Dollar Salivating For Euro Troubles Or 4Q Earnings To Force Break

Dollar Salivating for Euro Troubles or 4Q Earnings to Force Break

With the global economy slowing, rates fading and financial instability becoming the norm; my medium-term outlook is for a meaningful risk aversion move. Yet, at this point, I would settle for a short-term rally in risk trends. We have lacked any kind of meaningful momentum since before the year began. Giving us a sense of this inactivity, the equity market’s (my passive barometer for market-wide risk) VIX Volatility reading is plunging its lowest level since late July while the currency equivalent is testing comparative lows. This is a measure of future activity. Those measures of current activity are running at similar levels. If we were in fundamental trough or plateau – or even a mixed scenario – this anchoring wouldn’t surprise me. That said, we are not facing balanced conditions. The threat of financial and economic risk is clearly rising (even politicians are admitting to it), and yet we still lack for conviction.
What is needed is a catalyst that draws investors off of the sidelines and encourages them to be active in this market once again. The European downgrades have so far failed to stoke fears of our next global financial crisis taking root (more on that below) and the steady slide in economic activity across various regions has yielded the same. That is the risk side of the balance, so now we will try the ‘return’ side. With Tuesday’s session, we will kick off the 4Q US earnings season in earnest . Will these figures finally return to reality and offer a spark for broader risk?
Euro has Not Dodged a Bullet with Downgrades, French Bond Auction
The Euro has passed the first opportunity to respond to the Standard & Poor’s round of Friday evening rate cuts , and not only has the currency avoided a strong bearish slide – it didn’t move at all. Neither the shared currency nor risk appetite trends made a meaningful move liquidity filled out once again. Should we take this to mean that the downgrades have no influence? Of course not. Less controversial, does this mean that the downgrades themselves were fully priced in? We could argue this point on price action, but the reality of the situation is that the full impact of this change cannot be fully appreciated due to the complexity of how this can further and accelerate the region’s financial crisis. Therefore, the rate cut to France itself may have been adjusted for, but its influence in undermining the region’s safe haven options, unnerving regional banks and diverting capital flow won’t be known until it is already behind us.
Far more influential in the rating agency’s offensive is the continued degradation of those members that are already on the cusp. Now rated ‘junk’ status, Portugal has seen its 10-year bond yield soar over 225 basis points. This brings up a serious concern of whether another member that is tapping the bailout program could follow down the same path as Greece. More certain in its influence over the region, both Spain and Italy didn’t see significant impact on their respective yields on the day, but the rating hit no doubt weighs the market’s confidence. Spain will find a vote of confidence in bond auctions tomorrow (on 12 and 18 month maturities – short-term usually has less risk). Also of note, we have Greek and EFSF bond auctions. The later will be particularly interesting after the S&P downgraded its ‘AAA’ rating Monday . This didn’t strike the market as much of a surprise however as it was warned well in advance that should France lose its top rating, so too would the bailout program.

Japanese Yen: Noda Warns Japan Cannot Abide Rates Above 3 Percent

When a currency stands in as a safe haven, it can override a significant number of fundamental concerns . So it is with the Japanese yen. The Japanese markets offer the kind of liquidity and financial structure that resembles the United States’ roll – just in the Asian sector. However, the country never really solved its credit issues of two decades ago and their currency is severely undermining economic activity in the region. Prime Minister Noda warned Monday (it’s an issue if your leader voices it) that they must reign in debts as they can’t absorb even 3 percent rates.
Canadian Dollar Response to BoC Decision Depends on Expectations
What should we expect from the Bank of Canada rate decision in the upcoming session? There may very well be higher expectation for volatility in reaction to this release as the speculative ranks are riding high off their RBA expectations. However, the market and economists are pricing in little to no chance of a move over the coming 12 months (much less this particular meeting). That said, the group has held a dovish tone for months – generally ignored by the market. If they threaten action to that outlook, we have a good risk aversion amplifier to work with.
British Pound Will Try to Look for Separation from Euro with CPI Data
The sterling is still following the track that the euro has laid out for it. Chancellor of the Exchequer reminded us of the two currencies’ fundamental connection when he warned that the Euro Zone’s crisis is “extremely challenging” for the UK (our skepticism should curb the attention we pay to his optimism surrounding certain, recent indicator releases). If the crisis intensifies in the Euro-area, it will certainly spill over to Britain. That said, if we can hold on to quiet markets, perhaps the upcoming CPI data can provide a small, temporary separation.
Australian Dollar Advances before Chinese GDP, Data Impact Reserved
The issue with quiet markets is that the impact from data will be muted whether it releases to the bullish or bearish side. As the most risk attuned commodity currency and an important raw material provider for China, there was an expectation that the Asian giant’s 4Q GDP figures could generate substantial volatility for the Aussie. However, a pick up from a quiet level is still quiet. The economy expanded 2.0 percent on the quarter and a greater than expected 8.9 percent on an annual basis. It’s still a cooling trend, just not at the pace that can spark fear.
Gold Slowly Advances as European Financial Health Deteriorates
While the euro and risk trends remain sedate in the aftermath of the Euro Zone downgrades, there is still a sense of risk aversion related to the development. The currency holds steady as capital circulates to other European members while sensitive assets (like equities) find ill-earned confidence in the promises of stimulus from policy bodies. Nevertheless, the slide into recession and the low firepower for monetary policy officials as their balance sheets balloon aren’t going unnoticed. In this troubled mix, capital will find its way to the non-currency metal.
ECONOMIC DATA
Next 24 Hours

GMT	Currency	Release	Survey	Previous	Comments
2:00	CNY	Real GDP (YoY) (4Q)	8.7%	9.1%	Expectations are that Chinese growth will be the slowest since 2009
2:00	CNY	Real GDP (QoQ) (4Q)		2.3%
2:00	CNY	Real GDP YTD (YoY) (4Q)	9.2%	9.4%
2:00	CNY	Industrial Production YTD (YoY)	13.8%	14.0%
2:00	CNY	Industrial Production (YoY)	12.3%	12.4%
2:00	CNY	Fixed Assets Inv Excl. Rural YTD (YoY) (DEC)	24.1%	24.5%
2:00	CNY	Retail Sales YTD (YoY) (DEC)	17.0%	17.0%
2:00	CNY	Retail Sales (YoY) (DEC)	17.2%	17.3%
09:30	GBP	CPI (MoM) (DEC)	0.4%	0.2%	UK inflation continues to show signs of easing on austerity and subdued activity, data unlikely to alter BoE’s dovish stance
09:30	GBP	CPI (YoY) (DEC)	4.2%	4.8%
09:30	GBP	Core CPI (YoY) (DEC)	3.0%	3.2%
09:30	GBP	Retail Price Index (DEC)	239.1	238.5
09:30	GBP	RPI (MoM) (DEC)	0.3%	0.2%
09:30	GBP	RPI (YoY) (DEC)	4.7%	5.2%
10:00	EUR	Euro-Zone CPI - Core (YoY) (DEC)	1.6%	1.6%	Expected to ease amid threat of recession in Eurozone
10:00	EUR	Euro-Zone CPI (MoM) (DEC)	0.4%	0.1%
10:00	EUR	Euro-Zone CPI (YoY) (DEC)	2.8%	3.0%
10:00	EUR	ZEW Survey (German Current Situation) (JAN)	24	26.8	Data could provide insight into whether Germany slips into recession
10:00	EUR	ZEW Survey (Eurozone Econ. Sentiment) (JAN)		-54.1
10:00	EUR	ZEW Survey (German Econ. Sentiment) (JAN)	-49.4	-53.8
13:30	CAD	Int'l Securities Transactions (NOV)		2.03B
13:30	USD	Empire State Manufacturing (JAN)	11	9.53	Expected to reflect the overall positive direction of US economic indicators
14:00	CAD	Bank of Canada Rate Decision	1.00%	1.00%	No change expected as Canadian economy confronts challenges ranging from uncertain growth outlook to unstable labor market
23:30	AUD	Westpac Consumer Confidence s.a. (MoM) (JAN)		-8.3%
23:30	AUD	Westpac Consumer Confidence Index (JAN)		94.7

GMT	Currency	Upcoming Events & Speeches
9:00	EUR	French Finance Minister Baroin Speaks to the Press
9:30	EUR	Spain Bond Auction (364- and 518-Day Bills)
10:00	EUR	Greece Bond Auction
10:00	GBP	BoE’s King, Haldane, Cohrs, and Jenkins Speak in London
11:00	EUR	EFSF Bond Auctions (182-Day Bills)
12:30	EUR	EU’s Van Rompuy Meets Spanish Prime Minister Rajoy in Madrid
17:30	EUR	EU’s Almunia Speaks in Brussels
18:30	GBP	BoE’s Posen Speaks in London
23:00	EUR	Italy’s Monti Speaks in London

\ Currency	EUR/USD	GBP/USD	USD/JPY	USD/CHF	USD/CAD	AUD/USD	NZD/USD	EUR/JPY	GBP/JPY
Resist. 3	1.3193	1.5672	78.76	0.9516	1.0509	1.0054	0.7671	102.87	122.41
Resist. 2	1.3144	1.5629	78.58	0.9480	1.0477	1.0013	0.7640	102.51	122.05
Resist. 1	1.3095	1.5586	78.40	0.9445	1.0445	0.9972	0.7609	102.15	121.68
Spot	1.2998	1.5500	78.04	0.9374	1.0381	0.9891	0.7547	101.43	120.96
Support 1	1.2901	1.5414	77.68	0.9303	1.0317	0.9810	0.7485	100.71	120.23
Support 2	1.2852	1.5371	77.50	0.9268	1.0285	0.9769	0.7454	100.35	119.86
Support 3	1.2803	1.5328	77.32	0.9232	1.0253	0.9728	0.7423	99.99	119.50

v

Central Banking: A Study of Policy and Market Effects

Central Banking

Central Banks are institutions are utilized by nations around the world to assist in managing their commercial banking industry, interest rates and currency. The idea of a Central bank is not a new one though. The first examples of a central banking authority were seen in China with the first issuance of paper money nearly 1000 years ago. Other examples date back to the Knights Templar, looking for credit to finance their crusades. Many of the processes being tested in the past have been refined over hundreds of years of practice resulting in today’s modern banking systems.

Examples of Central Banking today include the Federal Reserve of the United States, European Central Bank (ECB), Bank of England (BOE), Bank of Canada, and the Reserve Bank of Australia. There sphere of influence of a central bank may range from a single country such as the Reserve Bank of Australia or, represent policy created for a region or group of countries such as the ECB. To show the effects of Central Banking in a modern society, we will focus on the Federal Reserve of the United States and their policy decisions.

The Fed

The origins of Central Banking developed in the United States as far back as the Revolutionary War. In 1775 the Continental Congress met with the intention of developing a national currency and a plan to finance the developing war effort. The sole value of the “Continental” relied on the future tax collection of the future independent nation. As the revolution drew on with no conclusion, overprinting and counterfeiting brought about the devaluation and ultimate demise of the Continental currency. When the constitutional convention of 1787 convened, one of the first priorities was the discussion of the current financial system. As of 1791 the First Bank of the United States was issued its original charter.

Much has changed since 1787! The Central Banking system of the United States is now known as The Federal Reserve, or simply the “Fed”. The modern Fed was created in 1913 by congress with the intent of providing the United States with a safer and consistently stable monetary system. The Federal Reserve achieves its goals by conducting monetary policy, and supervising and regulating banks.

Bank Regulations

The primary reason for the creation of the modern Federal Reserve System was to stave off banking panics in the United States. This issue came to a head in 1907 during what has been dubiously called the “Bankers Panic”. During this time, stocks on the New York Stock Exchange fell nearly 50% from their 1906 highs. The end result of this crisis is that many banks and business were forced to either close or declare bankruptcy. As people worried they funds were unsafe at local banks, they would rush to withdrawal funds creating a massive shortage of capital.

The Federal Reserve is setup to avert a crisis such as the one experienced in 1907. A system is set in place where short term needs of small local banks can be handled if a “run” on deposits occurs due to unexpected withdrawals or regional emergencies. The Federal Reserve can easily loan money to small regional banks at a nominal charge called the discount rate. Once a run has been met, banks can then return their obligation back to the Federal Reserve. This policy is one of many tools the fed utilizes assuring the solvency of financial markets and bank depositories.

What Exactly is Monetary Policy

Monetary policy is another tool directly at the Feds disposal to achieve its goals. Monetary policy describes the actions that the Fed takes to control the money supply inside of the United States. Depending on the state of the economy, the fed may select to either take an expansionary or contractionary policy, with the supply of money being influenced by two specific methods.

During times of economic slowdown, the Fed often selects to peruse an expansionary policy in the market. This process begins by expanding the monetary base and decreasing interest rates. The theory behind expansionary policy is to make money more available to banks and businesses in an attempt to increase growth and development. As a byproduct of an expansionary policy, fundamental indictors such as GDP are expected to grow and unemployment decline.

As the economy heats up, the Fed will consider taking on contractionary measures. At this point, the monetary base may begin to be restricted and interest rates can begin to increase. These actions make excess investment capital scares, and place a higher premium on lending. With less capital circulating, the economy is expected to contract and slow down. During a time of contraction, GDP is expected to decline and unemployment to contrarily increase.

Effects on Currency Rates

By controlling the money supply, and interest rates, the decisions mandated by the Federal Reserve System have a direct influence to the strength / weakness of the USD. Previously, we discussed that when an expansionary policy is put in place, the monetary base is increased and interest rates decrease. By supplying more money to the market and banks than what is demanded values increase. This over supply of funds creates a flood of cheap dollars onto the open market, effectively diluting their value. The same holds true with Interest rates in an expansionary environment. As interest rates move lower, it becomes easier to borrow funds and the value of a currency tends to decline.

The opposing scenario holds true when the Fed assumes a contractionary monetary policy. A decrease in money supplied on the open market make capital scare. Scarcity drives up value for remaining funds and increases the value of currency. Increasing interest rates also has the same affect. Higher rates make funds more expensive to borrow, the barrier for lending decreases the availability of funds. Again as capital becomes scarce, currency prices are expected to appreciate.

What this Means to Traders

Knowing which policy cycle a central bank is taking can be a fundamental asset to currency traders. One recent example of a bank taking expansionary measures is the European Central Bank. One policy the European Central bank has employed is the lowering of interest rates. From their peak levels of 4.25% in 2008, the rates have declined 3.25% to an effective rate of 1.00%. Factor this in with an expanding monetary base as new debt is extended and refinanced, the Euro has been in a state of decline versus most major currency pairs. Below we can see the Euros descent against the Australian Dollar from 2008 – present. So far this pair has produced a maximum trend of over 8000 pips. We can use this directional bias in the market to then proceed and trade the strategy of our choice.

Euro Falls on France, Italy, Spain Ratings - Further Declines Likely.?

Fundamental Forecast for the Euro: Bearish

What a week for the Euro. The single currency plummeted to fresh multi-month lows before surging above key technical resistance. Yet initial calls for a larger reversal proved premature as fresh Euro Zone sovereign credit rating downgrades pushed the EURUSD to new lows. Trading remains difficult amidst such unpredictable shifts in market sentiment, and the week ahead promises similar volatility on any and all changes in news coming out of the Euro Zone.

It seems imprudent to take a strong trading bias amidst such incredibly sharp swings in sentiment, and indeed we advise caution in the week ahead on potentially similar moves. The real question is whether recent deterioration in Euro Zone sentiment will be enough to force the EURUSD pair to fresh lows.

Standard and Poor’s spared almost no one as it downgraded the sovereign credit ratings of major Euro Zone countries. France lost its heralded AAA credit rating, while Italy and Spain both saw two-notch downgrades that leave them at BBB+ and A, respectively. Markets seemed focused on France, but it’s important to note that Italy is now a mere notch above ’Junk’.

One further downgrade for Italy could clearly have a negative effect on market sentiment. Yet perhaps more importantly, many investment funds are barred from holding any bonds below investment grade. Given Italy’s substantial debt load, forced selling of Italian bonds could have substantial effects on broader financial markets.

The immediate fallout from recent S&P downgrades may nonetheless be somewhat limited and short-lived given that traders had been pricing in such a possibility for quite some time now. The most recent CFTC Commitment of Traders report showed Non-Commercial futures traders—typically large speculators—were the most net-short Euro against the US Dollar in history. Commercial traders are likewise at their most net-long on record, and market sentiment is quite clearly extreme. The pronounced Euro downtrend undeniably favors continued lows, but reversal risks are especially high amidst such one-sided positioning.

The clear caveat remains that sentiment and positioning extremes are only visible in hindsight, and we could very well continue lower despite the overhang in short positions. This author has admittedly been warning of a potential bounce for some time now, and calling for a bigger EURUSD bounce proved premature.

Thus we’ll favor Euro declines until we see more clear evidence that price and positioning has recovered from extremes. Relatively limited European economic event risk leaves us trading off of broader market flows. It will be critical to watch early-week trade, as the first trading day often sets the tone for price action through Friday’s close.

Forex Market Outlook January @2012

Well we made it through another weekend after Friday's sell-off in risk currencies despite the fact that the Non-Farm Payrolls (NFP) came in much better than expected.  In Friday's discussion, I mentioned that even if the numbers exceed the official estimates there could be disappointment.  To be honest, the number was extraordinary and the market sold off anyway.  This means that it was very unlikely that any number could have satisfied the market and the Euro debt crisis is still the dominant economic story.

For further proof of this, look no further than the fact that another record was set for banks leaving money on deposit with the ECB, which is a sign of fear.  Another measure of this fear is that German short-term debt no has a negative interest rate.  In other words, there is so much demand for German paper that people are willing to pay to lend them money, and not receive interest.  This last happened here in the US back in 2008 during our banking crisis so the similarities are telling.

Enter Merkozy to the rescue!  Today's meeting between the French and German leaders is intended to hammer out the details of the fiscal rules that they agreed to last month and what further actions need to be taken in order to save the Euro.  Among these topics are the potential to increase the size of the bailout facility and how big of a haircut Greek bondholders may be required to take.  This could exceed the 50% losses that have already been discussed.

Meanwhile, the ECB is going to have their interest rate decision on Thursday and the speculation that Monti may try to emulate Bernanke's maneuvers is starting to pick up, as there is some thought that further monetary accommodation could be necessary to stave off a liquidity crisis.  This doesn't seem likely at this point and perhaps they will wait until the news out of the Merkozy meeting which they claim is going well at this point.

There is not a lot of news coming out of the US this week on the data front, but we are going into stock earnings season, which could have an effect on the US dollar if the correlations remain in tact.  But recently, it seems as though the correlations have been breaking down a bit so the impact could be lessened.

The Japanese markets were closed overnight for a holiday, and in the Euro zone German trade balance figures came in much better than expected on stronger exports, though industrial production figures came in worse than expected.  Later this week we will get the German Real GDP growth report on Wednesday, followed by CPI data and the rate policy decision on Thursday.

The Bank of England will also be releasing their rate policy but are not expected to have made a change.  Recall that the ECB decision also comes with an accompanying statement, whereas the BOE decision does not.

In Switzerland, the unemployment rate ticked slightly higher than expected to 3.3% from an expected 3.2% and retail sales figures came in better than expected showing a gain of 1.8% vs. the expectation of a .2% gain.  This comes in the midst of a minor scandal involving the currency trading prowess of the SNB honcho Hildebrand's wife, which is reminiscent of Hillary Clinton's commodities trading activity.  While this is likely much ado about nothing, there could be changes coming at the SNB.

Lastly, the Fed has the "dog and pony" show this week with a lot of Fed speak from various officials in different venues essentially trying to allay fears but you never know when one wrong statement can send the markets spinning.

And of course let's not forget the noise coming out of Iran and the potential oil supply disruptions that they threaten but likely won't act on.  Should the scene over there escalate then we could see oil spike higher.

So the markets are flat to slightly higher this morning, with US dollar weakness and the Euro bouncing off of lows that saw the Euro trade a 1.26 handle vs. USD.  If the Merkozy meeting produces positive results than this could quell the markets for a bit as the focus shifts to corporate earnings and the potential good economic story taking place here in the US.  So it may be risk-on again until the weekend where investors may want to lighten the load.

Another Year of Uncertainty; Expected Weakness in the First Half and a Rebound in the Second Half

Introduction 
After a tumultuous year in 2011 full of ups and downs and mixed sentiments, the U.K. economy may witness another year of uncertainty and turbulences as all signs indicate the British economy is not out of the woods yet. The U.K. economy witnessed a slowdown in growth pace along with high unemployment and inflation rates due to many factors led by the strong austerity measures adopted to lower the huge budget deficit. Other factors that yielded in the drop in consumer spending and contraction in the economy's major sectors were the crystal clear slowdown in major economies, most notably in the U.S., on the back of the sharp spending cuts and monetary tightening, the escalating European debt crisis, some natural crisis in some Asian economies and political changes in some countries. With further expected austerity measures by the British government to meet its budget shortfall targets, some time for major economies to recover from the imbalances of the 2008 financial crisis and unease in the European debt dilemma due to the political frictions, indecision and spread of debt contagion from one county to another, including large economies, seen clearly in the significant rise in borrowing cost at bond auctions, the U.K. is likely to face a shaky and uncertain macroeconomic prospects in 2012. A) Growth The British growth eased to 0.0% in the second quarter of 2011 form 0.4% in the first quarter while rebounded to 0.6% in the third quarter yet may drop again in the fourth quarter as seen by the latest data released by the U.K. economy. The major factors that affected growth were the strong austerity measures adopted by the government, global slowdown and the elevating European debt woes. In 2012, the outlook, as announced by many U.K. officials, refers to a downside revision in growth prospects. The BoE in its latest growth projections referred to an average 1% growth in 2012 from the previous estimates of 2%, clarifying that the U.K. economy will be under pressure from the euro zone debt crisis. BoE Deputy Charles Bean said the U.K. will face a difficult year in 2012, yet he still believes "some return to growth" in the second half as inflation slowdown will boost consumer spending. The Office of Budget Responsibility (OBR), the independent body that announces forecasts for the economy, also slashed its growth estimates to 0.7% in 2012 from the previously forecasted 2.5%. It said there is a 1-in-3 chance the British economy could experience a recession. Moreover, the OECD said the British economy will record an annual growth of 0.5% in 2012 from preceding estimates of 1.8%, where exports and household consumption are expected to recover, yet it mentioned the U.K. is heading toward a double dip recession in six-month time, while the IMF expects 1.6% expansion. B) Unemployment Due to the deep austerity measures and sluggish growth, the jobless rate remained high throughout the year, ranging between 7.9% and 8.0%, yet it rose further by the end of 2011 reaching 17-year high at 8.3% in the three months ended October, according to the ILO unemployment gauge. With the sluggish growth rate and decline in consumer spending, many companies cut jobs to lower their costs. The OBR predicts the rate to rise to 8.7% from the previously expected drop to 7.4%. The OECD also expect further rise in jobless rate to 8.8% in 2012. C) Public Debt Following the large spending by the British government in 2010 to boost the economy, the government found itself highly indebted which prompted it to launch strong austerity measures in 2011, including large spending cuts and rise in taxes. The latest budget deficit data showed that the shortfall narrowed in November. Net borrowing excluding support for banks retreated to 18.1 billion pounds compared with 20.4 billion pounds deficit a year earlier as the tax revenue advanced 7.1% while spending increased 0.8% from 0.5%, yet net debt jumped to 977 billion pounds, or 62.8% of gross domestic product. The drop in deficit remained slow in 2011 due to sluggish growth that resulted in lower tax receipts. The OBR expects the deficit to gradually decline to 53 billion pounds by 2015-2016 from 120 billion pounds in 2012-2013, where the structural budget deficit will reach 4.6% of GDP in 2011 while will record a surplus within five-year term, yet next year it seems that the government will miss its targets for deficit reduction as it will spend more than 48 billion pounds on debt interest payments in 2012, while has to borrow an extra 158 billion pounds over the next five years. The OECD expects the government debt to rise in 2012, where the IMF said the deficit will reach 7% of GDP. D) Inflation Throughout 2011, inflation has remained above the BoE's upper limit of 3% where the rate ranged from 4% to 4.5% till August, reaching its peak of 5.2% in September. In October and November, the rate decelerated to 5.0% and 4.8% respectively. With the expected spending cuts, weak growth and high unemployment in 2012, inflation is likely to recede. The BoE's latest inflation outlook refers to a sharp fall in the rate over 2012 as factors keeping inflation above the target which are the increase in the VAT from 17.5% to 20% at the beginning of 2011, previous depreciation of the pound and the rise in import and energy prices will face downward pressure from the slack in labor market and the spare economic capacity. Policy makers expect the rate to slow to below the 2% by late 2012. Also, the IMF said Britain's inflation will stand at 2.4% in 2012. II- Market Response A) The Sterling The cable took a downside trend versus the euro in the first six months of 2011, yet it managed to rebound in the second half as the escalating European debt crisis weighed on the euro. In 2012, the pound is predicted to show some advance against the 17-nation currency as the debt crisis is expected to take more effect. Against the U.S. dollar, the sterling advanced in the first half where it started to fall in the second half as the safe haven characteristic of the dollar gave it a privilege amid the turbulence in markets on the back of the debt woes and sluggish global growth. In 2012, the situation in the U.S. seems to be much better than the U.K. along with the refuge merit of the dollar which suggest further decline for the pound versus the green currency at least in the first half of the year. B) FTSE The FTSE showed bearishness with some rebound attempts in 2011 as it was affected by the uncertain outlook for the British economy, swelling European debt woes, slowdown in global demand and downbeat earnings by large European companies. For 2012, further uncertainty is predicted to prevail with the inability of European leaders to ease the debt crisis. Thus, the FTSE is predicted to undertake a track similar to the 2011, characterized by more bearishness and rebound attempts. III- BoE Action According to the aforesaid developments seen throughout 2011, the BoE kept interest rate low at 0.50% for the whole year to spur growth while decided to add 75 billion pounds to the Asset Purchase Facility (APF), to reach a total of 275 billon pounds in October 2011, for the first time since 2009. The action was taken after the latest data showed a significant slowdown signs which sparked concerns the U.K. is heading towards another recession. However, policy makers split as the high inflation rate -which remained above the target for the whole year- coincided with slow growth and accordingly caused some to call for raising interest rate to contain inflation while others asked for expanding the APF more to boost the economy. A) Interest rate In accordance with the expected severe spending reductions, slow growth and high unemployment, the BoE is likely to keep the borrowing cost unchanged at its low level of 0.50% to boost the economy, where if policy makers decided to raise interest rate this will probably be in the end 2012. Another reason that makes leaving interest rate an inevitable action by the bank is that inflation rate which is predicted to retreat gradually, yet will remain above the 2% target all over the year. Thus, there will be no pressure on the bank to raise interest rate as shoring up growth will be a higher priority. B) APF Further expansion in stimulus is expected at the beginning of the year, probably in February or shortly after, where another 50 billion pounds could be added, to see the impact of the program, launched in October, which will end in February, and with the release of the February's inflation report that will include the latest growth and inflation forecasts. Some BoE policy makers said there may be a need for more stimuli due to the high threats posed from euro area neighbors. Bean said the BoE will add to stimulus in February with the end of the program, if necessary. Policy maker Spencer Dale said with the likelihood that inflation would come below the 2% by late 2012; there are higher chances of expanding the bond purchases. The OECD mentioned that the BoE has to add to non-standard measures by 125 billion pounds in 2012, where the money printing process may take part in early 2012, as the economy is predicted to record contraction in the first half of the year. All in all, the outlook for the British economy is predicted to be dominated by uncertainty and likely to be affected by the latest developments in the euro area debt crisis. There is higher probability to see a slowdown and may be contraction in the first half of the year due to the debt crisis and strong spending cuts while a rebound in the second half is inevitable as the decline in inflation will bolster consumer spending, where the public debt will remain high. Consequently, the BoE is estimated to keep interest rate steady at its low level to spur recovery while adding to stimulus early in the year to stimulate the economy, especially amid expectations of deceleration in prices.
A)     Growth

The British growth eased to 0.0% in the second quarter of 2011 form 0.4% in the first quarter while rebounded to 0.6% in the third quarter yet may drop again in the fourth quarter as seen by the latest data released by the U.K. economy. The major factors that affected growth were the strong austerity measures adopted by the government, global slowdown and the elevating European debt woes.

In 2012, the outlook, as announced by many U.K. officials, refers to a downside revision in growth prospects. The BoE in its latest growth projections referred to an average 1% growth in 2012 from the previous estimates of 2%, clarifying that the U.K. economy will be under pressure from the euro zone debt crisis. BoE Deputy Charles Bean said the U.K. will face a difficult year in 2012, yet he still believes "some return to growth" in the second half as inflation slowdown will boost consumer spending.  

The Office of Budget Responsibility (OBR), the independent body that announces forecasts for the economy, also slashed its growth estimates to 0.7% in 2012 from the previously forecasted 2.5%. It said there is a 1-in-3 chance the British economy could experience a recession. 

Moreover, the OECD said the British economy will record an annual growth of 0.5% in 2012 from preceding estimates of 1.8%, where exports and household consumption are expected to recover, yet it mentioned the U.K. is heading toward a double dip recession in six-month time, while the IMF expects 1.6% expansion.

 

B)     Unemployment 

Due to the deep austerity measures and sluggish growth, the jobless rate remained high throughout the year, ranging between 7.9% and 8.0%, yet it rose further by the end of 2011 reaching 17-year high at 8.3% in the three months ended October, according to the ILO unemployment gauge. With the sluggish growth rate and decline in consumer spending, many companies cut jobs to lower their costs. 

The OBR predicts the rate to rise to 8.7% from the previously expected drop to 7.4%. The OECD also expect further rise in jobless rate to 8.8% in 2012.

C)     Public Debt

Following the large spending by the British government in 2010 to boost the economy, the government found itself highly indebted which prompted it to launch strong austerity measures in 2011, including large spending cuts and rise in taxes.  

The latest budget deficit data showed that the shortfall narrowed in November.  Net borrowing excluding support for banks retreated to 18.1 billion pounds compared with 20.4 billion pounds deficit a year earlier as the tax revenue advanced 7.1% while spending increased 0.8% from 0.5%, yet net debt jumped to 977 billion pounds, or 62.8% of gross domestic product. The drop in deficit remained slow in 2011 due to sluggish growth that resulted in lower tax receipts.

The OBR expects the deficit to gradually decline to 53 billion pounds by 2015-2016 from 120 billion pounds in 2012-2013, where the structural budget deficit will reach 4.6% of GDP in 2011 while will record a surplus within five-year term, yet next year it seems that the government will miss its targets for deficit reduction as it will spend more than 48 billion pounds on debt interest payments in 2012, while has to borrow an extra 158 billion pounds over the next five years.

The OECD expects the government debt to rise in 2012, where the IMF said the deficit will reach 7% of GDP. 

D)     Inflation

Throughout 2011, inflation has remained above the BoE's upper limit of 3% where the rate ranged from 4% to 4.5% till August, reaching its peak of 5.2% in September. In October and November, the rate decelerated to 5.0% and 4.8% respectively.

With the expected spending cuts, weak growth and high unemployment in 2012, inflation is likely to recede. 

The BoE's latest inflation outlook refers to a sharp fall in the rate over 2012 as factors keeping inflation above the target which are the increase in the VAT from 17.5% to 20% at the beginning of 2011, previous depreciation of the pound and the rise in import and energy prices will face downward pressure from the slack in labor market and the spare economic capacity. Policy makers expect the rate to slow to below the 2% by late 2012.

Also, the IMF said Britain's inflation will stand at 2.4% in 2012.

II- Market Response

A) The Sterling

The cable took a downside trend versus the euro in the first six months of 2011, yet it managed to rebound in the second half as the escalating European debt crisis weighed on the euro. In 2012, the pound is predicted to show some advance against the 17-nation currency as the debt crisis is expected to take more effect.

Against the U.S. dollar, the sterling advanced in the first half where it started to fall in the second half as the safe haven characteristic of the dollar gave it a privilege amid the turbulence in markets on the back of the debt woes and sluggish global growth. In 2012, the situation in the U.S. seems to be much better than the U.K. along with the refuge merit of the dollar which suggest further decline for the pound versus the green currency at least in the first half of the year.  

B) FTSE

The FTSE showed bearishness with some rebound attempts in 2011 as it was affected by the uncertain outlook for the British economy, swelling European debt woes, slowdown in global demand and downbeat earnings by large European companies. For 2012, further uncertainty is predicted to prevail with the inability of European leaders to ease the debt crisis. Thus, the FTSE is predicted to undertake a track similar to the 2011, characterized by more bearishness and rebound attempts.

III- BoE Action

According to the aforesaid developments seen throughout 2011, the BoE kept interest rate low at 0.50% for the whole year to spur growth while decided to add 75 billion pounds to the Asset Purchase Facility (APF), to reach a total of 275 billon pounds in October 2011, for the first time since 2009. The action was taken after the latest data showed a significant slowdown signs which sparked concerns the U.K. is heading towards another recession. However, policy makers split as the high inflation rate -which remained above the target for the whole year- coincided with slow growth and accordingly caused some to call for raising interest rate to contain inflation while others asked for expanding the APF more to boost the economy.

A) Interest rate

In accordance with the expected severe spending reductions, slow growth and high unemployment, the BoE is likely to keep the borrowing cost unchanged at its low level of 0.50% to boost the economy, where if policy makers decided to raise interest rate this will probably be in the end 2012. Another reason that makes leaving interest rate an inevitable action by the bank is that inflation rate which is predicted to retreat gradually, yet will remain above the 2% target all over the year. Thus, there will be no pressure on the bank to raise interest rate as shoring up growth will be a higher priority.

B) APF

Further expansion in stimulus is expected at the beginning of the year, probably in February or shortly after, where another 50 billion pounds could be added, to see the impact of the program, launched in October, which will end in February, and with the release of the February's inflation report that will include the latest growth and inflation forecasts.

Some BoE policy makers said there may be a need for more stimuli due to the high threats posed from euro area neighbors. Bean said the BoE will add to stimulus in February with the end of the program, if necessary.  Policy maker Spencer Dale said with the likelihood that inflation would come below the 2% by late 2012; there are higher chances of expanding the bond purchases.

The OECD mentioned that the BoE has to add to non-standard measures by 125 billion pounds in 2012, where the money printing process may take part in early 2012, as the economy is predicted to record contraction in the first half of the year.

All in all, the outlook for the British economy is predicted to be dominated by uncertainty and likely to be affected by the latest developments in the euro area debt crisis. There is higher probability to see a slowdown and may be contraction in the first half of the year due to the debt crisis and strong spending cuts while a rebound in the second half is inevitable as the decline in inflation will bolster consumer spending, where the public debt will remain high. Consequently, the BoE is estimated to keep interest rate steady at its low level to spur recovery while adding to stimulus early in the year to stimulate the economy, especially amid expectations of deceleration in prices.