Dollar Recovery Solidifying

The US dollar is finishing the week on a firm note and we look for additional gains next week. The proximate causes of the greenback's gains include heightened uncertainty over the near-term outlook in Egypt and , renewed pressure on the European peripheral bond market. One of the key factors we have emphasized, the movement of interest rate differentials in the US favor, have also helped underpin the greenback against both the euro and yen. The dollar is approaching its best levels against the yen of the year, set on Jan 7 near JPY83.70. We note that the 5-day moving average of the dollar is crossed above the 20-day moving average yesterday and there has been follow through dollar buying today. Option expires today and early next week, believed to have been struck near JPY84.00 may slow the greenback's advance.

The 5- and 20-day moving averages have crossed to the downside for the euro. Interest rate developments also seem an important element here as well. The US-German 2-year interest rate differential, where the change (more than the level) appears to continue to track the euro-dollar exchange rate fairly closely. Today it is just below 60 bp. It finished last week just below 70 bp and the week before just above 80 bp.

There are also important signals emanating from the options market as well. The one that seems particularly relevant now is implied volatility. Looking at the 3-month tenor, implied volatility hit the lowest level since last August yesterday, ahead of a key base near 11%. The decline in volatility from above 14% at the start of the year has corresponded with the euro's rise. In fact the euro-dollar exchange rate over the past few months enjoys a nearly 60% correlation with implied volatility. It is like spring coiling.

Market participants should be prepared for greater volatility in the euro. The Irish election is looming, as is the first of seven German state elections. In addition, the ECB/Weber uncertainty also adds volatility, as does the European struggle to find a "comprehensive plan" for the debt crisis. In the current context higher volatility is likely to correspond with a weaker euro. While there is support in the $1.3480-$1.3500 area, losses toward $1.3350 still seem reasonable as the short-term market, judging from the IMM and anecdotal reports, are leaning the wrong way.

Sterling is also breaking down too. It is moving below $1.60 today for the first time this month. And this is despite sharper than expected rise in January producer prices. The initial retracement target near $1.5950 has already been approached. The next target is near $1.5850. Input prices continue to rise, but more importantly for the BOE output prices have also risen. The 1% rise was twice what the market consensus was looking for and brings the year-over-year rate to 4.8% from 4.1% in Dec, This is ahead of next week's CPI report (February 15), which is likely to see the headline rate rise to 4% if not a little above and the BOE's quarterly inflation report the next day. The inflation report is seen as offering key insight into BOE thinking ahead before the release of the minutes from this week's meeting.

The central bank finds itself in a particularly nasty situation. A weak economy with fiscal headwinds urges patience with a higher price pressures and the passing through of the VAT hike and other administered prices. On the other hand, it has been patient as its letter-writing (to the Chancellor) exercises illustrate. While the risks of a rate hike are clearly rising, it is not immediately clear whether this will continue to support sterling as it is already discounted. The transmission mechanism from the base rate to the consumer via mortgage rates appears fairly efficient as most mortgages will be adjusted. Rising UK rates has also already caused a rise in rates for new mortgages.

Central banks were in the news this week but not in the usual way. Like others, we have been shocked by the uncertainty injected by reports suggesting BBK Weber was taking himself out of the running to replace Trichet when his term is over in October. Although Merkel and Weber are meeting today and will likely make an announcement later today, this seems more like damage control than a new initiative. This is a significant setback for Merkel, who appeared to do much horse trading to secure the post and this was part of the implicit inducement to German taxpayers, who may be called upon for more assistance. The market is also handicapping alternatives. Talking to various market participants, Finland's central bank governor Liikanen or Luxembourg's Mersh seem to be the favorites.

In the US, Warsh has indicated he will step down form the Board of Governors at the end of next month. Warsh was a close confident of Bernanke's, but was also the only governor to raise questions about the merits of QEII in public. His departure then would seem to solidify Bernanke's hand on the board. Assuming congress continues to drag its feet on Diamond's nomination, this will be the second vacant seat on the board. Meanwhile, as we have noted before, the new regional presidents that rotate onto the FOMC this year gives them a slightly more hawkish tint. In an unscientific survey we find that most appear to agree with our view that QEII is not extended, even if there is a rolling stop, as the Fed has done previously, rather than a dead stop. Those who expect the Fed to stop shy of the $600 bln purchases seems to outnumber those who look for an extension, though the Fed has consistently preserved flexibility in time and amount.