-Kathleen Brooks is research director at forex.com. The opinions expressed are her own.-

Looking through the minutes of the Bank of England’s policy meetings for the past year, there are a couple of patterns that you see emerge. Firstly, that rates are on hold, and secondly, that the UK’s elevated inflation rate is temporary. Now the European Central Bank has joined the chorus. ECB President Trichet recently sounded confident that prices will moderate, even though consumer prices rose above the ECB’s target rate of 2 per cent in December.

But how long will citizens of Europe and the UK accept rising prices and how long can central bankers continue to stand by while inflation smashes their target rates? To answer this we need to find out two things: firstly, is this rise in inflation really that bad? Secondly, why are central bankers willing to let inflation pass them by without exercising monetary control?

Inflation is a tricky thing to get right. A little is good since it helps growth, but not enough is bad as it can stunt an economy and leave it in a deflationary spiral. There is also another benefit to inflation: it helps to erode debt levels in real terms. When many developed economies are struggling with unsustainable debt loads, a little inflation helps to lower the size of the mountain.

But prices are rising at a 3.3 per cent annualised rate in the UK. While the Bank of England rightly points out that this is due to commodity prices, but its assertion that inflation will prove temporary has been incorrect for more than a year.

Commodity super-cycle:

We are in a super-cycle for commodities. Burgeoning demand for food and raw materials from the fast-growing emerging world is set to dominate demand for commodities for the next few years, possibly even for the next generation. This means that people in the west who were used to low prices for most of the last decade will have to get used to coughing up at the supermarket and at the petrol pump for a while yet.

-Kathleen Brooks is research director at forex.com. The opinions expressed are her own.-

Back in the summer, things in the U.S. were so dire that the Fed had to step in to the breach and boost the economy with a $600 billion cash injection. This was only formally announced in November, yet within two months the outlook for the U.S. economy has brightened markedly. The dollar has had a flying start to the year and appreciated more than 2 per cent against the other major currencies.

But is this reversal in fortunes too good to be true and can the huge juggernaut of the U.S. economy really turn around this quickly?

The chief reason for the boost in investor sentiment, particularly towards the dollar, is the uptick in some of the major U.S. economic indicators. The widely watched ISM surveys have jumped in recent months and there are positive signs that the recovery that was noticeable in the manufacturing sector of the U.S. economy is now spreading to the much larger services sector. Investment houses rushed to revise higher their growth forecasts at the end of last year after President Obama agreed to a two-year extension of the Bush tax cuts. All of a sudden the U.S. economy was hitting the headlines again for all of the right reasons, and after giving the dollar a wide berth for most of the second half of 2010 investors are once again happy to own the greenback.

The U.S.’s economic outlook is even brighter when it is compared to its western counterparts. The euro zone and the UK face a year of tax hikes and austerity measures designed to reign in budget deficits, which should keep a lid on growth. Already at the start of the year we have seen the UK services sector slip back into contraction and Europe’s core economies are leaving the weaker peripheral nations in their wake when it comes to the growth stakes. In the last months of 2010 investors were willing to support the euro on the back of a bright outlook for the core economies, but not so in 2011 – the motto seems to have changed for investors to one of “the euro zone is only as strong as its weakest members”, which at the moment means it is extremely weak. So part of the dollar’s attraction is relative: at the moment its future is brighter than its neighbours’.

But, the U.S. is far from out of the woods itself and investors could be accused of lowering their standards. Jobs growth is mediocre at best and it will take many more months of 100,000 per month job creation to bring down the unemployment rate to a level more acceptable to the Federal Reserve. This doesn’t suggest the U.S. is in rude health. Due to these headwinds, we don’t think that the U.S. growth path will follow a straight line. But if we get another economic hiatus like the one last summer, will the Fed be able to provide another round of quantitative easing? Probably not that easily.

So while the near-term outlook for the U.S. economy is one of gathering momentum lending support to the dollar, the very policy measures that are supporting growth now will hurt it later. Quantitative easing and the extension of the Bush tax cuts are only exacerbating the U.S.’s unfathomably large debt mountain – at last count it stood at $14 trillion. The U.S. needs to sort out its debt problems at both a federal and state level (California has a budget gap this year of more than $20 billion). This means a lower dollar for the long term and higher inflation to try and erode the debt load.

– Kathleen Brooks is research director at forex.com. The opinions expressed are her own. –

Ever since the U.S. Central Bank formally announced its second round of quantitative easing back in November, bond yields have trended higher. Ten-year Treasury yields have jumped by 100 basis points and are back at levels last reached in May 2010. Higher yields underpinned the dollar, which has risen by more than 5 percent over the same time period. So what does this tell us about the market, and has the Fed’s grand plan actually backfired?

Those in the ‘yes’ camp argue that quantitative easing was designed to help the most interest rate-sensitive sectors in the U.S. economy such as the housing market. However, the housing market in the U.S. remains depressed and rising Treasury yields are pushing up long-term mortgage rates, which on average rose to 4.86 percent in the week ending 10 December up from 4.66 percent the week before.

Rising borrowing costs are unlikely to attract buyers to purchase homes especially when house prices continue to fall. Without a convincing recovery in the housing market they argue, it is difficult to see how consumption and  growth can pick up to levels that will ward off deflation and help push the unemployment rate lower.

So what about those who believe the Fed did the right thing and QE2 is working? They say that QE2 will work with a lag and so-far-so good. Since Fed Chairman Bernanke first touted the idea of more QE back in August he has helped to re-flate the global economy after the financial crisis threatened to cause the worst depression since the 1930s.

While inflation isn’t showing up in consumer prices (core inflation in the U.S. remains a fairly meagre 0.8 percent) it is very much alive in the stock markets and in commodities fuelled by Fed-generated liquidity. Global stock markets have reached pre-Lehman Brothers highs and commodity prices are also reaching record levels; for example, oil is back above $90 per barrel.

This signals that investors are willing to take on more risk, and a risk-on environment is always inflationary. In contrast, a risk-off environment is deflationary as it signals weak growth. The key to sustaining the U.S. recovery is inflation. Thus QE2 was necessary to promote inflationary forces that, after a lag, will finally start to show up in the U.S. economy. Once prices are rising in line with the Fed’s 2 percent annual target then the unemployment rate should start to recede and, hey presto, the Fed has achieved its duel mandate and saved the economic day.

Ever since the financial crisis broke in 2008 some of the world’s major banks have their governments to thank for their survival. The fates of Royal Bank of Scotland or Citibank would have been much worse without large injections of capital from the UK and U.S. authorities. The UK government pumped more than £37 billion into its largest banks in the immediate aftermath of the Lehman Brothers crisis. Ireland took that a step further when it guaranteed all of its banks’ deposits and liabilities. This was affordable, the Irish government said at the time.

However, this policy failed spectacularly. Ireland’s bailout of its banking sector brought the country to the edge of bankruptcy and forced it to accept a 82 billion euro bailout loan from the IMF/ECB and the European Union. More than 30 billion euros of this loan is to re-capitalise the Irish banking sector and the rest is to shore up the state’s finances. The conditions of the loan mean that Ireland will have to implement harsh austerity measures for many years to come that will inevitably hurt growth.

So should governments always stand behind their banks? There are some success stories. Back in 2008, when the global financial sector teetered on the brink of collapse, it was necessary for the world’s major central banks and governments to offer unlimited support to their banks. The chief reason for this was to ensure that credit flowed through the economy to foster growth. In truth however, a mixture of stringent capital rules caused banks to shrink their balance sheets in the teeth of the recession, which didn’t help the overall economy but did boost their balance sheets. In the first six months of 2010 the UK’s four largest banks: Lloyds Banking Group, Royal Bank of Scotland, Barclays and HSBC (the latter two did not receive bailouts) made combined profits of £13.6 billion. This is a far cry from the £22.3 billion they lost in 2008.

The U.S. banking sector has also seen earnings recover sharply. The Federal Deposit Insurance Corporation (FDIC) announced that the earnings for U.S. banks rose by $14.5 billio in the third quarter of 2010. Now that the banking sector is back on its feet again one can hope that credit conditions will also become more supportive of economic growth. And strong earnings also increase the chances that taxpayers will profit from the capital injections at some point.

So why did things go so wrong for the Irish? There are two reasons. Firstly, the government’s guarantee to cover banks liabilities was too hasty. It didn’t inject capital, instead it promised to write an unlimited number of blank cheques. Secondly, there was a mis-match between the size of the banks’ liabilities and the size of the state. Ireland’s economy was 210 billion euros in 2008, the cost to bailout Anglo Irish Bank alone is at least 30 billion euros, and by some estimates it could be 50 billion. This makes the $40 billion plu capital injection (which then turned into equity) into Citibank look like small change for a $14 trillion economy like the U.S.

The trick is for governments not to bite off more than they can chew, and make sure they have conducted a rigorous analysis of a bank’ liabilities before underwriting its future losses. If you don’t do this then the punishment can be harsh, as Ireland has found out.

On paper Ireland’s banks guarantee doesn’t look like such a good idea, but a bank is also part of a country’s social fabric. Its citizens trust the banks to look after their deposits and expect 24-hour access to their money to fund their living costs – paying for a mortgages, school fees, clothing and food. If customers can’t access their money this hits confidence in the central plank of capitalism – the banks. The US has the FDIC to protect deposits of up to $250,000; Ireland didn’t have an equivalent institution so in October 2008 it had to offer a government guarantee for deposits. This was the right thing to do; however, it should have stopped there. A government should protect the hard-earned savings of its citizens, but it is learning how expensive it can be to essentially take on the risk for banks’ bondholders as well.

The second bailout of a Euro zone nation in less than a year has spooked the markets and looks set to be the dominant theme as we move into year end. Ireland’s financial crisis, culminating in the state’s application for EU/IMF funding on November 21, has shattered market confidence and caused some sizable moves in the forex markets. Since the start of November the euro has fallen nearly 6 percent against the dollar, and the dollar index – which measures the dollar versus its largest trading partners – has risen by 5.5 percent over the same period as the greenback attracts safe haven investor flows.

Europe’s periphery has witnessed their bond yields rise to extreme levels, Irish 10-yr yields are currently above 9 percent. The markets remain unwilling to hold Irish debt because the outlook for growth remains uncertain, which continues to worry investors that Ireland may not be able to finance its beleaguered banking sector – the nexus of the emerald isle’s fiscal woes. Right now peripheral Europe, including Greece, Ireland, Portugal and Spain, are in a negative debt spiral. Investors sell their bonds because they believe their budget deficits are unsustainable, and then they sell them some more when austerity measures designed to reign in these deficits look like they will stunt economic growth. This is a dangerous position to be in, and right now there is no easy solution to the problems of the periphery. While the market remains willing to punish excessive budget deficits, investors need to ask who could be targeted next, and could this sovereign debt crisis go global?

The most likely targets are the UK, the US and Japan. All of these nations have either high budget deficits (the UK’s deficit is expected to be 12 percent of GDP this year) or high levels of public debt (Japan’s public debt is above 220 percent of GDP), which make them ripe targets for the bond vigilantes. In the US several states are suffering from deep fiscal crisis, including California, and some are near to bankruptcy.

So will the market’s focus pan back to the debt problems in the major western economies? The markets can certainly force governments  of all sizes to reign in their public finances. The UK’s Conservative-led coalition government has embarked on one of the first and most harsh austerity programmes in the western world, which includes £80 billion of public spending cuts and £40 billion of tax increases to be implemented over the next four years. The scale of austerity measures were considered necessary to ensure the UK kept its top AAA credit rating. Indeed, after the government presented its budget in June, the top credit rating agencies reaffirmed that the UK’s sovereign rating was safe.  So, post the budget, UK bonds seem safe for now.

So far, the markets seem happy to leave Japan alone. This is probably because most of Japan’s huge public sector debt is held by domestic investors, giving the markets little incentive to target Japanese government bonds. This leaves the US. Although the yields on US Treasuries have been rising recently, they still remain at low levels. The 10-yr Treasury yield is below 3 percent suggesting that investors are still willing to fund the US government.

So does the US deficit matter? It all depends on the future outlook. The Congressional Budget Office in Washington estimates the US budget deficit to reach 9.1 percent of GDP this year, falling to 7 percent in 2011, 4.2 percent in 2012 before reaching a low of 2.6 percent in 2018. This looks like a sizable adjustment and should keep the markets happy. However, the canary in the coal mine for the US could be the finances of some individual states. State tax receipts have fallen sharply since the recession, falling 8.4 percent in 2009 relative to taxes collected in 2008 and are expected to be an additional 3.1 percent lower in 2010. As a result most states (46) struggled to balance their budgets for the fiscal year 2011. This means that states have had to embark on harsh austerity measures to try and get their finances back in shape.

But balancing the books hasn’t all been plain sailing. California, the biggest issuer of municipal debt in the US, which also has a budget deficit of $25 billion over the next 18 months, struggled to auction $14.5 billion in short-term notes and longer-term maturities to finance public sector works. It had to stagger the auction after the yields investors demanded to hold Californian debt surged to 12-month highs of 5.51 percent for long-term debt.

Kathleen Brooks is research director at forex.com. The opinions expressed are her own.

Ireland’s banking crisis reached boiling point this week. The Irish authorities are still adamant the country doesn’t need a bailout and are trying to draw a distinction between a sovereign bailout (which Irish Prime Minister Brian Cowen, Finance Minister Brian Lenihan et al claim they don’t need) and banking sector support (which they most definitely do).

Regardless of the semantics, it seems highly likely that Ireland will receive funds from the EU and the IMF possibly by the end of the week. With Ireland likely to be the second member of the Eurozone to require financial assistance in six months, it brings into question the “no bailout” clause in the European Union treaty.

2010 has been the year when Europe’s grand project was fundamentally altered, but where does this leave its most precious commodity – the euro?

Some argue that the precarious financial position of the peripheral nations is evidence that the European project did not work. Interest rates that were too low caused debt bubbles in the fast-growing peripheral nations that eventually burst. Cleaning up the mess is costing billions of euros, the European Financial Stability Fund – which is designed to provide “temporary” financial support to member states in financial difficulties will guarantee 440 billion euros of liabilities. And austerity measures for these nations will crimp growth for many years to come.

While the fund may be able to cope with the claims of Ireland and Greece, it could not cope with those of Spain, another debt-laden southern European economy that is at risk from bond vigilantes once the focus shifts from Ireland’s woes. If Spain was to require financing in the coming months then it would come down to Germany, as the largest economic force in the Euro zone, to cough up more cash. Angela Merkel certainly doesn’t seem to have the political will to “donate” any more money to bail out its Eurozone peers, and if the funds are not there then a situation where Spain is “too big to bail” could break the Eurozone and cause the demise of the Euro.

But we believe this is an extremely unlikely scenario. So what is a more realistic conclusion to the current crisis in Europe? At the moment, it appears that Ireland will receive some form of financial assistance, which will reduce the near-term risks of an Irish default and should calm the markets. But on a more fundamental level, the Irish crisis has shown the political will in Europe to keep the Union afloat. Ireland has been pushed to accept financial assistance from all corners of Europe in an attempt to calm the markets and stop contagion in other fiscally challenged members like Portugal and Spain.

Kathleen Brooks is research director at forex.com. The opinions expressed are her own.

The assault on the Irish bond market by bond investors has continued with a vengeance this week with 10-year bond yields hovering close to nine percent at 8.91 percent. Since August yields have been trending higher, but they accelerated sharply in mid-October, when they were at six percent. At this rate, yields could be in double figures by next week.

Investors are concerned that Ireland will not be able to meet its financial obligations due to the costs associated with bailing out its beleaguered banking sector. The government has estimated that these costs may top 50 billion euro (£42.7 million), however this sum remains a guess and the true bail-out cost is unknown.

Since the Irish debt crisis was precipitated by the bursting of a mega property bubble, the final cost of writing down the bad debt will not be known until there are some stabilization in house prices. As Irish house prices declined seven percent last year and the fall in prices has accelerated in 2010, this could be some way off.

The risk of a default in the near-term is reflected in rising shorter-term bond yields. The two-year yield has nearly doubled since the start of November and currently stands at just over 6.5 percent.

The Irish government has already reduced public spending sharply and is planning further cuts next year to bring down its deficit of 14.4 percent of  GDP, prompting fears that the Irish will have to follow Greece and use the EU/IMF debt stabilization fund.

The Federal Reserve’s second round of quantitative easing to the tune of $600bn put a firework under a trend that started back in August when Fed Governor Ben Bernanke first touted the idea of providing more monetary policy support to the US economy. Risky assets are in demand and the market is happy to sell dollars.

After digesting the Fed’s statement released after its meeting, investors aren’t willing to stand in the Fed’s way as it keeps its hand on the monetary policy trigger: “The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.”

But should investors worry that this euphoria in asset markets will end in tears? It was, after all, William McChesney Martin Jr., the longest-serving Fed President, who said that the job of the Federal Reserve is “to take away the punch bowl just as the party gets going”. The question is, what will Ben Bernanke do with his punchbowl? This is even more in focus after a strong October payroll report.

There are a number of risks with QE2 that investors should bear in mind while they are riding the wave of Fed liquidity. Firstly, inflation. Monetary stimulus has pushed down the value of the dollar, which pushes up the price of commodities. This causes inflationary pressure to build at the start of the pipeline, which will eventually feed into consumer prices. Once inflation looks like it could exceed the Fed’s threshold (around 2 percent) it will trigger tightening by the central bank. This is when a reversal will occur in the financial markets and bond yields rise as the price of Treasuries start to tumble.

But Ben Bernanke, writing an opinion piece for the Washington Post s, argued that QE1 (at the peak of the financial crisis) didn’t cause price increases to accelerate. But QE1 was to avoid a liquidity crunch and ensure the smooth running of the financial markets. This time, financial markets aren’t in distress and the economy is growing, albeit below the rate the Fed deems acceptable. In the same piece, Bernanke said the Fed is confident that it will have the tools to unwind these policies at the appropriate time. However, he also mentioned that asset purchases are relatively “unfamiliar as a tool of monetary policy”.

The truth is that the Fed doesn’t know what its exit policy will look like since it has pledged to re-invest the proceeds of assets purchased under QE1, rather than sell them back to the market. When it finally decides the time is right, the Fed’s exit programme will need to be handled with extreme care. It has already had to relax System Open Market Account (Soma) limits, which restricts it from buying more than 35 percent of any single issue in US Treasuries. QE2 heralds the Fed as a huge force in the US Treasury market, and the prospect of price distortions are great. But the Fed will want to leave the market with as little fuss as possible so as not to cause a huge spike in bond yields. To do this it needs to ensure the timing is perfect, which may end up delaying the Fed’s eventual exit.

Lastly, it’s worth remembering that it may not be the Fed who ultimately decides the timing of its asset sales. A year ago US authorities were called to explain to China, one of the largest holders of Treasuries, how it would manage its exit strategy from QE1 and deflect any criticism that it was trying to monetize its massive debt. So far the Chinese seem more concerned that QE2 will stoke asset price bubbles in its economy, but concerns about 1, the Fed monetizing the gigantic US debt, and 2, a sharp rise in inflation eroding the value of their Treasury holdings must be keeping some officials in Beijing awake at night.

The communiqué from last week’s IMF G20 finance minister’s meeting was the first step in trying to resolve the so-called global currency war. The ministers released a joint statement on October 23 which pledged that all countries would “move towards more market determined exchange rate systems that reflect underlying economic fundamentals and refrain from competitive devaluation of currencies.”

Even fears that the U.S. and China could have a bust-up over the U.S.’s charge that the renminibi is undervalued relative to the U.S. dollar were put to bed when it was reported that Treasury Secretary Geithner popped in to China on his way back from the G20 in South Korea to meet Chinese Vice Premier Wang Qishan.

While there was hope that a full-blown war could be avoided, reports were soon hitting the wires that South Korea (the host of this year’s G20 meetings) was back intervening in the FX markets to weaken the won, which has strengthened more than 10 percent against the U.S. dollar since June. Later in the week South Africa joined Brazil, Indonesia and Thailand by announcing measures to stem the value of its currency by loosening domestic capital controls to get money flowing out of the country rather than pumping up the value of the rand, which has appreciated by 12.5 percent against the dollar in five months. So beggar thy neighbour policies are still alive-and-well even after the G20 finance ministers’ show of unity over exchange rates.

If you boil down the currency war to its crudest form then you’ll get emerging market countries with positive financial positions and strong growth trajectories lamenting the weakness of the dollar, which has been falling in value since making a high in June. They are concerned that further quantitative easing from the Federal Reserve will only cause the dollar to fall even further. In contrast, authorities in the U.S. are unlikely to talk up the dollar until they see some meaningful commitment from Beijing to allow the renminbi to appreciate.

Reaching an international FX accord is going to be an incredibly difficult thing to achieve due to conflicting view points and each country thinking they are right to protect their own economies first and consider global FX harmony second.

This might sound like the chances of a resolution are remote and we’ll lurch from one diplomatic nightmare to the next. But luckily the FX market is deep enough and liquid enough to swallow political rhetoric and set its own rules. Ultimately the currency war will be solved by the markets: genuinely weak currencies will continue to weaken, while undervalued currencies will strengthen.

There are tentative signs since the G20 finance ministers’ meeting that this has already started to happen. Some dollar short positions have been unwound as investors get nervous that the Fed won’t turn on the monetary taps indefinitely when they meet on November 2-3. This has put upward pressure on the greenback, which has risen by more than 0.5 percent this week, stemming its losing streak. Likewise, the Swiss franc has fallen as the economic outlook continues to deteriorate. The pound also had a stellar run, after economic growth surprised to the upside in the third quarter, thereby easing expectations that the economy may need more monetary support. Not even the Bank of Japan can stem the rise in the yen while investors continue to pile into the Japanese currency. Who knows what the market will do next, but if the euro continues to strengthen, which then hurts growth in the Eurozone, it could be investors’ next target.

The strength of the single currency since August has astounded some commentators in the markets. After reaching a low back in June, the euro has appreciated more than 17 percent against the U.S. dollar and eight percent on a trade-weighted basis.

Not even last month’s debt crisis in Ireland, when the Irish government announced that its total budget deficit would top 30 percent of GDP this year due to the bailout of Anglo Irish Bank, stood in the way of the single currency. The ease with which the euro can brush off concerns about the Eurozone peripherals since the summer has led people to ask if the euro is trading like a proxy for the German economy.

There was confirmation earlier this week that the German economy is firing on all cylinders. PMI surveys, which measure activity in the manufacturing and services sectors of the economy, remain at elevated levels, industrial sector confidence measured by the IFO survey is back at pre-recession highs and the unemployment rate is at its lowest level since 1992. Combined with relatively low levels of public debt – it is currently running a deficit of 3.3 percent – and quarterly growth of 3.7 percent between April and June, Germany’s economy looks more like an emerging market than a western one.

As you can see in the chart below, the euro is riding on the coat tails of a strong Germany. The spread between German and U.S. two-year yields has tracked euro-U.S. dollar extremely closely.

But should the euro be a proxy for German economic strength? The euro is a currency union after all, and like any good team surely it should only be as strong as its weakest members, in this case Ireland and Greece. Growth in Ireland and Greece slipped back into negative territory in the second quarter, and the outlook for both economies remains weak as they embark on severe fiscal re-adjustment. If the euro was reflective of these economies, then it should be back around the lows of 1.18 against the dollar, some may even argue it should be below parity.

On the other hand, the euro should act like the Deutschmark as Germany is the largest and most important economy in the Eurozone. A stronger euro is therefore justified because strong growth and a tight labour market are pushing up German bond yields, putting upward pressure on the single currency.