The “Great Rotation”

Evidence that the “Great Rotation” is finally beginning to take place has been established. Capital is finding its way into US equities as reflected in recent flow data while flooding out of Treasuries and other fixed income instruments. However, another rotation of sorts is also taking place, with emerging market assets, both bonds and equities, continuing to register outflows much of which appears to be returning to the US.

Given that the Fed has helped to ease the transition process towards tapering, finally managing to establish effective communication with markets, there is little to suggest that this rotation will reverse. Indeed, the US equity risk premium remains high (ie bonds still look expensive relative to equities) despite the recent correction. Nonetheless, US bond yields pulled back last week (10 year yields have fallen by around 15 bps over the last two weeks) a factor that is also helping to take the wind out of the USD’s sails.

Events and data this week are unlikely to alter the dynamics noted above. US data will remain upbeat, with housing market data remaining positive; existing home sales will edge higher while new home sales will drop but largely due to low inventories, while durable goods orders will register solid gains, and Michigan consumer confidence will be revised higher.

Data in Europe will look less impressive but still encouraging as the German IFO and various purchasing managers’ indices record gains, albeit of an uneven nature. More distressing is the ongoing political travails in Spain, Portugal and Italy, factors that will likely continue to undermine Eurozone markets although EUR/USD will likely remain supported due to the recent softening in US yields.

In Japan, the political picture is now clearer, with an unsurprisingly solid election victory for Prime Minister Abe’s LDP, winning a majority in the Upper House with its partner New Komeito. Ultimately this should play for firmer Japanese assets and a weaker JPY although markets will now look for a clear reform strategy to justify such moves.

USD under pressure, except versus JPY

Following another positive week for risk assets where equities in particular benefitted from substantial capital inflows this week is unlikely to look much different. A host of earnings, especially from financials will help dictate the equity market and in turn risk tone over coming days. There will also be plenty of focus on speeches by various Fed and European Central Bank (ECB) officials including Fed Chairman Bernanke today.

The week will start off in more subdued fashion however, with a Japanese holiday and little fresh news to digest over the weekend. Hope and faith in global economic recovery helped by data releases in the US and China in particular, have helped to calm markets while there is little angst as yet about the looming debt ceiling / spending cut negotiations in the US.

Despite the rush into equities, core bond yields appear to have hit a short term ceiling. Meanwhile, the USD is likely to maintain a weaker tone over the short term except versus JPY where the currency pair has broken through key technical barriers on the top side and is verging on a break of 90.00 helped by more comments over the weekend by Japanese Prime Minister Abe pushing for a 2% inflation target to be implemented.

Data releases this week will maintain the growth recovery story in the US while the Eurozone will continue to show a weaker trajectory. In the US there are plenty of releases to chew on including December retail sales, inflation, industrial production, manufacturing surveys, housing starts, Michigan confidence, and the Fed’s Beige Book. Overall, US releases will help paint a picture of steady and gradual recovery.

In contrast the Eurozone data slate is more limited and what there is (German GDP, Eurozone industrial production) will be less impressive supporting the view of Eurozone economic underperformance over coming months. Admittedly this has yet to affect the EUR which continue to benefit from peripheral bond yield compression and receding crisis fears although EUR/USD will likely run into resistance around 1.3385 which if broken will open the door for a test of 1.3486.

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