Risk Bubble Back into Inflation Mode - as Market Declares "Long Live Liquidity!"

The logic of liquidity

The perverse bubble-inflating logic of the market continues as a new week begins. Last Friday's ugly US (un)employment report only served to embolden the risk bulls, who see the Fed on hold indefinitely and only helping to feed the liquidity and USD carry trade inflating risk bubble. After Friday's data, US 2-year rates, at a pathetic 85 basis points, have now fallen within a couple of basis points of their lows since this spring when the equity market was bottoming. Shortly put: Down with Logic, Long Live Liquidity! The worst thing for risk investors in this bizarre environment would be real signs of an economic recovery in the US, one that would put the real threat of a more hawkish Bernanke on the radar screen. As long as this eventuality fails to materialize, it appears this bubble will only pop under its own weight, or due to some black-swanish exogenous shock.

The market psychology here reminds this analyst of another frustrated analyst's morning daily report read several years ago, when the market's moves were especially defiant of economic common sense. The title of the report was "FX Trading in Bizarro World". For those unfamiliar with the term Bizarro World, it was a parallel, alternate universe created by the Superman comic book writers that allowed them to indulge in the creation of upside down logic and alternate realities on the planet Htrae (a cube shaped planet and Earth, spelled backwards). According to Wikipedia, Bizarro World is "used to describe anything that uses twisted logic or that is the opposite of something else." Right now, folks, we are living and breathing and trading currencies on the planet Htrae.

Bloomberg points out that the big three Wall Street banks (Goldman, JPMorgan, MorganStanley) are set to distribute almost $30 billion in bonuses this year, a new record, even beating the banner year of 2007, as the Fed's liquidity spree has reinvigorated asset markets. One can only wonder if this development will escape popular outrage in the US, where the underemployment gauge (the so-called U6) jumped to a new record high of 17.5% in October. Many would-be workers in the US must feel that they are living in Bizzaro world as well.

Lines in the sand redrawn?

The moves on Friday and into today cross some important lines in the sand and look to have delivered the deathblow for the hopes of a USD turnaround to the strong side for the shortest term. We mentioned EURUSD retracement levels that were still intact on Friday, but these were blown through this morning. Weekly AUDUSD momentum also was an area we focused on recently, but last week's strong close will need to see a strong reversal and lower close this week for that view to stay on track. One indicator that doesn't sit well with today's moves, however, is the level in the emerging market equities, which lag this latest dollar move to the downside. Over the past few months, these markets have followed one another in lock step, as EM is the favorite destination of USD funding, so this divergence is noteworthy. The market may have a hard time keeping weak USD momentum going if we see more strength in EM equities.

In other developments, the JPY crosses have started the weak with a fairly strong move to the upside, a move that doesn't look justified by the move in interest rates

Looking ahead: key data this week

This week is about as about as sparsely populated with interesting economic data as last week's was packed with key event risks. Here we include highlights only.

• Tuesday: Norway Oct. CPI, UK Sep. Trade Balance, Germany Nov. ZEW
• Wednesday: China Oct. Retail Sales, Inflation, and Industrial Production data, UK Quarterly Inflation Report
• Thursday: New Zealand Sep. Retail Sales, Australia Oct. Employment, US Weekly Initial Jobless Claims
• Friday: Germany Q3 GDP, US Sep. Trade Balance, Canada International Merchandise Trade, US Nov. Preliminary University of Michigan Confidence

Of all these data points, the three most important for apparent likelihood of causing significant moves in the country's currency we would list the UK Quarterly Inflation report on Wednesday, Australia's Employment Report, and the Norway CPI data up tomorrow.

Chart: EURGBP

EURGBP trying to make a new foray to the downside today, but will likely need a good look at Wednesday's Quarterly Inflation Report before any decisive move can be made. NOte the approaching 200-day moving average to the downside.

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