Custody Holdings and The Dollar

As is well appreciated, the Federal Reserve competes with private sector banks in providing custody services to foreign central banks. The data is reported on a weekly basis, every Thursday. Yesterday the Fed reported that custody holdings rose by about $5 bln. That brings the Q4 increase to about $93.5 bln and the year-to-date figure to $432 bln. In 2008, custody holdings at the Federal Reserve rose by about $460 bln. There still is a couple weeks worth of custody holdings data to complete the year, but the broadly speaking, 2009 growth has been in line with the 2008 increase. Custody holdings consist of both agency debt and Treasuries. Agency debt is gradually being divested, while Treasury holdings continue to grow. The increase in Treasury holdings are roughly on par with last year's so what appears to be minor change in the pace of overall custody holdings is more a function of the agency sales. The Treasury's TIC data tracks flows going through US banking system. So if say a foreign central bank bought Treasuries through a foreign bank it would not show up in the TIC data.

CNBC: King Dollar & Growth

What is Moving the Dollar? New Driver Around the Corner ?

There have been many developments in the past couple of weeks, including Dubai and Greek woes, generally stronger than expected US economic data, and further confirmation of the unwinding of the Fed's liquidity provisions that could help account for the dollar's broad based strength. It is up, since the Dec 1, almost 3.75% against the euro, 3.5% against the yen and 1.6% against sterling. Since the start of the month, the dollar has also appreciated against most of the emerging market currencies save the Mexican and Philippine pesos.

We are reluctant though to attribute the dollar's strength to a shift in expectations for Fed policy. On the day before the US Nov jobs report was released on Dec 4, the June Fed funds implied a yield of 28.5 bp. Last Friday after the stronger retail sales data, wholesale inventories and consumer confidence figures that prompted some economists to revise upward Q4 GDP forecasts, the June Fed funds finished the session implying 29.5% average effective Fed funds rate. Currently the June contract implies a 29 bp average.

Basel Committee Clarifies, Contradicts Japan

Japanese media had intimated that there would be a long--decade or more--transition period to new capital requirement rules. This apparently was a factor behind the surge in Japanese banks shares yesterday, before consolidating today, for example. However, the BIS' Basle Committee on Banking Supervision indicated earlier today that the new capital requirement rules will be phased in as financial conditions improve, with a target date of the end of 2012. Of course, this would presume the the end of the Mayan calendar and other astronomical events do not end civilization at the winter solstice that year.

Essentially, it appears that a global minimum liquidity standard should be introduced and new capital ratios that will be consistent with stricter supervision and leverage. The committee said it will analyze the likely impact of the new standards in H1 2010 and the details of the new requirements would be issued at the end of next year. One element that has not been worked out yet is whether financial institutions that are deemed too big to fail will have extra capital requirements or other supervisory measures.

Greece and the Euro Zone

Currency in Crisis

The heightened concerns about the fiscal situation in Greece and by extension the other weak credits in the euro-zone may be a source of pressure on the euro, but more than likely it is simply encouraging foreign exchange participants to do what they wanted to do in any event and reduce market exposure, which means buy back short dollars, ahead of the end of the year and the impact of which is being exaggerated in thinner holiday markets. Fitch had previously cut Greece's sovereign rating and maintained a negative outlook. S&P simply played catch-up yesterday.

Dollar Rally

Some observers are linking the dollar's rally to yesterday's FOMC statement. We do not see much new in the statement. There was a minor modification of its description of growth, but the policy guidance remained the same. Conditions were such that interest rates could remain extraordinarily low for an extended period. One U.S. investment bank suggested that this wording may have brought the first Fed tightening forward by 6 weeks, but it had not looked for a hike at all in 2010. That the economic conditions require exceptionally low rates while the financial markets do not require intensive care is not really new. For several months now the Fed has been indicating that many of the liquidity facilities would be allowed to expire. In fact the June 2010 Fed funds futures finished yesterday implying a 1.5 bp lower average Fed funds rate than was the case on Tuesday (31.5 bp vs 33 bp) and the June 2010 Eurodollar futures contract implied a yield of 63.5 bp at the close yesterday, 3.5 bp lower than the previous day. Further out on the curve there has been some movement of interest rate differentials in the US direction, but we do not think this is the main driver of the dollar's strength.

Chile--OECD Membership, Rates Steady, CLP Outlook

Yesterday was an important day for Chile. After two years of campaigning and making reforms Chile was invited to join the OECD. It is the first South American country to join and second behind Mexico in Latam. Chile becomes the 31st member of the OECD. Measures Chile adopted to pave the ground for membership included reforming the management of Codelco, the state-owned copper company, increase transparency in the banking sector and agree to the international anti-bribery rules. It is more prestigious to join than substantive.

Chile's central bank also decided yesterday to leave rates on hold. This was widely expected. Rates have been on hold since July after having been slashed 775 bp in the Jan-July period. Rates will likely be on hold during the first half of 2010 and a normalization of monetary policy should begin in H2.

FX Ignores Larger than Expected Rise in Nov US IP

Industrial output rose 0.8% in November, the most in 3 months but the dollar largely seems unaffected. The dollar had strengthened sharply against most of the major currencies earlier but had begun seeing those gains pared and that has continued after the industrial output data.

Manufacturing output rose an impressive 1.1% after a 0.2% decline in October. Strengths were seen in business equipment and computers/electronics, as both were up 0.4%. Utility output constrained the headline rise by falling 1.8% after rise in 1.7% in Oct. This may be reversed in December especially given the snowstorms that hit the midwest. Mining and drilling output rose 2.1%, which is the strongest since Oct 2008.

Preview of FOMC

The Federal Reserve's last meeting of the year begins today and concludes tomorrow. We do not anticipate much change in the FOMC statement and even less of a change in the Fed funds target (or the discount rate, which at FT columnist suggests is part of a risk scenario that should be taken seriously).

Recent FOMC statements have come in three paragraphs. The first paragraph is a review of recent data. Here the Fed is likely to repeat what it noted last month, namely that "economic activity has continued to pick-up." This would come on the heels of course of a series of data, including inventory, trade, retail sales and the smallest job loss of the year, that is encouraging Street economists to revise upward Q4 GDP forecasts. There may be some tweaking of the wording to reflect some nuanced changes.

Papandreou Long on Rhetoric, Short on Details

So far it does not appear that Greek Prime Minister Papandreou has provided much insight into how he will reduce Greece's heavy debt burden. Public debt is about 113% of GDP this year and set to rise toward 120% next year.

The most important take away point is that key decisions will be made over the next three months and the pain will be distribution.

Markets are Skeptical of Greece, but Short-End Attractive

Currency in Crisis

The markets await the speech by Greek Prime Minister Papandreou that will detail how he intends to address the fiscal woes that have created a bit of a crisis in Greece. The 2-year note yield has risen 175 bp over the past month, and 15 bp today to yield 3.05%, this is more than twice the German 2-year yield (1.23%) and half again as high as Ireland's 2-year yield (1.90%).

While Greece is under pressure from both the financial markets and European officials to take corrective action, we think a near-term default or an exodus from the euro zone is not a likely scenario. The most likely scenario seems to be some muddling through with measures that are not quite enough, but still a step in the right direction. The rating agencies are a bit mixed. Fitch last week cut Greece's sovereign rating to BBB+, the lowest of the rating agencies. S&P rates Greece A-,and negative watch, which is two notches above Moody's A1. Moody's placed Greece on credit watch with negative implications in October and given that Moody's rating is higher than the others, a downgrade in the coming weeks seems likely.

Independent Pressure on the Turkish Lira

As the dollar rallies on constructive economic news, emerging market currencies are being hit by a wave of profit-taking. However there is independent pressure on the Turkish lira. The Constitutional Court just banned the main pro-Kurdish political party for links to militants and 37 members have been banned from politics for five years. The immediate thoughts are the implication for social unrest in Turkey and the electoral impact.

The lira has sold off roughly 1%, which is more than most of the other emerging market currencies. The lira is now trading below where it was on Dec 1st when Fitch upgraded Turkey's sovereign rating by two notches. Thus far the dollar has held just below the week's high near TRY1.5143. A break of that area, however, could see a move toward TRY1.5220. A break of this area could signal a retest on the spike high from late Nov near TRY1.56.

Returning to the Scene of an Accident

The market overreacted to the recent U.S. jobs report and while expectations of Fed policy have returned to status quo ante, the dollar has not. We suspect the dollar is therefore vulnerable to a renewed near-term setback. The yen is obviously exceptional and the dollar has already surrendered its job-induced gains. We would also discount sterling on grounds that fiscal developments in the UK leave it particularly vulnerable.

Concerns about growing debt burden are likely to dominate discussions. While tax on bank bonus payments is not playing particularly well in the blogsphere and the op-ed pages, early indications suggest it is aiding Labour in the polls. This in turn increases the likelihood that Labour becomes more populist in the coming months and risks a hung parliament.

Yen Carry Trade by Unlikely Candidates

Speculators appear to be playing the yen from the long side. (Read more about the yen carry trade here.) The Commitment of Traders data showed near-historically extreme net long position prior to the middle of last week when the yen was sold off hard. Even if some of the speculative longs were cut, they likely remain net long yen.

Over the last couple of week the BOJ has provided more monetary support and the government has unveiled a larger than expected supplemental budget. At the same time, Q3 growth was revised to 1.3% from 4.8% and officials recognize that deflationary forces will retain a grip on the economy in the year ahead.

Watch Tomorrow's Report on US Business Inventories

The US reports the October business inventory data tomorrow. Economists are likely waiting for the report before revising Q4 GDP forecasts. Previously the consensus was coming in around 3% GDP for Q4 and the risk is that estimates are revised higher.

A little more than half of the business inventory raw data is known. Wholesale inventories released earlier this week account for about a quarter of business inventories. With the factory orders data is an inventory estimate of factory inventories, which account for about a third of business inventories. Wholesale inventories rose $1.3 bln in Oct. They had fallen for a little more than a year with the average drop being around $5.3 bln per month. Factory inventories, reported last week, rose $1.8 bln in Oct. They too had fallen for a little more than a year and the average monthly drawdown was for about $5.5 bln.

Turkey's Central Bank Intends to Roll Over Debt Holdings

Turkey's central bank holds about TRY8 bln in domestic debt that expires next year and indicated it will buy about TRY8 bln of government paper to replace it. It will begin buying TRY100 mln in twice a week auctions beginning on Dec 23 and continuing through June. It will buy TRY5 bln through this process. It will be focused on the 1-5 year part of the curve. It did not specify how it would purchase the other TRY3 bln.

The TRY8 bln amounts to about 5% of the Turkish Treasury's planned borrowings for 2010. Looking at the maturity structure of the Turkish paper held by the central bank indicates that TRY5 bln will mature in May and of the remaining matures TRY1 bln in each of the months of July, Sept and Nov.

The Future of the Carry Trade

The Japanese yen has been suffered the most in the wake of news that fewer Americans lost their jobs in November. There has been a debate in the market over what would happen when the dollar carry trade was exited. One camp thought the the end of the dollar carry trade would be marked by renewed crisis and the unwind of the risk trade. The other camp suspected the yen would replace the dollar as the key financing currency.

Consider the big picture developments this week. UK officials made some noises about perhaps selling some corporate bonds, ostensibly to boost liquidity, but the market sees it as another sign that quantitative easing policy is on its last leg. The ECB adopted an index rate to the 12-month refi operation and although Trichet said it did not signal anything about the trajectory of rates, the market realizes the only significance of the move it if the repo rate was hiked. And now the US jobs report and the revisions are more than even the most optimistic forecasters anticipated and as we previously noted, the market has brought forward the anticipated Fed hikes.

Fed Funds and The Dollar

The much stronger than expected US jobs data has triggered a large sell-off in the US debt market and is sparking sharp losses in European bonds as well. Of particular interest is the dramatic sell-off in the Fed funds futures as the market reassesses the trajectory of Fed policy in light of evidence of light at the end of the tunnel of long and deep job losses. Weekly initial jobless claims have long pointed to some improvement in labor conditions, but today's report goes a long way toward catching up.

December and the Dollar

Cognitive dissonance is when one holds contradictory beliefs simultaneously. This is the condition investors are in when they believe in regular patterns in the markets and the efficient market theory.

‘Tis the Season

The largely unregulated foreign exchange market has an average daily turnover last officially estimated (BIS 2007) at $3.2 trillion. As the year winds down, many investors and analysts, who otherwise believe foreign exchange is the most efficient market in the world, want to believe there is a seasonal pattern that allows one to profitably sell the dollar in the month of December.

Strong Canada Jobs Data Says Nothing About US

Canada reported much stronger jobs data than the market expected, sending the Canadian dollar broadly higher. However, the strong showing in Canada should not be seen as a hint or signal of what to expect from the US.

Canada grew 79.1k jobs in November, of which 38.6k were full time jobs. The consensus had look for a modest 15k rise after a 43.2k fall in October. November's jobs rise is third in the past four months and is the largest since Sept 2008.

Japanese Treasury Holdings

In the past we recommended that Japan consider using its massive reserve holdings to support the domestic economy. In particular we suggested selling 1/4 of their reserves and to finance domestic consumption. In early 2008, in response to our op-ed piece in the Financial Times, the IMF quickly argued that it did not think that Japan needed fiscal stimulus and Japanese officials tried to explain that the reserves were purchased by issuing financing bills and that would leave an unfunded liability (the financing bills would remain).

Mexican Peso New Highs for 2009

An upward revision in the central bank of Mexico's inflation forecasts announced yesterday propelled the peso to new highs for the year on ideas that the new forecasts are a signal of a rate hike early next year. We suspect the market, which the non-commercials (speculators) in the futures market held as of last week a net 89k long contracts, the most in over a year, is seeing what it wants to.

The central bank governor acknowledged that the increase in inflation will be temporary and largely a result of tax increases and administered price hikes. Income, sales and excise taxes were raised as part of the effort to offset the decline in revenue the energy sector. Higher prices for government provided goods like gasoline are also expected, but they have a one-off impact on inflation measures. Moreover these kinds of things, like higher taxes are disinflationary as it reduces discretionary spending.

Daimler Joins the Move to US

We have noted that the combination of the chronically weak dollar, strong productivity gains, and the threat of protectionism will likely encourage foreign companies to boost their productive capacity in the United States. A couple of Japanese auto producers have already made recent moves in this direction. Today, Germany's Daimler said it will shift some of the production of its best-selling Mercedes-Benz Class C model to its US facility.

Daimler officials were quoted on the news wires indicating that the shift was part of a larger effort to bring production closer to its main sales regions and reduce exposure to the variability of currencies. According to reports, Daimler estimates that producing its car in the US saves about 2000 euros per car.

Data and Policy Mix Frustrate Attempts to Stabilize BRL

Brazil has reported FIPE inflation and Oct industrial production figures today. The former did not rise as much as expected and the latter was a stronger than expected. FIPE calculation of CPI rose 0.29% in Nov. The consensus was for a rise of 0.32%-0.34%. In Oct, it rose 0.25%. The important point here is that Brazilian inflation appears to be back near the official target.

Industrial output rose 2.2% compared with consensus guesstimates of closer to 2% and the Sept series was revised to a 1.8% rise from the initially reported 0.8% gain. The important point here is that the economy is expanding at a reasonable clip and is capacity utilization rates appear to be rising.

Gulf Leaders Summit--Small Step toward Monetary Union

Yesterday we noted reasons to be skeptical of a single currency for several Latam currencies under Venezuela's leadership. We can be only slightly more optimistic about the near-term possibilities of a monetary union in the Gulf.

A Gulf leaders summit began today. Two political issues were on the opening agenda: support for Saudi Arabia over the Yemen rebels in a conflict that flared up since early November and encouraging Iran to comply with international rules, but urging the reliance on dialogue to resolve the problem.

Behind Better than Expected German Jobs Data

Germany reported today that November unemployment fell 7k instead of rising 5-10k as the market expected. This is the fifth consecutive month that the number of unemployed has fallen in Germany. It offers a stark contrast to the US jobs picture, where another net 125k are expected to have lost their jobs last month. But does it ?

There are two drivers behind German labor market developments.

The first applies strictly to today's report. There was a one-off change in methodology of calculating the unemployed totals. The German Labour Office says without this change, unemployment would have risen by 10k.

More Thinking About the Japan and the Yen

The Bank of Japan announced a new liquidity facility today of roughly JPY10 trillion in three month loans to commercial banks. The BOJ came under pressure from the DPJ government and BOJ Governor Shirakawa can be forgiven if he does not see much of a difference between the pressure brought to bear by the previous LDP government and the new DPJ administration. Shirakawa was clear that although he conceded that this measure be considered as a quantitative easing, a phrase he has generally avoided using, there was not change in the BOJ's economic assessment. The measure today was meant to address what Shirakawa says was potential adverse effects on corporate sentiment caused by the rising yen and weaker share prices.