US GDP, Japan, and Observations on Europe

The initial release of Q4 US GDP is the main economic highlight left of the week. The consensus is for 3.5%-3.6% print, which would be the fastest growth in about 3 years. The risk is that the market is disappointed, as recent trade and inventory data would have suggested economists should trim their forecasts a bit and yet the consensus does not seem to reflect that.

That said, the fact of the matter is that the government's first estimate is done without a complete information set of monthly data and is part of the reason why the preliminary release is subject to statistically significant revisions. Consumption and net exports are still likely to be contributors to growth.

The price deflators are likely to point to continued easing of inflation pressures. Nor will the Employment Cost Index, which is reported at the same time, point to any wage pressures. There seems to be an asymmetrical risk with the data. The dollar is more likely to sell-off on weak data than rally on strong data as less than 48 hours ago the FOMC had indicated that the somewhat stronger growth was insufficient to spur a material improvement in the labor market or deter it from continuing to buy Treasuries.

The day after S&P cut Japan's credit rating, Moody's has indicated that the US AAA rating faces a small but growing risk. While no action is contemplated now, it suggesting that the risks are rising of a cut in the outlook over the next couple of years. Unlike many observers, Moody's opines that the new configuration of the US Congress lessens the chance of fiscal consolidation. The dollar did not seem to react much to the Moody's statements and was generally firm through the Asian session.

Outside of the knee-jerk reaction, the market has taken the Japanese downgrade in stride, as we expected. Japanese government bonds were unchanged and net-net the dollar is trading little changed against the yen for the week near JPY82.60. Japanese officials speaking in Davos seemed to welcome the minor yen weakness, but said the "right" things about the need for fiscal consolidation. Japanese reported a slightly higher Dec CPI at flat year over year, while the consensus called for a 0.1% decline. The core rate, which in Japan excludes fresh food, fell 0.4% year-over-year. Excluding food and energy, Japan's deflation was 0.7%. Separately Japan reported that unemployment unexpectedly fell to 4.9% from 5.1%. Note that both the central bank and the government lifted their economic assessments this month.

The euro dollar price action over the last few weeks feels like in did in October last year in the run-up to QEII. However, like then, one of our key points is that the demise of the greenback is exaggerated. This is not a call to buy dollars today. As we have noted, the 2-year interest rate differential continues to move against the US and there is little technical indication one can hang one's hat on to pick a dollar bottom.

But that day is approaching. Two observations to draw your attention to today:

First, like in October, as the euro rallied, the European debt crisis was smouldering. European officials still have not actually done anything except to say they are talking about it and will have something in a couple of months (March). After falling for a couple of weeks, the credit default swaps in the periphery have begun rising again in recent days. And the premium the periphery has to pay over Germany has increased by nearly 30 bp for Portugal, Ireland and Spain and a bit less for Greece.

Second, as recognized in Oct, the pricing in the options market indicates that the premium for euro puts is increasing relative to calls, even though the euro has continued to rise. In fact the put premium is the widest now since Jan 11. One reasonable interpretation is that the euro longs are feeling less comfortable.