Strength

The market is doing alright today with broad participation. The cyclicals stand out as particularily strong. The steel stocks also seem to be putting in an impressive day. Oil also reversed off morning lows and even managed to pull Haliburton (HAL) into the green. Silver stocks feel like they want to go green but not much has really changed for them since last week.

The news that Friday's GDP number may have been mistated seems like it would have hit bonds harder. It now appears in line with expectations so I am not sure why markets would not just rewind.

Army of One

Apple (AAPL) is trading a new all-time high. I realize it is just one stock but it makes me think the tape will make new highs following this brief try lower.

Is it Mania Yet?

While I know the market overreached a bit in Q4, I still view these mergers as near-term positives. While these big deals are happening for stock they are still a sign of management's confidence. These deals seem to be reflected a bit with positive looking charts in the XBD. Check or Merrill (MER) for example.

Chavez: The Weakest Link

For a while I was watching the news out of Russia and wondering what sort of troubles Putin might have if the price of oil goes back below $40 / barrel, but after reading this I would say Hugo Chavez problems are actually worse.

While the diversion of oil exports to China for political reasons is at an early stage, analysts say that its expansion will damage Venezuela's credit rating because it will receive less income, especially if oil prices decline. The issue of Venezuela's creditworthiness was called in to question two weeks ago when Standard & Poor's, the ratings agency, dropped the country's debt rating to "selective default" after the country missed a $35m payment due in October.

Richard Francis, analyst at Standard & Poor's, said: "It was more for technical issues, we don't believe that the ability or willingness of the government is really in question, at least at this point."

Venezuelan officials said the payment was missed because of an "error", but other observers are concerned.

"The selective default reflects the state of disarray the public administration is in," said an investment banker dealing in Latin American debt.

Given the complete mismanagement of his country since he took power in 1998, it is hard not to see Chavez as the biggest long in the oil market. It will be interesting to see how the market trades tomorrow on the Opec meeting with expectations for a production cut in March and these odd headlines about Venzuela shipping oil to China. Part of me thinks it could goose the market through 50 but more likely we drop like a stone and get to see oil producers sweat for a bit.

SBC - AT&T Announcement Might Come Monday

Apparently it is now a done deal and it is just a matter of here what the final deal looks like.

The boards of SBC Communications and AT&T were meeting on Sunday to approve a $16bn merger that would create the largest telecommunications company in the US and end AT&T’s 120-history as an independent company.

Executives of both companies had already held extensive discussions about the terms, and board approval was considered extremely likely, with an announcement expected as early as Monday, said people familiar with the discussions.

Long-term Interest Rates

I lost some money short treasuries through the end of last year and beginning of this year. I am still a bit confused as to why long rates are so unresponsive to short rates crawling higher. In particular I am amazed that the bond market completely underestimated the length of this hiking cycle expecting the FOMC to leave O/N rates at 2% or lower. In November the Fed promptly informed the markets that view was incorrect and while the short markets quickly projected a new series of hikes to 3% the long end yawned. At least I am not alone in wondering what is going on.

If America's economy continues to grow robustly, monetary policy will shift from "loose" to "neutral" and rates will go up. Although there is plenty of controversy about what a neutral fed-funds rate might be, estimates tend to be 3.5-5.5%. Oddly, financial markets are pitching it lower. Futures contracts imply that the central bank will raise short-term rates at each of its next three meetings to 3%, but will then stop, so there will be virtually no more Fed tightening in the second half of 2005 or in 2006.

If that is puzzling, the behavior of long-term interest rates is even odder. At around 4.2%, yields on ten-year Treasury bonds, America's benchmark long-term interest rate, are virtually identical to where they were a year ago (see chart). Adjusted for some measures of inflation, real long-term interest rates are lower. Stephen Roach of Morgan Stanley reckons inflation-adjusted long-term rates are now more than 2.5 percentage points below their average level of the past 20 years.

This long-term rate has a big impact on how much American companies and consumers borrow, and thus on the American economy and Mr Bush's second term. Its level reflects all sorts of things, including demand from investors for bonds, expectations of future inflation and a risk premium for holding longer-term assets. But if you look at what has happened to America's economy over the past year, you would expect long-term rates to be heading much higher. After all, short-term interest rates and inflation are both rising, the current-account deficit is huge and widening, the dollar has fallen and the fiscal outlook has worsened. Surely investors looking over the next ten years will want a better return than 4.2%?

Economists are genuinely puzzled by all this. There are several explanations, each of which has a different implication for Mr Bush's second term. None of them are terribly good.

• The most gloomy theory is that America's economy is, in fact, rather more fragile than the current statistics suggest (and most forecasters presume). Debt-laden American consumers, so the argument goes, will not be able to sustain their current spending patterns, particularly if the housing bubble bursts. Low long-term interest rates, far from being out of kilter, are actually an accurate sign of incipient economic weakness. Mr Bush's second term, in other words, may see another sharp slowdown - not a good backdrop to his domestic revolution.

• A more hopeful argument for Mr Bush is that there has been a deeper "structural" change in the investment markets in favour of bonds. A new theory on Wall Street is that domestic pension funds are shifting more of their cash into long-term bonds in advance of possible regulatory changes from Washington. Asia's central banks have also been buying Treasury bonds to stop their currencies appreciating against the dollar; that demand has certainly pushed down the yields on American bonds, but nobody really knows by how much or how much longer the Asians will continue to be such unchoosy investors. If the Asians were to moderate their appetite, interest rates would shoot up.

• A third theory is that investors are so convinced by the Fed's record as an inflation-slayer that they don't need higher rates on long-term bonds. Overall inflation is indeed much lower than it was a generation ago. But plenty of aspects of America's economy should spook even the most trusting admirer of Alan Greenspan (not to mention the Fed chairman himself). These include that worsening budget outlook and America's rising reliance on foreign capital.

• Which leaves the last possibility: that the financial markets have temporarily mispriced the risks involved. Investors are too complacent about inflation and about America's enormous budget and current-account imbalances. If that theory is correct, long-term interest rates could rise sharply and suddenly.

I lean towards 1 or 4 but would tend to see elements of all the alternatives at work. I would lay out a thesis like this. Foreign central banks are distorting the market process for interest rates and risk premium by involvement in the UST bonds and agency assets. Asset managers also buy the "gloomy" economy scenario that Fed hikes are capped by the interest rate dependence of a liquidity induced recovery. The inflation picture is mixed with booming commodity markets and low capacity utilization rates. The last factor is that the markets are willing to discount the U.S. fiscal deficit and resulting trade imbalance because it has persisted since the Reagan years.

Whatever the causes of the yield curve flattening it is difficult to believe investors won't dump the long-end for the safety of the short-end at some point this year.

Opec keeps Production Unchanged

Opec apparently likes the price of oil just where it is.

Opec, which produces about 40 per cent of global oil supplies, also put consumers on notice that it was prepared to act swiftly to cut supply should prices fall dramatically or should global oil inventories rise to within 56-60 days of consumption from the level of 51 days. Global oil inventories are expected to rise during spring as world oil demand slows.

and...

The minister said Opec was currently producing 500,000 barrels a day above the official output ceiling of 27m b/d, and reiterated Opec's recommendation from its meeting last month in Cairo that members must comply with quotas. This in effect signals a possible cut in supplies in the near term.

From the FT.

Soros from Davos

Soros is making a couple of comments. Nothing too revolutionary but from a trading perspective I always like to know what he thinks. Here are some quotes.

"Greenspan lost credibility with me when he became too political," Soros, 74, said in an interview today at the World Economic Forum in Davos, Switzerland. "He tried to push interest rates further down in order to help the re-election campaign, and also reached out beyond his sphere of competence by advocating tax cuts which then led to the current deficit."

Soros said he expected the U.S. currency to extend its three-year slide as officials and executives from the U.S., Europe and Asia at Davos blamed the U.S. budget and current account deficits for causing a plunge in the dollar. Microsoft Corp. Chairman Bill Gates, the world's richest man, said yesterday that he's betting on a further slide in the dollar, calling the deficits "scary."

He also had this to say about the yuan:

Financier George Soros warned that China should not be forced by other countries into taking action to allow its currency to find its own level of foreign currency markets.

Speaking at the World Economic Forum's annual meeting here, Soros said: 'China is in a good position to do something about the renmimbi, and I think they are probably going to do it, but I don't think it would be a good idea to push them into it.'

'I think it would be good policy now for them to do something about the exchange rate and widen the band, which would mean effectively some revaluation, and also perhaps go to a currency basket instead of the dollar.'

Rough Waters

I mentioned the won as being in the same boat at the yen a while back. Over the long run that should be true but this week they diverged a bit.

In contrast the South Korean won, another proxy for the renminbi, rose 1.3 per cent to a seven-year high of Won1,024 to the dollar as the central bank refrained from intervening.

The won strength also adds conviction to the idea that the yen will be strengthening shortly.

I see the GBP as the best currency to be short. Because of their weakening retail and housing market I expect them to start lowering rates soon.

Liquidation?

Heard some third hand rumors of a mutual fund being liquidated as the cause for today's weakness. No way to comment if it was true or not. In my opinion Monday's action felt like a liquidation with supports being sawed through in the early going without much thought. Check out a chart of CME to see what I mean. Very rarely do stocks (or any asset) recover so quickly after such intense selling.

Maybe there was some short-term cause for the weakness but whether that is true or not there was certainly a lack of buying interest.

Because of the time difference we should have a fair idea of the Iraqi election turnout and the press reaction by the time we show up on Monday. Because of the range we have put in this week Monday's action should get follow through either way.