The themes for the month-

Each month I want to start with the themes that are having the most impact on the markets or which believe will be the most important driver in the next month. The focus will be on foreign exchange, fixed income, commodity and global stock markets. It is not supposed to be specific stock recommendations but key events that will drive markets.

The Greece problem – Some are calling this the “Ne Lehman” but what this issue really represents is the next leg of the credit crisis. The over leverage credit problems were not solved but switched from private to government extension of credit. Now we are seeing the potential failure of governments who over levered.

Key questions:

Will there be a bail-out? Yes, the form is unclear and this is what is taking the market lower. he timing is also unclear. This could be an overhang for weeks or months.

Will there be contagion to the other PIIGS? Yes, Greece is small The bigger potential problems are Spain and Italy.

How will this carry over to other regions and markets? The banks have significant exposure to the PIIGS.

China monetary policy – The increase in reserve requirements last month suggests that the run-away growth of Chinese credit may be curtailed. Certainly, it will not reverse but a change or deceleration of credit will have an effect on global markets. We are already seeing it with copper prices. We are seeing a reaction with the RBA not raising rates.

Key questions:

Will the impact of tightening regulation have an impact on the Chinese economy? Hard t say in the short-run, but the credit will have to slow.

Will this action be followed by more? Sales have slowed in real estate but lending is continuing. These is a bubble.

Will this lead to a global slowdown especially in the commodity markets? We are already seeing this in copper.

Monetary exits – The Fed is supposed to end their purchase program of mortgages next months. We are already seeing some dismantling of Fed credit programs. The BOE is also talking about reducing their quantitative easing. The markets have become addicted to cheap money, so it is unclear whether the Fed or other central banks can wean economies off of their programs. The next sixty days will be a significant test of the resolve of central banks to cut exit programs.

Key questions:

What will the Fed do with their mortgage purchase program? This is still a wild card. Fed economist say that an end of the mortgage program may add 100 bps to fixed mortgage rates.

What will be reaction to any Fed action? It is hard to own mortgages in this environment.

The deficit questions – We now have an idea of what the 2011 deficit will be, over $1.5 trillion based on the government’s aggressive growth forecasts. Debt to GDP was 83% for fiscal 2009 for just the public sector and is set to hit 94% in 2009, 99% in 2010 and 101% in 2011. Taxes are going up and so are spending as well as continued entitlement plans which the government cannot easily cut back.

The book This Time is Different by Ken Rogoff and Carmen Reinhart has reached #23 in the Amazon sales count as of last week and is #1 of all business books. The debt problem is not going away and will be a theme that continues to overhang the markets. Can the markets handle the continued increase in debt coming to market., The sovereign problems of other countries actually may be a help for the US as the capital has moved back to the US, where else can the money go?

Key questions:

What is the link between debt and interest rates?The research is mixed bu the size of the current problem is unprecedented. We do know that the surprise in deficit ill be more important than the issuance. However, the Fed purchase program has made a difference in rates.

What happens when you mix large deficits with less quantitative easing? Rates will move higher. The qustion is how much and how fast.

Employment numbers – continued muddle

The rule of thumb is that that a 100,000 number up or down is necessary for a change in the employment number to be meaningful. We did not get it this month with a 20,000 down report. Yes, unemployment moved to 9.7% from 10% but the absolute jobs number is the only thing that counts now in the minds of investors. We did get a revision of overall employment for its annual benchmark by over 900,000 down. This is more pain but something that has already been taken.

Investors are focused on the employment yet this is the one economic number which has shown the poorest rebound relative to other macro numbers. The employment number is a lagging indicator but there has been no real improvement. There has been no job creation for the last decade.

Greek problem - an issue of contagion

Hard to say what the EU will do with Greece. There is a “no bail-out clause” in the Maaschrit Agreement so the EU governments have to be creative in their handling of the situation. There is also a significant moral hazard problem because the other PIIGS may need money. If you do something for one, there will be expectations that something will have to be done for others.The size of Greece within the EU is small. It is the contagion which is the problem.

Spreads on Greek 10-year bonds have moved up to 370 bps over bunds. The spreads have been moving in only one direction because it is hard to find any buyers for Greek bonds.There are no comparable spreads because when they were higher was before the introduction of the Euro.

The deficit to GDP will be just under 13% assuming that the tally of all liabilities is correct. This is a brash assumption when it comes to Greece as the EU has found out that differences in government accounting can have a strong impact on the numbers.

Does EU need the IMF? This is an interesting question. They have the money and know-how to impose austerity programs. It would be a political embarrassment, but it gets the EU off the hook.

This is a problem that will not go away anytime soon and should be considered the next shoe to drop in the same credit crisis.

Risks in the EMU - You do not want to be a member of the debt club

A scatter plot of debt to GDP and fiscal deficit to GDP shows that there is an exclusive club of countries with both levels being higher than normal, Ireland, UK, Spain, and Greece. The red ink is growing and there do not seem to be easy solutions. Think of a state bail-out, only worse. There is not the same deep connection between the countries of the EU.

The scenarios as listed by Merrill Lynch are not very appealing and getting worse as the market reacts to the lack of action.