Short Summary before New Year's Celebration

It is difficult to read much into the price action today as activity appears to be dominated by a few last minute orders. Whatever muted signal there may be is drowned by the noise.  Nevertheless, there are a few things to note before heading off to celebrate the end of what has an exceptionally good year for equity investors, especially in the high income economies.  

First, although the US economy is unlikely to repeat the 4.1% growth rate seen in Q3, final sales (GDP minus inventory accumulation) may fare better in Q4. However, the expiration of emergency jobless benefits is headwind, unless renewed.  There have been several bills proposed to do this, but House Republican leadership insists on new spending cuts in exchange for a new extension.  

Although one might expect an agreement given the mid-term elections, Democrats may have more to gain electorally by making a campaign issue out of the Republican's blockage. Obama's support ratings have fallen in general and on economic issues in particular, and are now in a virtual tie with House Republicans.  

Almost 1.4 mln Americans have already lost the emergency jobless benefits, and another 1.9 mln will do so, by mid-year.  The $24 bln hit can be expected to shave 0.2-0.4% off GDP, according to various estimates.  It will impact income and consumption.  Many of the people knocked off the rolls will likely drop out of the labor force, making the participation rate fall, and weighing on the unemployment rate.  

January marks the beginning of the Fed's tapering.  Of note, the tapering has not translated into a major trend change for the dollar, which continues to be generally firm against most of the majors, but the euro (and Swiss franc) and sterling.  The long-end of the Treasury curve has firmed but the short-end remains anchored in what appears to be the opposite of Operation Twist.   We find dollar-yen to be more sensitive to long-term interest rate differentials, but that the euro-dollar rate is more sensitive to shorter-term differentials.  

Second, EONIA has trended higher since mid-November.  The 1-year forward of the 1-year EONIA has been above the 25 bp refi rate for eight days here at the end of the year.  The ECB has failed to fully sterilize the bond purchases under the SMP program for the last three weeks.   The bulk of this seems to be due to calendar effects, but the excess liquidity in the euro area has generally trended lower, mostly due to the repayment of LTRO borrowings.  Many observers look for the ECB to address this early in 2014 with some sort of funding-for-lending scheme and, possibly, some collateral rule changes that encourage securitization.  

Third, despite ebb and flow of speculation that this country or that would leave the euro area, not only has none done so, Latvia will officially become the 18th member of the euro area.   Lithuania is on track to join in a year's time.   

We would make two points about the monetary union.  First, that it is not optimal from a purely economic point of view is really beside the point, and that is what many investors find so vexing.  It is, as we have long maintained, an economic solution for what is ultimately a political problem and it is the political will (of the elites) that has been under-estimated by many observers. Second, the institutional capacity and edifice of rules and agreements have grown and continue to grow, making the EMU that exists now at the end of 2013 significantly different that the EMU that entered the financial crisis.   Greater integration and coordination is taking place, even if the transmission mechanism (recycling surpluses from north to south) has not fully recovered.   The divergence between the German and French economies continues to grow, pointing to a important political fissure.

Fourth, the Chinese yuan finished the year with a surge, lifting it to new multi-year highs against the dollar.  It appreciated a little more than 2.9% this year, with almost 1/7 of it delivered in the past five sessions.  It has appreciated against all the Asian and G10 currencies, save the euro and Danish krone.  Although many observers (and media) cite this as a record high for the yuan, it is factually untrue.  Before the massive devaluation a decade ago, the yuan was trading near 5.80 to the dollar.  We look for it to move back there.   At the same time, we do expect China to push back more against the yen's depreciation and we will be carefully monitoring the data for signs that China will use its economic wherewithal to express its displeasure with Japanese political developments. 

Lastly, we note that starting the in New Year,  China will re-open the initial public offering market. The IPO market in the mainland has been closed since October 2012.  There is pent up supply, with reports claiming as many as 760 businesses want to go public.