Who Speaks for the Fed, and Fiscal Brinkmanship

Many market observers seem to be exaggerating the role of some Federal Reserve officials. Bullard, who has mentioned exiting from QE2 before completing the $600 bln of purchases. Plosser, a voting member has also sounded a bit hawkish, though not as much as Bullard. However, while these views have been highlighted, the comments by Evans, a voting member, and Rosengren, a non-voted have been played down, though they seem to reflect the general majority at the Fed.

The hawks will dominate tomorrow as well. Hoenig, who retires in October, Lacker and Bullard all will speak. It is not until Thurs that the centrists are heard in the form of Gov Tarullo and non-voting Pianalto. Lacker also speaks on Thurs. Friday, in addition to the jobs report, hawks Plosser and Fisher, the most likely dissenters at upcoming FOMC meetings speak, but this may be offset or blunted by NY Fed's Dudley. While attentive to the divergence of opinion among the Fed, we suspect that QEII will continue unabated and that monthly reviews are part of the process.

Portugal Update

Portuguese bonds are holding their own against the Germany today. The government seems to need around 1 bln euros to meet next months coupon and redemptions. There is some talk that it may seek a bridge loan. That will buy it time until the nearly 7 bln euros are needed in mid-June. A new government could be in place by then as well (55 days after election called), but it is calling it close.

Becalmed FX

US dollar is mixed, but the downside momentum seen recently seems to be taking a hiatus.  It is difficult for me to believe that it was comments by Bullard and Plosser turned the market as the former does not vote on the FOMC and Plosser's comments did not represent any new ground.  Both are known to be on the hawkish side of the Fed's spectrum.  Now Rosengren (non voter) and Evans have weighed in.  In my understanding, thsoe forces that favor a continuation of QEII are in the majority and will carry the day.   

Trichet: Seeing What Your Want

ECB President Trichet remained hawkish in comments today, noting that inflation is persistently above the target of just below 2%. Yet ECB monetary policy is not based on one pillar but two. The other pillar is money supply. Money supply measured by M3 rose 2% year-over-year in Feb. The ECB's reference rate is 4.5%. This is to say that money supply in the euro zone is less than half the ECB's reference rate and not validating the price pressures, which seem to be emanating largely from commodity prices. Headline inflation was 2.4% in Feb, while the core rate stood at 1%.

Fiddling while the Periphery Burns

After more than a year since the European debt crisis began, officials have still failed to resolve it. They raised expectations for a “grand bargain” only to crash them on the shoals of political reality. The March 24-25 Summit was to finally provide closure and yet the situation remains fundamentally unresolved.

Dollar Firm, But Cable Weakness Pronounced

The US dollar is firmer in the aftermath of this weekend's event, which inlcuded a loss by the ruling parties in France and Germany, Japanese continuing to struggle to contain radioactive leaks and increased unrest in Yemen and Syria.  Sterling, which reached a multi-month high last Tuesday near $1.64 is off nearly a nickle as intreest rate differentials and talk of insurance payout to Australia and New Zealand take a toll.    Some observers are highlighting Fed's Bullard comments about ending QEII early.  This seems to me to be an exercise in exageration as Bullard is not a voting member. 

The euro climbed back above above $1.4080 after gapping lower in Asia (to ~ $1.4028).  Support now seen near $1.4040.  April 7th rate hike by the ECB remains a key factor as is the fact that Spain continues to appear to have decoupled from the woes of the periphery.

Quick Note on Weekend Developments

The US dollar is opening broadly higher in early and thin Asian activity.  The thinness of market conditions is surely playing a role, but the weekend news would encourage risk aversion.  First, the radioactive leak in Japan has yet to stabilize.  Second, the MENA tensions rose in especially in Syria.  Third both Merkel and Sarkozy's parties took a thumping in local elections.  Fourth, Portugal is still in denial about the need of assistance and the bond.  Portugal's 2-year yield rose rose 84 bp last week to 6.65%.

By late Friday it became clear that there were to be no grand bargain at the EU Summit.  Still the key driver of the euro has been the signals that the ECB will hike rates at the April 7 meeting.  Some dollar bears ask, "Where would the euro be if it weren't for the debt crisis in the periphery ?".  I wonder where the euro would be if the Fed was pursuing only easy monetary policy and not extraordinarily loose monetary policy.   On balance, the week's events were largely unsurprising and that warns that these early dollar gains are vulnerable. 

Thank You Sir, Can I Have Another ?

Portugal has been downgraded by both Fitch (A-) and S&P (BBB) and the EU Summit looks like modest techical adjustments that have largely been unveiled.  The euro (yawn) is little changed.    On the week it is a mere 0.1% lower, less than a rounding error for most participants.  Its resilience remains remarkable.  It is coming at the same time that Q1 US GDP expectations have been shaved and few doubt that the Fed will abandon its Treasury purchases.  I continue to suspect the market is setting up for "buy the rumor sell the fact" on the April 7th rate hike. 

The strongest currencies this week have been the dollar-bloc currencies, with the New Zealand dollar leading with a 2.8% rise.  Although it has been difficult to play, given the Japanese events adn cross impacts, but I have liked the Kiwi since the 50 bp rate cut and think many observers have misconstrued the implications.  It is movoing above $0.7500 today and I think there is potential toward $0.7700 or so.

Bloomberg: Chandler, Lyons Interview on Spain, Portugal Debt

No Crisis Unless Spain Falls?

The resilience of the euro in the face of seemingly incontrovertible evidence that Portugal will need to get assistance and that very same program and approach has not been enough to stabilize the Greek and Irish situation is amazing.

It can be arguably explained by two considerations. First that come hell or high water, the ECB, which does not pre commit has all be indicated a rate hike at the April 7 meeting. Second, existing facilities and liquidity provisions are good enough provided that Spain does not come under attack.

European Crisis Deepens, Euro Higher

The European debt crisis is deepening as the Portugal government has fallen, Moody's follows-up the recent Spanish sovereign downgrade with a downgrade of 30 cajas.  European officials have also indicated that some key issues that we thought to be settled at the summit that starts today will likely be dealt with later, like funding for the ESM and Ireland,   There had been some reports that Portugal aid would wait until June, but the risk is much sooner.  Estimates based on projected financing needs for the next three years suggest a package of 70-80 bln euros may be necessary. 

And yet the euro's resilience is remarkable.  Yes it was sold from near $1.4220 yesterday and reached a low near $1.4050 earlier today, but it is come back quickly in Europe and the beachball underwater analogy comes to mind.  It is as if the market is focused on one thing:  super easy US monetary policy and the near certainty of an ECB ratre hike. 

Two Governments Could Fall, but Euro Resilience Continues

The US dollar is mostly lower.  The exception is sterling which was yesterday's outperformer.  Minutes from BOE meeting contained no surprises, but the market awaits the budget.  

Even though European bourses are higher, anxiety levels are running high--not just because of Libya, but also Yemen, Syria, Gaza strip, among the MENA, but also as I noted yesterday, it looks likely that the Canadian government and the Portuguese government will fall.  Meanwhile, Finland, ahead of next month's election, is balking at increasing funding for EFSF, while Germany is not happy with the funding of the ESM.   

Portugal Government Under Pressure

Rumors of a missed coupon payment in Ireland made the rounds and many now are down playing it. However, the problems in the periphery have not lessened. The real immediate focus is on Portugal. The government's new austerity measures will be debated tomorrow. All of the main opposition parties are opposed to the extra spending cuts that EU leaders so warmly praised.

Looking Past Canadian Retail Sales

Canada reported weaker than expected retail sales. Instead of a 1.0% rise in January, StatsCan reported a 0.3% decline. Weakness was especially noted in the ex-auto component which was flat instead of up 0.7% as the consensus expected. This is the second consecutive monthly decline (Dec -0.2%) and should reinforce perceptions the BOC is on hold until at least midyear.

Canada led the G7 countries in growth in Q4 and is the first to regain all the jobs lost in the economic downturn. However, the consumption is expected to slow this year and the central bank expects housing to also may be a drag on growth. In addition to the disappointing retail sales data, Canada's fragile political climate warrants caution for CAD bulls.

UK CPI Sends Sterling Higher, Other Majors Little Changed

The US dollar is little changed against most of the major currencies, remaining near the recent trough and in the post-intervention environment, where implied volatility has been sharply reduced. Sterling is the main exception and as a higher than expected inflation figure encouraged rate hike expected to be brought forward.

UK Feb CPI rose 0.7% to 4.4% year-over-year.  The consensus had been for 4.2% rate after Jan's 4.0%.  Unlike in the euro zone and the US, it cannot be simply dismissed as commodity prices.  The UK's core rate is 3.4%, while 3.1% was expected after Jan's 3.0%.   However, the rub here is that if one were to exclude administered price hikes, like VAT, tuition and the like, the UK core rate is considerably lower according to industry estimates.

CNBC: Volatile Global Markets

Dollar Bloc Advances

The dollar-bloc is lead the move against the dollar. The easing of some anxiety around Japan's nuclear crisis and firmer commodity and equity prices are helping to lift the Canadian dollar and antipodean currencies.

We had noted recently that the Canadian dollar's correlation with oil prices and the S&P 500 had broken down. The Canadian dollar's correlation with the price of oil had actually become inverted in the first half of March, but now has swung back to slightly positive (r2= 0.11). The recent peak was around Xmas (r2=0.76).

The Canadian dollar correlation with the S&P also broke down from a recent peak (r2=0.78) in early Feb and bottomed earlier this month (with an r2 near 0.47) but has risen since mid-month (now r2 near 0.67).

Again our correlation work is conducted based on rolling 60-day correlations on percentage change. This work suggests that traditional or intuitive relationships with the Canadian dollar appear to be turning.

The data highlight of the week for Canada is tomorrow's retail sales. It is a January release and the consensus is for around a 1% rise after a monthly average of 0.7% in Q4 10 and 0.5% in Q3 10.

Last week saw the US dollar test its 100-day moving average against the Canadian dollar. It comes in now near CAD0.9972. Initial support is seen near CAD0.9750 and then CAD0.9700. Over the slightly longer term, there is potential toward CAD0.9500. A proper test on the late 07 low near CAD0.9060 would seem to require bringing forward BOC tightening and pushing out the end of US quantitative easing efforts.

The Australian dollar is a different kettle of fish. It has been chopping back and forth in the fairly clear range of $0.9800 and $1.0200 since last December. It did break out of the range to the downside last week, as the yen surged, but rebounded smartly on the back of the intervention. It has managed to largely shrug off the hike in reserve requirements in China. Some nearby resistance in the Australian dollar is noted in the $1.0060 area, which is where the 20-day moving average is found and then $1.0150-60 last week's high.

US Treasury Unwinds MBS Securities, Lifts Dollar

News that the US Treasury will begin selling off its portfolio of mortgage-backed securities was greeted with dollar buying. The Treasury's portfolio of $142 bln of agency guaranteed MBS will be sold at a pace of $10 bln a month. The sales will start this month, according to reports and that Treasury Dept expects to make a $15-$20 bln profit.

This is of course different than the Federal Reserve sales, but the fact that the Treasury is citing improved market conditions is notable. The consensus is for the Federal Reserve to complete its $600 bln Treasury purchases under QEII. The question is the Fed's exit strategy. In particular, what happens to the maturing issues and will it continue to recycle those proceeds back into the Treasury market or will it accept a passive shrinkage of its balance sheet.

Big Week Begins Off Slowly

The US dollar is mixed to start the new week.  The G7 intervention has been successful insofar as the yen volatility has fallen sharply.  It had neared 17% last week and is now near 12.5%.  Japanese markets were closed on Monday and there has been no intervention. 

German and French ruling parties were weakened in the local elections.  The EU Summit on March 24-25 is the main highlight, but the flash PMIs will be out first and it wouldn't be surprising to see some moderation in the pace of activity.    The EU Summit looks to stop far shy of what the market needs for closure, but may very well see a package of Portugal.  Although the premium over Germany narrowed in recent days, yields from 4-years out are above 7%. 

Fox News: Stabilizing the Yen a Success?

Word of the Day: Coordination

The G7 nations agreed to intervene in the foreign exchange market for the first time since 2000 and the UN approved enformcement of a no-fly zone over Libya. The net consequence has been to take the yen broadly lower.  The euro has rallied to above $1.41 on ideas, suggested by the Japanese finance minister that intervention could take place on euro-yen as well as dollar-yen.  The dollar-bloc currencies are bid, while sterling and the Swiss franc are a bit heavier. 

The intervention lifted the dollar from about JPY79 to about JPY82.    The JPY82.00 area is noteworthy.  It is around where the dollar was traidng prior to the nuclear crisis.  However, Japanese exporters are believed to have sold into the dollar rally and capped it near there.   Generally the first bout of intervention is the most effective and then a point of diminishing returns quckly is reached. 

Yen: Speculation, Repatriation and More

There seems to be a general consensus among observers that contrary to the talk of repatriation that the yen's rise is largely speculative in nature. This is very much in line with our assessment from the get-go. Subsequently, data strengthened out conviction. At the same time, there are a couple of other elements that we have mentioned but are worth reiterating given the pace of the yen's rise.

Intervention Risks Rising

The yen is bid and the dollar has slipped to a new low for the year against it, and just slipped through the the low set late Nov near JPY80.20. Given that Japanese investors typically invest in fixed income when venturing offshore, evidence of repatriation is difficult to detect given the general rally in major bond markets. Yet the anticipation of repatriation is strong.

France, which tends to be more interventionist-minded in general, is the chair of both the G7 and the G20. French officials have reportedly called a G7 meeting of finance minister and central bankers to discuss the economic impact of Japan's crisis and "possible measures to calm financial markets".

Some European Implications of Japan's Nuclear Accident

The Japanese nuclear accident has implications for Europe. The EU wants to have stress tests on members nuclear plants. The tests are not mandatory, but may be difficult to refuse. Switzerland has halted its nuclear program, according to reports. Perhaps the most interesting response is in Germany.

Chancellor Merkel has been an advocate of extending the use of nuclear power in Germany and until yesterday was seeking to extend the operation of seven of the oldest (of 17) nuclear plants. She bowed to strong pressure announced a stoppage of these old nuclear reactors a day after she and announced a 3-month moratorium of the extension she had previously sought.

Key Developments

The dollar is a mixed.  It is firmer against the major European currencies and many of the more actively traded emerging market currencies, but lower against the dollar-bloc and little changed against the yen.

The two most important developments have been the apparent stabilization of the situation in Japan and Moody's two-step cut in Portugal'd debt rating to A3 and maintaining a negative outlook.  This comes, of course, on the heels of the last week's extra 0.8% of GDP spending cuts and the weekend European summit that was trumpted as a big step toward closure of the debt crisis.    Moody's cut Greece and Spain's rating last week.  It should not be surprising if Moody's follows up and cuts the ratings of several Portuguese banks. 

Fed Tweaks Assessment and Does Nothing New with QEII

The FOMC tweaked their economic assessment and recognized the sharp rise in commodity prices in recent months, but believes that longer-term inflation expectations remain anchored. It specifically says that it expects the rise in commodity prices to be transitory. It seemed to also heighten its alertness to changes in inflation and inflation expectations. And no surprise, it indicated it would continue to buy Treasuries as it had previously outlined.

CNBC: Flight to Safey

Japanese Policy Response to Yen Strength

The dollar is firm against most of the major and emerging market currencies. The yen and Swiss franc are exceptions.

The dollar has fallen to new record lows against the franc. The franc is up about 1.5% against the euro, but is still about 3% above the record low carved out at the end of last year and earlier this year. The Swiss National Bank meets on Thursday and is unlikely to do anything. Even its complaints about the Swiss franc's strength has waned in recent weeks, though government officials seem somewhat more concerned.

Why is the Dollar Finding A Safe Haven Bid?

The jasmine revolutions in MENA and euro-era high yields on the peripheral of Europe failed to give the US dollar a safe haven bid. And yet today, it is difficult to deny the greenback is benefitting from the broader risk aversion.

Previously I explained the lack of dollar safe haven bid by noting that it was precisely because US Treasuries were a safe haven, that the dollar was not, in the sense that 1) the market was particular sensitive to the divergence of monetary policy and 2) the interest rate spread between the US and Germany widened. Now while US Treasuries have rallied, German bunds have rallied more so. The 2-year interest rate differential has moved 7 bp in the US favor today and now stands at 97 bp the lowest since before the March 3 ECB meeting in which signalled a near-term rate hike.

Japan Drives Markets

There is one overwhelming driver in the global capital markets today and its is risk aversion sparked by leaks of radiation from Japan's nuclear facilities.  This has prompted sharp drop in equity markets, a rally in bonds and lo and behold the dollar caught a good safe haven bid.  In addition to the dollar, the yen and Swiss franc are firmer, but the other major and emerging market currencies are broadly lower. 

There are two factors that I think explain the dollar's safe haven bid that it did not have previously.  First, while US Treasuries have rallied, German bunds have rallied even more and this has resulted in a shift in interest rate differentials in the US favor.  The 2-year spread which I continue to find is tracking the euro-dollar exchange rate has moved into the US favor by about 5 bp and at 99 basis points is the lowest since the start of the month.  Second, with oil prices coming off, there is somewhat less talk about petrodollars being recycled.  

FOMC Outlook: Little Change

The FOMC meets tomorrow. The statement is likely to be little changed from the January statement and is unlikely to spur much of a market reaction.

The statement is very formulaic. The first paragraph offers an economic assessment. While the precise wording may be tweaked, the Fed's assessment that the pace of recovery is insufficient to "bring about significant improvement in labor market conditions" remains valid.

Parry and Feint: Outlines of Europe's Next Chapter

Currency in Crisis

European officials have reached an agreement in principle that falls well shy of the “comprehensive plan” officials had promised and is unlikely to provide investors with a sense of closure to the debt crisis that began in late 2009. Yet progress was sufficient that the debt crisis is unlikely to override the divergence of US and European interest rate policy as the main driver in the euro-dollar exchange rate.

Ironically, Greece, which had acknowledged just as the summit was beginning that its budget deficit was about 9% wider in the Jan-Feb period compared with year ago levels, was the biggest winner from the agreement in principle that requires an EU vote at the March 24-25 summit.

Japan and Europe Update

There is no good time for a disaster to hit, but this is a particular bad time for Japan. The Japanese economy is fragile, deflationary forces are still evident despite the jump in energy and food prices. Prime Minister Kan and the ruling DPJ party have been torn by internecine struggles and a series of financing scandals. In foreign affairs is a mess as Russia and China have increased their claims on contested territories. The BOJ has injected a record JPY15 trillion in to the banking system and increased its asset purchases under quantitative easing by JPY5 trilion. This appears to have helped stabilize the yen after the dollar briefly fell below JPY81.00.

Japan’s accumulated gross debt, the most among the major industrialized countries, including the periphery in Europe, constrains the use of fiscal policy. However a supplementary budget is likely. The opposition Liberal Democrat Party, which has threatened to vote against the government’s proposal to issue more than JPY44.3 trillion in JGBs in the new fiscal year beginning April 1, has indicated it will endorse spending related to the disaster.

Earthquake Sends Yen Higher, Dollar Continues to Recover

There are two main features in the foreign exchange market as North American participants return to close out the week. The first is a continued recovery of the US dollar in a backdrop of widening peripheral European bond spreads, the continued reversal of the global equity market rally and the ongoing MENA tensions and within the context of market positioning which has amassed a sizeable short dollar position in recent weeks, judging from the IMM data, the dollar's steady decline and proprietary information. The second feature is the strength of the Japanese yen in the wake of an earthquake that may have been near 9.0 on the Richter scale.

The typical expectation, based on past experience, is for Japanese investors to repatriate funds. This, of course, was very unlike the market response to the recent earthquake in New Zealand, when the local dollar was sold off. Two key differences: Japan's net international investment position is in surplus. It has funds it can repatriate. And judging from the margin trading figures, retail in Japan, which industry estimates suggests could be in excess of 25% of the Japan's foreign exchange turnover, had built a large long dollar position.

More Color on Spain

The market continues to digest the meaning and implications of Moody's decision to cut its rating to Aa2 from Aa1. The two main considerations behind Moody's decision are that the cost to restructure the banks will be greater than Spanish officials have estimated and the sustainability of current austerity measures.

At 40-50 bln euros, Moody's new estimate is more than twice the estimate it had made late last year and is well above the government's estimate. Moody's downgrade of FROB, which is the government arm that is to help raise the funds for the bank restructuring. The ECB was quick to point out that FROB has the capacity to provide as much as 90 bln euro in funding. What was not said was that like the EFSF, FROB is not pre-financed. That as banks request funds, it needs to raise them by issuing bonds and will then in some ways compete with the government in the capital market.

Key Developments

After a largely quiet first half of the week, there are a number of noteworthy developments today. The most important of which is arguably Moody's downgrade of Spain to Aa2 and maintaining a negative outlook. It is important because it took place hours before the Bank of Spain is to publish each bank's capital needs. Spanish officials have indicated that it would not exceed en toto 20 bln euros or 2% of GDP. Moody's says it could really cost up to 50 bln euros.

The government seems livid. Greece, which Moody's cut three notches earlier in the week is also irate, complaining to the EU and there has been some suggestion of legal action. The euro fell on the unexpectedly timed to almost $1.3800 where demand, purportedly from Middle East and sovereigns, emerged and lifted the single currency back toward yesterday's lows near $1.3850. Talk that the ECB has continued for the second day to buy peripheral bonds also may have helped stabilize the situation.

Stressing Out over European Bank Stress Tests

The newly created European Banking Authority will be overseeing the stress tests on almost 90 European banks. Recall that the stress tests last year met broad criticism for the lack of rigor. It was anticipated that the EBA would indeed provide for a more robust test this year. However, doubts are already being raised.

Initially there are two areas of concern. The first is on the definition of Tier 1 capital, which is that part that can absorb unexpected losses. The early indication is that the EBA will likely allow countries to use their own definition of Tier 1 capital. The UK, for example, is believed to have a more stricter definition than say Spain. That would give Spanish banks an advantage.

Euro Resilience Noteworthy, UK Trade Improvement, Japan Update

Peripheral European bonds are under pressure and the euro slipped through yesterday's lows against the dollar, but we continue to suspect the price action is largely technical in nature. The dollar's downside stalled encouraging momentum traders to square up positions. The underlying signal is still one euro resilience as it appears the interest rate story continues to trump the debt crisis story.

The euro managed to record only a marginal new low, it was recorded in early European activity and stayed there only briefly. The weakness was not confirmed by sterling, which held above yesterday's lows. Divergences on the short-term momentum indicators suggest the euro is likely to recover in North America today. Top end of the immediate range is seen around $1.3930 and a break of could be the first signal of another run above $1.40. On the other other hand, a break of $1.3850 would likely force another round of position squaring.

Spanish Bonds Decouple from Portugal

There have been two main surprises this year. The first is how the jasmine revolutions in MENA. It is one thing to recognize the fragility of those ancient regimes, it is another thing to watch a number of government's collapse. The second is that the European debt crisis seems to be having a marginal influence at best on the global capital markets. We had thought this was going to be the main driver at the start of this year.

The debt crisis appears to have been trumped by monetary policy. Starting with the first ECB meeting of the year, officials have sounded particularly hawkish and this of course culminated with last week's ECB meeting at which Trichet used some word plays to signal the intent to raise interest rates very soon. The use of "strong vigilance" and the failure to say that "rates are appropriate" were understood by market participants as they were intended.

Yen Notes

The yen is largely sidelined as the market's focus is elsewhere--ECB policy trajectory, the European debt crisis, MENA, etc. This is reflected by the fact that dollar-yen volatility (implied 3-month) is sitting on its 3-year low near 9.55%.

At 45 bp, the US-Japan 2-year interest rate spread is a few bp above its 100-day moving average. At 218 bp, the 10-year spread is about 15 bp above its 100-day moving average. For all practical purposes the dollar is at its 100-day moving average (JPY82.60) and euro-yen is about 2.6% above its 10--day moving average. The move in euro-yen has largely been achieved over the past week and is related to the ECB rate signals.

Turn Around Tuesday?

Corrective pressures grip the foreign exchange market today. The short-term momentum traders have been frustrated with the euro's inability to convincingly break above the $1.40 level and sterling's four attempts at $1.6350 appears to be the main impetus behind today's pullback. With today's losses, the euro has slipped through the post-Trichet's "strong vigilance" reference (~$1.3925). The next band of support is seen in the $1.3850-80 area. Net speculative long euro positions rose in the week through last Tuesday to 51.3k contracts, the upper end of positioning since the the crisis began, it likely understates positioning given the euro's surge following Trichet's rate hike signal.

Sterling has slipped to six day lows today. A break of $1.6150 now could see loss toward trend line support near $1.6070 (drawn off Feb 11, 16 and 25 lows). Today offers the first test of the dollar bearish sentiment in North America. Asian consolidation has been followed by European selling. On balance, we suspect the dollar bears remain in the driver's seat and that this pullback is largely technical in nature. The US-German 2-year yield captures, we think, main forces at work. At the end of last year the US 2-year yield was about 20 bp less than Germany. Now it is at 105 bp discount, having finished last week at 108 bp.

When Will Portugal Ask for Assistance

Portugal will be selling 750 mln to 1 bln euro of 2 1/2 year bonds on Wednesday. It will be the first bond offering since the syndicated offering in mid-Feb. It has been trying to buy back bonds that expire this year, but these have generally seen lukewarm interest. Portugal is trying to raise funds not only to cover this year's deficit, but it also faces a 5 bln euro maturities in April and another 5 bln in June (and roughly 2 bln in coupon payments). It has already raised about 6 bln euros.

The problem is that foreign investors have been net sellers of Portuguese bonds. Today the on the run 10-year yield hit a EMU-era high. Most of last year's issuance was absorbed by domestic financial institutions, which historically were not large holders. Some estimates suggest that the ECB purchases have essentially covered the foreign selling, but ECB purchases are not transparent or detailed, making it difficult to know what it actually has purchased.

CNBC: Choice Currency Plays

Canada and Oil: More Complicated than One Might Suspect

It seems clear. Canada is one of the few developed countries that is a net exporter of oil. Oil prices have soared and the Canadian dollar is at its best level against the US dollar since late 2007. But a closer look suggests a more complicated picture. Since February 15, oil prices have shot up by around 25%, while the Canadian dollar has rallied just shy of 2%, and is actually among the under-performers among the major currencies (3rd worst among the G10, better only than the New Zealand dollar (-1.8% ahead of an anticipated rate cut later this week) and sterling (+0.8%).

We have found that the correlation between oil and the Canadian dollar has collapsed. We conduct the correlation analysis on a 60-day rolling basis, using percent change. The correlation peaked at the end of last year near 0.76. It now stands at -0.1.

ECB Rate Outlook Dominates

It appears the foreign exchange market is being driven by one overriding consideration and that is that the ECB is going to raise rates as early as next month. The debt crisis on the periphery has been ignored. Fitch cut the outlook for Spain before the weekend, noting that the financial sector may need another 38 bln euros and the euro bulls where unfazed.

Earlier today Moody's slashed Greece's rating by three notches to B1 and retained a negative outlook, citing difficulty collecting revenues and implementation risk. The rating agency said that the risks of default or distressed exchange had increased since it last cut Greece's rating near the middle of last year. Moody's noted that 20% of the B1 rated sovereigns and companies default within five years. The euro wobbled, pulled back to near $1.3960 and then soared to new highs since November.

Euro and Yen: Surprising Correlations

It looks so easy. Risk on and risk off. When risk trades are being put on, equity market and commodities prices, like gold and oil, rise. The euro appreciates and the yen sells off. When risk trades come off, just the opposite takes place.

Jobs Data Disappointing, though Unemployment Rate Falls

The US employment data was in line with expectations, but this is disappointing in that it suggests that there has been no acceleration of private sector job growth from Q4 10. The 222k rise in price sector jobs was a bit more than expected and the upward revision to the Jan data keeps the monthly average around 140k. Manufacturing jobs grew by 33k, better than the 25k the consensus expected and the Jan data was also revised up a little. This bodes well for the manufacturing output figures due out later in March.

Yet the flat hourly earnings figure is disappointing and suggests limited gains in income. Auto sales point to good retail sales report, but consumption may have to have been fueled by dipping into savings more than wage and salary income. The work also did not bounce back from last Jan's weather induced weakness and this is also disappointing. The continued decline in the unemployment rate to 8.9% is surprising, but does not appear to be reflecting underlying jobs growth as much as changes in the participation rate.

To Key Issues Today: ECB Intentions and US Jobs

Currency market participants are focused on two things today. The first is the implication of ECB's Trichet comments yesterday. The reference to "strong vigilance" and explicit refusal to indicate that "rates are appropriate" are understood as powerful signals of the ECB's intent to raise rates as early as next month. A Reuters poll found 39 of 49 expect the ECB to raise rates a quarter of a point at its next meeting in early April. While it is difficult to deny the ECB's hawkishness, my reservation lies with the key EU summit on March 24-25. The ECB has, like the Federal Reserve, drawn a distinction between liquidity provisions and monetary policy (interest rate policy), but the ECB had to backtrack at the end of last year, due primarily to the Irish crisis, from ending its three-month liquidity facility. It now says that facility will last through Q2, under which banks can borrow unlimited funds at a fixed rate (presently 1%).

Trichet Hawkishness to Exacerbate Peripheral Woes

ECB President Trichet is signaling a rate hike and the market debate seems to be between April and May. While the monetary setting may be too easy for Germany, the peripheral countries, where the debt crisis has been concentrated, monetary conditions (currency plus rates) are too tight. Germany 2-year yields are up 20 bp, but periphery yields are up even more, with Portugal, for example, up 32 bp. The ECB's hawkishness is boosting the odds that Portugal seeks aid by the end of the month. The ECB's hawkishness is also adding on pressure on European governments collectively to resolve the debt crisis as super easy money from the ECB is coming to an end.

The leaders of what will be the new government in Ireland is arguing the economy is in worse shape than it had been led to believe and it could very well turn out the Ireland needs more funds if it is going to make senior bond holders whole.

Trichet Sends Euro and Interest Rates Sharply Higher

Trichet has stayed true to form and issued relative hawkish signals. Two key points--"strong vigilance" is needed and no reiteration of the mantra that "interest rates are appropriate". He explicitly said that this could mean a rate hike as early as next month, but the ECB does not pre-commit.

The staff forecast for inflation was lifted this year and next year.

ECB and Europe Front and Center, Ahead US Jobs Tomorrow

The ECB meeting and more importantly the press conference that follows is the main event of the session. The market generally expects Trichet to continue to sing from the hawkish hymn book. Although many observers have been critical of the July 2008 rate hike decision, Trichet has referred to it, almost as a badge of honor, demonstrating beyond reproach his anti-inflation credentials. Indicative prices suggest the market has discounted two quarter-point rate hikes this year.

While the odds of a hike today are above zero, they are not much higher. The ECB still appears to have some preparation work to do. First, the ECB will likely lift its medium-term inflation outlook. Second, it may want to normalize money market operations, even though this is not a necessity. Yet, it seems that if conditions are beginning to warrant a rate hike, is unlimited amount of 3-month funding still needed? Mover, with weak growth in money supply, arguably the monetarists at the ECB need not be in a hurry. Lastly, another argument against a hike is that the ECB may need to respond if the euro zone governments fail to present a compelling comprehensive plan to resolve the European debt crisis at the summit later this month.

CNBC: Gold: New Reserve Currency

FX Forces: Rate Expectations and Petrodollar Recycling

There are two main drivers of the US dollar presently: divergent interest rate expectations and the recycling of petrodollars. Developments over the past 24 hours reinforce those drivers. The higher euro zone manufacturing PMI readings yesterday have been followed by news of a larger than expected jump in Jan producer prices. The 1.5% m/m increase was half again as much as the consensus forecast and lifts the year-over-year rate to 6.1%, the fastest since Sept 08.

The ECB meets tomorrow. The market appears to be pricing in two 25 bp rate hikes this year. However before hiking rates, the ECB will likely end its provision of unlimited 3-month funds. Recall it had been moving in this direction before the Irish crisis last November. In contrast, Fed Chairman Bernanke was fairly clear yesterday, while the recovery appears to be strengthening, employment growth has been frustratingly slow and the rally in commodity prices may provide only a temporary lift to prices, but inflation expectations remain anchored. Some argue that the Fed is slipping behind the curve, but this assumes that both central banks are dealing with the same conditions.

Fight Over Budget, Opposition Balks at Financing, but Not US

The government submits a budget. Their majority in one house allows it to be passed there. The opposition is trying to obstruct it and it is raising concern about the world's largest public debt. This is not the US but Japan.

Earlier today the lower house of parliament approved the record JPY92.4 trillion budget for the new fiscal year that begins April 1. It does not need the upper house's approval.

However, where the upper house is needed is in the financing of the budget. The budget is predicated on JPY44.3 trillion of new bond issuance.

Policy Divergence Theme Driven Home

The combination of the strength of the European data and Federal Reserve Chairman Bernanke's semiannual testimony before the Senate, which is unlikely to signal an early end to QEII, is reinforcing ideas that Europe is likely to raise rates before the US. This continues to weigh on the dollar. Talk of recycling of petrodollars as oil producers seeking to maintain allocation of reserves adds to the dollar pressure.

Nearly every euro zone country that reported a manufacturing PMI came in above market expectations. Both the German and French series beat the flash report out last week. Germany posted a new record high. The overall euro zone reading matched the flash at 59.0 from 57.3 in January, which is the best since June 2000. That that priced moderated to 85.3 from 85.7 in the flash report offers little consolation. It was 79.2 in January and the EMU flash February CPI came in at 2.4%, a tick higher form January. The strength of some of the periphery PMIs, such as Ireland to 56.7 from 55.8, its highest since 2000, must be seen as a favorable development. Even Spain's headline that ticked up ever so slightly to 52.1 from 52.0, is the strongest in 10-months. On top of this Germany reported joblessness fell 52k in February, more than three times more than the market expected.