Swedish Krona Surges

The Swedish krona is surging today. Hawkish central bank comments have offset disappointing retail sales figures and there is some talk of month-end related demand.

The euro recorded multi-year lows against the krona on Feb 16 just above SEK8.7 and had recovered to a high near SEK8.8550 earlier today before reversing sharply. In recent hours the euro has given back nearly everything it has recorded since Feb 16.

Dollar Finishes the Month Softly

After a soft start in Asia, the euro has rallied to approach the year's high set February 2 just above $1.3860. The ECB rhetoric ahead of the meeting later this week is expected to reiterate the hawkish tone seen in recent weeks, the euro seems particularly vulnerable to negative news that is mounting, though momentum and technical players have their sights set on $1.40.

First, the Jan euro zone CPI came in at 2.3%, off slightly from the 2.4% flash reading. While still the highest since Oct 08, it is not as bad as feared.

March Madness

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If you thought this year was off to a challenging start for investors, fasten your seatbelts. March could very well turn out to be the most important month of the year. This does not mean there is easy money to be made or low-hanging fruit that can be picked.

To the contrary, the event risks are such that even the most insightful investors may be hard pressed to have much market conviction. Hugging benchmarks and defensive strategies will likely be a preferred strategy of many money managers. At the same time, understanding the significance and the meaning of the events may grant investors insight into the investment climate in the period ahead.

Sterling Warning, ECB M3 and Swiss Resilience

One noteworthy take away from this week's price action is the under-performance of sterling. It's 1% loss against the dollar makes it one of the weakest currencies, second only to the New Zealand dollar, which was undermined by a swing in rate expectations following the devastating earthquake.

Sterling continues its under-performance today, perhaps weighed by the downward revision to Q4 GDP to -0.6% from -0.5%. ONS maintains that the weather still accounted for 0.5%. The details released were disappointing and, one would think, supports the less hawkish members of the MPC. GDP was still flattered, for example, by a 0.7% rise in government spending, which is unlikely to be repeated. Private consumption had all but stagnated (+0.1%) and that was before the VAT hike. Gross fixed capital formation slumped 2.5%. The implied yield on the June short sterling futures contract has fallen form 1.27% at midweek to 1.06% earlier today.

Anti-Inflation Credibility Examined

The common narrative in the market is that the ECB inherited the German anti-inflation resolve. The ECB has a formal inflation target unlike the Fed. As the euro zone as a whole recovered, the ECB has gradually unwound many of their extraordinary liquidity facilities. It is expected to signal intentions to return to only weekly and monthly liquidity provisions next week. It is also expected to raise its inflation forecast. Given the recent rhetoric, many expect the ECB to in effect adopt a tightening bias, within the framework in which it does not pre-commit.

The historic record of the ECB more nuanced. Of the past 11 years, CPI in the euro zone has surpassed the 2% target 6 times. Twice when inflation came in below the 2% level, the euro zone was in a recession. Over the past 11 years, euro zone CPI averaged 2.1% annually. While the CPI baskets vary, it is interesting to note in comparison the US CPI has averaged 2.4% over the past 11 years. Slightly higher, but arguably not significantly so.

Because Treasuries are Safe Haven, Dollar is Not

The US dollar has been unable to find much traction in recent days despite the heightened tensions in the Middle East and North Africa. The price action has raised questions about the dollar's role as a safe haven.

What does seem to be a safe haven are US Treasuries. Despite greater confidence that the US economy has gained momentum, the US yields have fallen. Some of the rally in Treasuries may be reflecting portfolio shifts away from equities and toward fixed income. Anecdotal evidence suggests a good foreign bid as well. Demand from indirect bidders, which include foreign central banks, was above last month's for the 2 year note, but was a little softer for yesterday's 5-year note, but still took down a little more than a third.

Bread and Circuses: Reform Saudi Style

The time tested way to dampen popular unrest is to provide food and entertainment to the masses. The problem of course is that sometimes the funds are lacking. In Kuwait and Saudi Arabia, for example, this is not the case and the government's have been "generous" in providing relief. Given the impact on oil prices of what appears to be a modest loss of output from Libya, investors are understandably concerned that the "jasmine revolution" could spread to the largest oil producer Saudi Arabia.

Saudi King Abduallah announced today increased social spending. A package valued at more than $11 bln was announced today, including increased spending on housing, education, social welfare; the creation of 1200 jobs in "supervision programs" and a 15% cost of living allowances for civil servants.

The Weight on the Dollar

The week's two main themes, political unrest in Northern Africa and the Middle East and rate hike speculation have joined forces and is serving to undermine the greenback. The surge in oil prices appears to be shifting the finely balanced outlook for interest rates in favor of tightening, while the Federal Reserve remains committed to easing of monetary policy through its Treasury purchases.

The contrast between the hawkish rhetoric by ECB officials and the dovish remarks of the Fed's Evan yesterday who opined that the improved growth prospects should not spur the Fed into hiking rates, could not be starker. Over the past five days, short-term interest rate differentials have moved decidedly against the dollar. The 2-year US-German spread has moved 25 bp against the dollar over the past week, while the US-Japanese and US-UK 2-year spreads have moved about 15 bp against the greenback.

Hamburgers vs Frankfurters: German Politics and the Euro

Hamburg, the second largest city in Germany, gave the Social Democrats a stunning victory in the weekend election. It won an outright majority. It is the party's best showing in any state election since 1998. Merkel's CDU drew a little less than 22% of the vote, nearly halved from the 2008 contest.

Local issues, like the failed education reform efforts and the controversial plans the dredge the Elbe River played a role, but it is hard not to draw larger implications from the election.

Politics Drives FX , Safe Havens Sought

The events in the Middle East and Northern Africa are the main spur of market action. The position adjusting pressures that had sent the euro nearly two cents from the high seen earlier yesterday ran into hawkish comments from ECB's Mersch that spurred the short-covering bounce in mid-morning turnover in Europe. Mersch hinted that the ECB may raise its inflation forecast and in effect adopt a tightening bias, within its "no pre-committing" framework.

Yet in some ways Mersch's comments are not new in substance and recent official comments have played up the upside risks to inflation. With oil prices at two year highs and given the ECB's penchant for viewing higher oil prices as inflationary, the ECB's rhetoric has taken a more hawkish turn of late.

Kitco News: Currency Wars

President's Day Comment

Foreign Exchange: The US dollar is posting modest gains against most of the major currencies as geopolitical concerns blunt the impact of stronger than expected euro zone flash PMI and German IFO reports. The euro extended last week's gains to almost $1.3730 in this pre-Asia activity, retreated and then had another try at it in early Europe, but could not get above $1.3710. Support is seen near $1.3650.

Sterling, for its part was unable to extended last week's 2.5 cent rally, but profit-taking pressure has been kept in check by speculation that the BOE's Bean may have joined the hawkish dissents at the recent MPC meeting. The minutes from the meeting are slated for release on Wednesday. Initial support is seen in the $1.6180-$1.6200 band. The dollar has traded in about a 20 pip range against the yen, finding support near JPY83.00. Safe haven flows have not benefitted it or the Swiss franc very much at this point, though the market is monitoring developments in Libya, Bahrain and Yemen and gold has made a new high for the year and oil looks 3% higher.

CNBC: G20 Finance Ministers Meet

Watch the Hamburgers

The German city-state of Hamburg goes to to polls this weekend. It is the first of seven state elections this year ahead of next year's national campaign. Next year promises to be a momentous year in politics and it is a theme I will return to, but consider for a moment that in addition to being the end of the Mayan calendar, the US, Germany, France, China, Russia and Mexico go to the polls. Elections are also possible in Canada and Japan and they always seem possible in Italy.

FOMC Minutes and FX

As hinted by the FOMC statement last month, the minutes showed the Fed is a bit more optimistic about growth this year--forecasting 3.4%-3.9% growth vs 3.0%-3.6% previously. The inflation forecasts look essentially unchanged at 1.3%-1.7%. That said, the risks of deflation have diminished. The minutes also confirm that the a minority at the Fed are not convinced that the bond purchases are helping the economy much and want to reconsider the purchases if the data continues to point strong growth. The minutes are clear, however, that the economic outlook is unlikely to change by such a magnitude before the $600 bln of Treasuries are purchased. Worries include muni bond market, housing market and Europe.

Sterling Spanked

Following soft consumer confidence and employment data, the Bank of Enlgand's inflation report failed to satisfy the sterling bulls, who have had the upper hand in the foreign exchange market, and the rate hawks, who have had their way in the debt market. The BOE maintained its view that CPI will be below target in 2-years time at 1.7% compared with 1.6% in the November report. BOE expects further upside pressure on CPI in the coming months.

Although at first read, the report and King's comments have something for everyone, on balance, the BOE still sees the price pressures as largely temporary. King specifically noted that he was not endorsing the market's outlook for rates, which as we have noted previously, was consistent with a hike in the next three quarters. The take away message is that the BOE is not in a hurry to hike rates, with King suggesting that the economic shocks and excess capacity means the BOE can take longer to meet the CPI target.

More Thinking about BBK and ECB

It is now widely expected that Merkel's economic advisor Jens Weidmann will be named tomorrow as Weber's successor at the helm of the Bundesbank. There is some marginal concern that his close relationship with Merkel jeopardizes the BBK's independence. While perhaps not ideal, it is unlikely to derail the appointment. However, it does nothing to shed light on Trichet's successor.

There continues to be talk in some quarters, like the op-ed piece in yesterday's FT that head of Italy's central bank, Draghi, is the obvious choice, but this seems to under estimate Merkel's political astuteness. In order to help solidify Weber's chances, she successfully campaigned for Portugal's Constancio to be the vice president of the ECB. The reason this would have helped Weber is that by European tradition, a vice president from the south is balanced with a president from the north. This is not a question of ethnocentrism, or checking passports as has been claimed by some critics. It is about broader balance.

TIC Data December--2nd Month QEII, Little Impact

Foreign purchases of US assets was a bit stronger than expected at $48.2 bln. This is 10% more than the market anticipated and 30%+ above Nov's $35.6 bln. Demand for longer-term securities slipped to $66 bln from $85 bln, but was well above the $40 bln expected. Central banks sold $45 bln of US securities after selling almost $41 bln in Nov. That is not really negative news as the private sector purchases have stepped up. It bought $93.3 bln in December after $76.4 bln in November.

Country breakdowns may be deceiving given the use of other financial centers and revisions, but the preliminary data suggests China may have reduced its Treasury holdings by about $4 bln, while Japan increased its holdings by about $6 bln. The UK increased its holdings by about $30 bln, which likely reflects its status as a financial center for Middle East and Asian accounts.

Grenback Under Pressure, but Consolidative Tone

The euro remains vulnerable. The Q4 10 GDP figures were slightly disappointing (0.3% rather than 0.4% consensus), but the adverse impact of the weather and the stronger PMI readings this this year encourage the market to look past these figures. Same is true with the ZEW survey. The current assessment remains strong, but the future expectations at 15.7 (consensus was 20).

The Sword of Democles that hangs over the euro remains the unresolved and, arguably worsening, debt crisis. It is true that Spain and Greece has successful bill auctions today, But more importantly, Portuguese 10-year yields remain well above 7%.

Europe Update

The euro briefly dipped below $1.3430, but this could very well prove to be the low of the day, but is likely capped around $1.3480. The tone may remain fragile as peripheral issues are in the forefront. Germany and France are not finding much support for their proposals at the EU Fin Min meetings. It is increasingly looking like increasing the efficiency of the EFSF is the greatest common denominator. Efficiency refers to the gaps between guarantees and loan capacity in order to retain a triple-A rating.

Dollar Steady, Euro Hit

The euro experiencing independent weakness today. There are a number of considerations at work, nearly all of which are negative. Peripheral tensions are running high. Portugal's 10-year bond yield remains well above 7% for the seventh consecutive session and 12 of the past 15 sessions. A sustained rise through 7% seemed to have intensified the pressure on both Greece and Ireland to seek international assistance.

Atlantic Council Interview: Euro Debt Crisis

Here is an interview I did with the Atlantic Council on the Euro Debt Crisis.

CNBC: Where is Oil Headed?

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.

Dollar on Back Foot

The ECB's hawkish stance has underpinned the euro. Not only was the market reminded that rates can be hiked before the ECB finishes normalizing monetary policy, but Trichet was explicit that restructuring of Greek and Irish debt. The ECB's stance was reinforced by its market operations, where it had a net drain of about 66 bln euros. EONIA and 2-year German (and French) jumped as well. The real test for the euro bulls comes in the $1.3700-$1.3725.

The weaker than expected German industrial production figures (-1.5% vs consensus of 0.3%), like yesterday's disappointing industrial orders report, took the steam from the euro's advance. The $1.3580 should near-term support.

Sterling Downside Risks Second Half of the Week

The British pound remains among the better performing currencies in the wake of the dollar's recovery that began in the second half of last week. Underpinning it are ideas that the BOE may very well be the first of the major central banks to hike rates. In fact, various market based measures suggest the risk is about 1 in 5 that a hike takes place this week. Subjectively, we suspect the odds are half of this at best.

It is true that the shadow MPC at the IEA favored an immediate hike and that at the last MPC meeting, two members favored a hike. However, the economic data is sufficiently mixed and there is still a reasonable argument to be made over the transitory nature of the price pressures, insofar as there is no real pressure coming from wages, that the BOE will leave rates on hold Thursday.

Dollar Firm

Talk of continued official demand for euros out of Asia appears to be being absorbed by the market that seems keen to pare back positions. Support has been seen in the $1.3540 area and a break would initially target $1.3480 and then later $1.3350. Sterling is lower for the third consecutive session, but is holding up a bit better. The market recognizes about a 1in 5 chance of a surprise rate hike at this week's MPC meeting. Support is seen near $1.6040. On Friday, the dollar traded on both sides of Thursday's range against the the yen and closed above Thursday's high. This outside up day is usually seen as a positive technical sign and there has been follow through. The next objective is near JPY83.00.

There has been a sharp rise in US interest rates in recent days and this fueled a dollar-supportive move in interest rate differentials. The US 2-year yield risen 21 bp since Jan 31 and the 10-year yield has risen 30 bp. The 2-year differential that continues to track the euro-dollar exchange rate has move 20 bp in the US for since the middle of last week. The US-Japanese 2-year spread is at its widest since last June (~55 bp) and at just below 240 bp the 10-year spread now the widest since last May.

What About that Yen?

Overshadowed by developments in the US and Europe, the Japanese yen has been largely sidelined and its movement more a function of the other side of the trade, like the euro, dollar and even the Australian dollar. The dollar appears poised to trade higher, with a move back toward the upper end of its Q4 range in the JPY84 area.

This will require a change of drivers. Japanese investors are not the prodigious overseas investors that they were from mid-May through mid-Nov last year. In that period, Japanese investors were putting an average of JPY886 bln (~$11 bln) a week overseas. Since then Japanese investors have been repatriating an average of about JPY63 bln a week.

Is the Dollar Turn At Hand?

The US dollar sold off in recent weeks. While we recognized the fundamental considerations behind its decline, we disagreed with them. Prudence and financial discipline warned against fighting the market. Now, however, a crack in the dollar bear case has crystallized and there is a potential opportunity here for medium term investors to reduce short dollar exposure or increase hedges on foreign exposures.

To understand the dollar’s decline in recent weeks, one much appreciate market positioning. The active trading market had built an apparently sizeable long dollar position. In discussions with clients and other market participants, the position was not so much based on a constructive view of the dollar, but more a case of a stronger negative view of the euro and sterling.

Chef's Special: Disappointment

Disappointment may be served up as the chef's special today Market expectations are at risk of getting ahead of themselves on the two main events today, the US jobs data and the EU Summit. Nearly every economic report showed an improvement in the US labor market, including both ISM reports, Challenger report, weekly initial jobless claims and details in consumer confidence reports.

However, there are two factors that many observers may be under-appreciating. First, the weather was poor and the other time series may not have picked it up and many economic forecasting models may not have been a sufficient adjustment. Admittedly it is difficult to forecast the impact of the winter storms, but a conservative estimate may be around 30k. Second, there seems to be a quirk in the January time series beginning in 2004 and may be related to the birth/death adjustment the BLS uses to account for employment changes at small business. The January nonfarm payrolls report has disappointed in each of the past seven years.

Euro Observations

I have been skeptical of the euro's rally in recent weeks, fueled by a shift in interest rate expectations and confidence that European officials are going to come up with a "comprehensive plan" to arrest the more than a year old debt crisis. However, there have been few signs that selling the euro was a low risk venture. Today could very well be the turning point.

Two market indicators in particular are flashing important warning signs the dollar bears. First and most important, Trichet's comments have prompted a sharp decline in short-term European rates. The 2-year German rate has fallen 11 bp, while the US 2-year yield is up 4 bp. This swing has resulted in a sharp move in the 2-year differential, which we find tracks the euro-dollar exchange rate fairly closely. That spread is now at about 69 bp in Germany's factor, which is the lowest since early last week. Yesterday the spread was over 83 bp. We find the change is more important than the level. For the record, at Trichet's press conference last month the spread was about 23 bp.

Euro Eases Ahead of ECB Press Conference

The consoldiative tone in the euro appears to be more a function of caution ahead of Trichet's press conference following the ECB meeting. The January service PMI rose to 55.9 from 55.2 of the flash reading and 54.2 in Dec. Coupled with the strength of the manufacturing PMI earlier in the week, a broadening of the euro zone recovery would seem to be confirmed. However, the fact that Dec retail sales so badly disappointed (-0.6% vs consensus of +0.5%) warns of the continued sluggishness of domestic demand.

There are two main focal points for the market and neither is the economic data:

Some Thoughts about US Autos and Manufacturing

Currency analysis often focuses on the macro economics and does not delve into sectoral performance. Yet what is happening in the auto sector looks promising and is in fact impacting the macro economic variables. The first clue was actually in Q4 GDP figures. Household purchases of durable goods is very cyclical. This jumped in Q4 and consumption vehicles rose by almost 1/3. Yet goods imports, which includes vehicles fell by 15.5%.

This hinted to us that there may be a shift underway from foreign producers to domestic producers. The January vehicle sales bear out this point as well. The total monthly sales were 12.53 mln units (seasonally adjusted annualized rate) from 11.46 mln in August. Sale by domestic producers rose from 8.66 mln to 9.59 mln.

Understanding the FX Drivers

Many investors are concluding that the Federal Reserve will lag not only many emerging markets, but also a wider number of European countries. Yesterday’s PMIs drive home the point that growth at the start of the New Year is accelerating. This helps embolden the risk appetite at the same time that the market is being told by European officials that they are serious this time about arresting the debt crisis in the periphery of Europe.

News that Egyptian President Mubarak will step down in September has seen the army call for the end to the protests. It is too early to tell whether the army, which is highly respected in Egypt, will succeed or whether the protesters will feel emboldened by Mubarak’s decision. Provided there is not significant impact on oil prices, the market appears willing to look past these largely political events.

Highlights for Groundhog's Day

The US dollar remains under pressure in the foreign exchange market, driven by its resumption as a financing currency as growth and inflation raise prospects of BOE and ECB rate hikes while the Federal Reserve is still committed easing monetary conditions.

At the same time, investors growing more confident that officials will address the peripheral debt situation and barring a significant rise in oil prices, the turmoil in the Middle East is seen largely as a political event. Sterling takes the lead today following the much stronger than expected construction sector PMI (53.7 vs 49.1 in Dec) and shoots above $1.62. The early Nov high was set near $1.63 and this is the immediate target. The euro is extending its recent gains and the $1.40 level beckons.