Dollar Consolidates

The US dollar is consolidating yesterday’s outsized gains. Profit-taking appears largely minimal, though sterling did receive a boost by the much stronger than expected February retail sales report (2.1% vs consensus of 0.7%). However, the market quickly appreciated the weather distortions and the January series was revised sharply lower (from -1.8% to -3.0%), the momentum stalled. The European summit kicks off among much rancor still and amid talk of a 10-20 bln euro package led by the IMF for Greece, though repeatedly since the crisis first broke there have been expectations of material aid only to be disappointed. The most likely scenario is further consolidation in a choppy North American session.

One of the key points that I have been making is that while the Greek/European issue has been a major force underpinning the dollar, it is not the only factor in the foreign exchange market.

On one hand, the proverbial toothpaste is out of the tube and there ain’t no putting it back easily. The largest reserve manager in the world, who a year ago excited many European officials with his call for an alternative reserve currency to the US dollar, clearly is rejecting the euro as an alternative, warning Greece is just the beginning and that Spain and Italy also pose risks. This assessment is nothing new of course, but it seems revealing about the Chinese attitude toward the euro.

On the other hand, there has been a substantial swing higher in US interest rates. We have been tracking the rise in different money market rates and noted earlier this week that for the first time in nearly 3-years the US 2-year yield was moving above the comparable German yield. Yesterday say the US 10-year note record its biggest decline in three-quarters of a year. The weak 2-year reception on Tuesday was followed by a poor 5-year auction yesterday.

Some commentators attributed poor reception to concern about the fiscal implication of the national health care. While such discussions can get politically charged, in any event, it seems that this is a difficult environment for Treasury auctions—fiscal year end for some investors and quarter-end, heightened anxiety over sovereign debt in general and a gradual realization that a potentially strong US employment report is around the corner. Note that early expectations are coming in around 200k.

While many observers have seen the link between the Treasury’s Special Financing Program, under which it will sell $200 bln in T-bills and deposit them at the Fed, and an increase in money market rates. This is a fine technical explanation for as far as it goes. However, it is not becoming clearer that there is something else going on as well. As a consequence of the deluge in supply, there are other bottlenecks appearing as financing vehicles and collateral are in abundance. The interest rates swaps, for example, that allow one to move to floating from fixed fell to -10 bp yesterday, which seems to be the lowest in at least 20-years.

However, from a foreign exchange point of view, the rising US interest rates may also be lending the dollar support, especially against the Japanese yen. The 2-year US-Japan spread for example has widened by 11 bp over the past 5 days to 94 bp. Proportionately, this is a large move. In the same time, the 10-year spread has widened by 15 bp to about 248 bp. In the year to date period, the dollar-yen is correlated with the 2-year differential 70.5% and with the 10-year differential by almost 75%. Note that the dollar finished yesterday’s North American session above its 200-day moving average for the first time since the middle of August 2009. That level comes in today near JPY91.50, which corresponds with a retracement objective from the week’s low near JPY89.85 on Monday.

Three pieces of economic data are worth reviewing. First, Japanese corporate service price index was weaker than expected falling 1.3% year-over-year in February and the Jan series was revised down to -1.2% from -1.0%. Tomorrow Japan reports CPI figures and a slight moderation in the pace of deflation is expected, but the fact that it persists to such a degree means pressure will likely remain on the BOJ to do more QE.

Second, the euro zone money supply was much weaker than expected, contracting by 0.4% year-over-year. It has been contracting in Nov and Dec 09, but turned slightly positive in Jan. One need not be a monetarist to appreciation that the contraction in money supply underscores the non-inflationary environment.

Third, Feb UK retail sales jumped 2.1%, well above market expectations but the downward revision to the January series and the hefty contribution of petrol sales undercut the headline surprise. The particularly harsh winter is distorting early Q1 data.

Finally, not to be lost in the shuffle, late yesterday the Carney, the Governor of the Bank of Canada sounded more hawkish than has bene the case and seemingly more accepting of the strength of the Canadian dollar. He reminded investors that the pledge to keep rates at record low levels in H1 was “expressly conditional” on the outlook for prices. And he said he viewed the Canadian dollar’s exchange rate through the “prism” of the inflation target. He acknowledged that core inflation has risen faster than the BOC expected. The next key date in this regard may be the April 22, update of the BOC’s inflation forecast. The bottom line here is that interest rates matter and the Bank of Canada is likely to hike in early H2, before the Federal Reserve.