The Dollar: Punishment Now, Reward Later

The divergent paths between the ECB on one hand and the Fed, BOE and BOJ on the other hand are very stark. The ECB seems determined to reduce the extraordinary liquidity provisions as they expire at the end of the year. In contrast, the market seems to be acting as if new bond purchases by the Federal Reserve are a done deal. Japan is moving to provide additional monetary and fiscal support. Despite the immediate retort by the BOE’s dissenting hawk Sentance, fellow-member Posen’s comments suggest a dovish consensus may be emerging at the MPC for additional measures, though it might not be quite there yet.

The ECB is the outlier and although in the short-term this is favoring the euro, this may not lay the basis for a sustained rally. The less supportive monetary conditions coupled with tighter fiscal policy will mean that the region is unlikely to generate the growth needed to stabilize debt ratios. So once again the old formula by which the dollar is punished in the short-run for pro-growth policies and later rewarded still seems to be operative.

The prospects for new asset purchases in the US are overwhelming the continued stress in Ireland and Portugal as a driver in the foreign exchange market. The Irish and Portuguese economies are roughly the same size and about 1/3 smaller than Greece. If the problems are contained there, then the European fire wall has worked. Italy’s 7.9 bln euro bond sale today went off without a hit, (slightly higher bid-cover than the last auctions) even though there is heightened political uncertainty ahead of the confidence vote later today.

Spain is experiencing its first general strike in eight years. Speculation continues to run high that Moody’s will soon cut Spain’s triple-A rating. That rating agency has had them on credit watch since late June. A one-notch cut would bring it to where Fitch has been. S&P has Spain a notch lower than that. Most seem to be looking for Moody’s to bring Spain down to Fitch’s level, but a two-step move cannot be entirely ruled out. As the rating agencies often lag behind the markets, and in this case Moody’s is truly lagging, the market impact may not be significant. There used to be talk about a multi-speed Europe and there appears to be one emerging, but not quite the way it was initially envisioned. It is fragmented. There is Greece with its separate EU/IMF package. There is Ireland and Portugal, where the wolf seems to be knocking on the door. There is Italy and Spain, which strains but still fairly well contained. There is Belgium and Austria where some pressure is beginning to be evident. As noted here yesterday, after Portugal and Ireland, Belgium bonds are the third worst performing euro zone bond market this month. The budget pressures in the region are likely to get worse as higher interest rates means higher debt servicing costs, which means more savings are necessary.

The US House of Representatives are expected to vote on the bill that seeks to make it harder for the Commerce Department to reject corporations seeking countervailing duties on Chinese goods because of the undervalued yuan. This may make headlines but it remains aimed primarily at a domestic audience ahead of the midterm election.

Although contacts reported that the Senate was unlikely to take up the measure before their recess early next month, the champion of the bill there, NY Senator Schumer, let confirmed this may saying he would push for the bill after the election. China seems to be responding on two channels. One is they have let the yuan appreciate at a faster pace recently. The reference rate was set today at CNY.66936, the lowest for the dollar since July 2005. The 12-month NDF’s now imply a 2% pace of appreciation. It has appreciated 1.85% this month.