then, however, we are likely to witness a resumption of the uptrend driven by Central Bank financed liquidity. In short any concerns about the viability of the recovery will be trumped by the availability of substantial “cheap” money.

The speed at which stocks have recovered convinces me that we are likely to see the recent highs tested and broken in the run-up to the New Year.

Given the behaviour of markets since March 2009 any questions about the likelihood of other sovereign debt defaults, the latest failure of rating agencies to warn over Dubai’s perilous financial position, how well international investors have priced risk in Global Government debt or over the bubble characteristics clearly present in current financial-asset prices will be conveniently put to one side. Well for now at least….

In July, September and October clear buying signals were fired on the FTSE and Dow by the system and lo markets rallied!

Great you are probably saying to yourself. Writing after the fact is as much good as the proverbial chocolate fireguard, but in my defense I did not and do not want to become a cheerleader for stocks. Frankly I cannot believe what I am seeing on a daily basis in markets.

Forget about expensive P/E valuations, staggering money invention, rising unemployment, political paralysis, excessive banking bonuses and all the other clear warning signs out there; the stock market is telling us that the good times are set for a comeback in 2010. For now at least…

– As an aside if I keep consistently writing about a severe correction at some point I am bound to be right, but this could be in a decade! –

Hindsight is 20/20 vision and the current stock market rally is not that surprising in the context of the stimulatory policies adopted by governments and central banks around the World. The tidal wave of stimulus money was bound to have an inflationary affect on financial assets. The likelihood is that this will translate into “real” inflation in the coming years, but more of that another day.

In the meantime both the Dow and FTSE have hit passed critical technical levels, indicating that this bull run is likely to remain strong in the near term.

Starting with the Dow its October 2007 retraction zone stands a 10190:10211. The fact that it has broken through this is extremely significant. Remember that stocks peaked in October 2007 and carnage followed. If we continue to see gains in the next week or so, then the Dow really could surpass 11,000 before the year end. As of writing the Dow is at 10,380.

In the case of the FTSE100 the picture is even more bullish. This index actually broke its October 2007 retraction zone in September, moved further forward, pulled back and then rallied off it at the start of this month. Again this is an extremely bullish sign. Currently the FTSE100 October 2007 retraction zone is 5059:5067. The FTSE100 closed today 5339.

The difference between the FTSE100’s rally and the Dow’s can be explained by the relative weighting of mining and oil stocks in both indices. In the case of the FTSE100 this weighting is substantially higher than the Dow’s. As such this index has been more exposed to the rally in oil and commodity prices.

While the price patterns look very positive, volume in both indices is still not as high as one would expect. Average volume has consistently fallen in the past 4 months and continues to decline. The trend for volume is clearly on a downward trajectory, with a succession of lower lows and lower highs.

Although this contradiction in price/volume movements will be unsustainable in the medium term, the tidal pressures of excess liquidity in the market will likely ensure that all ships continue to rise in the near term.

This still leaves me feeling utterly bemused. I am either completely wrong in my assessment of the macro-economic outlook (certainly conceivable) or we are simply witnessing yet another hope/liquidity/greed-fuelled (pick any combination) bubble in financial assets.

Whatever the case there is one clear picture emerging; Britain is going to take far longer to extricate itself from this mess than other developed nations. While there are still serious doubts over US plans for the removal of fiscal stimulus, at least they are debating their exit strategy. Over here there is no such debate. It is not even likely that we have seen the end of the QE programme.

I read Stephanie Flanders’ blog yesterday and one statistic caught my attention. Of the £175billion of “invented money” issued through QE, £173billion has been used to by Gilts (UK Government debt). In other words this has been used to fund the deficit. Officially the reason for this has been to underpin the UK bond market and therefore alleviate pressure on banking sector balance sheets. In reality such has been the unwillingness of the Government to address public sector spending in an election year that the BoE has been boxed into a corner.

There cannot be much demand amongst international investors for British bonds. This would have meant much higher financing costs and the likely reduction in Britain’s AAA rating. Had this happened then the Government and BoE’s ability to steer Britain out of recession would be severely hampered.

The problem is that it is highly likely both will still happen. The structural imbalances in our economy, which are clear to all, have not been addressed but rather have been exacerbated as the Government has vainly attempted to paper over gaping crevaces. The longer this goes on the worse our predicament becomes as more money is being spent on unsustainable spending programmes. The argument that these spending programmes are propping up the economy is tenuous to say the least. The last quarter’s GDP figure was testament to this (a surprise 0.4% decline).

I wrote last summer that we needed a General Election then. This has now become desperately true and the only question we should really ask ourselves is can we afford to wait another 7-8 months?

I am still very cautious about accepting these figures as proof of the worst being behind us, but the market seems more than happy to seize on them as a reason to maintain buying. Volume is still light on the up days and heavier on the down days, so there are definite warning signals of indices being near tops, but these signals have been around for several months. The October correction I thought would happen didn’t and it is clear that the affects of fiscal stimulus are being felt throughout the financial system (not least manifested in the obscene quarterly profits again reported by investment banks earlier in the month).  

Are current stock valuations indicative of yet another bubble?

Based on earnings the answer to this is almost certainly yes, but what I am more interested in at the moment is the debate surrounding exit strategies for fiscal stimulus. Remember my view that any talk of recovery is premature until the process of removing fiscal stimulus measures has started. Until that point, such is the magnitude of the measures that were introduced they continue to have a hugely distorting affect on fundamental economic data and financial market participation.

One problem we have faced in determining how our prospects are likely to fair in 2010 has been the lack of information surrounding global Government and Central Bank exit strategies. While comprehensive plans are still lacking we have finally seen some significant developments in the US and Europe.

Earlier in the week there was a substantial sell off of European financial stocks as the European Central Bank (ECB) issued a warning to banks who had received state aid from Governments that if they did not present plans for unwinding support by mid-November then the ECB would step in directly to resolve this. Given the strength of the warning the sell-off was not at all surprising and this issue is bound to have an impact in the coming month.

However this announcement was then overshadowed by US Treasury Secretary Tim Geithner’s testimony in Congress yesterday. I was able to watch this live and the atmosphere was tense to say the least. There is serious disquiet about the viability of the Obama Administration’s plans, specifically there are fears of too complicated a regulatory structure being created and the threat of the moral hazard of formalising a process for future bailouts.

After all the previous regulatory system failed to curb the excessive behaviour behind the Credit Crisis so what hope is there that a more arcane incarnation will prevent future crises? Not much. This fear is then amplified with the prospect that the US Government will underwrite the financial system, no matter what it does. I have written about this before, but if you are interested in reading more this Wall Street Journal blog provides some excellent analysis.

One particularly interesting exchange during Geithner’s testimony occurred over the idea of setting up an equivalent of the Federal Deposit Insurance Corporation to prepay for any future bailouts. I have to admit on this issue I agree with Geithner completely, the idea is ridiculous. Such a fund would be to institutionalise failure within the financial system. The sole purpose of the fund would be to bail out those banks “too big to fail”. The last thing the Global Economy needs is such a backstop  for banking executives. This would almost certainly guarantee a return to (if not a surpassing of) some of the worst behaviours, which caused the Credit Crisis.

However watching this exchange got me thinking about a creative method of ensuring appropriate banking behaviour in the future. The financial system is too complex to regulate and there isn’t the serious appetite for substantially simplifying it. At the same time prepaying to compensate for excessive risk taking is nonsense. We need a system that does not encourage or, more importantly, reward wild gambling but rather discourages and penalises it.

This brings me back to retrospective taxation. You may remember that I was deeply in favour of retrospective taxation on individual bankers’ bonuses, earned from failed or mis sold financial instruments. As it turned out this did not happen back in the spring, apparently because Governments did not have the legal right to do this.

Now though, I feel retrospective taxation should be revisited as an idea for encouraging future banking stability. New rules, regulations and laws are being crafted at the moment so the time is right to put in place such a structure. I am convinced that the threat of retrospective personal and corporate taxation would be the perfect antedote to greed-driven banking.

If we have learnt nothing else from the Credit Crisis and its after-tremors it is the total commitment bankers have to acting in their own interests. I am fully in favour of people being rewarded for creative, hard work, but the manner in which the financial system operates means we cannot trust it to self-regulate. At the same time we cannot trust our Governments or Central Banks to perform effective oversight. However we will always be able to rely on politicians to react to public outrage.

In creating a system that relies on bankers’ instincts for self-preservation and which provides politicians with the tools to respond to public outrage at financial mismanagement this strikes me as having the potential to be a finely balanced, but powerful deterrent. I am not suggesting this would be a complete solution, but it could form an intrinsic part. 

We will find out more over the course of the next month, but I really hope we will start to get a much clearer picture of how the Fed, the US Treasury and the ECB plan to remove fiscal stimulus measures.

And while all this is happening what have we heard about the Bank of England’s plans? If yesterday’s Times is to be believed then the BoE is going to extend Quantative Easing by another £25billion. Wonderful, juts what the Nation’s balance sheet needs — more debt! We need to wait and see if this happens at next week’s Monetary Policy Committee meeting, but if it does our prospects for a decent recovery in the next few years continue to wane.

On Tuesday the Reserve Bank of Australia raised interest rates. On Wednesday the Consumer Price Index in the UK fell to 1.1%. Then on Friday the US trade deficit fell to $30.7bn.

Taken together these three announcements have reinforced my view that the Global Economy is still woefully imbalanced and any talk of serious recovery is premature at best, deluded at worst.

If we were truly witnessing the beginning of a global upturn then the Reserve Bank of Australia would be acting as the vanguard for the other central banks of the G20. The removal of fiscal stimulus measures and rising interest rates would be the clearest indicators that policy makers have faith that their endeavours have worked.

There is an argument that the bias of Australia’s economy towards its rich base of natural resources make it likely that it will be one of the first developed nations to emerge from the recession. However this does not mean that the US and UK will necessarily be hot on its heels. Australia’s major trading partner is China. While there are still serious question marks over the true state of Chinese markets, the country will still maintain a voracious appetite for metals and minerals. It is for this reason that the Australians can start to talk seriously about reducing central bank intervention and start focusing on building again.

Sadly the same cannot be said for us in this country. Wednesday’s inflation data scotched any speculation that the Bank of England sees rates rising in the foreseeable future. By extension it is not a great leap of analysis to expect that Quantitative Easing will also persist and might even be extended.

The longer this strategy is pursued then the more difficult it is going to be to unwind. The current inflation data is giving us a stark warning. People and companies are spending a lot less money. There is less demand, which means there must be less economic activity. When we consider this is against the backdrop of unprecedented fiscal stimulus then this picture is deeply troubling.

Historically excessive money supply has caused inflationary pressure. Admittedly this can take some time to have a noticeable affect, but what are we supposed to believe when we hear that “interest rates are to remain low for years” as the Centre for Economic Business Research predicted?

Faced with poor economic prospects and a worrying inflation outlook it is no wonder that Sterling has taken the pounding it has in the last week. And it was not alone. The Dollar has also taken a substantial hit, prompting the latest upwards burst in commodity prices.

While the narrowing of the US trade deficit could be viewed as a positive consequence of Fed fiscal policy, it also belays underlying problems. As the Dollar has continued to tank it is natural that US purchasers are buying more American goods and importing fewer foreign ones. However the pace of decline of the deficit clearly points to falling demand. After all do we seriously believe that a 20% decline in the Dollar in the last two years (a rough estimate against a basket of currencies) has suddenly made the American labour force that much more competitive than the Chinese? Certainly European goods and services are a lot more expensive, but the substantial bulk of US imports are from the Far East.

If Sterling and the Dollar continue to extend their declines in the coming months then we all need to pay a lot more attention to our prospects, in the event of the failure of the last two year’s fiscal policy.

And yet in spite of this stocks have continued to rise……

A friend sent it to me and it gives a fascinating insight into events surrounding the British bailout of Lloyds and RBS. If accurate (and I don’t see any reason why it isn’t) this article clearly shows how rushed this was. Given the scale and complexity of it, the fact it was put together so hastily doesn’t fill me with that much confidence and only heightens my sense that we are living through the greatest economic experiment ever attempted.

Talk of recovery is premature.

The stress tests were meant to restore our faith in the American banking system.

While the official measures used in these tests were never released, the consistency of reports about some of the key ones was such that it gave the impression details had been leaked. Given the importance of this information to markets and the number of organisations and people involved this was hardly surprising. Apart from anything else it gave beleaguered banking CEOs the opportunity to “prove” that their institutions were now safe.

Of course the official purpose of the stress tests was to provide the Administration with justification for the huge level of fiscal stimulus they proposed, by painting a worst case scenario of economic decline.

The hope was that so long as the economy did not decline beyond the worst predictions then taxpayer exposure to the Credit Crisis would be kept to a minimum as further collapse in the banking sector would be avoided. Economic growth could resume and the nation state would avoid bankruptcy. We could all then breathe a huge collective sigh of relief and get back to living our happy lives of blissful consumption.

Or at least so long as the fiscal stimulus works….

Yesterday’s US Payrolls report should have sounded a serious warning to markets, not that you would have guessed it by the reaction of equities or the majority of coverage on this event. In case you missed it the US labour market shed an additional 263,000 jobs in September, well beyond the 175,000 expected. While this figure can be subject to large revisions, the unemployment rate tends to be a more stable data set. This now stands at 9.8% in the US.

It is this figure that has caused me most concern.

In April one of the most reported measures used in the stress tests was the unemployment rate. There were two main reasons for this. First unemployment is an economic figure which all people have an intuitive feel for. The more unemployed there are the worse shape an economy is in. The second reason is slightly more subtle. Higher unemployment affects all areas of what should be a bank’s core activities, namely commercial and consumer lending. The fewer jobs there are then the worse companies are performing and the less able individuals are to honour existing loans.  In short this equates to larger losses for the bank.

If what was written was true then the Administration projected a maximum rise in unemployment to 10%. That was a maximum rise. In other words the worst case scenario.

Assuming that the official figures do not get revised lower, which might happen, then we are fast approaching the point at which the banking sector was expected to start to come under serious recessionary pressure, on top of the self-inflicted balance sheet pain of the Credit Crisis.

If we consider the last set of results from the banking sector we will remember that their activities in the real economy were already showing substantial losses. The profits were generated from their ephemeral trading activities pushing digital paper around the World and raking commission off transactional volume.

I wrote at the time how this was both morally and economically problematic.

Well if we use the increasing unemployment rate as a proxy for determining further strain on banking balance sheets, then it would not be a great stretch of the imagination to expect the “need” for more fiscal stimulus in 2010. If this happens then the only question will be who will trust this policy?

 The timing of large-scale selling is particularly important and this time is no exception.

On Wednesday the Federal Open Markets Committee (FOMC) gave their latest decision on US interest rates. As expected they kept them on hold, but it was the accompanying note that caused market concern. Specifically it became clear that the Fed does not have a clear exit strategy for its fiscal stimulus measures.

At the start of the year and during the debate over the Public Private Investment Programme (PPIP), Fed-Chairman, Ben Bernanke, made a clear commitment that fiscal stimulus would only be required in the US until September 2009. With this in mind it would not have been too unreasonable to have expected the Fed to take the opportunity at its September meeting to announce its plans for unwinding this strategy.

I am concerned at the absence of such an announcement as it leads me to one of two conclusions. Either there is a recognition at higher levels that the fiscal stimulus has not worked and there is a need for more or the scale of the grand economic experiment of the last two years is so great that policy makers are still overwhelmed by it and cannot see a way out.

Whatever the case, economies are still desperately in need of strong leadership.

Seductive headlines and data sets over the summer have created an optimistic view that the worst is behind us. While I don’t agree with this, I am even more convinced that the last thing the economy can cope with is lethargy at the top. Until fiscal stimulus is withdrawn we are living in economic limbo. The withdrawal of fiscal stimulus is going to have to be both well-timed and managed in an orderly fashion. Given the sheer volume of liquidity pumped into global markets by central banks we cannot underestimate the complexity of this task.

It now falls on the shoulders of the architects of these fiscal initiatives to demonstrate to markets that they are up to the challenge. Failure to do so could well prove to be the catalyst of further substantial stock market declines.

If we see another end of day sell-off today then the signs are not looking good.