Holiday Update

UK and US markets are closed. Quieter trading has seen the US dollar pare some of the late Friday gains scored in the wake of the Fitch downgrade of Spanish sovereign risk.

The combination of only a one notch move, when many observers, including ourselves, believe more is justified, and a stable outlook has seems to be a case of "it could be worse". Despite the lack of follow through euro selling, few think the decline is over.

Even pressure from the European sovereign debt crisis eases for the time being, the other force we expect to underpin the dollar will likely receive more of the limelight this week. This is the relative strength of the US economy. The main focus here will be on US employment data at the end of the week. We note that the Bloomberg consensus is creeping up to now stand at 508k.

Euro Surrenders Earlier Gains

The euro has surrendered its earlier gain, dropping a full cent from the session highs set in early Europe just above $1.2450.

The short-term technical indicators were a bit stretched, but the proximate cause seems to be news from the Germany's Bafin, the financial regulator, that the German government remains committed to the naked short ban despite the lack of international or even European support.

Fallout

Increasingly policy makers and investors are thinking about the consequences of the European financial crisis. The following focuses on two such consequences that are unlikely to appear on other lists. The attempt here is to be additive not exhaustive.

Europe: Re-writing the Social Contract

This year was supposed to be about the US and UK exiting quantitative easing programs at the end of the first quarter and for the global economy to continue the recovery begun, albeit slowly, in 2009.

While this did indeed take place, it was obviously overshadowed by the European debt crisis and the strengthening of the deflationary grip in Japan. This resulted in both the European Central Bank and the Bank of Japan extending, and in the former’s case, devising new emergency facilities.

Euro, Canadian Dollar, Swedish Krona, Yen

The euro has broken above the $1.2350-$1.2400 band of resistance that has capped the corrective upticks in recent days. If this is sustained, we have suggested there is potential in the coming sessions toward $1.2600.

Our constructive outlook for the dollar was never based solely on Europe’s woes, though of course that has been the dominant factor. The other support for the greenback comes form favorable economic developments in the US. Our hypothesis has been that macro-economic fundamentals will replace the “risk-on/risk-off” matrix. We have focused on the output gap, and the countries that can close it first should have stronger currencies.

Euro in Play, Calmer Markets

The US dollar is mostly little changed today. The main feature is the covering of short euro positions and this has lifted the single currency to new four-day highs against the dollar.

As I have noted in recent days, its downside momentum had faded and the near-term risk was bout of position squaring.

Dollar Firms NY Morning

The dollar is still lower on the day, but it has recouped more than half of its earlier losses against the euro and sterling.

Sterling has peaked just before the disappointing CBI retail sales report. After being turned back as it approached $1.4600, it is now testing support near $1.4450. A break of this could see another half cent decline today. The hourly uptrend and congestion area is seen near the $1.4400 area.

Money Market Developments

Three month dollar LIBOR has edged up again today. It has risen every day since May 10th, though the pace has slowed. This reflects the demand for dollar funding. While the focus in on European banks, the scramble to secure funding seems more widespread. The fx forward market is one avenue that dollar funding can be secured and contacts report this is widespread, including in some Middle East currency forwards.

Meanwhile, reports suggest that US fund managers are trimming their holdings of commercial paper issued by European banks. Funds also appear to be shortening maturities and letting paper roll-off, which is more passive than outright selling.

Today's Drivers

The euro has largely retraced yesterday’s losses. The euro’s cyclical low was recorded last Wednesday and it has successfully been retested. This is the longest the euro has gone without making a new low in a month. The $1.2150 area marks the lower end of the range that has emerged. The upper end of the range is seen in the $1.2350 area. A move through the band of resistance that extends to $1.2400, would signal an advance toward $1.26 initially.

Some of the recent losses in the euro were likely fueled by momentum traders and now that the momentum has stalled, some of these seem vulnerable to a squeeze. On the other hand, the negativity toward the euro we have picked up in discussions with medium term and longer term investors is powerful. It will take more than a modest correction to force a strategic change from that market segment. The leveraged community may roll spot positions in to the options market to give them more staying power. We note that the premium that is being paid for euro puts over euro calls is wider today despite the euro’s advance and this lends credence to this assessment.

Calmer Capital Markets

The US dollar is broadly weaker today as is the Japanese yen as the latest bout of market anxiety eases. News that China indicated that it is not planning on selling its European bond holdings helped the euro recover yesterday’s slide.

A couple of Japanese life insurers made similar supportive comments as did South Korea’s central bank. At the same time, are reports suggesting that North Korea may be looking for a back channel way to step ease tensions and this has also encouraged a more stable tone in capital markets.

Euro Slips Anew

The euro has broken down again and has been pushed through the $1.22 level. It is not as if the market needs new reasons to be bearish the euro, but the news that the market seems to be reacting to now is a Financial Times piece claiming, apparently without attribution, that China's State Administration of Foreign Exchange (SAFE) is reviewing its holdings of European bonds.

China is very secretive about the composition of its reserves and does not reveal them to the IMF for their COFER report. Nevertheless the FT note claims that SAFE has about $630 bln of euro zone bonds in its reserves. This is roughly 25% of their reserves as of March and is close to what the market assumed (namely that China's allocation largely mirrored the world's as a whole).

A$ Takes Off

The Australian dollar is rallying on the back of local press reports claiming the government is preparing a major retreat from its super 40% resource tax.

The resource tax is part of a larger tax reform package and it went over like the proverbial lead balloon. It is too early for us to determine the veracity of the claim, but it is driving the Australian dollar higher.

The Australian dollar moved to $0.8386, roughly a cent higher from where it was trading as NY markets opened.

Spain Still in Focus

The euro is grinding lower in the North American morning. Traders here are talking about the Wall Street Journal article that reports talk that a large Spanish bank has been struggling to roll over $1 bln short-term funding in the US commercial paper market.

Dollar LIBOR crept higher today for the 11th consecutive session and is now at a new 10-month high. Clearly there is a party or parties are are still trying to secure dollar funding At today's ECB auction for dollars, three banks took down $5.4 bln. There continues to be talk that officials are considering cutting the punitive rate charged (100 bp on top of OIS). There is also talk that longer dated swaps might also be made available shortly.

Asian Security Issues May Undermine Japan

Japan's DPJ government has been forced to back down on its campaign pledge regarding the moving of the US Marine Corp base in Okinawa. Prime Minister Hatayama's retreat may come at a high political cost. It appears to have weakened his already poor standing in opinion polls and appears to be undermining his governing coalition. In sum, it adds to the odds that the DPJ will lose the upper house election in July.

Hatayama's decision came before the latest tensions on the Korean peninsula, but likely reinforce the decision that now is not the best time to reassess the US-Japanese security relationship.

However much the tensions in Korea are unsettling, what investors do not seem to fully appreciate is that China's recent actions may an even greater cause of concern.

Euro, Swiss franc, Fed Update

There is no significant driver of the foreign exchange market today. The tone is less tense than it has been in recent days, but there still does not appear to be closure and calm seems fragile.

While the euro, for example, has risen above yesterday’s highs, those gains were recorded in early Asia and Europe has need managed to get the euro above $1.2350. This $1.2350-$1.2400 area is a resistance band that the euro may have difficulty taking out in North America today. However, while euro shorts are dominate, the downside momentum has stalled, leaving some of the late euro shorts in week hands. The price action suggests some kind of consolidation is at hand. The issue is whether the consolidation is a brief respite in the euro’s slide or will it transform into a bona fide correction. Confirmation of a near-term bottoming pattern in the euro requires gains through the resistance band identified. Such a move could signal a move toward $1.2600. Given the deep-seated euro bearishness, and still concerns about the viability of the euro zone over anything but the shortest of terms, the core euro shorts will be patient.

Calmer Markets, but Fragile

The US dollar is narrowly mixed in calmer foreign exchange markets today. Sterling and the Japanese yen are trading around levels seen in late NY yesterday, while the euro is slipping back toward the session lows near midday in London.

The Swiss franc and Australian dollars are modestly firmer. The news stream is light and the market almost appears to be waiting for new developments. Perhaps it is the gain in equity markets that is encouraging the more stable tone in the foreign exchange market. Most emerging market currencies are slightly firmer today as well.

Hard Asset Investor: Major Depression in Greece Likely

Currency in Crisis

I did an interview with Mike Norman of Hard Asset Investor you can watch it here.

Spain is the Pain

Currency in Crisis

If there was a doubt about it, there isn't any more. The European debt crisis is not simply a Greek phenomenon. Spain is the focus now. Spain (sovereign and private) owes foreign investors roughly $1.1 trillion. In comparison, Greece's external debt is closer to $236 bln.

Besides the news that every one is now aware of (a savings bank taken over by the central bank over the weekend, the merger of 4 additional banks and the IMF's warnings), two other developments are noteworthy.

Rujors Helping Euro Catch a Bid in Early North America

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There is talk that officials will take another step up the escalation ladder to combat the continued rise in LIBOR. The three-month rate has doubled now during the European debt crisis.

The Fed has renewed swap lines to provide foreign central banks dollars that they in turn can auction to their members. The problem is that banks are not taking advantage of this source of funding. The most compelling reason seems to be that the punitivive price the central bank want is too much. It is more than double the price that banks can secure funding in the market.

Asian Central Banks May Have Sold Dollars

Strong upward pressure on the dollar emanating from the European debt crisis and the tensions on the Korean peninsula apparently was countered by intervention from several Asian central banks.

At one point the dollar was nearly 5.25% stronger against the Korean won on the day, bringing its advance to more than 13% since May 14. The central bank is rumored to have sold $3.5-$4 bln. The dollar now is about 3% higher on the day.

FX Drivers

The main driver today is fear that the European debt crisis is spreading to Spain. Three developments in the past couple of days have put Spain in the market’s cross-hairs. First, the Spanish central bank had to take over a savings bank over the weekend. Second this was followed yesterday by 4 other savings banks merging. Third, the IMF yesterday urged Spain to do more to overhaul its banking system warning that its response has been too slow. It also commented on some of its structural rigidities, as in the labor market.

In addition to its much larger size, Spain also differs from Greece in that the bulk of Spain’s debt issue is not (yet) a sovereign issue as it is in Greece. As in Portugal, the debt is still largely a private sector issue. However, all share that common trait of requiring external financing.

Dollar Races Higher

The US dollar is posting strong across the board gains. The sole exception is the Japanese yen, which is also benefiting from the heightened anxiety.

There are three main drivers today. First, there is fear that the European sovereign debt crisis is spreading, with banking issues front and center in Spain. Second, there is concern that some central banks may be shifting euro holdings into dollars. Third, tensions in the Korean peninsula continue to run high. The euro and sterling have thus far held above last week’s lows (~$1.2144 and $1.4231 respectively). However, the euro has fallen to its lowest level against the yen since Nov 2001.

Is Move From May 10th Over? If So, then What?

On May 7th, the market covered some short euro exposure in anticipation of some sort of response by European officials. As we know they came up with a large package of guarantees (not just for Greece) and loans, and the ECB provided now liquidity facilities and agreed to buy sovereign bonds in the secondary market.

The euro initially reacted positively but that lasted around 12 hours and the euro was sold off anew. From the high on May 10th to the low recorded on May 19th, the euro dropped 7.25%. The euro's decline today retraced almost to the tick 61.8% of the gains since May 19th low. The recovery back above $1.24 is lends credence to the idea that the euro is caught up in some kind of correction that could still have more room to run. The $1.2450 offers the initial barrier and then $1.25.

Diversification into Dollars ?

There has been more talk of central banks moving out of euros into dollars. As far as we can tell, the only confirmation appears to be Russia. Despite its campaign for an alternative to the US dollar, recent comments by the central bank suggest the dollar's share of Russian reserves have increased and it is not simply on a valuation basis.

On a slightly different front, we note that Japan's Post Bank, the largest bank in the world in terms of deposits bought US dollar bonds for the first time since 2006. Its dollar bond holdings rose to $9.4 bln from $335 mln at the end of Sept 2009. It had no dollar bond holdings at the end of the previous fiscal year (March 2009).

Korea: New Wrinkle in SED

The compelling evidence that North Korea sank the South Korean vessel that killed 46 sailors has added an extra wrinkle into the US-Chinese Special Economic Dialogue that are underway.

Some 200 US policy makers and advisors have made the trip, including companies who are hoping to export more clean energy technology. There are unlikely to be significant developments on the yuan exchange rate mechanism. In fact the 12-month non-deliverable forwards imply the lowest rate (smallest revaluation of the yuan) in nearly 8 months. China exports more to Europe than it does the US and this is as good of a reason as any to maintain the status quo. Note that the yuan has appreciated by more than 14% against the euro this year.

European Developments in Focus

The absence of fresh developments over the weekend encouraged euro selling today. Before North American traders returned to their posts, the euro has already retraced 50% of the gains in the second half of last week. The next retracement objective is seen near $1.2346. Recall last week’s low was recorded mid-week near $1.2144.

News that the Spanish central bank had to rescue a savings bank is more suggestive of the underlying problems than substantive in its own right.

New Week, Same Dollar--Higher

The US dollar is broadly higher to start the last full week of the month. The pre-weekend short-covering of the euro has been reversed and with today’s more than 1.5% loss has retraced more than 50% of its gains scored in the second half of last week.

News that Spain rescued a savings bank over the weekend contributed the undermining of sentiment. Sterling traded up to almost $1.4530 before being setback in the European morning. Support was found ahead of $1.4400. Although the reports of GBP6.24 bln in spending cuts announced by the new government have attracted interest, but the June 22 emergency budget is seen as more significant. Meanwhile the dollar is trying to re-establish a foothold above the JPY90 level, but risk aversion may help capped the greenback in the JPY90.50-75 area. High yielding emerging market currencies are generally firmer today.

CNBC: Euro's Downfall: Should US Intervene?

Canada Dollar Good Buy, not Good Bye

Canada has reported stronger than expected April inflation reading and March retail sales data. The foreign exchange market remains gripped by the sovereign debt crisis in Europe and the threats to world growth, but the economic data underscores the bullish case for the Canadian dollar. When the crisis passes, I expect the Canadian dollar to be one of the strongest currencies.

The Bloomberg consensus had been for a 0.1% increase in March retail sales, and Canada reported a dramatic 2.1% increase and revised up the Feb gain to 0.8% from 0.5%. Auto and related sales were strong, but gains were broadly based. Excluding the automotive sector (autos, parts and gasoline) retail sales were up a still impressive 1.6%.

ECB Intervention Just Now: Color Me Skeptical

The euro has rallied about 1% and has spurred talk of ECB intervention. I am skeptical.

There seems to be little reason to expect the ECB to intervene outside of its time zone in a unilateral fashion. Convention, we understand, would dictate that the ECB would have to notify (ask permission?) of the Federal Reserve to intervene in the US market.

In addition, the ECB would intervene to drive a message home to the market and to burn the fingers if not more of the speculators. It would seek to get the biggest bang possible, in which case there would be no doubt whether there was intervention of not.

Europe Still in Denial

Eurogroup head and Lux Prime Minister Jean-Claude Juncker has played down need to intervene in the foreign exchange market, saying there was no need to defend the euro. Yet in the same interview, he claimed that the EU/IMF/ECB Stabilization Mechanism was necessary to defend the single currency.

Yet since the new initiative was announced, the euro has fallen over 5% against the US dollar and even more against the Japanese yen. If the goal of the Stabilization Mechanism was to defend the euro, it does not look like it has been particularly effective.

European Financial Reform: Bluster or Substance?

Germany's unilateral imposition of a ban on naked short sales of European bonds, CDS and shares of the top 10 financial firms has stolen the headlines for sure, but it is part of a larger development that needs to be understood. The poor reception to the German moves seemed so obvious it begs the question of why did it do it and why then.

Germany's announcement followed a two-day European finance ministers meeting that reached important decisions on a tax on financial transactions and regulation of hedge funds. In order to reach an agreement required a political compromise within the German ruling coalition. Moreover, the German parliament may vote on the Stabilization Mechanism as early as the end of the week and the compromise enhances the chances of smooth passage.

Rumors Fuel Euro Short Squeeze

Given the sharp recovery in the foreign currencies in the North American morning, it is hardly surprising that there are numerous rumors seeking to explain what happened.

Although no dealers are reporting actual intervention, there is talk that the pace of the euro's decline has become more salient for policy makers. There is talk that the officials are preparing for intervention.

More Thoughts on Germany's Move

German financial regulators announced an immediate ban on naked short sales of European government bonds, credit-default swaps, and shares of the top ten banks and insurers. This appeared to precipitate new euro selling that continued through the North American afternoon and into early Asian trading.

Market participants concluded that the move was ill-thought out, uncoordinated, and likely ineffective. This would seem to be yet another case of a European government taking the wrong fork in the road.

What the Options Market is Telling Us about the Euro

The euro's decline is relentless and the foreign exchange market is becoming disorderly. This is how the spot price action feels and this is what the options market is confirming.

The standard metric is 3-month volatility and it is quoted a little above 14.6% currently. To put this in perspective, during the 9/11 period 3-month euro vol reached about 14.4% and in late 2008, it reached almost 25.5%. Three-month vol reached almost 16% last week.

Ten of 15 Countries Pony Up for Greece

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Greece received an estimated 14.5 bln euros earlier today and this ensures it will be able to service the debt that comes due tomorrow. There apparently had been some jitters ahead of the event and with today's transfer, Greek bonds staged the biggest rally in several days.

Currency in Crisis

However, what is noteworthy is that there are 16 countries that share the euro. One country was the recipient of the aid, that leaves 15 countries, but only ten countries came through. Although Wellink, Weber and Stark reportedly objected to the Stabilization Mechanism, their respective countries did pony up money for Greece.

What To Make Of US Senate Conditionality on IMF Funds

Late Monday the US Senate approved, by an overwhelming majority (94-0--and who said bipartisanship is dead?), an amendment to the financial regulation overhaul bill that prohibits the US support for IMF loans to countries that aren't likely to repay them. In particular the amendment requires the Treasury Dept to certify whether a loan by the IMF to a country with a public debt to GDP of more than 100% can be repaid.

The equity market and the euro had appeared to be stabilizing late in the North American session, but this news seemed to undercut the stabilization. The euro dropped 3/4 of a cent and Asian equity markets opened broadly lower at least partly on ideas that the US may torpedo the recent IMF/EU/ECB stabilization efforts.

Stark Revelations

Comments by European Central Bank board member Juergen Stark may be more important that the market initially understood. He indicated that the sovereign bonds the ECB purchases will be held until maturity. This is significant in terms of debt restructuring.

Many observers have seen the dramatic decline in the risk premium that Club Med and especially Greece pays over Germany and the decline in credit default swap prices and have argued that the EU/ECB/IMF plan reduces the risk of a debt restructuring. I do not think it is that clear.

Not Just Failure, but Success Weighs on the Euro

Many observers are attributing the euro's weakness to concerns that the measures taken by the EU/ECB/IMF may fail to contain the crisis. There is surely an element of this. Yet that interpretation may rely too much on the foreign exchange market rather than the debt market, where the crisis began.

Looking at the dramatic rally in Club Med bonds, especially Greece and Portugal, suggests that the measures have succeeded reducing premiums and credit default swap prices. Money markets are seeing an easing of tensions as well.

Is Near-Term Euro Momentum Stalling

After returning to levels prior to the Europe's 'shock and awe offensive the euro appears to be trying to find a base. There is a bullish divergence in the hourly RSIs.

There also is a stark contrast between the bond market reaction and the currency market response. In the bond market the measures have supported prices and the risk premiums have been reduced dramatically. After the initial 12-hour rally the euro has traded heavily.

Merkel's No Tax Cut Warning is Euro Negative

The market has scrambled to adjust positions in the wake of the new European initiative. German Chancellor Merkel, who lost control of the upper house of parliament yesterday, has told reporters that there cannot be new tax cuts for at least two years. This is unfortunate. It means that the underlying imbalances in Europe will not be addressed. It means that the fiscal tightening that is going to take place in Greece, Portugal, Spain and Ireland is not going to be offset by some easing of policy by Germany.

Most of the euro's gains were registered before Europe opened and since a little after 8 gmt (4 am est) just below $1.3100, the euro has pulled back a little more than 1% to find support near $1.2940 (trend line on hourly charts and near a retracement target) This may prove to be a swing area, determining its near-term fate.

Europe Update

Word is still not official, but clearly European officials have taken another step up the escalation ladder to combat the sovereign debt crisis that is threatening to disrupt the recovery seen in the capital markets over the past year.

The latest is that as much as a 600 bln euro package is being put together. It appears that it may consist of around 440 bln euro of loan guarantees and another 60 bln euro stabilization fund. The IMF may provide another 100 bln euros.

ECB Rumors and the Euro

Rumors circulated the markets today that as early as this weekend the ECB will announced a 600 bln euro 1-year loan facility. Just yesterday the ECB had a chance to do this, but as we know declined to do anything. Perhaps, the ECB was protesting the political pressure brought to bear on it recently and consequently sat on its hands. However, if the ECB does announce a facility over the weekend, outside its regular meetings, it would also appear to be back tracking. The price will be more erosion of its credibility.

The funding pressures are acute. That is probably what the banks told the ECB in their meeting today. Moreover, recall that last year the ECB provided unlimited 12-month funding at 1%. That operation needs to be unwound in several weeks and there was a need in any event, leaving Greece aside, to manage this process. Some term refinancing facility is desired and needed. It is not immediately clear why the ECB did not move in this direction yesterday.

Strong US Jobs Report, despite Rise in Unemployment

For the second consecutive month the US economy grew more than 200k jobs. The private sector has added 400k jobs in the March-April period. The unemployment rate ticked up to 9.9% from 9.7% as more than 800k people joined the work force. This looks like discouraged workers getting back involved and in some ways is a sign of returning optimism.

Two Trade Ideas

I recommended to our clients to buy Canadian dollars against the yen in Asia today near JPY86.80. During the near panic yesterday this cross collapsed to a degree we have simply not seen before. It traded 5 standard deviations form the 20-day moving average. A move of this extreme was not during the 2007-2009 crisis.

The Canadian fundamentals are among the least impacted by Greece. US banks have some small exposure, according to the BIS and US companies that service Europe either through exports or through local affiliate sales are exposed in a way that Canada and Canadian companies are not. As the April employment data illustrates, the Canadian economy is the only G7 economy that can compare to the US growth prospects this year and next. The combination of the weaker Canadian dollar and strong employment data should reinforce expectations that the BOC raises rates. Japan's growth prospects look a bit better than the they did at the start of the year.

European Tensions Pose Systemic Risks

The euro has recovered more than two cents off of yesterday’s low set late in the North American session yesterday. Many participants seem concerned that such dramatic price action in the capital markets will elicit a policy response. Japanese officials were happy to push this and revealed that the G7 will have a conference call today to discuss the events. The risk of intervention was mentioned, but also played down as it is not a currency crisis per se.

Separately the ECB is holding a conference call with banks to ostensibly discuss funding issues. The French parliament and the lower house of the German parliament have approved the EU/IMF/Greece agreement. This has help stabilize the euro. With hourly momentum studies over-extended for the euro, resistance in the $1.2850 may be sufficient to cap the single currency, barring a significant surprise in the US jobs data or from policy makers.

A Little of Everything

The US dollar is broadly mixed in still volatile market conditions. The euro has been boosted by indications of a G7 conference call. Sterling has been punished in the wake of the indecisive electoral outcome. The yen has weakened as the BOJ injected one-day liquidity for the first time since December. Although there are some large moves today in the foreign exchange market, it is not the panic conditions seen yesterday. However, tensions continue to run high and the tone is fragile. Canada reported a huge jump in jobs. The 108.7k was four times greater than the market expected and sent the Loonie sharply higher.

Greece Says Yes, but Germany's SPD Says No

The Greek parliament has approved the austerity measures the government agreed to and this saw the euro tick up. However, Market News International reports that the German SPD said that it will not vote for the Greek aid bill.

The parliamentary head of the SPD indicated that the government refused to agree to a financial transaction tax, which the SPD had indicated was their price of support. The SPD will urge its members to abstain in tomorrow's vote. As recently as earlier today the SPD was holding out the possibility of supporting the government.

Why is the Euro Still Selling Off?

The euro has been sold to new lows in the aftermath of the ECB meeting and Trichet's press conference. Trichet did not say or do anything to stop the rot.

There was no attempt to address the liquidity squeeze that is apparent not only in the euribor market but also in short end of the dollar LIBOR curve. To the extent Trichet addressed the euro itself, he showed no real concern. Indeed his silence in the face of the euro's near free fall this week (-5% against the dollar) was deafening. German Economics Minister Bruederle was quite explicit: he is not worried about the euro's depreciation. The headline appeared to coincide with the break of $1.27.

Critical ECB Meeting, SNB Steps Aside

The European Central Bank meeting today is critical. As is its pattern, it holds two meetings a year outside of Frankfurt. Today’s meeting is in Lisbon, which is one of the local governments (five in all) that Moody’s put on credit-watch yesterday for a possible downgrade alongside the sovereign. To be sure, what is at stake here is not so much a change in rates. ECB President Trichet’s prepared remarks and the following press conference is where the real interest lies. The market is looking for the ECB to take some additional measures to address the crisis.

Capital Market Developments

The US dollar remains firm against most of the major currencies today as the participants await the ECB meeting, which given the events in Europe, is the most important meeting arguably since 2008.

There are three currencies that stand out today. First, sterling is independently heavy. A weak CIPS service PMI (55.3 vs 57 expected and 56.5 in March) and last minute jitters ahead of the election results weighed on sterling and encouraged paring back of long sterling/short euro cross positions after nine month lows were set just below GBNP0.8470 in Asia.

Moody's, Protest in Athens turns Violent, Euro Moves below $1.29

News that Moody's has put Portugal's debt on review for a possible downgrade to the AA2 rating has pushed the euro to a new low for the move. Moody's says a 1 or 2 notch downgrade is possible. As we have noted, the rating agencies, and in particular Moody's seems way more optimistic on the debt quality than our proprietary models and the market. Downgrades seem like a matter of time--not if but when and how much.

Norway Hikes, but Sounds more Neutral

Norway's central bank, the Norges Bank, hiked key deposit rate by 25 bp today to 2%. It was a close call in terms of opinion surveys and the bank's board did consider keeping rates on hold. I had favored that scenario given some softness in recent data and the ongoing market turmoil.

The Norges Bank hiked rates twice in Q4 09 and this is the first hike this year. The immediate comments following the decision seemed to suggest a more neutral near-term outlook. The krone strengthened on the announcement. Euro support near yesterday's lows around NOK7.82 area held, at least initially.

Second Verse Same as the First: European Debt Crisis Continues

There is one major force at work in the global capital markets and it remains the European debt crisis. The basic concern is that the debt dynamics present not simply a liquidity crisis but a solvency issue. The latter point is underscored by the poor growth prospects in the periphery of Europe, which in turn also reflects underlying competitive issues. Of course, European officials are correct: Greece is unique. Spain and Portugal are different. But the market is right too that the similarities are striking.

Greece stands out as an extreme case, for sure, but others have been hobbled by the same problem, even if each national iteration is somewhat different. For example, public sector indebtedness in Spain and Portugal is not as large as Greece, the private sector debt burden is substantial and rigidities in the labor market, contracting economies and weak competitiveness are generally similar.

Capital Markets Overivew

The US dollar is narrowly mixed as a nervous pall hangs over the market. The European debt crisis remains front and center and the euro has been unable to resurface above the $1.30 level today after it gave way in North America yesterday. Like yesterday, the Swiss National Bank seems determined that the flight to safety does trigger franc appreciation. Sterling has been aided by demand against the euro. The euro broke below GBP0.8600 yesterday and has been unable to recapture that level, while cable has been largely confined to a $1.5100-$1.5200 trading range for the past 24 hours. The JPY95.00 level remains intact, but the yen’s ability to draw much safe may be limited by concern about Japan’s own debt rating and tensions on the Korean peninsula.

Don't Chase the Euro, Wait for a Bounce

The euro dipped below the $1.30 level, but losses below there were shallow. This is and has been a crowded trade, but the $1.30 level was the objective of many and the price action feels a bit like the end of a boxer's punch, when it loses much of its sting.

To be sure, I remain a euro bear. European officials have lost a degree of credibility. The EU/IMF plan was not bold. If it were bold, there would be not question about whether it was sufficient. European officials are still in denial, or seemed to be before today. No reason for contagion? Really? No convincing effort to get ahead of the market expectations, such a preemptive package or facility for other countries, like Portugal. The ECB has backtracked a couple of times from positions Trichet initially staked out. This does not bolster credibility, even if his capitulations were economically necessary.

Deflationary Forces in US and Senior Loan Officer Survey

After the PCE deflator was reported yesterday the Dallas Fed re-jigs it, cutting out strongest and weakest to arrive at a trimmed mean. By its calculations the PCE deflator rose 0.1% at an annualized basis, which is the result of rounding up. On a year-over-year basis the Dallas trimmed mean measure is up 1% vs the 1.3% increase of the core PCE.

A key aspect of the report that few are paying attention to is that of the components, some 44.4% fell in March, down ever so slightly from 45.5 in February. This is quite a large percentage of goods/services experiencing outright price declines from a historical perspective. Although the expansion of the Fed's balance sheet during the crisis, the variant of QE, the large government deficit, many observers are still worried about inflation. The point here is that deflationary forces have not yet been fully defeated.

Thai Market Euphoria may be Exaggerated

The beleaguered Thai Prime Minister Vejjajia proposed a mid-Nov election as part of a broader compromise meant to end the eight weeks of violent protests and keep him in office until next year's budget makes its way through parliament. Although the financial markets responded positively, with a 4.4% rise in local shares--to the highest level in a month and the largest rise in the Thai baht in a couple of weeks. The hospitality industries account for around 6% of Thailand's GDP and this sector had been hit hard by the civil unrest. The local airlines and hotels led the market today.

The civil disorder has already shaved 0.5% off GDP, according the finance ministry, which had warned that if the demonstrations persist, it could lower growth by 2%. Previously the government had forecast 4.5% growth this year. Ironically last week, the central bank increased its Jan forecast of 3.3%-5.3% to 4.3%-5.8%.

Greenback's Two Legs and Developments in Japan

I have argued that the dollar’s rally stands on two legs. The first leg, arguably the bigger of the two, is negative developments elsewhere in the world. While the European debt crisis is the most obvious consideration; it is not the only one. China’s incremental removal of excess liquidity and concerns of an unsustainable rise in real estate has deterred investment there. There appears to have been a shift away from cross border equity investment toward fixed income investment and dollar bonds, not just issued by US names, have drawn interest.

Snapshot of Global Capital Markets

The US dollar remains firmer across the board. A certain degree of skepticism continues to weigh on the euro. There are suspicions that Greece may need more funds and/or that the official moves do not prevent contagion. Others recognize that even if the package for Greece does the trick, a lower euro is still the likely consequence. In the UK, a weak mortgage approval data offset the tick up in the CIPS manufacturing survey, and with a risk of a hung parliament, sterling lost another cent to almost $1.5160 before finding a decent bid. The Reserve Bank of Australia hiked rates for the 6th time since last October, but seemed to signal a pause now and this coupled more negativity surrounding the “super-tax” on resource companies has seen the liquidation of stale Australian dollar longs. Near-term risk extends to last week’s low just below $0.9140. Meanwhile, the greenback held just below the JPY95 level, where options structures are thought to have been placed. Support is pegged near JPY94.40. Emerging market currencies are generally softer.

North American Players Not Convinced by Greek Bailout

After trading sideways in the London-less European session, North Americans have picked up where Asia had left off and have bought up the greenback. The euro has been pushed below $1.3200 and is approaching the $1.3115 low seen last week. Many have their sights set on $1.30.

The dollar has traded on both sides of last Friday's trading range against the euro, Swiss franc and the yen. Sterling, ironically, despite the glimmers of hope in some quarters that the Tories might just pull off an outright victory, was unable to rise above last Friday's high, but did take out its lows. Support is seen near $1.5200 and then $1.5160.

Yen is Vulnerable

Japan's markets are closed until Thursday. That means that Japanese exporters believed to have capped the dollar's upticks in the JPY94.40-70 in recent weeks may not be there now. At the same time, a recovery in US equities and rising US yields may also favor a push higher for the greenback.

We note that the dollar-yen exchange rate is more correlated to interest rate differentials and is it has been fairly steady this year. Conducting the correlation at the level of percentage change, finds the correlation between US-Japan 2-year differentials and dollar-yen is about 69.2%. The correlation at with 10-year differentials is 71.1%. This correlation has been relatively steady over the past month, when US Treasuries appeared to draw a safe haven bid when Greece and peripheral European tensions were running high. Over the last month the correlations have been 79% and 71.8% for the 2-year and 10-year differentials respectively.

Global Update

The euro initially opened in higher in Asia in response to the Greek/EU/IMF package. However, it trended lower in Asia, though lost its momentum in Europe ahead of $1.3200. The generally firm manufacturing PMIs failed to elicit fresh buying. Many remain skeptical of the lasting impact and are not convinced that closure is really at hand. And in any event, a weaker euro may still be desirable given the drag on aggregate domestic demand. The broad details of the plan were leaked toward the end of last week, so European officials denied themselves of much of a surprise factor. German Chancellor Merkel, who stopped campaigning for the May 9th election in North Westphalia, congratulated herself on correctly seeing that Greece could be in for more concessions. Greece did announce a package of additional 30 bln euros in savings, including wage cuts, a three year freeze on pensions, abolishing the 13-14th month wage payments to civil servants and the second increase in the VAT this year (latest to 23% from 21%). While this may helped Merkel protect here own flanks, the cost will be greater social upheaval in Greece and the undermining of the support of the Greek government. Large scale protests are planned for this week and support for the Socialist government continues to decline.

FX Market Unimpressed with Europe

The US dollar is firmer across the board. The deal worked out by Greece and EU/IMF/ECB is helping to ease strains in the European debt market, but does not appear to have dealt a significant blow to those who think that some form of debt restructuring remains. Support for the euro is seen near $1.3200, while resistance in the North American session is in the $1.3250-60 area. Sterling has shown little reaction to the barrage of newspaper endorsements for the Tories or the polls that suggest the Tories have widened the lead to 10 percentage points. Sterling appears comfortable in a $1.5200-$1.5300 range for the very near-term. The dollar held support in front of the 20-day moving average near JPY93.40. Offers are seen in the JPY94.30-40 area.