CNBC: New Year Fear: Euro Crack

Three Revealing Developments

I am on vacation, but I have a television interview later today and as I was reviewing what happened today and three things strike me as noteworthy.  

First, China had its second failed auction this month today.  It sold about 80% of the 3-month bills as it wanted to.  The 7-day repo rate, which is similar to our Fed funds rate insofar as it shows the liquidity of the interbank market, has doubled in the past couple of weeks to almost 5.7%--a 3yr high..  The 3m bills that the government was selling yielded 3.68%.

CNBC: Currency Flow in 2011

Big Move on 2-Year US-German Spreads

The euro-dollar exchange rate has done a fairly good job of tracking the movement in the US-Germany 2-year interest rate differential over the past several quarters.  There is a big move today.  The premium Germany offers over the US has narrowed sharply.  At 35 bp, it is the narrowest since Dec 7. 

The main driver seems to be flows out of the periphery.  Irish 2-year yield is up 65 bp now and Portugal, which some reports suggest China will support, is up 13 bp.  With the peripheral countries on credit watch, downgrades are likely in Q1 11 and this will likely take place as these Portugal and Spain have large funding needs.   Not only do the sovereigns faces funding pressures but so will the banks.   It is possible Portugal seeks EU/IMF assistance before the end of Q1.   At the same time, higher quality sovereigns, including Germany, will also be raising funds. 

Mistrust Euro Bounce

The US dollar is generally weaker across the board.  These are holiday thin markets and the price action seems a reflection of necessary flows.  The main news that appeared to steady the euro were reports suggesting China is prepared to by 4-5 bln euros of  Portuguese debt.  Other reports indicate PBOC officials have not confirmed the earlier reports. 

Euro Rot Continues

The steady drum beat of negative European news continues and the euro has been sold off in response.  It is not simply limited to the periphery, as we have pointed out.  There are rumors today that Belgium faces an imminent downgrade.  Recall that Belgium's outlook was cut to negative from S&P on Dec 14.  There is also increasing concern that France's turn may be coming. Our proprietary models warn that France is on the borderline and insurance via credit default swaps has tripled to over 100 bp.  

Lloyds Bank in the UK warned that it faces GBP7 bln loss on Irish loans and the ECB arranged a GBP10 bln swap line with the Bank of England before the weekend.  The Speaker of the Slovakian parliament called for preparing plans to drop out of the euro and reintroduce its own national currency  Greeks demonstrated against austerity. 

Handicapping European End Game Scenarios

The European financial crisis is of historic proportions and it remains unresolved as the year draws to a close. The resolution remains elusive, but there seems to be a finite number of ways that the situation will ultimately be resolved. Let’s consider them.

Scenario I: Country Leaving Monetary Union (3%)

Many observers suggest that the only solution of the debt crisis is for a troubled country to leave the union, introduce a new, devalued currency. We would attribute a very slight chance of this taking place. A robust cost/benefit analysis would reveal the high costs and uncertain benefits of such a course.

Fade Euro Resilience

The EU Summit may have ended, but the European debt crisis has most certainly not. What does it really matter to current investors, under mark-to-market pressure that the European officials have agreed to some wording changes in their Treaty to allow for a permanent crisis facility at the end of 2013?  Even the aid packages for Greece and Ireland have not stabilized their situations as Moody's 5-notch cut in Ireland's debt rating to Baa1 and a negative outlook today illustrates.

Recently Moody's also put Greece (and Spain) on credit watch for a possible downgrade. European officials do not appear to have taken any fresh initiatives to address the current pressures. It is disappointing and there is a price to pay for that disappointment.

ECB Increase Subscription Capital by 5 bln Euros

The ECB announced its subscription capital base of 5.8 bln euros would effectively be doubled to 10.8 bln euros effective at the end of the year. The move is not surprising and has been hinted for the better part of a week at least.

It does not have market implications. The ECB will have 10.8 bln euro capital base and asset holdings that are just below 2 trillion euros. In the private sector, this is a gearing ratio or leverage of about 175x. In comparison the Fed has a capital base of about $57 bln with assets in excess of $2.2 trillion. Its leverage is around 45 times. The private sector comparison is interesting, but the importance or value is not immediately evident.

Dollar Consolidates Wednesday's Gains

The EU Summit begins shortly. Out of the cacophony of voices will come some agreements, principally the modifications of the Lisbon Treaty, the closest thing to a constitution that Europe may have for quite some time, that will enshrine the European Stabilization Mechanism--the successor of the EFSF. This may include an agreement on collective action clauses.

German Chancellor Merkel was sharply criticized by political opposition in Parliament on grounds of not being supportive enough of Europe. SPD leadership is clearly more supportive of initiatives like a collective bond than is the CDU. This and the need for an agreement could see politicians do what politicians do and kick the can of controversial issues down the road. There is unlikely to be agreements on collective bonds, or increasing the guarantees of the EFSF,or having the EFSF purchase bonds. There may be agreement on new funding for the ECB. This year will finish without a clear and convincing strategy to address the debt crisis which will be a major force into next year.

FOMC Says Little News

The last FOMC meeting of the year produced a statement that reads very much like the Nov statement. It recognizes that although the economic data has improved it has not been sufficient to lower the unemployment rate. Contrary to some speculation prior to the meeting, it did not change its $600 bln Treasury purchase figure. There is little new or very interesting in the Fed's statement.

The market reaction has been similarly muted. The dollar initially was sold but quickly bounced back. Bonds remain pinned near session lows and the equity market is firm near session high.

There is one important event left this year and that is the EU Summit later this week.

Outlook for Swiss National Bank

The Swiss National Bank meets Thursday. A change in its monetary stance is not likely for several months at least. However, the SNB will provide new GDP and inflation forecasts that investors may find helpful. The Swiss government provided new forecasts today, ahead of the SNB. Growth this year is put at 2.7%, while the SNB's forecast is for 2.5%. The government raised its forecast for next year's GDP to 1.5% from 1.2%. It will be interesting to see if the SNB sees such a marked slowdown. The government expects 0.7% CPI this year and next.

The Dollar Slips More, but Weights are Transitory

The US dollar's pullback has been attributed to three main factors. First, some are placing emphasis on Moody's warning that the Obama- Republican fiscal compromise increases the likelihood of a negative outlook within two years. While this is potentially worrisome, the market most directly impacted would be the Treasury market and it rallied after the Moody's announcement. If the Treasury market did not respond, this does not seem like a very satisfying explanation.

Second there is some speculation that at today's meeting, the FOMC may decide to step up its bond purchases to protest the recent dramatic rise in rates. To the extent that this has indeed been weighing on the greenback, we suspect it will be lifted as the Fed has only begun its bond purchases. It could have chosen to increase the pace of purchases, but it did not. It seems highly unlikely that the Fed will change its asset purchase program in any substantial way at this juncture. Moreover, the Fed's statement from last month as whole is unlikely to deviate very much from last month. Core inflation remains soft and while the data has come in better than expected, clearly it has not been sufficient to bring down the critical unemployment rate.

ECB: Where is the Shock and Awe ?

The Financial Times reported that as Trichet was holding a press conference after the recent ECB meeting, European central banks were buying large amounts of sovereign European bonds. Reports suggested that the amounts were in 100-200 mln euro clips, 2-4 times more than usual. The market bandied about estimates of the ECB's bond purchases in the 5-10 bln euro range.

Atlantic Council Interview: Financial Impact of the Lisbon Summit

Here is an interview I did with the Atlantic Council on the Financial Impact of the Lisbon Summit.

FOMC Preivew and Dollar Outlook

A new factor has arisen that complicates the Federal Reserve’s task as it prepares for its last meeting of the year. The broad outlines of the agreement between President Obama and the Republican leadership on fiscal policy is significant, even if the compromise is tweaked a bit now or passes retroactively early in the new year.

Although few call will it that, but in essence a new fiscal stimulus package will be agreed upon under the guise of tax cuts. One of the biggest surprises is the 2% payroll savings tax cut that replaces the “Make Work Pay” tax cut that was the largest single item in 2009 stimulus package. Economists are revising up their 2011 GDP forecasts by 0.5%-1.0%.

Consolidative Tone

The major currencies are little changed against the US dollar at the start of the new week.  The exception is sterling, where it has been undermined by weak, but housing data from Rightmove but more importantly by the euro's recovery on the crosses.  The dollar is holding just below the JPY84.40. 

The modest gains in the the euro and Australian dollar have left the hourly momentum indicators over-extended and may struggle to extgend gains in NorthAmerica, which may be devoid of fresh trading incentives. 

Spanish Bonds Continue to Retreat ahead of Supply

Spanish bonds have fallen each day this week. The 13 bp increase today brings the 10-year yield increase to 30 bp this week, easily the worst performing bond market within the euro zone. Portugal has the dubious honor of being in second place with a 19 bp yield increase. Pressure is also evident in the short end of the coupon curve. The 2-year yield is up 19 bp on the day and 32 bp on the week; again easily the word performer over the past five sessions. Italian bonds 2-year yields are getting hit as well and are up 20 bp.

Dollar Softer

One of the most important developments in recent days has been the sharp backing up of global interest rates, spurred primarily by indications that contrary to expectations, US fiscal policy is in play again beyond simply preventing the expiration of the 2001 and 2003 tax cuts. While the rise in US rates has helped keep the dollar supported, we are concerned that two-year German rates have risen even faster than 2-year U.S. interest rates and that this may serve to dampen the ability for the dollar to extend gains against the euro significantly without continued poor news stream from Europe.

Euro Skids

The euro bounce toward the middle of the day's range ran into a wall of selling. Rumors that Italy may see its rating cut and news that Irish Labour Party will vote against IMF/EU aid package drove the euro briefly through yesterday's lows. The former may be true, but we are not inclined to believe it. The latter is true but hardly news. The true signal is the Irish budget will pass and the EU/IMF package will be approved. The next government--maybe in March--may seek to renegotiate that terms later.

The euro has been range bound. It may take a break of $1.3150 to convincingly indicate the range has broken. Such a breakdown would re-target the $1.2970-$1.30 low from earlier this month.

UK Tuition Debate Begins

British press call it a hung parliament, but in countries it would be thought of a coalition government. And today is the first challenge to the UK coalition government and it is likely to pass the controversial bill to raise college tuition fees.

The political cost may be to see the Lib-Dem support continue to erode as it has since the election and at some point cause strain in the Lib-Dems to ensure they preserve a viable political entity. It may also show the failure of Labour leadership, which had in 2004 proposed its own tuition fee increase after promising not to. Labour is likely to vote against the government's proposal.

The Treasury Conundrum

The sharp rise in bond yields emerged as an important market force in recent days. US Treasury yields are stabilizing today with note and bond yields near six month highs. The sell-off in US Treasuries in the past two days is the largest in a couple of years. It has caught the market wrong-footed in light of the disappointing jobs data last Friday and the ongoing Fed purchases. It has taken the widening the the 10-year spread to five month highs (just above 200 bp) to keep the dollar at the upper end of its 2 1/2 month trading range.

A Few Thoughts on China

Three observations to share about China, regarding purchases of Japanese assets, suspension of 3-year debt auction for tomorrow and rate hike possibility.

First, Japan's MOF reported that China bought JPY262.6 bln of Japanese debt instruments in Oct. Its purchases were concentrated in the bills sector (JPY232 bln) and accounted for 23% of foreign purchases of Japanese bills in the month.

Russia Moving toward WTO Memebership

Russia is the last of the major countries that has not joined the World Trade Organization. The importance of the WTO may not be so much in liberalizing trade as negotiations take years. The WTO predecessor was GATT, which some suggested stood for the general agreement to talk and talk. Rather the value of the WTO may be in conflict resolution. This too takes time, but the is part of rule of law trade regime which may help prevent trade issues from spilling over into political or military spheres.

Dollar Drivers Re-Examined

In recent weeks, the US dollar's recovery from the Sept-Oct decline seemed to be largely a function of the deteriorating situation in Europe. U.S. economic data generally surprised on the upside, the with notable exception of the November jobs report, but growth in Q4 looks to be around the pace seen in Q3 and in any event, not sufficient to bring down the unemployment rate at a politically or economically acceptable pace.

However, a new driver has been added to the mix and that is the compromise between Obama and the Republican on tax policy. Congress still needs to pass the legislation and it may not be a sure thing given the likely resistance by many of the lame duck members, but it cold be passed retroactively by the new Congress. The dramatic backing up of US interest rates has given the dollar a new fillip on top the ongoing European financial crisis, high anxiety from the Korean peninsula, and Chinese rate hike fears encouraging some profit-takin on emerging market exposures.

US Yields Jump, Dollar Advances: Game Changer?

When I wrote in my first post of the day that I expected the euro, which was bid in Europe and appeared moving toward $1.3400, to come off to $1.3300 and possibly $1.3250 in North America and maybe into tomorrow, several readers dismissed this as unwarranted bullishness. In many ways I too am surprised that this objective was nearly met, with today's late afternoon low so far just below $1.3270.

However, I was dead wrong on the driver. It was not Europe, which is what I have been writing extensively about. It was the US side of the equation. It was, I think, the sharp rise in US interest rates. The two-year note yield finished up about 11 bp, the largest single day increase in nine months. The 10-year yield jumped 21 bp. Of course in there conditions, it is hardly surprising that the 3-year note auction was poorly received.

India: Will the Tortoise Pass the Hare ?

India's Finance Ministry raised its economic forecast for the year ending March 31, 2011. Back in Feb it had forecast 8.25%-8.75% growth and today increased that forecast to as much as 9.1%. Ironically, the increase in the growth pace is not expected to be accompanied by higher inflation. The revisions to growth appear to be at least in part driven by the heaviest monsoon rains in three years, helping the agriculture sector recovery from last year's drought.

For the current year, China is still positioned to outstrip India's growth, but next year it may be closer. China is shifting monetary policy in light of the higher inflation and robust lending and money growth. We anticipate China's economy slowing into the 8-9% range next year. India is likely to grow around 9%. There may be some quarters that India's growth exceeds China's.

Need to Look Past Irish Austerity

For More on Ireland
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(For my earlier post on this topic click here.)

By most reckoning the Irish parliament will approve the government's austere budget, the fourth emergency budget since 2008. This may help ensure that Ireland secures the aid package it did not really want in the first place. Besides that, little else will be resolved. Oh, the country will have another year (2015) to bring its deficit to below 3%, but most investors are looking well beyond the budget.

Euro zone members pursuing austerity have not been rewarded. Peripheral countries in Europe, the only members to really engage in fiscal tightening this year have not seen the pressure in the bond or credit default swaps market ease because of their austerity.

Trade Rec to Sell Dollar vs JPY Update

On Nov 30,we recommended selling dollar-yen with a tight stop just above JPY84.40. Initially, we looked for JPY82.80 and then possibly JPY81.80. The dollar fell to its lowest level since Nov 12th today near JPY82.35, but has bounced back strongly. Those who followed us may want to take profits near here.

The major driver of the trade has weakened. It was that US rates had fallen relative to Japanese rates. US rates are spiking higher and this may give the dollar better support. In addition, we identified the heightened volatility of the capital markets supportive of the yen. This force also seems to have weakened as the market focuses on 1) risk of extending QE in US and Japan and 2) new bond purchases by the ECB and more generous provisions of liquidity. Near-term risk on the dollar extends to JPY83.30. JPY84.40 remains an important barrier on the upside.

Irish Budget, US Tax Compromise, Strong UK Mfg Output

For more on Ireland
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There does not appear to be the basis of agreement among European officials of what to do next to stem the financial crisis. Neither expanding the EFSF nor issuing so-called E-bonds has found strong support. A German-Netherlands-Austria axis has been sufficient to stymie additional reforms at this juncture and peripheral bonds continue to be under modest pressure. The Irish budget vote appears a bit anti-climactic after two independent MPs signaled their intention to vote with the government today. The budget debate will begin around 10:45 am EDT and the vote is scheduled for around 2:00 pm EDT.

The government's budget will include about 4.5 bln euros in spending cuts and 1.5 bln euros in tax increases. In order to meet the budget targets while keeping the senior bond holders whole is forcing the government to include more people in the income tax net, cut minimum wage by about 11.5% (to 7.65 euros an hour) and trim welfare benefits.

South Korea: Free Trade Agrement, Foreign Demand for Assets, and Near-Term Outlook for KRW

At the end of last week, the US and Korea appeared to reach the basis of agreement that will also resuscitate the moribund free-trade effort. In essence it appears that slowing down the liberalization in the auto sector and pork was what broke the log jam.

The US tariff on Korean auto will end in five years rather than immediately or in three years as earlier drafts suggested. Korea's 8% tariff on US auto imports will be cut to 4% immediately instead of being eliminated entirely. The US will maintain its 25% tariff on truck imports for 8 years instead of beginning to phase them out immediately. In addition, each US auto makers can send to South Korea 25k cars a year that meet US safety standards and would be exempt from separate South Korea standards.

UK Politics--Thursday Vote is Key

Some observers are talking about M&A activity and sterling. Vodafone is said to be close to selling its nearly 45% stake in mobile operators SFR to France's Vivendi for about 3.6 bln euros. Yet it is only giving sterling a bit of comfort as the broader dollar move takes its toll. The $1.5650 area corresponds with a 50% retracement of the sterling's bounce last Thurs and Friday. Below there, $1.5575, the low from Friday is the next obvious target. There is a host of UK data this week and outside of house prices, the data has been generally better than expected. Resistance is seen near $1.5720 now.

European Weight Returns

The pessimism over the US dollar expressed last Friday after the disappointing US jobs data has eased. The market's focus has turned back to Europe. Finance ministers meet today and tomorrow and appear hopelessly divided over how to restore market confidence. The IMF reportedly is calling for an increase in the EFSF and ECB bond purchases. Belgium, which has turned in among the worst euro zone bond performance over the past month, and holds the rotating EU presidency, though it continues to struggle to put together a government since the summer elections, supports the idea, but Merkel and Sarkozy have opposed.

Bernanke and Bond Buying, and Some Thoughts about Early Next Week

Federal Reserve Chairman Bernanke will tell the "60 Minutes" audience on Sunday that he does not rule out buying more than $600 bln of Treasuries.  This helped lift the euro to new session highs late in the day.  This is important and caps a volatile day and week.  

There are several take-aways from this week.  First the debt dynamics in Europe are worsening and pressure on Italy and Belgium is new, or the intensity of it is.

US Jobs Data: As Disappointing as it Gets

US employment data is wholly disappointing.  Job creation much less than expected, unemployment rate jumps, hourly earnings flat and work week flat. The back month revisions pale in comparison to the disappointment.  

Trichet's Feint Works for the Moment

The ECB must be pleased with itself.   The strategic ambiguity card that Trichet played yesterday is succeeding in supporting the peripheral bond markets and a relaxation of prices in the credit default swaps market.  Because the ECB never indicated a amount of sovereign bonds it would buy, an increase, as we have saw last week and this week, does not require an announcement or change of stance.  The ECB's Nowotny acknowledged that purchases were "energetic" this week. 

Some Thoughts on US Jobs Report

The November US jobs report is slated for release tomorrow and there does not seem to be any reason not to look for a relatively robust report. The usual inputs have been uniformly constructive. This includes, the ADP report, the weekly initial jobless claims (especially the week in which the survey was conducted) and the ISM reports.

More generally, the string of top tier and most of the secondary data for the past several weeks has been not only better than expected but also suggestive of some modest acceleration of the US economy. The Beige Book yesterday indicated that 10 of 12 regions are seeing improvement.

Thoughts on ECB

European officials must have known they were going to disappoint the market with the decision to simply postpone draining liquidity. The firewall around Greece failed. The firewall around Ireland has failed. The politicians have dropped the ball and the left Trichet holding the bag. Many from the periphery appeared to lobby the ECB to help out. Trichet in essence says there is little it can do and that it is really up to the governments. What Trichet announced today seems like the bare minimum of what it could do without immediately intensifying the crisis.

ECB Does Bare Minimum

The ECB has done the bare minumum by pushing out its plans to withdraw liquidity.  Previously it was expected to take place in early Q1 and now it has been delayed to early Q2 at the earliest.  This is hardly a solution.  It kicks part of the ball down the road, but banks locked out of the wholesale market will remain locked out.     Trichet has also kicked the bal back to the finance ministers and while there had been speculation of a summit, but has been denied. 

ECB Front and Center: Can Do Little, but Disappoint?

Today is the most important ECB meeting in several months. Nervousness ahead of it has encouraged some modest position adjusting across asset classes. Given that the Irish aid package failed to stabilize the markets, many are looking at the ECB step into the breach. It seems that there are only four potential courses of action. The first is simply not to take any new initiative and continue with its plan to continue to normalize operations. Currently the ECB provides unlimited amount of 3-month funds at a fixed rate of 1%. The next step would be to auction the three-month money, which if done in sufficient size could still be fairly generous in terms of liquidity. This would like see a strong against the euro and European bonds.

Water, Wheat and Russia

In a time when there is much discussion of peak oil and the idea that other commodities are less abundant or more costly to access, one issue that might not get enough attention among investors is the shortage of water. Some political scientists, for example, have suggested that the next war in the Middle East may be over water not oil.

Grain is very water intensive. Roughly speaking, it takes 1000 tons (100 cubic meters) to grow a ton of grain. Find a country that is importing grain, and you'll find a country that has a water deficit.

Euro Bounce, Sustainable?

Ideas that at its meeting tomorrow the ECB may take additional measures to stem the financial crisis that has threatened this week to spread outside the periphery and toward countries like Belgium, are prompting some position adjustment in both the foreign exchange and fixed income markets. While observers are not at a loss at making recommendations to policy makers, the immediate challenge, however, as ECB President Trichet point out yesterday, many of the recommendations, like a European bond, is for the governments to decide not the central bank.