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Risk-on crowding in set to support the US dollar at the start of 2011

Jan. 04, 2011 12:53 PM ET
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Investors continue to embrace risk as global monetary conditions remain extremely accommodative in the face of stronger growth figures in mature economies and ample liquidity in developing markets. Monday's figures showed that US manufacturing grew in December for a 17th month, capping a strong year for a key sector that has historically acted as a bellwether of the global business cycle. Early positive indications of consumer spending from the Christmas shopping season have also offered encouragement about the sustainability of the recent stronger run of US growth figures. That the robust global growth momentum is flattering peripheral Eurozone manufacturing figures, as indicated by yesterday’s upward revision to the December Eurozone composite PMI, underlines the market’s bias towards positive carry and short volatility trades. This morning's stronger-than-expected factory PMI and money supply figures out of the UK have also helped to inject some balance into the "private sector expansion versus public austerity" debate.

Expectations that US growth and asset price inflation are set to accelerate in the first three months of the year, supported by the triple stimulus of the tax cuts, the Fed's quantitative easing and recovering market liquidity at the start of the year, are complemented by general perceptions that a hard landing from the overheating in emerging markets is some way off into the future. Sentiment has turned 180 degrees versus six months ago as fears about double-dip recession are overcome by expectations of growing inflation pressures though from the starting point of policy in the West fighting deflation risks and government bond yields still at historically low levels, the prospect of a damaging inflation/rate hike spiral appears remote, particularly in the cash-rich corporate sector.

So a foot firmly on the risk pedal appears to be the modus operandi for equity markets at the start of 2011. The crowding in that tends to happen around momentum "risk on, risk off" trades at the turn of the year, plus the positive running analyst commentary that risk asset price appreciation tends to produce, will ensure that this remains a dominant theme in the markets short term. Technically, the Fed’s punishment of long cash positions through QE2 plus a growing trade-off between fixed income and equity portfolio return prospects in favour of the latter will tend to benefit risk-positive portfolio flows. In the short term, this may mean a break-down of the strong negative correlation between dollar weakness and equities strength, particularly in light of overstretched long CHF and JPY positions, with the greenback set to benefit from a more balanced tone to the December FOMC minutes and Fed Chairman Bernanke's testimony this week as well as from another positive NFP report pushing real long-term interest rates higher. Yet, fundamentally, the longer the risk-on financial liquidity rally runs, the more uncomfortably it sits with the notion of a real recovery built on shifting sands, including unsustainably low mortgage rates, artificial central bank support for bank leverage, deteriorating public debt prospects, overheating emerging markets and deepening global imbalances.

First published at 10am GMT on 4 January.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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