The momentum behind the western European economic recovery and the US economy are taking a heavy toll on emerging economies and currencies. The trend is most visible in the rise of the blue-chip Euro STOXX Index, which has gained 9 points this year and in the remarkable strength of US equities. Similarly, the MSCI Index of equities from emerging powerhouses Russia, India, China and Brazil has slid 13 points in 2013.

The euro continued its recent stable trend after good data from Germany boosted the currency. With a more stable euro and renewed whispers about the tapering of the US Federal Reserve’s sustained buying spree, investors have shifted their attention to the more stable currencies. With improved yields in US Treasuries, emerging economies are seeing larger than expected outflows.

Perhaps the most encouraging news from Europe is the resurgence of private sector enterprises. Data from this sector showed growth in July for the first time in the last 18 months. At the same time, private industry growth around the world dipped by 13 percent.

However, the effect of the Federal Reserve’s tapering initiative is driving the world currency markets. Projections show that currencies in Turkey, Brazil, Russia, India and South Africa will decline between 7 and 14 percent in 2013. Meanwhile, the yen has lost more ground to the euro and continues to fluctuate wildly against the dollar.

The European Central Bank has indicated the region must remain focused on unemployment and private sector job development. However, economists feel that the front-loaded austerity measures enacted two and three years ago are easing. The hope is that credit markets will ease and that private businesses will pursue growth more aggressively.

Tapering Is Coming

Markets appear to have adjusted to the reality that tapering is on the horizon. The dollar continues to gain relative strength and the benchmark ten-year Treasury is gaining favor with international investors. Speculation that tapering could begin as early as October was fueled by remarks from two separate governor’s of the Federal reserve on Tuesday. The strength of US corporations supports tapering and Chairman Bernanke would like to see the reduction plan underway when he leaves office.

At the same time, the Bank of England’s (BoE) new head, Mark Carney, has announced steps to boost British sterling and to encourage job growth, clearly a top priority. Encouraging economic data indicates that the UK has climbed out of recession and is recovering. Carney has said the BOE will leave interest rates at 0.5 percent until the unemployment rate dips to 7 percent. Experts feel that will require about 3 years.

UK manufacturing has finally ended three years of dismal reports with some encouraging data. Consumer confidence is rebounding and the strained financial system appears stable. In overnight trading, sterling reached its highest point since June 21^st at $1.5493 before settling at $1.5446, a 7 percent gain.

In Japan, the Nikkei Index shed 4 percent as the yen gained strength against the dollar. The USD struck a 45-day low at 96.76 yen. The yen’s strength reflects pullbacks from riskier economies in Asia and in returns on the country’s massive investments in the US.

As an anxious world awaits President Obama’s State of The Union address, a bitter game of cat and mouse seems to be circulating global currency markets. At the center of the controversy is Japan’s yen causing the Group of Seven nations to call for cessation of devaluing of currencies to gain trade advantages.

Of late, currency markets have been volatile. As the USD has given ground to the euro, the euro has also soared against the yen. The euro has gained 24 percent against the yen in just three months. China has long been accused of manipulating its currency and international tensions are high.

Mario Draghi of the ECB spoke on Tuesday saying that exchange rates are equally important for growth and stability. Japan has implemented a large quantitative easing initiative that has lowered the US policy of continuing assistance from the Federal Reserve have kept the two currencies at low levels.

The US has made headway in its trade balance in the past two months with December closing the imbalance to its lowest level since the mid 1990’s. China also rode a strong export balance to its main buyers the US and Europe to a big spike in its January GDP.

Draghi said that he believes Spain is “on the right track” towards economic recovery. Meanwhile, Italy captured a significant windfall from its 2012 property tax enforcement. Italy collected 23.7 billion euros in property taxes, surpassing Treasury’s estimate by 1.2 billion euros.

It is expected that the windfall will be used to reduce the nation’s budget deficit below 3 percent of 2012 GDP. The target was 2.6 percent but analysts think that bar will not be achieved even with the windfall. The 2012 annual review will be published on march 1, 2013.

The US, Britain, France, Germany, Japan, Canada and Italy, the member nations of the G-7, was called to consider Tokyo’s expansive monetary policy. Reuters quoted a spokesperson for the G-7 as saying; “The G7 statement signaled concern about excess moves in the yen. The G7 is concerned about unilateral guidance on the yen. Japan will be in the spotlight at the G20 in Moscow this weekend.”

The G20 finance ministers are scheduled to convene in Moscow this weekend. It is a full plate this time around and currency valuations will be at the fore.

Britain heads the G-8 which includes the G-7 nations and Russia and released a statement saying that as far as Britain’s easing and restructuring: “We reaffirm that our fiscal and monetary policies have been and will remain oriented towards meeting our respective domestic objectives using domestic instruments, and that we will not target exchange rates.” This is the intent of easing to assist national economies meet oppressive challenges.

Japan’s Finance Minister, Taro Aso, insists that the country’s policy is aimed at reviving the stagnant economy. It is unclear what leverage the G-20 has to stabilize the disparities.

Japan gained support for the US when Treasury official Lael Brainard told the media that the US recognized Tokyo as easing efforts as a remedy for the lackluster economy with massive unemployment.

Regarding the euro, France has been most vocal about setting a large for the currency that does not yield a competitive edge. Many euro members have concerns about the exchange rate but Germany lowered the anchor on such speculation. Finance minister Wolfgang Schaeuble said, “There’s no foreign exchange problem in Europe. There are concerns that there could be something like this in other parts of the world.”

Since December 2012, the euro has climbed 10 cents against the USD. This is the effect of the ECB tightening its balance sheet while Japan and the US continue to expand their easing programs.

Analysts hope that the President’s State of the Union will pave the way for a political compromise to reduce the deficit in reasonable terms and engage the public sector in a powerful growth initiative.

On Thursday, Chairman Ben Bernanke of the Federal Reserve announced the Fed’s much awaited easing stimulus program.  Under this program, the Federal Reserve will pump $40 billion into the US economy each month until the depressed job market turns significantly downward.  Bernanke’s decision came under fire from Republicans but was praised by Democrats.

Republican members of congress immediately denounced the stimulus, calling it a political maneuver to support President Obama.  This morning, CNBC analysts quickly reminded congressional members that it was congress that added the unemployment to Federal Reserve’s responsibilities.

The new initiative sparked a strong rally for all U.S.  equity markets as did most international equity markets.  In his announcement, Bernanke said the fed would increase its purchasing policy for mortgage-backed securities.  The goal is to encourage activity in the troubled housing sector, which Bernanke prescribed as the “missing piston in the economic recovery.”

In the question and answer session following the announcement, Chairman Bernanke fended off accusations of political favoritism calling the initiative nothing more than a direct effort to improve the employment marketplace.  “While the economy appears to be on a path of moderate recovery, it isn’t growing fast enough to make significant progress reducing the unemployment rate.”

QE3 is designed to reduce mortgage rates, thus boost the housing market and encourage investors in mortgage-backed securities to invest in other assets, like corporate bonds.  Lowering the yield of corporate bonds is expected to encourage more aggressive lending which will lead to faster and stronger economic growth and cut une3mployment. On the surface, the theory is practical but the Fed and the Treasury has been fooled before.   US GDP fell below the projected 2.0 percent annual rate in the second quarter, settling at 1.7 percent annual rate.

However, August provided the Federal Reserve all the data needed to approve QE3.  Only 96,000 jobs were created in the month.  The unemployment rate did fall to 8.1 percent, but analysts believe the improvement was due to more Americans losing their benefits or giving up looking for work.

US businesses have been slow to hire.  Despite strong balance sheets, businesses have kept a nervous eye on the European debt crisis and another eye on what is called the US fiscal cliff, which consists of scheduled tax increases combined with deeper government spending cuts.  Many analysts believe this formula will set the recovery back and may create a perfect economic storm.

Bernanke’s language was forceful and direct.  The Chairman made it clear that if the labor market does not improve substantially The Fed will not only continue these purchases of mortgage-backed securities but will also expand the range of asset purchases and deploy all tools at its disposal until unemployment does improve. Some analysts projected that the Federal reserve could conceivably buy more than $ 1 trillion dollars in new debt before the unemployment rate improves.

Becky Quick of CNBC struggled to explain the Fed’s position. She explained that this initiative favored high income taxpayers because these individuals profit when the equity markets rise.  At the same time, low income people suffer as the cost of goods increases as the dollar weakens.  Ms. Quick commented that there is a form of trickle-down economics.  The Fed appears to be helping the rich at the expense of Main Street.  Ms. Quick thought it ironic that Republicans criticized this initiative, while Democrats supported Bernanke’s position.

The Dow Jones industrial average hit its highest level since December of 2007.  Gold hit a six month high as oil topped the $100 per barrel milestone. The Federal Reserve is continuing its Operation Twist program which calls for the Feed to sell short-term bonds for the purpose of purchasing longer-term debt.

The Fed projects the unemployment rate will range between 6.7% and 7.3% into 2014. Only one Federal Reserve Bank President, Jeffrey Lacker of the Richmond Federal Reserve Bank, dissented against QE3.

Asked to quantify the Federal Reserve goals one analyst referred to the position held by Chicago Federal Reserve President, Charles Evans. The Chicago Fed President has advocated a benchmark at 7.0% for unemployment and an inflation benchmark of 3.0%. Currently, unemployment is 8.1% and inflation is below 2.0%, comfortably below the 3.0 benchmark.

If Governor Romney is elected president and the Republicans control Congress, Chairman Bernanke term will not be renewed. Throughout the recession and the recovery, Bernanke has distanced himself from the political rhetoric.  In fact, the Federal Reserve remains apolitical. Bernanke’s actions are bold but necessary. Here’s hoping he got it right.

Pound sterling gains were halted in the overnight following the release of the Markit/CIPS UK construction PMI survey.  Although still relatively positive, survey results were worse than had been anticipated by analysts, leaving some still skeptical of any short term UK economic recovery.  As a result, the British pound traded slightly lower to yesterday’s high at 1.5841 against the US dollar.  The exchange rate hit as high as 1.5869 in midday trading yesterday.

According to the construction sector survey, index readings dipped to a 51.4 in January – below the December 53.2 mark.  Although this is the 13th consecutive month of gains, the figure stands as the weakest reading in 4 months and compounds fears that the recession isn’t just over yet.  Notably, however, today’s survey findings still portend to a thin silver lining for Europe’s second largest economy.  According to subcomponent readings, confidence among construction companies and business leaders continues to be optimistic – although the same companies are unlikely to add to current payrolls.

The recent round of optimism seems to have been spurred on by improving month to month comparisons in recent weeks.  Notably, manufacturing sector activity improved to an 8-month high, while confidence among consumers recovered to the highest in almost the same time period.

Given the overwhelming and rising optimistic sentiment, today’s results may be temporary as traders begin to shift their sentiment to a potential turnaround in the UK economy.  This should support the current sterling momentum – if at least for another session or two.

While I have written quite about forex correlations in recent posts, the focus has primarily been on correlations that exist between currencies. In this post, I would like to address a correlation that exists between currencies and other forex markets- specifically the relationship between the Euro and US stocks.

If you look at the chart above, you can see that an unmistakable correlation exists between the S&P500 and the EUR/USD that stretches back at least six months. Generally speaking, when the EURUSD has risen, so has the S&P 500, and vice versa. In fact, this correlation is so airtight that one analyst recently discovered that the two financial vehicles often reach intra-day highs and lows within minutes of one another!

Why is this the case? In a nutshell, it is because the Euro – especially relative to the dollar – is a proxy for risk appetite. The same is necessarily true for US stocks. When investors are confident in the strength of the global economic recovery and the possibility of crisis is distant, the euro will rise. This has nothing to do with fundamentals in Europe, which are probably at least as bad as they are in the US. Of course, it may be connected with dollar weakness, since it is arguably the case that quantitative easing has both depressed the dollar and buoyed US stocks.

As I intimated in the title of this post, however, the S&P recently decoupled from the euro. Since the beginning of June, US equities have declined sharply, to the extent that they have given back most of their gains in the year-to-date. The EUR/USD, meanwhile, continued rising all the way until last week. While this has happened on a couple previous occasions, this was perhaps the sharpest break between the two.

I’m personally at a loss to explain why this happened. It has been conjectured that the driving force behind the correlation is algorithmic trading, and that hence, it must also represent the source of the break. In other words, high-frequency traders – which account for an ever-increasing proportion of forex volume – tweaked their trading algorithms so as not to buy the S&P 500 when the EURUSD rises, and vice versa.

It’s probably also the case that S&P 500 was falling for endogenous reasons- specifically a decline in GDP growth and earnings expectations which need not necessarily reflect itself in a stronger euro. In fact, in a normal functioning market, you would expect an inverse correlation; strong US economic fundamentals should translate into both a strong dollar and rising stocks. Could it be that worsening fundamentals are manifesting themselves in the form of a weak dollar and weak stocks?

Alas, the correlation has re-established itself over the last week, which means this is largely a moot issue. At the very least, it’s still worth being aware of, both insofar as it remains intact and in the event that it breaks down again.

On the heels of a disappointing S&P Case-Shiller real estate report, a disturbing Consumer Confidence Index report, reductions in manufacturing and a troubling ADP projection about jobs, equity markets fell sharply in Wednesday trading.  Adding a bounce in the euro to the formula and the dollar fell sharply against the euro and the yen as the U.S. economic recovery appears stalled.

Economists pointed to the disaster in Japan and the series of tornados that have ravaged the U.S. as reasons for the slowdown.  Many analysts cite the failure of Washington to agree on a plan to increase the debt ceiling, the government’s inability to structure a realistic plan to lower national debt and the rise in oil and food prices as factors that directly impact consumer confidence.  The dollar and the country struggle under the weight of these stale problems.

Only the retail sales report has continued to grow and shares of Macy’s held steady on a day when the equity market struggled to hold value.  Bank stocks were hit the hardest.  JP Morgan was off 3 percent, US Bancorp fell 2.7 percent and the KBW bank index dropped 3 percent.

On top of the Case-Shiller real estate report that had property values back to 2002 levels, ADP released their report that shows that only 38,000 jobs were added in May.  This marks the lowest private sector jobs report since September 2010.

The Institute of Supply Management’s index of national factory activity dropped to 53.5 from 60.4 in April.  The May rate is the lowest since September 2009.  Analysts pointed out that the factory activity is still above 50.00 and is consistent with growth in manufacturing.

The Euro Surges

The euro hit a four-week high against the dollar.  Prompted by Germany’s commitment to allow Greece to restructure some of their debt and the apparent influx of new funds to boost the sagging economy.  The fate of new money for Greece is now in the hands of the EU/IMF who handle distributions from the 110 billion euro bailout fund.  Greece stands to receive 12 billion euros in new funds.

The euro rose more than 3 percent from a two-month low against the dollar.  Driving the rise was Greece’s agreement to privatize assets in order to secure new funds issued by the IMF.  The country continues with its austerity measures but this ma6y be one example of the European Union kicking the can down the road.

The euro stood at 1.4448 against the dollar.  Projections suggest the by year’s end the euro will be at 1.47 against the dollar. For the year, the euro is up 7 percent agaoins5t the dollar.  The dollar was trading at 80.84 against the yen.

The Federal Reserve

These negative reports hit the Fed at the worst time.  The Chairman of the Federal Reserve has stated that quantitative Easing in its QE2 program is about wind down its investments in troubled assets.  There is mention of a new QE3 program but the political backlash may prevent an injection of more money. 

These troubling reports increase fears of a double dip in the overall economy.  Peter Kenney, a Managing Director of Knight Capital in Jersey City, said, “Honestly I do not think the Street is shocked.  It fits very neatly in with the puzzle we are putting together that speaks to another soft patch and really, a genuinely failed stimulus approach to grow the economy.  And, it’s not just about jobs.  It’s about manufacturing, it’s about real estate, it’s about consumer confidence.  This is one data point in a very broad picture and it is not encouraging.” 

Well over two years have passed since the collapse of Lehman Brothers and the accompanying climax of the credit crisis. Most economies have emerged from recession, stocks have recovered, credit markets are strong, and commodities prices are well on their way to new record highs. And yet, even the most cursory scanning of headlines reveals that all is not well in forex markets. Hardly a week goes by without a report of “risk averse” investors flocking to “safe haven” currencies.

As you can see from the chart below, forex volatility has risen steadily since the Japanese earthquake/tsunami in March. Ignoring the spike of the day (clearly visible in the chart), volatility is nearing a 2011 high.What’s driving this trend? Bank of America Merrill Lynch calls it the “known unknown.” In a word: uncertainty. Fiscal pressures are mounting across the G7. The Eurozone’s woes are certainly the most pressing, but that doesn’t mean the debt situation in the US, UK, and Japan are any less serious. There is also general economic uncertainty, over whether economic recovery can be sustained, or whether it will flag in the absence of government or monetary stimulus. Speaking of which, investors are struggling to get a grip on how the end of quantitative easing will impact exchange rates, and when and to what extent central banks will have to raise interest rates. Commodity prices and too much cash in the system are driving price inflation, and it’s unclear how long the Fed, ECB, etc. will continue to play chicken with monetary policy.

Every time doubt is cast into the system – whether from a natural disaster, monetary press release, surprise economic indicator, ratings downgrade – investors have been quick to flock back into so-called safe haven currencies, showing that appearances aside, they are still relatively on edge. Even the flipside of this phenomenon – risk appetite – is really just another manifestation of risk aversion. In other words, if traders weren’t still so nervous about the prospect of another crisis, they would have no reasons to constantly tweak their risk exposure and reevaluate their appetite for risk.

Over the last few weeks, the US dollar has been reborn as a preeminent safe haven currency, having previously surrendered that role to the Swiss Franc and Japanese Yen. Both of these currencies have already touched record highs against the dollar in 2011. For all of the concern over quantitative easing and runaway inflation and low interest rates and surging national debt and economic stagnation and high unemployment (and the list certainly goes on…), the dollar is still the go-to currency in times of serious risk aversion. Its capital markets are still the deepest and broadest, and the indestructible Treasury security is still the world’s most secure and liquid investment asset. When the Fed ceases its purchases of Treasuries (in June), US long-term rates should rise, further entrenching the dollar’s safe haven status. In fact, the size of US capital markets is a double-edge sword; since the US is able to absorb many times as much risk-averse capital as Japan (and especially Switzerland, sudden jumps in the dollar due to risk aversion will always be understated compared to the franc and yen.

On the other side of this equation stands virtually every other currency: commodity currencies, emerging market currencies, and the British pound and euro. When safe haven currencies go up (because of risk aversion), other currencies will typically fall, though some currencies will certainly be impacted more than others. The highest-yielding currencies, for example, are typically bought on that basis, and not necessarily for fundamental reasons. (The Australian Dollar and Brazilian Real are somewhere in between, featuring good fundamentals and high short-term interest rates). As volatility is the sworn enemy of the carry trade, these currencies are usually the first to fall when the markets are gripped by a bout of risk aversion.

Of course, it’s nearly impossible to anticipate ebbs and flows in risk appetite. Still, just being aware how these fluctuations will manifest themselves in forex markets means that you will be a step ahead when they take place.

As you can see from the chart below, the world’s foreign exchange reserves (held by central banks) have undergone a veritable explosion over the last decade. While emerging markets (especially China!) have accounted for the majority of this growth, there are indications that this could soon change. China’s reserve accumulation is set to slow, while advanced economies’ reserves are set to increase.

In the past, central banks from advanced economies have accumulated reserves only sparingly, and in fact, much of this growth can be claimed by Japan. This is no mystery. While held by emerging economy central banks, most of the reserves are denominated in advanced economy currencies. This has ensured a plentiful supply of cheap capital, to support both economic expansion and perennial current account deficits (namely in the US!). In addition, advanced economy central bankers tend to hew towards economic orthodoxy, which precludes them from intervening in forex markets, and obviates the need to accumulate forex reserves. Emerging economies, on the other hand, depend principally on exports to drive growth. As a result, many are driven towards holding down their currencies in order to maintain competitiveness. China has taken this to an extreme, by exercising rigid control over the value of the Yuan, and necessitating the accumulation of $3 trillion in foreign exchange reserves.

This trend accelerated in 2010 with the inception of the so-called currency wars (which have not yet abated). Competing primarily with each other, emerging economies bought vast sums of foreign currency in order to promote economic recovery. Many countries from South America and Asia which don’t normally intervene were also drawn in. The result was a tremendous accumulation of foreign exchange reserves, which is reflected in the chart above.

There is already evidence that this phenomenon is starting to reverse itself. Consider first that advanced economies have participated in the currency wars as well. Japan’s reserves have swelled to more than $1.1 Trillion. Switzerland spent $200 Billion defending the Franc, and South Korea has spent more than $300 Billion over the last five years trying to hold down the Won. The Bank of England (BOE) recently announced plans to rebuild its reserves (the majority of which were redeployed towards gilt purchases). The European Central Bank (ECB) has announced similar plans, and may be joined by the Bank of Canada and US Federal Reserve Bank.

Advanced economies need currency reserves for a couple reasons. First of all, they can no longer rely on monetary easing to reduce their exchange rates because of the inflationary side-effects. Second, the recent coordinated intervention on Japan’s behalf showed that the G7 will move to protect its members when need be. Finally, political forces are compelling advanced economies to slow the outflow of jobs and production, and this requires more competitive exchange rates.

Emerging economies, meanwhile, are starting to recognize that unchecked reserve accumulation is neither sustainable nor desirable. First of all, managing those reserves can be tricky. Intervention is not free, and exchange rate and investment losses must be accounted for somewhere. Second, continued intervention has several detrimental byproducts, namely inflation and the handicapping of domestic industry. Finally, emerging economy currency appreciation is inevitable. Constant intervention merely forestalls the inevitable and invites unending speculation and inflows of hot-money.

There are a few of ways that currency investors can position themselves for this change. As emerging market economies stop the accumulation of (or worse, sell off) their reserves, a major source of demand for advanced economy currency will be curtailed. This will accelerate the broad-based appreciation of emerging market currencies against their advanced economy counterparts. At the same time, I’m not sure how much reshuffling we will say in the composition of reserves. The euro is plagued by existential uncertainty, while the yen and pound have serious fiscal problems. In the short-term, the Chinese Yuan is prevented by several factors from becoming a legitimate reserve currency, namely that it is too difficult to obtain. (As soon as this changes, you can bet that emerging economy central banks will begin accumulating it. After all, they are competing with China – not with the US). The dollar is certainly also an “ugly” currency, but given the size of the US economy, the depth of its capital markets, and the liquidity with which the dollar can be traded, it will remain the go-to choice for the immediate future.

In the short-term, traders that wish to short advanced economy currencies (namely the Japanese yen) can do so in the secure knowledge that they are backstopped by the G7 central banks. It’s like you have an automatic put option that limits downside losses. If the Yen falls, you win! If the yen rises, the BOJ & G7 should step in, and at least you won’t lose!

After a meeting between key Republicans and Democrats at the White House fell apart, President Obama alerted various federal government agencies to prepare for a shutdown effective Friday.  The shutdown will be caused by the failure of Republicans and Democrats to reach an agreement on the long overdue 2011 budget.  The budget has six months remaining.  

The Obama Administration warns that a shutdown would be a monumental setback to the country’s economic recovery, an event that the world is watching with interest.  The consequences of such action would cause massive delays and disruptions to taxpayers and businesses as well as thousands upon thousands of unemployed federal workers.

Political posturing makes the rigid Republicans look like they do not care about the operation of the federal government or the consequences of a shutdown. 

The possible shutdown reflects the widening and bitter differences between Democrats and Republicans.  All the while, there seem deeper than usual differences within the Republican party.  Traditional conservative Republicans, like Speaker Boehner, are being confronted by the ultra-conservative Tea Party Republicans, many of whom were elected on a promise of change. 

The quest for fiscal change has met reality squarely and the federal government is the hostage. 

In December, Republicans held the Administration hostage over a proposed extension of the Bush Tax Cuts, which the Administration did not favor.  At that time, Republicans would not agree to the extension of unemployment benefits for millions of Americans unless the  Bush Tax Cuts were extended.

Should Boehner Step Aside?

The House of Representatives Majority Speaker, John Boehner, discussed the failure of the two parties to reach an agreement and disputed the Administration’s report that he had originally agreed to cuts totaling $33 billion.  The Speaker said deeper cuts were necessary.   

President Obama has agreed to $33 billion in cuts, the largest budget reduction on record.  The President is frustrated that most federal government operations will cease if the two sides do not come to an agreement and that Boehner has now upped the ante.

Of  late, Boehner has adopted a more stringent line of rhetoric that indicates the United States does not have a revenue problem, but does have a spending problem.  This is a popular line from Tea Party advocates.  Not coincidentally, the Republican cuts virtually go after every Obama initiative including the President’s health care program. 

At this time, Boehner’s position is difficult to defend because the politicians are arguing about a budget that has been in place for six months and the Democrats have met the reported $33 billion number originally offered by the Speaker.  What now exists is a disagreement over an acceptable amount to be trimmed from the 2011 budget and where the cuts must be applied.  There is six months to put an acceptable 2012 budget in place.  

Michele Bachmann, a possible Tea Party candidate for President, has said her goal is to deny Obama a second term.  This popular Tea Party theme appears a driving force in the Republican Party.  The Tea Party is a powerful block within the Republican Party and is a block that Boehner apparently cannot control.

With wars in Afghanistan and a presence in Iraq and the new action in Libya, a shutdown of the federal government hardly seems appropriate.  Boehner needs to tearfully step aside as Speaker of the House or take control of his Party.  Either way, it is time for the Speaker to man-up.   

To untangle the gridlock between ideology and politics, it is time for compromise. 

The Differences

Most taxpayers agree that deep cuts are necessary, but believe these issues are best discussed and debated in the upcoming October budget for 2012.  A budget proposal program from the Chairman of the House Budget Committee Paul Ryan was unveiled today.  This will certainly set the stage for great debate before October.

The Ryan proposal has incorporated some components of the Bowles-Simpson report issued in late 2010.  Ryan’s budget would trim the deficit by $4 Trillion over the next decade and balance the budget in twenty years.

However, the issue at hand is 2011 budget cuts and the operation of government.  Many Republicans are using the term “government slowdown” to describe what will actually happen on Friday.  Tea Party activists have no problem with the “slowdown.”

The budget tussle is focused on the 14 percent that Congress approves for domestic projects each year.  Republicans want to address the discretionary spending set by Congress because it would establish a lower baseline for the future.

These are the Republican demands. 

• Deeper cuts than the $33 billion approved by Democrats. 
• Many of the cuts would target many of the Obama Initiatives. 
• The Republican plan would increase defense spending by about $8 billion.

What no body wants to talk about is referred to as the Big Three; Social Security, the Medicare health plan for retirees, and Medicaid for the poor.  Ryan’s plan and the Bowles-Simpson report do address these issues.  Although Ryan indicated there would be no changes for people receiving benefits now, Americans should expect changes to begin in the next fiscal year.

In Washington, change is the word.  Perhaps politicians need to put Compromise back in their political dictionaries.  The American debt problem is deep and aggravating.  But, as every businessman knows, sometimes you have to give a little to start the ball rolling.  The time is now and the eyes of the world are on Washington.

Forex traders have very suddenly tilted their collective focus towards interest rate differentials. Given that the Dollar is once again in a state of free fall, it seems the consensus is that the Fed will be the last among the majors to hike rates. As I’ll explain below, however, there are a number of reasons why this might not be the case.

First of all, the economic recovery is gathering momentum. According to a Bloomberg News poll, “The US economy is forecast to expand at a 3.4 percent rate this quarter and 3.3 percent rate in the second quarter.” More importantly, the unemployment rate has finally begun to tick down, and recently touched an 18-month low. While it’s not clear whether this represents a bona fide increase in employment or merely job-hunting fatigue among the unemployed, it nonetheless will directly feed into the Fed’s decision-making process.

In fact, the Fed made such an observation in its March 15 FOMC monetary policy statement, though it prefaced this with a warning about the weak housing market. Similarly, it noted that a stronger economy combined with rising commodity prices could feed into inflation, but this too, it tempered with the dovish remark that “measures of underlying inflation continue to be somewhat low.” As such, it warned of “exceptionally low levels for the federal funds rate for an extended period.”

To be sure, interest rate futures reflect a 0% likelihood of any rate hikes in the next 6 months. In fact, there is a 33% chance that the Fed will hike before the end of the year, and only a 75% chance of a 25 basis point rise in January of 2012. On the other hand, some of the Fed Governors are starting to take more hawkish positions in the media about the prospect of rate hikes: “Minneapolis Federal Reserve President Narayana Kocherlakota said rates should rise by up to 75 basis points by year-end if core inflation and economic growth picked up as he expected.” Given that he is a voting member of the FOMC, this should not be written off as idle talk.

Meanwhile, Saint Louis Fed President James Bullard has urged the Fed to end its QE2 program, and he isn’t alone. “Philadelphia Fed President Charles Plosner and Richmond Fed President Jeffrey Lacker have also urged a review of the purchases in light of a strengthening economy and concern over future inflation.” While the FOMC voted in March to “maintain its existing policy of reinvesting principal payments from its securities holdings and…purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011,” it has yet to reiterate this position in light of these recent comments to the contrary, and investors have taken notice.

Assumptions will probably be revised further following tomorrow’s release of the minutes from the March meeting, though investors will probably have to wait until April 27 for any substantive developments. The FOMC statement from that meeting will be scrutinized closely for any subtle tweaks in wording.

Ultimately, the take-away from all of this is that this record period of easy money will soon come to an end. Whether this year or the next, the Fed is finally going to put some monetary muscle behind the Dollar.