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Stability: no longer what it used to be.

Summary

*The market has been looking for better visibility since Lehman's bankruptcy. At each stage of exit from the crisis, any success in stabilising a particular item was expected to be an important step forward towards an improved economic and financial outlook: from the mess in the banking industry to the sovereign crisis in peripheral Eurozone countries. Alas, the series of issues to fix seems to grow every time any progress is made. Very recent dramatic events in Japan and the Middle East/North Africa region just make the scenario of a consolidation in global recovery and a return to a more widespread preference for risky assets more uncertain.

*Measuring the impact of the events in Japan on the global economy is not an easy task. A strict accounting approach would reach a limited conclusion: the Japanese economy makes up less than 10% of the total and its contribution to global growth has averaged about 2-3% over the past five years. However, the relationship is likely to be more complex and a more detailed analysis is needed. Global growth will be hit in many different ways: less demand from Japan for the outside world; possible disruptions to the supply of key components imported from Japan; repatriation of capital to the archipelago with a negative impact on the related asset prices; greater demand for oil and gas. The Japanese earthquake, the latest in a series of natural disasters and geopolitical crises, could highlight the current fragility of the international situation and lead to a decline in confidence from households, corporates and investors. If we estimate that GDP growth in Japan for this year will be revised down by 1.5%, the accounting impact on global growth would be minimal (less than 0.2%). But multiplier effects in relation to these different mechanisms need to be taken into account. To what extent? For the moment we do not know.

*The oil market has reacted to the recent events in the MENA region: from the coalition's air strikes in Libya to an even more complex situation in the Gulf countries (especially the GCC army intervention in Bahrain and the spectacular fiscal stimulus plan launched in Saudi Arabia). Uncertainty could last longer than expected with an obvious implications for oil prices, which would stay higher for longer than initially expected. How would the world economy react to a crude oil price above USD100/bl for a number of months? How great would the growth slowdown for advanced countries and acceleration in prices for emerging countries be? Bear in mind that a ratio of oil expenses to global GDP above 4% (the world is around this level currently) has historically been a sign of economic hardship.

Special: Accumulation of issues for the global economy - the new do not erase the old

Herve Goulletquer

In the current complex global environment, the search for simple issues, offering clear and immediate translation into portfolio allocation, is no doubt somewhat in vain. Growth prospects are perhaps less of an issue than the return of country risk, the pace of debt reduction or changes in policy. For any investor, It is vital to remain nimble, and liquidity has a value that is no doubt higher than its mere remuneration.

Only a few months ago, there was the idea in the market that visibility was improving. Global growth was forecast to come in at 4.5% this year and next. Growth should be driven by the emerging countries, of course (+6.5%), but the US would also come out of it well, with growth at around 3%. Only the Eurozone and Japan were likely to lag behind. The Japanese economy will face a new recession, but its contribution to global growth has been limited in the recent past; so the impact of the former on the latter should be minimal. Europe, with growth expectations in the region of 1.5-2.0% with quite a large divergence between the countries' performances, also looked like a weak link. That impression, obviously, has been exacerbated by the persistence of sovereign risk.

However, it was clear even at the end of last year that in the coming quarters markets would be sensitive to topics other than growth. The search for simple issues, offering a clear, immediate translation in terms of portfolio allocation, is no doubt somewhat in vain. Above all this is a time of uncertainty and of gambling on future trends and operations. Until recently, the main issues in the market environment, next to the question of growth, have been the pace of debt reduction and the likely changes in policy and regulation. As often happens, tensions have appeared where they were not expected, at least not immediately.

Tensions in the Middle East and North Africa (MENA) are not abating. The transition to a more liberal society is still chaotic in both Tunisia and Egypt; in Libya, the current troubles point to a risk of civil war. Bahrain, overshadowed by the Libyan events, is a matter of concern. The other Gulf monarchies and also Iran cannot be indifferent to the request for change expressed by the Bahraini people. It seems likely that,

even if there is no disruption to oil output, political uncertainties - in relation to the time needed to come back to more institutional stability - will negatively impact the different markets and the oil market first of all. Of course, it is impossible to propose any serious quantification of the expected magnitude of the impact.

In emerging countries, with a more supportive growth environment and a larger weight given to energy and goods in the consumer basket, the surge in oil prices argues for the prospect of accelerating inflation. This element combined with growing country risk should keep investors cautious vis-Ea-vis enlarging their exposure to emerging markets. The main point is that the perception of the return to risk ratio in emerging countries is changing. Until recently, a stable political regime (often an undemocratic one) combined with a strong pace of growth was perceived as a positive sign for both quite a high expected return and an acceptably low level of risk. Now, it is changing, even if the reasons why are not yet well known. Is it because of the unequal distribution of incomes and excessively high unemployment rate among young people? Is it because the elevated growth momentum forces social change with both winners and losers? In an undemocratic environment, any related tensions are poorly managed and lead to a social crisis. In any case, investors monitoring country risk will have less confidence in autocratic regimes than has been the case in the past, and not just those located in the MENA region.

The surge in oil prices is an issue not only for emerging countries;it also challenges the developed economies, which grow at a slower pace. It is key to note that the current upward pressure on oil prices is related to a supply shock (geopolitical tensions and a threat of disruption), not a demand shock. This is taking place at a time of weakness in domestic spending for developed countries. Higher oil prices will weigh on purchasing power. Consumers will not easily decrease their saving ratio to maintain their pace of spending, and indebted governments cannot really decide upon new stimulus measures.

At the same time, accelerating inflation can be an incentive for central banks to begin the normalisation of their official rates from the current very low levels. Such developments are not the best way to consolidate the recovery. In any case, differences exist between the US and Europe: the US is characterised by greater vulnerability to energy prices, an expansionary fiscal policy and core CPI (without the energy and food components) as the central bank's inflation reference; in Europe, the energy intensity of the economy is weaker, fiscal policy is tightening and the inflation reference of both the ECB and the BoE is the CPI headline index. Ultimately, because of differences in both the sensitivity of the respective economies to oil price developments and the price reference of central banks, it would not be that much of a surprise to see earlier monetary tightening in Europe than in the US.

In any case, the unexpected return of country risk and its related impact on the oil price send a double message of less visibility and more vulnerability than were expected some time ago. This does not mean that the themes previously identified and able to challenge a reassuring economic and financial outlook have disappeared.

The idea of the more or less inevitable nature of a new set of game rules in the field of economic policy is confirmed if we take our cue from recent history. Economic policy has changed markedly in the wake of every major economic shock, forcing every agent in the business community to adjust their actions and expectations. Thus, after the 'Great Depression' Keynesianism imposed itself as the main means of fiscal intervention in the shape of contra-cyclical policies. Similarly, after the 'Great Inflation' central bank independence became the norm, and the targeting of inflation the prime objective of monetary policy. It may also be noted that the Great Depression 'begat' a greater role from the state in the economy either through more levies and spending, or in the form of more extensive regulation. After the Great Inflation the emphasis was placed squarely on the need to give more weight to market-driven mechanisms and to ease regulatory constraints. What will happen in the wake of the 'Great Recession'? That is undoubtedly a valid question, but it does not mean that the answers are already to hand. So, let us content ourselves with suggesting a few avenues - there is already no shortage of them!

*The first point concerns the 'market versus state' debate. In all likelihood, market forces - in the sense of less restrictive regulations - are set to lose ground. If there has to be a substantial state presence, it will be first in the shape of greater efforts to ensure better operation of the markets (regulation and structural policy) in order to achieve greater economic efficiency and to facilitate a higher level of individual and collective well-being. This quest for more efficient public action could also involve more initiatives in favour of improved co- ordination between states, with the idea that intervention is especially effective when it impacts an entire market, which is very often trans-national, if not global, and not simply a part of the market, limited to the space within the borders of a country or a union. Globalised markets require co-ordinated action.

*With respect to monetary policy, it is clear that a mix of targeting inflation, measured at the level of goods and services, and independent central banks has not proved to be fully comprehensive insurance against the risk of a very serious crisis. The debate as to whether the accepted definition of inflation should be enlarged to include asset prices will need to be re-opened. More specifically, for emerging countries, exchange rate trends and capital inflows are also constraints that may need to be factored into any monetary policy equation.

*With respect to fiscal policy, especially in Europe, placing the emphasis officially on the size of both the budget deficit and public debt did not prevent a sudden increase in sovereign risk. Of course, the determination of some was to comply with the criteria and for others to ensure compliance was lacking. Herein undoubtedly lies some of the explanation for the ongoing doubts about the quality of sovereign risk in the Eurozone periphery. Yet, other factors should have been included in the analysis and would probably have made it easier to see the deterioration looming in the public accounts. We would have needed to know how to integrate fine-grained monitoring of both the external balance and changes in competitiveness at an earlier stage.

*In an environment of limited growth prospects (for the advanced countries at least) and reduced room for manoeuvre as regards recovery policy (both fiscal and monetary instruments have been heavily used in recent years), the question of optimising policy mix has become a 'burning necessity'. One very recent example illustrates this constraint. The US central bank, faced with a fall in confidence on the part of most economic agents and convinced that no recovery measures would come from the institutions in charge of fiscal policy, decided in November to embark, no doubt by default, on a non-orthodox monetary policy of purchasing government bonds, the effects of which on the rate of growth are somewhat uncertain. The following month, and quite unexpectedly, the White House and Congress reached agreement on a programme of tax cuts and spending increases. Where is the overall consistency, especially when the degree of freedom is so limited?

Keeping in mind this inevitable need to adjust the game rules, we now need to look at the sovereign crisis in Europe, which will likely still serve as a backdrop to market movements in the coming months and quarters.

*The situation of the public accounts is, more often than not, poor, with unsustainable levels of debt.

*Although the deployment of austerity plans is an unavoidable solution, the implications in terms of (1) economic acceptability (what are the consequences at an internal level and as regards the operation of the Eurozone of zero or very low economic growth for a certain period and in a certain number of countries?); and (2) political acceptability (government fragility, changes in political balances, with the threat of a rise in 'extreme' parties and general discontent among the population) are scary.

*The complexity of the web of economic and financial relations inside the Eurozone, and the importance of government bonds in the financial savings of European households, makes the prospect of a sovereign default in a peripheral country a very unattractive outcome, above all because it is difficult, ex ante, to measure the implications. The concern is most definitely that the chain reaction process will lead to a higher level of losses than initially thought.

*Solidarity and assistance, alongside a tightening of sound management criteria and close oversight of the public finances and economic policies of member states, should therefore be seen as an essential means of resolving the crisis. But how does one guarantee the support of public opinion in the contributing countries and how can one be certain of the legality of the operations under consideration in European and national law?

Europe needs in-depth restructuring - as recent events have shown - and no doubt more than the people and their leaders were envisaging even quite recently. What initiatives will be taken, what will the timetable be, and what new shocks will be needed to force them to move forward? At present, there is no answer to any of these questions.

In an environment under reconstruction, one cannot simply extrapolate from yesterday's trends. Europe and the US will have to recreate at least partially their economic models, and emerging countries will have to push on with assimilating the limitations and opportunities of the culture of macroeconomic stability, while for many of them deepening their understanding of the political and social dialogue. The stakes are huge, and visibility will improve only gradually. We should not allow ourselves to be guided by what can look like trends but which will turn out only to be blips. It is vital to stay nimble, and liquidity has a value that is no doubt higher than its mere remuneration.

Monetary Policy: From one regime to another

Isabelle Job

Financial inflation originates in industrialised countries, which have ultra-accommodative monetary policies and abundant cheap liquidity, some of which is flooding high-yielding emerging markets. Real inflation (minus supply-side shocks) is born from production pressures in the emerging sphere and is symptomatic of overheating economies. This is exported to the industrialised economies in the shape of higher commodity prices. These far-reaching changes to the inflation regime(s) are likely to prompt central banks to re-think their monetary policy strategies.

Inflation-free growth

Central banks have built up and anchored their credibility by combating the main stigma of cyclical excess, ie, inflation. After WWII, economic cycles became fairly clear, with a relatively foreseeable sequence of events, when - very simply put - phases of economic overheating, often fuelled by lending overload, triggered rapidly rising goods and services inflation reflecting excessive demand and/or labour market pressures. To stop the economic locomotive running out of control, all central banks had to do was apply the monetary brake to tighten lending conditions and cushion the cycle (which, unfortunately, often plunged economies into recession) so as to erase the inflationary footprint, before subsequently back-tracking to trigger a new growth cycle. Once the war against inflation was won, the idea was to act as far upstream as possible before the threatened inflation materialised in order to smooth these cyclical ups-and-downs. This nominal anchoring policy proved to be worthwhile since, from the mid-1980s, growth and prices, as hoped, have demonstrated greater regularity, to such an extent that the past 15 years have been dubbed the 'great moderation'.

This nominal stability can certainly be credited to the central banks, as anticipated inflation and/or the memories of inflation converged towards low, stable price targets. But, there was more to it than that. Globalisation and the emergence of 'low-cost' countries, with the corollary of an ultra-competitive manufacturing base, were powerful disinflation factors. In the absence of inflation pressures in the real economy, central banks were in fact able to sustain accommodative monetary policies on a lasting basis without ever jeopardising their mandate for nominal anchoring.

The problem is that, as inflation deserted the real economy, the issues gradually shifted towards the financial sphere, which developed a chronic instability, with galloping asset price inflation (ie, equities then property) against a backdrop of increasing leverage in a low- interest-rate environment synonymous with access to abundant, cheap liquidity. The potentially devastating effects linked to this change in the inflation regime were severely underestimated, including by central banks, which were steeped in the dominant paradigm where nominal stability and financial stability went hand- in-hand. Because markets are efficient, they thought, any change in asset prices had to reflect changes in underlying fundamentals, with the financial sphere able to self-regulate on the basis of the signals received from the real economy.

The unprecedented scale of the 2008 crisis swept away those certainties. It became an absolute priority to tame the pendulum swings of the financial sphere. Central banks have often been blamed for leaving interest rates too low and so encouraging financial excesses. That is an easy criticism, which takes no account of the complex global chain of responsibilities and collective blindness, the cruel lack of oversight, and the wave of poorly- regulated and toxic financial innovations. The accent today is on a combination of regulation and supervision to constrain banks' risky activities and increase their resilience in the event of a shock. There is also talk of implementing macro-prudential policies that turn against the cyclical grain using countercyclical provisioning and capitalisation mechanisms, alongside micro-prudential measures in order to make the financial system more stable.

In a 'silo' situation, monetary policy, in the conventional sense of the term (ie, the use of interest rates) must continue to manage the position in the cycle, which in a sense boils down to considering that the pre-crisis financial inflation regime was only a temporary blip which, once purged (and better controlled), ought to return us to a not-so-distant past when inflation wrought its havoc in the real economy above all.

In Europe, the rise in sovereign risk among peripherals highlights a number of serious dysfunctions, and the resolution of the liquidity crisis (guaranteeing the refinancing of government debt) is no more than a partial answer. Here is a simplified presentation of the issues:

Growth-free inflation

In fact, it is clear to see that the old inflation demons are coming back to challenge the credibility of our central banks. In recent months, commodity price rises in general, and oil price rises in particular, have returned inflation to centre stage. If spiralling prices do echo economic excesses (excluding the supply-side shock due to Middle East uncertainties), it must be admitted that these cyclical excesses are not developing here, at home, but elsewhere in the emerging world. The emerging countries still seem able to apply pressure to the price chain (in the tradable goods sector) as they move up the quality chain, but the bulldozer finds it increasingly hard to hold down rising commodity prices - the other side of the coin as regards the ongoing economic catch-up. As these countries approach the centre, they will have to cope with a highly conventional growth-inflation arbitrage when upstream price increases spread to their own economies. The right answer is a smart balancing of slightly higher interest rates and slightly stronger exchange rates, to avoid any overheating.

In the industrialised economies the situation is very different. If the emerging sphere exports less disinflation, there is a risk that it will be faced with an equilibrium regime characterised by higher inflation, but also lower growth. This is because the crisis has left deep scars in the productive sphere, with considerable under-used capacity, as well as on the labour markets, with record-high levels of unemployment, which make it very unlikely that those upstream price rises will be passed downstream, notably via price-wage spirals or second-round effects. This deformation of relative prices is, on the other hand, likely to adversely affect growth due to eroding household purchasing power and squeezed corporate profit margins. Central banks in the industrialised countries, which have no direct leverage on cyclical developments outside their national borders, have to trust their emerging-country counterparts to apply the right monetary setting.

One way to return the favour would be to do something about the considerable loosening of our monetary policies, which has led to over- abundant liquidity, in the face of market conditions which have yet to stabilise clearly. By setting the price of liquidity and lending, monetary policy influences the markets' perceptions and level of tolerance for risk (Borio & Zhu, 2008). Rates that are too low can artificially swell asset price valuations based on calculating future income streams or cash flows on a present value basis. In a low-interest-rate environment, the search for yield can encourage investors to take reckless positions while disregarding the risks. Not to mention that the asymmetric behaviour of the central banks (soft during the bubble and activist after it bursts) can constitute an additional incentive to take more risks, with the certainty that the kindly monetary authorities will put out the fires - a form of prior insurance encouraged by central bank behaviour during the last cycle. In other words, keeping interest rates low over a very long period is not the right signal to send the markets. Some of this abundant, cheap liquidity is hoarded, certainly, and ends up on central bank balance sheets in the shape of excess reserves; however, another part of it will flood into the financial markets - notably into high-yielding emerging markets - creating a risk of generating asset price bubbles in those economies.

To put it another way, the industrialised countries are exporting their financial inflation to the emerging countries, which themselves are exporting real economy inflation back, through rising commodity prices. Each has a responsibility to minimise these negative externalities, failing which, the growing economic and financial imbalances developing at either end of the chain are likely sooner or later to lead to some painful adjustments.

US Interest Rates: Questioning Fed policy David Keeble

The consensus today is that inflation is not a threat. Put yourself in December 2011, with another nine months of economic growth and rising core deflator. Even if the Fed rate is near zero, the market will be questioning the sustainability of that policy.

Near absolute confidence that the inflation threat is dead

After the big bond market liquidation in the fourth quarter of last year, US Treasury yields have entered a kind of holding pattern...temporarily.

Even though breakeven inflations are rising as an obvious consequence of the oil price spike, forward inflations such as the 5Y5Y have actually declined slightly. We would like to think that this decline is mostly a mathematical result of a rapidly flattening breakeven curve rather than a vote of confidence on the Fed's anti- inflation credibility, but we know we are wrong.

At the moment, there is a never-ending echo that there is enough slack in the US economy to prevent a rapid rise in core inflation. Indeed, the market, economists and the Fed are firmly centred upon this view. The market forecast for core PCE in 2012 is 1.5%, and 82% of forecasters expect core PCE to remain below 2.0%.

We think that the recent decline in the forward breakevens is simply wrong. At the very least, the pick-up in energy prices increases the risk of second- round effects - and risks require risk premia. Gasoline and food are, after all, purchased on a very regular basis and attract lots of press attention, so when these components rise in price people are very aware. The market is wrong to assume zero extra risk in the price-wage pass-through.

Furthermore, unemployment has fallen far more quickly than expected, and confusion still surrounds why the pool of available workers has shrunk so rapidly and why payroll numbers disagree with other measures of the labour market.

Bond markets do not react to 'rear-view mirror' forecasts but continue to reassess and often extrapolate.

The DeLorean approach to forecasting

When we make our bond yield forecasts, we put ourselves in the information set of future periods. Jumping into our time machine and projecting ourselves to the end of 2011, the information set should look something like the following.

The economic recovery would be older by three quarters, core inflation will likely have been rising gradually for around the same time and jobs growth would have been positive for 15 months. The BoE and ECB would have hiked rates to fend off inflation, but the Fed will have kept rates at close to 0% for three years.

At year-end, the year-ahead forecast for the PCE deflator would not show itself as a very tight normal distribution with an average around 1.5%. It would be higher and the distribution much wider. Our bet is that there would be growing discontent with the Fed's desire to reflate. The market will request a high yield to compensate for increasing risks of a Fed mistake.

Also, whilst the peak in US Treasury supply may have peaked before the end of this year, the amount of supply will still be very, very large and the Fed purchases will have disappeared.

There are risks to any recovery but then the force of an economic cycle is strong once it gets going. We believe that, if the recovery continues as it is, then there are many reasons to avoid US debt; the only pertinent question is how high will yields go? We would be especially careful of the 2Y area around the middle of the year as we expect that part of the yield curve to undergo a change in sentiment once the Fed finally stops QE2. That date represents the end of the Fed's easing cycle and the market will ask 'what's next?...'

Eurozone Interest Rates: ECB steps up the pace

Luca Jellinek

The last box in the list of bond bear market prerequisites has been ticked, in the Eurozone, with the ECB signalling that the tightening cycle is very close to its start. That signal follows the turnaround in inflation expectations, monetary growth and business sentiment, suggesting that the normalisation of interest rates will be 'full size', rather than truncated. A higher and flatter yield curve now beckons, unless the Japanese disaster somehow triggers a full-blown global economic downturn.

Frankfurt steps on the (policy) gas pedal

Careful observers of the ECB policy 'reaction function' have been pointing out for a while that the monetary and business confidence readings to which the ECB has historically been sensitive have been moving in the direction of tightening. Nonetheless, the ongoing need to provide money market liquidity to some European banking systems and the broader periphery vs core issue lulled many market participants into a false sense of security.

As a result, money market rates evinced surprise in both January, when Trichet used the words "very close monitoring of price developments", and in March, when he uttered the phrase "strong vigilance", which historically has preceded rate hikes by one meeting. Cue a general repricing of the EUR term structure. Note that, ultimately, regardless of whether the ECB delays the first hike by a month or so, in response to financial turmoil following the Japanese disaster, the basic pace and extent of the hikes is unlikely to be affected.

Not a single reason to be bullish about Bunds

With the delivery of a pretty clear signal from the ECB that liquidity provision and the price at which it is given are quite separate issues, the Eurozone bond market has nowhere to hide. Exports, industrial production, business sentiment and, to boot, inflation, are at pretty robust levels and show no sign of inverting. Though fiscal retrenchment and burst asset bubbles will continue to imply significant divergence in the performance of individual countries, on the other hand gross government bond supply will also remain rather heavy.

Furthermore, the starting point for rates, from which they have risen substantially, essentially discounted depression-like conditions that did not even remotely materialise. Finally, corporate profits globally and within Europe have gone from strength to strength. When one adds up all these factors, it is apparent that the process of rate normalisation to the upside will be protracted. In that sort of environment, the yield curve can and will flatten substantially. The preferred strategy is to reduce duration risk substantially and achieve a similar running yield by increasing diversified credit risk. Both trends have already been evident but have quite some way to go yet. We believe it would take a substantial slowdown in economic growth to derail this and, so far, the events in Japan and MENA do not suggest that will happen.

Pressure on peripherals returns

For several months now, when looking at peripheral Eurozone issuers, investors have placed as much emphasis on the retention of primary market liquidity as the underlying fiscal dynamics (which, after all, change only very slowly). At the beginning of Q1, the impression was that the 'AAA' sovereigns would allow the EFSF to provide a liquidity backstop to peripheral issuers, and that helped non-core paper outperform sharply.

That hope faded in February but was partly rekindled by the recent EFSF/ESM announcement. Current trading in periphery spreads is clouded by the risk aversion provoked by the headlines in Japan and MENA. That leaves the question of whether Portugal can remain present on the primary market - as well as whether Spain-Portugal decoupling is a permanent feature - rather open.

Exchange Rates: USD pressure to ease

Mitul Kotecha

The USD has started the year weaker, having suffered from a relatively dovish Fed compared with a hawkish ECB and BOE. We believe USD weakness will be short-lived and the EUR will eventually be undone by overly optimistic expectations especially with regard to the periphery. Commodity currencies remain the best performers in our forecast grid.

Various influences have buffeted currency markets so far in 2011. The fact that there has been no clear FX driver but rather a confluence of various factors has meant that, aside from USD weakness, direction in FX markets has been difficult to discern. Despite this uncertainty, our expectation that the USD would be weak over Q111 and strengthen over the remainder of 2011 remains on track.

One theme that has been evident since the start of the year is an improvement in sentiment towards the Eurozone periphery as hopes of an enlargement/extension of the European Union bailout fund (EFSF) have increased. There is a strong chance that, eventually, market expectations will prove overly optimistic, which in conjunction with growth divergence and economic underperformance relative to the US will see EUR/USD drop again, with a move to around 1.25 likely by year- end.

The second major theme impacting FX markets is global inflation, driven by higher food and energy prices. Certainly, this has had an impact on interest rate expectations and in some cases resulted in a hawkish shift in central bank language, notably in the Eurozone and UK. The EUR has benefited from a relative tightening in Eurozone interest rate expectations compared with the US, but markets have already priced in quite a hawkish stance on Eurozone policy rates, suggesting some risk of EUR weakness should rate expectations be pared back.

A third theme is an improvement in US economic indicators. The recent run of US data has been encouraging, confirming that the economy is gaining momentum. The US is set to outperform many other major economies this year, especially the Eurozone, which will be beset with a diverging growth outlook between north and south. Eventually,

growth outperformance and some reversal in US yields will push the USD higher against many currencies, but the time is not yet ripe for this, with correlations showing only a few currencies (mostly EUR crosses) that possess statistically significant correlations with interest rate differentials.

Two currencies that we believe will be significantly influenced by yield differentials are CHF and JPY. Clearly, this is not the case at present otherwise USD/JPY would be a lot higher according to our quantitative estimates. The recent earthquake in Japan may have changed the perspective for the JPY given the likelihood of huge repatriation flows by Japanese life insurance companies. However, whilst this suggests significant upside risk for the JPY over coming weeks, JPY strength will be opposed by FX intervention by the Japanese authorities. Eventually, relatively higher US yields will push USD/JPY higher. USD/CHF has come under downward pressure, with the CHF benefiting from safe- haven flows as tensions in the Middle East and Japan nuclear worries escalate. We look for the CHF to weaken against both EUR and USD as an eventual easing in risk aversion, peripheral bond concerns and higher relative yields elsewhere weigh on the currency and it regains its role alongside the JPY as a funding currency.

Scandinavian currencies have been the main outperformers so far in 2011 but we do not expect the SEK and NOK to retain this performance. GBP has also performed well versus USD so far this year, dragged higher on the coat-tails of a stronger EUR. This may reflect a relatively more hawkish bias to UK interest rate expectations as inflation concerns intensify, but we expect GBP gains to be more evident versus EUR than USD this year. Commodity currencies have been less impressive, turning in mixed performances over recent weeks - AUD and especially NZD have weakened since the turn of the year whilst CAD is firmer. These three currencies are the main outperformers in our forecast carry-adjusted returns grid and we believe that firm commodity prices, relatively high yields and strong growth will help propel these currencies higher.

Energy: Oil prices to correct downwards in Q211 Christophe Barret

OPEC heavyweights have started to increase production, more than offsetting the 1Mbd of Libyan production losses. Assuming that Libya will progressively return to full production in April, we expect Dtd. Brent prices to return to USD85/bl in the coming months, after their incursion close to USD120/bl in Q111.

Saudi Arabia is believed to have pushed output to close to 9.4Mbd in March, a 700kbd increase compared with end-January levels. Kuwait and the UAE are also raising output. At this stage two broad scenarios are emerging. The first is that the Libyan uprising degenerates into a long civil war, putting oil installations at risk and leading to lengthy disruptions to oil supplies and exports. Under this scenario, oil could remain above USD100/bl for the

next six months, and the impact of the subsequent oil price shock would rebalance oil supply/demand in the second half of the year. In an alternative scenario the Libya conflict ends with no destruction to oil installations, and production could resume at close to normal levels in April. As a result, markets would likely be oversupplied in Q211, as additional production from OPEC and Libya will face low demand. Under this scenario - our base case - prices are expected to sharply correct in Q211. Contagion spreading to more oil-producing countries in the Gulf is also helping to support prices. There is no necessary causality from a popular uprising to oil supply disruption, but unrest would increase the risk of disruption and introduce a 'risk premium' on prices. This 'risk premium' reflects the fact that operators in the oil chain want to hold higher stocks to offset any potential disruption to supplies. They bid oil higher, pushing prices above levels that would clear supply and demand, thereby allowing the building-up of stocks. When these stocks are built, however, the 'risk premium' should progressively disappear, as markets cannot remain in a state of excess supply forever.

Metals: Geopolitical risk premium returns to gold

Robin Bhar

The outlook for gold has improved considerably given recent events, and prices are likely to reflect a geopolitical risk premium, underpinned by inflation worries and concerns over sovereign risk. However, silver is the preferred choice of investors and likely to remain so. Industrial metals should find support from Q211 peak seasonal demand.

Geopolitical risk has become the latest threat to global growth and is continuing to spread, raising the spectre of rising inflation and receding growth. The safe- haven bid for gold has returned in force as tensions intensify in the Middle East and North Africa, with Libya on the brink of civil war. Markets are beginning to price a shift of contagion from North Africa to some of the Gulf economies, principally Bahrain and Saudi Arabia. With the MENA region a significant crude-oil producer, energy prices are likely to remain elevated for longer, and higher inflation is positive for gold. Concerns over sovereign risk have resurfaced and there is a growing acceptance by investors that the Eurozone debt crisis will get worse before it gets better and that this also will be gold-positive. However, gold is also a risky asset that is likely to suffer bouts of heavy selling from time to time, while falls in equity and other commodity markets could force investors to sell gold to cover margin calls. Corrections within the strong uptrend though are good opportunities to buy, in our view, as the case for gold to reach USD1,550-1,600/oz has been considerably bolstered by recent events.

Silver has continued to outperform gold; the gold: silver ratio has fallen below 40 for the first time since February 1998. Investors appear to be favouring silver in relation to gold because it is a precious metal (has all the attributes of gold but is much cheaper), a supply- constrained commodity (market is in backwardation) and an industrial metal. In short, silver is seen as being in a win-win situation.

US: Recovery on track despite new headwinds

Mike Carey

The US economic recovery is expected to accelerate in 2011, despite headwinds of higher oil prices and increased fiscal restraint. Unemployment is expected to decline slowly while economic slack and anchored inflation expectations suggest continued accommodative Fed policy into next year. The unsustainable long-term budget deficit remains a challenge.

Consumer spending will benefit this year from improving employment conditions, reduced payroll taxes and the satisfaction of some 'pent- up' demand. Household balance sheets are in better shape, given deleveraging and savings trends. We look for real consumer spending to advance by 3.2% over the four quarters of 2011- up from 2.7% in 2010. There are positives and negatives in the consumer outlook. Over the near term, the reduction in purchasing power, due to higher energy and commodity prices, will curb the pace of spending. We expect this effect to be transitory but it will reduce, for some period, the positive impact of payroll tax reductions that are boosting disposable income this year. However, in 2012, payroll taxes return to previous levels, reversing the boost to disposable income. Household net worth may reflect a stabilisation in house values but broad financial market conditions will likely be less supportive with higher interest rates and a less buoyant equity market.

US labour market conditions are improving and there are grounds for optimism in the months ahead. Initial claims for unemployment insurance are trending lower and, as indicated in the accompanying chart, strong corporate profits are generally a good precursor of increased hiring, especially as labour costs are competitive, given declining unit-labour costs. We expect to see non- farm payroll gains of around 150,000- 200,000 over the next few months. The jobless rate, however, is likely to decline slowly from current elevated levels. The labour force participation rate has declined sharply, despite the economic recovery as many have dropped out of the workforce. However, as job market conditions improve, many will likely be drawn back into the job market.

Business investment spending is expected to continue at a healthy pace, albeit lower than in 2010. Orders for non-defense capital goods (excluding aircraft) suggest solid capex spending by firms. The need to invest reflects not only the pick-up in orders but the need to continually increase productivity through the more efficient technologies embedded in newer equipment and software. The financing of such investments has been supported by today's relatively low interest rates and by an increased willingness by banks to make commercial and industrial loans. Moreover, US business confidence seems to be improving as the Obama Administration makes more overtures to business groups, seeking input on how the government can help firms thrive in the current environment.

Our updated forecast assumes that a compromise over government outlays leads to a moderate decline in spending vis-Ea- vis the current budget baseline this year and next. However, while the political argument for near-term spending reductions is couched in terms of reducing the large Federal government budget deficit, the proposals do not deal seriously with the longer-term issues of unsustainable spending on entitlement programmes, such as social security and Medicare/Medicaid. Instead, politicians try and score points by showing how 'tough' they can be on the 12% of the budget where spending cuts have been proposed. Serious progress on the budget deficit will require bipartisan agreement, which will be very difficult to forge in today's highly polarised political environment. The Republican majority in the House sees its mandate as shrinking government spending. The Tea Party caucus was successful in pushing the Republicans to vote for USD61bn in spending cuts for the balance of FY11 (HR1) and further reductions can be anticipated for FY12. The implementation of HR1 could trim about half a percentage point from growth and would add to the fiscal restraint at the state and local level.

The housing sector is likely to stabilise this year. The excess inventory of homes for sale is slowly being whittled away but continued foreclosures this year will feed the excess supply. Mortgage rates are trending higher (but remain low by historical standards) and lending conditions are tighter than they have been in past years.

Top-line inflation figures will move higher in the near term given the supply shock to oil prices. We assume that this will be transitory and that recent USD100+/bl oil prices will not be sustained. However, we believe that the surge in energy prices will help boost the YoY CPI inflation rate to peak over 3% this summer but then trend downwards towards year-end and into 2012. Core inflation measures, however, are expected to drift only modestly higher to 1.5% YoY in December 2011 from the 1.0% rate posted in January. The two key factors that will keep core inflation from accelerating sharply are excess slack in labour and product markets and well-anchored inflation expectations.

The excess slack is evident in estimates of a large output gap, the elevated level of unemployment and below-average capacity utilisation rates. Survey evidence, such as the inflation expectations of professional forecasters or market measures of expected breakeven inflation, suggests that inflation expectations are relatively well anchored. This makes sense if the period of the 'great moderation' has increased the Fed's inflation- fighting credentials. Temporary price increases, due to a supply shock, for example, would see only limited pass- through into the wage-price nexus. As wage costs make up roughly two-thirds of total product costs it is difficult to see an inflation spiral developing. However, with housing vacancy rates declining,

some upward pressure on owner's equivalent rent will exert some upward pressure on the core CPI.

The Fed is counting on inflation expectations remaining relatively well anchored, and this may explain why the central bank's response this year will be different from say the 1970s, when inflation expectations were not well anchored. Currently, the FOMC is monitoring the recovery to assess when the current accommodative monetary policy should be withdrawn. Mr Bernanke has stated that the FOMC will wait until the economy is in a self- sustaining recovery, unemployment is improving and core inflation is approaching the Fed's preferred range (PCE deflator 1.6-2.0%) before tightening policy.

We see no reason for the FOMC to change policy this year. The current asset-purchase programme (QE2), which has been providing supportive financial market conditions for recovery, will expire mid- year and is unlikely to be extended, barring a significant downturn in activity. The FOMC's policy stance seeks to meet its dual mandate of maximum employment consistent with price stability. Next year, we believe that the FOMC will begin preparing the markets for a normalisation of policy. This process will take some time, beginning with a more upbeat characterisation of economic activity in the FOMC meeting statement. Secondly, the FOMC could cease rolling over its MBS holdings, passively shrinking its balance sheet. At the appropriate time the "extended period" language in the FOMC statement would have to be changed. That could be followed by reserve-draining operations, such as reverse RPs, term deposits at the Fed and increased interest paid on excess reserves in order to ensure that the subsequent increase in the Fed funds rate was well communicated and executed. We suspect that the FOMC would wait to assess the impact of the exit strategy and higher rates before selling assets to return the balance sheet to a normal size. We believe this sequence will result in a rising Fed funds target in the second half of next year but the timing will ultimately be determined by the evolution of inflation expectations and the pace of the recovery.

Risks to the outlook: These are uncertain times and so it is very important to underscore some of the risks to our US outlook. These include: (1) a sustained acceleration in oil prices, (2) too much fiscal austerity too soon, (3) renewed weakness in housing, and (4) a potential slump in foreign growth, if the European sovereign debt issues are not properly resolved.

A sustained rise in oil prices, due to heightened tensions in North Africa and the Middle East, could reduce real consumer spending significantly, given short-term price elasticities, thereby short- circuiting the recovery. Excessive near-term fiscal austerity could be counterproductive at this stage of the recovery as the recovery still needs fiscal support. A healthy pace of housing activity is not expected until next year. Greater-than-expected home price declines this year would weigh heavily on household sentiment and spending, and potentially delay the housing recovery. Should the sovereign debt crisis in Europe fester, the prospect of lower growth and increased financial market stress would hurt growth prospects.

Japan: Recession is coming but strong recovery to follow

Susumu Kato

Following the earthquake and tsunami that hit Japan, economic growth will turn negative in Q1 and Q2, making three consecutive quarters since Q410. However, major reconstruction demand thereafter will bring very strong growth for Q3 and Q4. We revise our economic growth forecast for 2011 down to -0.1% from +1.4% before the earthquake.

Robust recovery in 2010: After two years of large falls in economic growth in 2008 and 2009, Japan's economy experienced a V-shaped recovery. Real exports grew by 24.0% thanks to emerging economies that did not suffer much from the credit crisis and helped Japan to recover from the deep collapse in external demand. Consumption grew by 1.9% on the back of government subsidies for auto and household appliance purchases. However, the recovery in capex has been rather sluggish, growing by only 2.2% reflecting the conservative strategy made by companies that considered capacity at home to be more than sufficient. Increased fiscal expenditure in the public sector made a slightly positive contribution to real GDP but remained virtually flat or only slightly positive. More importantly, nominal GDP growth recorded +1.8% growth in 2010, turning positive after two consecutive years of large contractions.

Temporary recession will be followed by robust recovery: While the scale of the total losses caused by the earthquake is yet to be confirmed, the important point is that damage to existing infrastructure in itself does not have a direct impact as GDP is an aggregate of value-added for a given period of time. However, it is the combination of negative wealth effects due to lost national wealth and supply constraints due to destroyed infrastructure that will affect GDP. Thus, those negative impacts will result in negative real GDP growth in the Jan-Mar and Apr-Jun quarters. However, the positive impact from reconstruction demand will start outweighing the negatives thereafter. Thus, while we revise down our real GDP forecast for 2011 to -0.1% (previous forecast +1.4%), this will be followed by robust +2.5% growth for 2012 (previous forecast +1.9%).

Moderate inflation in 2011 and 2012: The combination of supply-side shortages due to lost infrastructure and the expected emergence of reconstruction demand will mean that the impact of the earthquake on prices will be inflationary. As such, we maintain our call that, coupled with the surge in raw-material prices, deflationary pressures will continue to ease and we will see moderate inflation at 0.4% in 2011 and another 0.6% for 2012.

Higher expectation for the Bank of Japan to increase Rimban: While the Bank of Japan has been aggressively conducting liquidity provisioning operations at an unprecedented scale every single day since the earthquake, our frank assessment of the BOJ's decision to double the asset purchase scheme is that it will turn out not to be enough. On the one hand, the massive liquidity provisioning campaign has been effective in keeping the policy interest rate trading in the targeted range.

On the other hand, given monetary policy's independence from politics, the BOJ can act much more quickly than the government in bringing back stability to the financial markets and in our view the decision was short of meeting such an expectation. Going forward, the government will need to increase issuance of JGB to raise money for reconstruction, and there will be ever- greater expectations that the BOJ will decide to increase the outright purchase of JGB (Rimban operations).

Fiscal policy will remain expansionary: Although fiscal consolidation is quite urgent for Japan, support for economic recovery will be given even higher priority given the disaster. We expect that a JPY5trn (1% of nominal GDP) economic package will be put together to provide money for immediate needs in a first stage and then another JPY10trn (2% of nominal GDP) package will be put together to fund reconstruction activities. With about JPY10trn of the total JPY15trn likely being financed through JGB, the government will face tough pressure to cope with the higher cost of borrowing without the co-operation of the BOJ. While we maintain our view that corporate and household savings are enough to finance the government deficit, the benchmark 10Y JGB yield will reach 1.5% sooner rather than later.

Disclaimer

This research report or summary has been prepared by Credit Agricole Corporate and Investment Bank or one of its affiliates (collectively "Credit Agricole CIB") from information believed to be reliable. Such information has not been independently verified and no guarantee, representation or warranty, express or implied, is made as to its accuracy, completeness or correctness.

Source : Credit Agricole, Corporate & Investment Bank, FIM Research, March 24, 2011

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Date:Apr 6, 2011
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