Interim Correction: Short & Deep or Long & Shallow?     

• Essentially all risk trades, i.e., equities, commodities, high yield currencies and lower quality bonds, have entered an interim correction. We believe this correction marks a shift from market prices being driven by excess liquidity “steroids” to more sustainable economic and corporate profit “fundamentals”.  The question is, will this correction be short and deep or long and shallow?
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  The two markets to watch for this deep or shallow debate are the Shanghai market and the USD index.
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  Since China was the first to respond to the global crisis with substantial stimulus and since their economy seems to have recovered first, China is now the first test of the success of government strategies to exit from extraordinary monetary and fiscal stimulus. The yellow card is that the Shanghai market is now right at its 200-day MA, or its long-term recovery trend line. Among the BRICs, it appears that India may be next, as the central bank moves to put a lid on inflationary pressure.
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  On the other hand, the USD is breaking up through its 200-day moving average. The USD move is probably more than mere risk-avoidance knee-jerk. As the US economy continues to recover, the Fed will also make its move to implement its exit strategy, the first stage being the halting of mortgage-backed securities purchases at the end of March. The question here is, when does USD begin to de-link from the risk avoidance trade?
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  For the Japanese market, the question is, when do the divergent monetary policy stages of the Fed and BOJ begin to weaken JPY? Market expectations are that the Fed may not move in 2010 on rates, whereas we are keying more on the relative growth of high-powered money in the US versus Japan.  As the BOJ is likely to continue disappointing currency traders regarding the use of its balance sheet, the trigger is more likely to be the Fed.
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  We are still basically “buy cyclical Japan and secular growth emerging” investors, but without a move back to JPY100/USD or weaker, Japan’s market is likely to be just as susceptible to the interim correction, although downside risk is more limited because, a) the Nikkei 225 has severely lagged the recovery in other markets, and b) Japan has now become the flavor of the week for global investors.

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