Click Here to View .pdf file

The original "Valentine's Day massacre" was an event in 1929 when notorious mobster Al Capone [tried to] clean up the opposition by wiping out members of a rival [Bugs Moran] gang. This event was widely seen as the turning point in the gang wars of Chicago, and led to the cleaning up, to the extent that such things ever get cleaned up, of organized crime in the U.S.

The "Saturday night massacre" was the name given to a series of firings and resignations from Richard Nixon's administration on October 20, 1973, which resulted in an uproar in public opinion that finally resulted in Mr. Nixon's resignation as President of the United States. I was in the U.S. at the time, a relatively fresh-off-the-boat graduate student at Rice University. I remember marching in anti-war (Viet Nam) protests at Times Square when I visited New York in Christmas 1972 and the angry enthusiasm on campus as the nightly news unfolded the Watergate scandal. While clearly the world circa 2005 is certainly another place circa 1973, and, of course, I am not on the ground in the U.S. right now, it seems to me that the current reported political environment in the U.S. bears an uncanny resemblance to that time.

Opposition to the Iraq war is growing by the day, senior administration officers, including the once-and-future-kingmaker Karl Rove, are under suspicion, with the Vice President's chief of staff already under indictment, and the President's approval ratings have fallen to all-time lows (around 35%). Bush continues to attract comedians and satirists, just as Nixon did. It feels just like the mid-1970s all over again - all that's missing is a petulant Mr. Bush wringing his hands pacing the Oval Office muttering, "I am not a crook." And, judging from media reports, that may not be too far off.

Worse yet, the appalling level of global discontent with U.S. "leadership" further queers the pitch. The anti-Bush protests at the Summit of the Americas in Argentina last week shows how far U.S. influence has fallen - it sometimes feels as if Mr. Bush has succeeded in uniting well over 95% of humanity against his leadership.

And, then, of course, there are the tricky facts of a robust but hugely indebted U.S. economy (complete with moral hazard issues of a few large - read Asian government - holders of U.S. government debt), a U.S. current account deficit at an all-time high of 5+%, sky-high oil prices, inflation showing signs of life after almost a decade, and a new chairman taking over the U.S. Federal Reserve (on February 1, 2006) after 18-years of "heroic" stewardship by Alan Greenspan.

All the makings of an econo-political potboiler.

Here's one way it could unfold.

With the U.S. economy turning out to be surprisingly strong (3Q growth came in at 3.8%, above the 3-3.2% expected range), and wage pressures beginning to build up (the average hourly earnings rose by 0.5% in October, the highest rise since February 2003), the market is quite sanguine that U.S. interest rates are going to continue to rise steadily - in fact, Fed fund futures for February are at 4.48%, signaling that market believes that Mr. Greenspan will hike rates at both of the remaining meetings (Dec 13 and Jan 31, which will be Mr. Greenspan's last as Fed Chairman).

Now, given that Mr. Greenspan has built quite a reputation over the past 18 years, culminating in these 12 (14 by Jan 31) successive 25 basis point hikes in the Fed rate, it is clear that Mr. Bernanke, his successor, will have a tough act to follow, particularly in convincing the markets that he is as tough on inflation as his predecessor. While many analysts are spouting positive comments about Mr. Bernanke, there are some who see him as too much of a theoretician and, to be honest, his "dropping dollars from helicopters" comment is hard to forget.

In any event, analysts are not the market. The market is the market and [one of] its job[s] is to test the resolve of policymakers. Mr. George Soros took advantage of this in 1972, when the market tested the resolve of the Bank of England not to raise interest rates - it pushed the sterling lower and lower, till the Bank had to relent. Mr. Greenspan himself was tested months after he took office in 1987, when Wall Street crumbled; he acquitted himself admirably (at the time) by pouring money into the system. Closer to home, Mr. Bimal Jalan was tested, weeks after he took office in 1997, when the Asian crisis threatened to blow the rupee out of the water; he acquitted himself (some would say) admirably by slamming down the shutters on capital flows.

Markets have a habit of testing policy makers, although it does seem like a long time since there's been any such test - it's been 7 years since the LTCM debacle (caused by arrogant over-leveraging and Russia's default on its sovereign debt) and close to 5 years since the technology bubble burst in 2000.

Putting all this together, its possible that Mr. Bernanke will be tested soon after his arrival at the Fed - say, on February 14, 2006. Mr. Greenspan will just have concluded his reign after presiding over the 14th Fed funds hike (to 4.5%), the U.S. economy will continue to confound with 4th quarter growth coming in (say) at 3.5%, oil prices will continue to rule in the (say) 60-70 range (abetted, say, by a severe winter in the West), and the equity markets - in a response, say, to the now-fully-blown political crisis, threatening a Bush resignation - will collapse. The Dow, which will, by then have spent 18 months in the 10,000 to 11,000 range, will slump, falling substantively below the critical 10,000 mark. [Let's not forget that on Black Monday in 1987 the market fell by 22.6% in a single day. Could this be repeated? Certainly, there are few technical supports left below 9,000.]

What will Bernanke do? Will he, a la Greenspan, announce that "liquidity support will be made available" and call out his helicopters? If he were to try to support the market with liquidity, would his attempt to create credibility be dashed? Would the bond market get spooked and, finally, push long term rates up, up, up - above, say, 6 or even 7%? Would this bring the U.S. housing market crashing down?

Would this, finally, in a poetic echo of historic timing, begin the clean-up - to the extent, of course, that such things can ever get cleaned up - of U.S. economic (and foreign) policy that is long overdue?

I don't know. Wait for Valentine's Day 2006 to find out.INR

currency markets view: rupee and majors

INR

Fortnightly movement: O-45.12 H-45.56 L-44.93 C-45.54
Sentiment - dollar driven weakness; expect higher volatility
Expected range for 1 Month: 45.25-46.00
Expected range for 3 Months: 44.75-46.50

Marked by increasing volatility, the rupee traded in a 60 paise range during the fortnight closing about 1% weaker at 45.53/54. While FII outflows from the domestic financial markets weighed on the rupee, it was mainly dollar strength in the overseas markets that was the chief culprit behind the decline in the domestic unit. The dollar's move to a one-year high against the rupee coincided with its new highs against JPY and EUR.

Earlier in the fortnight, RBI hiked its reverse repo by 25 bps in the monetary policy review. While it did not change the Bank Rate (with the Governor implying that this was because the central bank's "medium term" view on inflation had not changed), RBI did raise the repo rate by 25 basis points as well, indicating that in the near term there may be some pressure on liquidity. While the policy announcements were upbeat in tone - RBI revised its forecast for economic growth to 7-7.5% its April estimate of 7% - the central bank did raise some flags about the risk to the domestic economy from surging international crude prices, and, significantly, it also pointed out the threats of asset inflation (housing and equities). In this, Dr. Reddy appears to be stepping away from his global colleagues, and has won plaudits from some international analysts for his conservative approach.

The benchmark 7.38% 2015 bond yield rose to 7.12% after the rate hike but fell back to 7.10% over the fortnight, indicating that market is quite comfortable with RBI's approach. The Reserve Bank of India will auction the 7.49 percent 2017 bond for Rs.5000 cr and the 7.4 percent 2035 bond for Rs.3000 cr later this week as part of its market borrowings, and, with liquidity still ample, traders see good demand for these bonds from mutual funds and insurance companies, respectively.

The credit policy was a bit thin in terms of reforms. Although intra-day short-selling of gilts - long a demand by the market - was permitted, it was limited only to primary dealers. Mutual funds and insurance companies, sizeable investors in the debt market were left out. There was nothing done to boost volumes in the corporate debt market, which is another investment avenue for FII's and mutual funds.

The rupee perked up a bit with the rate hike, breaking above the 45 level, albeit briefly, as the dollar's strength overseas and RBI's apparent new tolerance for volatility pushed the rupee down to its recent lows.

The rupee is expected to continue under pressure as the dollar remains strong overseas and as the US Fed's delivered and anticipated rate hikes increase global investor risk aversion, which will reduce FII flows into emerging markets. However, we expect that RBI will come in to support the rupee if it threatens the 46 level, particularly since inflation is close to the edge of RBI's (and the Finance Minister's) forecast range of 5 to 5.5%. Again, despite the fact that liquidity could well thin a bit with lower inflows and increased corporate demand, we could see another rate hike in the January policy if the rupee remains under threat.

EUR

Fortnightly movement: O-1.1928 H- 1.2172 L-1.1801 C-1.1819
Sentiment - negative and could worsen further
Expected range for 1 Month: 1.1600 -1.1900
Expected range for 3 Months: 1.1600-1.2300

The Euro started the fornight with a smart rally to nearly 1.2175 on an upbeat report on German business confidence and disappointing report on US consumer confidence. However, the underlying negative sentiment asserted itself right before the US FOMC meeting, and the euro did a sharp U-turn. sliding by about 2 cents. It remained volatile, rising about a cent before last Thursday's European Central Bank (ECB) meeting. The ECB's announcement not to hike interest rates was widely expected. However, the market's disappointment with the ECB President's post-announcement remarks as being less hawkish than expected combined with strong US data viz. jobless claims, productivity and ISM service sector index to push the euro down by over a cent. Last Friday's disappointing US headline payrolls number provided only a little, knee-jerk boost to the euro as a market overly pre-occupied with US inflation and Fed rate hikes hammered the euro (and other majors) on a perception that the strong rise in US wages could lead to even more Fed rate hikes than anticipated so far. In the event, the euro tumbled below the major 1.1875 support all the way down to about 1.18.

Follow-through selling this week could extend the euro's decline to 1.1750 or even as far as 1.16 before a modest recovery towards 1.1875. However, prospects for a 7-cent or larger corrective rally, which we have feared for some time, would appear quite bleak unless the euro can stage a sustained recovery over 1.1875.

GBP

Fortnightly movement: O-1.7660 H- 1.7901 L-1.7458 C-1.7505
Sentiment: negative and could worsen further
Expected range for 1 Month: 1.7300-1.7600
Expected range for 3 Months: 1.7300-1.8300

Sterling moved in tandem with the euro, rose to 1.79 initially and then tumbled all the way to about 1.7450 before closing last Friday just over 1.75.

Sterling could find support in the 1.74-1.73 area but only a sustained recovery over 1.76 could pave the way for a larger upward correction.

JPY

Fortnightly movement: O-115.88 H- 118.39 L-114.59 C-118.30
Sentiment: very negative (for yen)
Expected range for 1 Month: 116.00-120.00
Expected range for 3 Months: 113.75-120.00

Except for a brief dip to about 114.50, the dollar had little difficulty in climbing up to about 118.40.

Apart from strong US data and the Fed's hawkish statement accompanying the 12th consecutive rate hike, the yen was also hit by Bank of Japan's dovish comments that Japanese interest rates could remain 'very low' even after an end to its current quantitative easing policy. Speculation appears to have begun circulating in FX markets that the BoJ is encouraging yen weakness to force inflation into becoming positive. In any case, as long as the central bank states that an end to its quantitative easing policy does not imply an end of zero interest rate policy, the yen may remain under pressure.

The dollar's rise to 118.40 marks a 50% retracement of its last major decline from 135.10 to 101.70. Yet, it seems very likely that the dollar will rise to the psychological 120-yen level before a pause. In the very near term, the only spanner in the works could be a sudden Chinese yuan revaluation before President Bush's visit to China later this month, a volte face by BoJ or a disappointing TICS report showing a sharp fall in net capital flows into the US.