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!!MARKET INSIGHT REPORT When the German Recession Shows its Face By John R Taylor, Jr. Chief Investment Officer You might ask: What German recession? We would reply there is clearly one just over the horizon as the real data coming out of the country spells trouble: dropping exports, dropping imports, and sharply lower manufacturing and industrial production numbers, plus a weakening trend in retail sales. These coincident indicators are beginning to appear to match the cooling of the markets led by the year-long decline in rates and the recent under-performance of German equities. Although the German economy grew at a 0.8% rate in Q1, almost a 3.4% rate in an annualized format, dragging the Eurozone growth from negative to positive all by itself, Q2 will show a dramatic reversal. Germany (30% of Eurozone GDP) will not be the locomotive to keep the other 17 countries (70%) on the positive growth path. Look for the Eurozone to register GDP growth of 0.0% in Q2. Very recent forecasts for Germany now range from 0.1% to 0.5%, as there is still a strong presumption that the services side of the economy will hold up the total. !With the May industrial production index now below that of a year ago, this very dangerous soft spot leaves the country exposed to global uncertainty. The German strategy stressing exports, primarily sophisticated manufactures or capital equipment, to fast growing emerging markets could backfire as they have become tied to the more volatile part of the world economy. The Germans have ridden the upward move, but now must suffer the contraction. With expensive labor, even after adjusting for productivity, and an incredibly high cost of energy the country’s policy of moving away from nuclear power while the Russians hold the high cards in the natural gas arena, is very risky. There is no room for error. BMW has announced it will be making energy intensive equipment in the US state of Washington where the cost of electricity is one-sixth of that in Germany. Add in a weak hinterland – the periphery states in the Eurozone – and a shrinking population and it is hard to see how Germany can power Europe much in the next few years. !We are not really worrying about Germany, but about the whole euro-financial system, the shrinking bank asset base, and the value of the euro. What can the ECB do? If growth fails to perk up in Q2 and the present quarter looks similar, the ECB will be forced to act even though core financial leaders like Couere and Schaeuble just repeated again that the ECB moves made in June will be enough. The Europeans’ hope and emotion have been more positive than reality. High automobile sales are a sign euro-consumers have run down their rolling stock and need to replace it, not that things are great. And the positive PMI, ZEW, and Ifo numbers are a function of the ‘been down so long, the bottom looks up to me’ outlook that lightens the mood in difficult times. Our experience with the statements of European leaders as well as the opinion surveys is that over the last five years, they have proven to be very wide of the mark, erring always in a positive direction. With the AQR financial strength results coming in the fall, with the T-LTRO only applying after September 1, and remembering that Couere and Schaeuble are at the center of European power, we must concede the ECB will stay pat until at least the September meeting and more likely into the October one. If the German numbers are telling us anything, and if Hollande’s France is unable to move even its PMI into a positive position, where can the Eurozone be? Only Spain (11% of euro-GDP) can be identified with a positive story. The next step has to be some kind of QE, even if it involves buying bonds of other countries like the US and Japan. The ECB must force-feed the economy, no matter how un-European it might seem.

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!!CURRENCY – Asia Long-Term View !Time to Position for a Weak Yen By John R. Taylor, Jr. _____________________________________________________________________________ !The Japanese seem determined to do it their own way. Even though we again don't understand how expanding the Bank of Japan's balance sheet at a rate more than twice as fast as the Fed or the Bank of England at their most aggressive while leaving all the growth restricting structures, well known and analyzed by everyone, untouched can possibly succeed, Abe seems to be doing it. Our task here is not to judge the pros, cons and probabilities of success of Abe’s unorthodox strategy over the long run, but to predict how the price of the yen will develop in the next three to six months. !Before we look at the cycles at this very important point in time, we would like to think about the positioning of the major players in the Japanese financial markets. The masters of the hedge fund world played the Nikkei aggressively, while selling the yen in the run up from the 4th quarter of 2012 into the end of last year, but now they have lost their yen for the Nikkei but have become more certain of a bad end to Abe’s strategy, including a weak yen and a falling bond market. JGBs are turning from a yield of 0.56%. As the trend establishes itself it will draw hedge funds like flies bringing a sale of yen, longer swaps and debt futures. The thought is there but the positions are still small. Simple short yen positions will come first and the leveraged community will climb on once the 102.40 resistance is cleared by the end of July at the latest. The government is pushing its agents and anyone listening to move away from domestic markets and into offshore ones, driving the yen down. A sluggish Nikkei and weak bonds should accelerate this process and the government will not stop pushing this until the JGB rates move at least to 1.00%, still in the comfortable range of the past few years. Exporters need a weak yen to improve margins, especially as they are losing market share and need to raise wages as good corporate citizens. The US authorities are neutral and the only ones against this weaker yen are Korea and China. We all know where they rank, and they aren’t even in the G-7. !The major cycles tell us the USD/JPY could turn higher any day, but the medium term ones warn that later next week of even the week of July 21 would be more appropriate. As the currency pair is almost frozen, it will be a slow reversal and we will probably get very excited on some day with very little movement. The 101.20 to 101.45 area is full of strong support. A break below changes everything and would result in a very quick move to the 100.50 level. A close over 102.40 would be the trigger to an upmove into November or more likely December. Our target is the 104.25 area in mid-September and the 107.50 level at a minimum near the end of the year. Right now we are throwing caution to the winds and buying some USD/JPY with the Bank of Japan buying some too – or so the recent rumors say.