FT Feature Video: Marc Chandler bets on Euro Survival

I've written for the FT before on the resilience of the Euro. Here is an interview with Nicole Bullock on Euro survival via Europe to move toward a tighter fiscal union to avoid a break up here.

Official Action and Why Italy is Still at the Vortex

The focus is on next week's ECB meeting and the EU summit. Nearly every one is expecting a 25 bp rate cut and if expectations are wrong, it is more likely that it is because of more aggressive action, like a 50 bp cut, than less. Separately, it will also likely provide long-term refi operations. It currently has a 1 year repo outstanding and next month will offer 13-month money that covers two year end periods. Next week it may offer 2-3 year money. It may also liberalize its collateral rules again.

The EU Summit is the last opportunity of the year, and some observers say the last opportunity period, for action that will begin seriously addressing the crisis. Tomorrow France's Sarkozy is expected to present his proposals tomorrow and Germany's Merkel Friday.

Choppy Market: Push Me Pull You

There have been several developments and they have imparted conflicting impulses into the market.  The S&P downgrade of a number of large banks based on a new methodology that has been unfolding over the past couple of years comes at a poor time, when many banks, especially in Europe, are having funding problems and different measures of financial stress are elevated.  Today's development of the German 1 year note yield falling below zero for the first time is reflective of those pressures. 

EuroGroup Meeting Day One

The first day of the eurogroup (European finance ministers) meeting results in two decisions.  The first is the approval to the next tranche of Greek aid.  It is about 5.8 bln euros.  This is the sixth disbursement and there is no reason to think that next year's disbursements won't be the same nail-biting exercise as this year's have been.  The second decision involves the EFSF and only broad strokes appear to have been decided.  

As has widely been discussed, the EFSF form will be one of insurer rather than bank.  It will not borrow from the ECB as some had previously suggested.  Instead the EFSF will issue partial protection certificates that can guarantee up to 30% of a sovereign bond.

CNBC: EFSF Bailout and the Euro

CNBC: QE3 and Europe in 3 Minutes

More Thoughts on End Game Scenarios

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The euro zone finance ministers meet today and tomorrow. Approval of the next tranche of aid to Greece and an agreement on EFSF leveraging is sought. Yet the real deal is still a week away and that is the EU summit.

A year ago, we handicapped the likely end games to the European debt crisis. We attributed a 3% chance of a country leaving the union. Although there has been heightened talk of a country leaving and different systems have contingency plans or stress tests to ensure the ability to cope in such an event, no country has left and the knock-on effects of a country leaving, possibly sinking the entire project, do not appear to have been thoroughly thought through by the advocates.

Dollar Heavier as Position Squaring Dominates

After rallying in Europe yesterday, as weekend developments encouraged risk appetites, the euro and sterling retreated in North America.  That pullback went about as deep as possible without negating my expectation of corrective forces at the start of the week.  Despite more poor rating news and talk, those corrective forces remain intact today.  

That said North American operators appear more skeptical or more euro negative/dollar bullish than Europe, judging from the recent price action.  Short-term technical indicators also once again suggest North American dealers will open their books with the short-term market over-stretched.    

The much anticipated Italian bond auction saw respectable demand and the upper end of the 5.5-8.0 bln euros were raised and the euro rested the lower end of a band of resistance that runs from around $1.3440 to $1.3480.   

Risk Assets Jump, Smell Something, See Nothing

Equities, most foreign currencies and commodities have rallied.  It is not as if there has been a great deal of clarity over the weekend.  There have been a number of press reports that have been suggestive, but some, like the report that the IMF was preparing a massive loan program to Italy, has been denied. 

Hopes that the Tue-Wed Eurogroup meeting could resolve the issue of leveraging the EFSF seem to have eased and the market does not appear convinced that it will decide to make the next aid payment to Greece as Greek yields are broadly higher today.   Moreover, the Italian auction raised just above the minimum amount though with a big jump in yields and addition supply is scheduled this week. 

Weekend Developments and Their Significance Going Forward

There have been several important developments over the weekend which are likely to support the euro at the start of the week, after falling for the past four consecutive weeks and recording a 7-week low before the weekend. However, I continue to expect corrective gains in the euro will be short-lived and subject to headline risks. I still think that the $1.29 year end target for the euro is reasonable.

There are two important developments in Europe.

The first are reports that Germany and France have agreed to fast track a new agreement on what Merkel has called a "stability union" that is said to be able to be in place in a period that may be measured in weeks rather than months or years that are often required for treaty changes.

Euro Pressures Mount--Necessary for Eventual Resolution

Personal challenges may help one overcome certain modes of thought and behavior.  So too,  a crisis allow officials to transcend ideological constraints.  First principles and sacred cows can get sacrificed if political necessity is strong enough.  

Those that call for the ECB to substantially increase its sovereign bond purchases, or for Germany to agree to euro bonds, want the opposition to unilaterally disarm.  They insist on putting the cart before the horse.  

In effect, under monetary union, members outsourced monetary policy to the ECB.  It took the early 1990s ERM crisis and the threat of a united but loosely tethered Germany to get countries to cede monetary authority, and just barely at that remember Germany never had a euro referendum and France approved with only the slimmest majority.

CNBC: Case for German-led Fiscal Union

What the End Game in the Euro Zone may Look Like

A headline says that an investment bank survey found almost half the respondents expect at least one country to drop out of the euro zone next year. This is twice the percentage of a couple of months ago. While such a scenario cannot be ruled out, cost/benefit analysis still argues against a country leaving.

Currency in Crisis

Greece is seen as the most likely candidate to leave, and some eminent minds argue it should. However, whatever benefits it may get by a devalued currency, assuming that it were to be accepted by businesses and consumers knowing full well it would not a store of value, would quickly be eroded by higher inflation, a deeper economic downturn, weaker export markets, a destruction of its banking system, not to mention escalating social tensions, which could undermine its political stability.

Euro Punched Lower by Series of Jabs

What was to be a subdued period in the markets is turning into a rout.  There have been a number of poor developments that have sent the US dollar broadly higher and has weighed on the highly correlated risk assets, equities, emerging market and commodities. 

The combination of Belgium apparently wanting to renegotiate the Dexia bail out and the poor flash China PMI from HSBC's flash reading (nearly a 3-year low of 48.0 from 51.0 in Oct) got the ball rolling initially, but this has been followed up by poor developments in Europe. 

The flash PMI showed continuing deterioration.  The composite remained below the 50 boom/bust for the third month.  Manufacturing fell to 46.4 from 47.3 in Oct.  It is at the lowest since mid-09.  The service sector was a bit more resilient at 47.8 from 47.2 in Oct.

IMF is Lender of Last Resort to Sovereigns

Many observers are confused.  They cry for the ECB to "man up" and "do what it is supposed to do" and be the lender of last resort.  It does have that function for banks, not for sovereigns.  The lender of last resort to sovereigns in the IMF. 

The IMF has been grasping for new facilities to address the current crisis.  Today it announced new precautionary and liquidity facilities, providing funds for between six and 24 months.    The likely candidates in the euro zone are Italy and Spain, while countries in eastern and central Europe would be other potential candidates. 

India Update: INR Slumps, Policy Response Looming

As the dollar is in uncharted water against the INR, it is difficult to have much confidence technical levels of support or resistance. Talk of a new range for the dollar between INR54-INR56 seems reasonable, but the RBI may want to try to push the INR higher, breaking the one-way market and allowing corporations an change to adjust. Key dollar support is seen near INR50.

The Indian rupee is has recovered most of the nearly 1% it lost against the US dollar in the local session today, which made it the poorest EM currency. Subsequently, it surrendered that dubious honor to South Korea and South Africa. The rupee's slide accelerated in early Asia as local participants reacted to yesterday comments from officials suggesting the central bank did not have much room to intervene in the foreign exchange market. The rupee is the worst performing EM currency this month, off nearly 7%.

ECB: Funding, Collateral, Outlook

In addition to data showing a broadening and deepening of the downturn and continued stress in the money markets, the ECB will also have new staff forecasts, which will likely acknowledge the slower growth and the inflation implications of the economic outlook. A particularly soft PMI data will encourage rate cut expectations. Looking further out, it is possible that the Draghi-led ECB manages to cut rates below the 1% floor that Trichet did during the 2008-2009 crisis.

This is about 17 bln euros more than were borrowed at last week's operation, which was then the most for the year. It is about 52 bln euros more than the amount borrowed two weeks ago. The number of banks participating also rose--to 178 from 161 a week ago.

Bank borrowing from the ECB reach a new high for the year at today's 7-day repo operation. Banks borrowed 247.17 bln euros for a week at 1.25% fixed rate.

Dollar Softer Amid Consolidation

The US dollar is trading with a softer bias in what largely appears to be a consolidation.  The euro held support near $1.34, sterling near $1.56 and Aussie near $0.9800.  The news stream is light and corrective forces are seen in equities, which are mostly higher, and bond markets, which are mostly lower.  Emerging market currencies are also generally firmer. 

S&P and Moody's affirmed their sovereign US ratings, though Fitch will decide later this month.  Fitch appears to be moving toward putting its ratings on review.  The across the board cuts envisioned in the aromaticity hit the military and this what some in Congress will move to mitigate first.  Obama has signaled his refusal to play that game and threatens to veto any attempt to dodge the cuts without a larger solution.  

The real fiscal drag won't come from the automatic cuts, which do not come into effect until 2013, but the expiry of the payrolls savings tax holiday and

The Four Key Issues that are Dividing Europe

Currency in Crisis

The ECB settled the purchase of almost 8 bln euros of sovereign bonds in the past week. This is a noticeable increase from the almost 4.5 bln euros settled in the prior week and it has managed to push Italian bond yields back below 7%. Nevertheless, funding pressure (the cost of swapping from euros to dollars, for example) remains elevated and the pressure on European bond markets have broadened to include core bond markets of France, Austria and Belgium, where the spreads over bunds are their widest since EMU began.

A solution in Europe remain elusive for a number of reasons, but one that seems under appreciated is that German and French interests and views are diverging. There are four main issues that divide them and by extension Europe. Germany and France are the two pillars of EMU and their disagreement reflects a larger split in Europe.

Dollar Bid as European Woes Dominate

News that the US super committee failed to reach an agreement has done little to eclipse the negative impulses coming from Europe.   Rajoy won no honeymoon in Spain despite achieving an outright majority in parliament.  Spain's 10-year bond yield is up around 15 bp today, the worst performer in the euro zone.  Moody's warned that rising debt costs and weaker GDP is negative for France and maintained its negative outlook for Irish banking system, despite its improved capital position. 

The euro has given back its pre-weekend gains and is holding in Europe just above last week's low near $1.3422.  A break of $1.3380-$1.3400 area is needed to signal the return to the early Oct low near $1.3150.  Note that net speculative short position at the IMM jumped to 76.1k from 54.2k in the prior period.  This leaves it little changed since the end of Oct, though the euro is off almost 3% thus far this month. 

Fifth New Government in Periphery and Thoughts to Start Week

Spain is the latest euro zone country to change governments. Since the debt crisis materialized, Ireland, Portugal, Greece, Italy have new leaders. The exact vote is not clear and does not really matter for international investors. The important take away is that as expected the Popular Party (PP) won a clear absolute majority.

Rajoy, the new prime minister will be able to count 180-185 seats, according to the exit polls, of the 350-member chamber. As in the other changes in governments in the euro zone, Spain's electoral results do not signify a change in the basic agenda. In a word, austerity. Different personalities and different coalitions may be reflected, and on the margins this may benefit one special interest group over another, but throughout Europe, the political elites across the ideological spectrum have embraced austerity.

Yen Strength: FX Forensics

Japan's economy has recovered after three consecutive quarters of contraction.  The recovery is sharp but is likely to be short-lived with much of the pent up demand satiated and new disruptions in the form of the floods in Thailand and the fragility of the world economy. 

The yen and the Swiss franc were seen as safe haven currencies during the tumultuous crisis in Europe.  The Swiss National Bank has effectively and apparently cheaply took the franc out of the game.  This may have increased some speculative pressure toward the yen. 

Austerity or Not: Spain is the Next Shoe to Drop

ECB and Fed Action: Forget About It

Some press reports are linking the recovery in the euro to comments from Boston's Fed Rosengren who seemed to suggest that an intensification of the debt crisis could prompt a joint response by both the Federal Reserve and the ECB.   Immediately people thought about intervention and/or coordinated easing. Don't hold your breath for it. 

Rosengren quickly added, though not quick enough for headline readers, that Europe has the financial capacity to address the challenges represented by Italy, but need the political will.  As powerful as the Fed may be, it does not have the strength to bolster the euro zone's political will. 

This is not to say the Fed and ECB don't or won't cooperate.  After all, there are the swap lines.  And, many of the Fed's programs, during the 2008-2009 period, but also more recently, as in QE2, seemed to benefit to a larger extent than many realize European banks.  Under QE2 for example, the bulk of the excess reserves created have ended up on the books of foreign, mostly European, bank branches. 

Interview: Euro Remains Resilient in Face of EU Debt Fears

Check it out here

Yahoo Finance: Euro Remains Resilient in Face of EU Debt Fears

Check out an interview I did for Breakout Yahoo Finance here.

Spain: Another Pain

Pressure is mounting on Spain. The 10-year yield today is essentially back to where it was when the ECB broadened its sovereign bond purchase scheme to include Spanish and Italian bonds. On Oct 27, the 10-year yield was near 5.33%. Today it is 100 bp higher. This is not a very conducive environment for tomorrow's new benchmark offering (up to 4 bln euros of bonds that mature in 2022).

Spain has elections on Sunday and there is little doubt over the outcome. The Popular Party (PP) is going to win handily. It may garner around 200 seats and the PP also governs most of the regions. It will have a strong political mandate.

Roller Coaster Foreign Exchange Market, but Ride the Dollar

After falling in Asia to new lows since October 10, the euro rallied in  Europe, briefly turned positive on the day, before coming off hard.  The short squeeze higher seemed to be largely based on what will likely be proven untrue.  There were reports and speculation that the ECB would agreed to defend certain interest rate spreads for the periphery.  This would commit the ECB into unlimited buying, which it does not want to do and some say is illegal for it to do.  It also confuses why the ECB buys sovereign bonds in the secondary market; not to defend a rate (e.g. 7%), but to ensure the transmission of monetary policy. 

Some suspect that China is getting ready to ride to Europe's rescue.  This also does not seem very likely.  Europe has sufficient assets and wealth to address the crisis.  It requires hard choices, but if they do not want to buy their own bonds, why should China?  EFSF bonds have performed worse than bunds, so it is hard to make a case based on performance, liquidity or transparency. 

Meeting Capital Requirements in Europe and the Euro

There are a number of ways that European banks are moving to boost their Tier 1 capital and strengthen their balance sheets.

One tactic that is more evident in practice than in observation is adjusting the risk weighted optimization models of the projected capital need (~13.6 bln euros) by adjusting their models.

Political Theatre Intermission, Economic Drama Returns

The political theatre in Europe in recent weeks was a distraction.  With it easing as new governments come to the fore in Greece and Italy, investors can return to the economic drivers.   Investors appear to be focused on the vacuum and how the ECB is the only institution that can immediately address the situation, but is reluctant to do so.   It refuses to offer unconditional or unlimited assistance. 

This in turn means the financial stresses, like the continued widening of the cross currency basis swaps (cost to swap from dollars into euros) to a new three year high, the take up at the ECB's regular refi operation, highest in a year, and the continued creep up of dollar and sterling LIBOR.  

Five Uncommon Observations about Europe

The escalation of the European debt crisis and mounting evidence of new economic contraction have increased the scrutiny on the region. Yet it seems like many observers may be failing to grasp several important points, including the nature of the new governments, the Italian challenge, pressure on the ECB, risks of a euro zone break up and the coming election in Spain.

1. With tough austerity being demanded of Greece and Italy new governments seem to reflect a greater part of the elites than the previous governments and in this light considering it "technocratic" does not do justice to what is happening. Papademos government has 100-day mandate with elections slated for Feb 19th.

Thoughts on the Data in the Week Ahead and the Foreign Exchange Market

Economic data has been of tertiary concern to the market recently, overwhelmed by the drama in Europe. Given that the drama may die down, with new governments in Greece and Italy, the economic data may become somewhat more important.

U.S.

The US production and consumption data are likely to confirm that the economic momentum from Q3 is carrying over into early Q4. Manufacturing remains a bright spot of the economy. And mining and drilling is also doing well. On the other hand, weakness in real earnings, consumer surveys and chain store sales suggest more moderate increases in retail sales. Consumption in general is unlikely to contribute as much to GDP in Q4 as it did in Q3 (1.7 percentage points, or a little more than 2/3 of the 2.5% growth).

Week that Began with a Bang Ends with a Whimper

The foreign exchange is calmer and narrower ranges have prevailed. The political uncertainty appears gradually easing. A new Greek technocrat government is taking office in Greece and Italy's Senate will vote on the austerity measures and the Chamber of Deputies will vote on them over the weekend. This will pace the way for a technocrat government early next week. A euro move above $1.3675 could spur a further advance toward $1.38.

Equity markets are generally higher after the Wall Street rally yesterday and the better news stream from Europe. The MSCI Asia-Pacific Index rose 0.8% today, recouping a bit of Thursday's 3.3% decline, the largest downdraft in seven weeks. Korean shares jumped 2.5%. Korean companies are to be one of the beneficiaries of the yen's appreciation. European shares are 0.6-1.3% higher near midday in London. Industrials and financials are leading the advances, with telecom and oil the laggards. The US equity market is open on Veterans' Day, but activity is expected to be light.

CNBC: Apple, The Euro, & Bernanke

Euro Zone: Size Matters

Currency in Crisis

The German Christian Democrats hold a party congress next weekend. There are a number of proposals that members are trying to get incorporate into the party position and platform. Many observers seem to be exaggerating the significance of some of the proposals that have been reported in the press.

One such proposal is to give the national central banks weighted votes on the ECB. The proposal calls for weighting the votes by GDP. This would of course give large countries more influence, and Germany in particular.

ECB Tries to Put the Genie Back in the Bottle

The sun has risen today and Italy is still there and so is Europe and monetary union, despite concerns about a point of no return being passed or some Rubicon has been crossed.  The combination of an acceptable Italian T-bill auction and apparently stepped up ECB buying has seen the Italian debt market recover some of yesterday's drubbing.   The 10-year (generic) yield is off 30 bp today to just below 7% and the 2-year yields is off almost 80 bp to 6.40%.  Note also this reflects a re-steepening of what was an inverted yield curve.    This has helped stabilize the euro and the non-dollar currencies more broadly. 

The Italian 1 year bill auction saw the yield rise to almost 6.09% from 3.57% last month.  However there are two other considerations that mitigate the outcome.  First, the yield for the 1-year bill in the cash market was over 8% and the bid-cover was nearly 2:1. 

Is Greece Italy's Future?

Currency in Crisis

This seems to be the question on nearly every one's mind today, with Italian 10-year yields rocketing through the 7% threshold and a vicious cycle of rising yields, triggering more sales, leading to margin increases, spurring more sales. Does Italy now need to go to the EU and IMF with hat in hand?

Italian mythology borrowed much from ancient Greece, but that was then than this is now. Greece is not the future of Italy. The scale of the Italian challenge is far greater than Greece's as Italy's sovereign debt is bigger than Greece, Ireland, Spain and Portugal's put together. Greece has, prior to the coming haircuts, about 350 bln euros of debt. Italy has to roll over about 300 bln euros in debt next year and another 200 bln in 2013. Together this is about 25% of Italy's debt and about 30% of GDP.

Rome Burns

There is one overarching story today and it is Italy.  Berlusconi's resignation reveals political fragility of the euro zone''s third largest economy.  Lost on many observers is the fact that the Berlusconi phenomenon is just a much an effect as cause of the political paralysis.  As Italian yields move into panic zone, with the 10-year yield shoot well through 7%, the euro has comes off sharply.  It is poised to test the $1.3570-$1.3600 bank of support after having briefly risen through yesterday's highs in early Asia. 

Thai Floods and Yen Appreciation

The dollar has slipped to almost JPY77.50, the lowest since the massive intervention last week. At today's lows, the dollar has given back almost 50% of what the intervention had achieved. It is still mind boggling the magnitude of the intervention. In one fell swoop the BOJ accounted for about 20% of the average daily yen turnover. In one fell swoop it recycled all of last year's trade surplus (in the first eight month of the 2011, Japan is recording a trade deficit). However, if the size is breath-taking, the actual impact is hardly inspiring.

Given the poor track record of intervention, unilateral or multilateral, sterilized or unsterilized, there may be no compelling need to understand why the $100 bln intervention is not sticking. All sorts of possible explanations seem partly at play. Intervention has not been repeated. The failure to push the greenback above JPY80 lent bullish yen safe haven views intact. Spot intervention is less effective than repeated operations in the swaps and options market too, as the SNB is thought to have done.

Choppy Calm Ahead of Potential Storm

The major foreign currenices are little changed against the US dollar as the North American session begins.  The Italian vote (9:30 EDT/14:30 GMT) is the key event and news that Berlusconi's ally/rival Bossi, head of the Northern League, called for the PM's resignation increases the probability that the government falls.  Meanwhile the new unity government in Greece has not been named.  Failure to do so today would be disappointing and raises the prospects of a less orderly demise of the Papandreou government. 

The euro is likely to remain confined to the range seen in recent days--$1.3660-$1.3860.  The dollar remains confined to extremely narrow ranges against the yen--less than 15 ticks.  The BOJ intervention has not been successful in terms of weakening the yen, but it has taken volatility out of the market. 

Italy's Political Drama: Tuesday Climax?

The Italian Chamber of Deputies will vote on a minor formality regarding last year's budget report on Tuesday around 14:30 GMT (9:30 EDT), but it holds within it the potential to topple the second euro zone prime minister in less than a week.  

Greek Prime Minister Papandreou has stopped down in favor of a national unity government which has yet to be named.  If Italy's ruling coalition does not secure a simple majority in the 630-seat chamber, the Berlusconi government will collapse.  Last month, a confidence vote, which is a parliamentary tactic used to enforce discipline, just passed with the minimum of 316 votes.  

However, in recent days, 3 MPs have defected and another six have openly called for Berlusconi's resignation.  It is not clear that Berlusconi can pull it off or at what cost.  If he fails, the opposition has reportedly indicated that it is prepared to call for a vote of no-confidence.  This is a parliamentary tactic used to see if the government still holds a majority in parliament.

Italy Takes Limelight from Greece

With Greece moving to a political solution, Italy is moving to center stage.  A national unity government in Greece, with former ECB vice president Papademos seen as slightly more likely than current finance minister Venizelos.  The national unity government will likely secure the 180 super majority vote to approve the late Oct agreement with Europe.  Elections look likely early next year. 

While there was some sigh of relief that initially lifted the euro, as the focus shifted to Italy, the euro fell to almost $1.3680 from the $1.3840 area.   The $1.3850 area corresponds with the 38.2% retracement of the euro's slide from the EU crisis summit euphoria of about $1.4240 on Oct 27 to $1.3610 on Nov 1.  

What Europe Can Learn from the NY Mets, Eurocrat Occupation and Other Observations

Last week, the New York Mets announced that the fences of its ballpark would be brought in by about 12 feet starting next year. The creation of 100 new seats is what economists might call a positive externality of the primary objective: Boost the number of home runs. Since moving to the new stadium in 2009, the Mets have hit a major league low 331 home runs. By way of comparison, their cross-town rival Yankees have hit more than twice the number of home runs over the same period.

Watch Switzerland on Monday

Switzerland reports its October consumer prices on Monday. This could be important. The Swiss National Bank's decision to cap the franc took place on the same day that the August CPI was reported (Sept 6). It showed a 0.3% month-over-month decline after a 0.8% decline in July. There are many observers who expect the SNB to lower its cap for the franc (that is raise the euro floor form CHF1.20 to CHF1.25 or higher) and see the risk of deflation as a potential trigger.

The Bloomberg consensus is for a 0.2% month-over-month rise in Oct after Sept's 0.3% increase. That Sept increase was the first increase in four months. However, the year-over-year rate is expected to slip toward 0.2% from 0.5%, suggesting that the risks of deflation have increased. Due to base effects, the year-over-year rate is likely to be zero of below in this month's report, before stabilizing in December and Jan '12. New weakness is likely toward the end of Q1 12.

Friday Thoughts

The diverging economic data between Europe and the US was underscored in recent days.  The US economy expanded 2.5% at annualized rate in Q3 and early indications for Q4, including ISM, regional surveys, strongest auto sales in eight months, and the employment data, are constructive.  To be sure, the data does not point to spectacular growth.  In fact it is still likely to be below trend, which is often thought of to be around 2.75%.   

Whatever disappointment one sees with the headline private sector non-farm payroll growth (104k instead of consensus near 125k) is more than offset with the back-month upwards (+102k), the decline in the unemployment rate (unexpectedly to 9.0% from 9.1%) and easing of the under-employment condition.  

The Draw Down of the Fed's Custody Holdings Ends

The Federal Reserve reports its custody holdings for foreign central banks on a weekly average basis and on a Wednesday-to-Wednesday basis.  The data is reported every Thursday.  In this space I have been tracking a sustained decline in these holdings in recent weeks.   It now looks like the trend is over.   

On a weekly average basis, custody holdings still slipped almost $2 bln.  However, on a Wednesday-to Wednesday basis they rose by $50.6 bln.  Custody holdings include a range of Treasury and Agency paper. The increase was overwhelmingly Treasuries.

US Jobs Report and A Look at Youth/Education/Race and Unemployment

The US monthly jobs report is among the hardest of the high frequency data for the market to forecast. There are few inputs and the inputs are there are track the general trends but frequently deviate on a month-to-month basis.

The Bloomberg consensus is for the private sector to have added 125k private sector jobs in October, this is around the 3 and 6 month averages. The ADP report showed an increase of about 110k from the private sector. The weekly initial jobless claims fell between the Sept and Oct NFP survey weeks. The ISM manufacturing employment index slipped 0.3 points but held above 50. The ISM non-manufacturing rose to 53.3 from 48.7.

ECB Surprises and Greece says 'Never Mind'

The ECB surprised the market by cutting the key rates 25 bp.  This was Draghi's first meeting.  With the euro zone economy either in a recession or quickly headed into one, which in turn will help bring inflation off the 3% area, Draghi led the ECB to reversing the rate hike delivered four months ago. Around the same time, the Greek Prime Minister Papandreou told Sky News that there would be no referendum.  

I had expected, along with the consensus, for the ECB to hold off cutting rates.  I had thought Draghi would resist the economic pressure to do so.  He is the first ECB President from a peripheral, highly indebted country.  Headline inflation is running at 3% (Sept).   The ECB staff provides new forecasts of growth and inflation next month and, for the first time, include 2013 forecasts.  This is important because the ECB policy on a forward looking basis.  

Yet he delivered the cut, returning the key rates to where they were before July.  Given the move and subsequent comments, another 25 bp rate cut in likely next month, but of course, like Trichet, Draghi says no pre-commitment.

The Elusiveness of Currency Diversification

One challenge investors and portfolio managers is achieving diversification. Impressionistic views gained from every day experience are confirmed by a number of academic studies. Diversification in the international capital markets is becoming increasingly difficult. Bond markets have long been highly correlated. Equity markets have become increasingly so. Foreign exchange was embraced by some money managers as a way to regain diversification, long thought to be a key aspect of modern portfolio theory.

The foreign exchange market itself is becoming more correlated. In recent reports we noted that the euro's correlation to the US S&P 500 has never been greater, using daily correlations on a 30- and 60-day rolling basis. This is true going back before the euro was born in 1999, using the synthetic measure on Bloomberg. In this note we look at the euro's correlation with a handful of major and emerging market currencies. The main findings are:

1) Other foreign currencies are highly correlated with the euro and are increasing

2) That there have been some substantial swings in some pairs

FOMC as Expected, but Only a Dove Cries

The FOMC statement contained no surprises and no change in asset purchases.

The statement recognized somewhat better growth in Q3 (better than H1).  It said growth strengthened somewhat while previously it said growth remained slow.  Weakness in the labor market continued to be noted, but despite this and the depressed housing market conditions, it noted spending had improved.  Yesterday's auto sales report bodes will for headline Oct retail sales, suggesting that some of the consumption momentum in Q3 is carrying over into the start of Q4. 

Hump Day and Beyond

Even though a great sense of stability appears to return to the markets after the blood-letting of Monday and Tuesday, there has been fresh developments on the ground to suggest these market moves will be sustained.  The purchasing managers surveys in Europe were generally poor with the region as a whole coming in at 47.1, down from 47.3 in the flash report and 48,5 in September.  If Europe is not in a recession, it is headed there quickly.  

The Greek situation remains unsettled by far. First is the vote of confidence slated for Friday.  It is a close call, but it does appear that the Socialist government will survive.  Although there have been some defects (at least one) and a call by one to form a national unity government, some unaligned MPS may support Papandreou.

Evolution of Fed's Economic Views--to be Updated Tomorrow

The Federal Reserve holds a two day meeting that concludes near midday tomorrow. It will likely be the first meeting in a while where there is not change in the composition or size of the balance sheet and no fresh initiatives, like cutting the rate of interest paid on excess reserves, or guidance. The tweaks in the communication are likely to be modest at best.

There is some talk that the Fed will announce renewed MBS purchases, but we are not convinced the Fed is there. Clearly increasing the balance sheet remains an option that the Fed refuses to reject. We expect the option not to be exercised unless there is a material risk of a renewed US economic contraction or that the risks of deflation increase markedly.

However, two elements of the FOMC meeting prevent us from arguing it is a non-event.

Some Thoughts on the CDS Market and Greek Developments

There is much truth to the generalization that European banks took on direct exposure to European sovereigns through the bond market, while top banks took exposure through selling insurance, primarily CDS, on the sovereigns. The latest BIS data suggest that in H1 2011, US banks increased their CDS sales by almost $81 bln to $518 bln. Two thirds are tied Greece, Ireland, Portugal, Italy and Spain. Five US banks count for more than 90% of the CDS exposure (JP Morgan, Morgan Stanley, Goldman Sachs, Bank of America and Citi, according to a report by the US government.

US banks also use CDS to hedge exposures to sovereigns as well as counter-parties. The late June BIS report showed that US banks have directly lent about $181 bln to these five European countries and have nearly 3 times more CDS coverage. When US holdings of CDS are taken into account, US exposure (total risk) rises to $767 bln, according to the BIS.

Dollar Recovery Continues

News of Greece's political gambit, fallout from haircut that is not a default, and poor economic data have seen risk come off in a big way after last week's near euphoria. While the euro never recovered from the news of that Greece will call a referendum, news that China's official PMI fell to 50.4 in Oct from 51.2 in Sept, contradicting the HSBC version of PMI did not to risk takers any favors.

Equities are sharply lower and and financials are leading the way. Sovereign bonds spreads are widening over bunds, with Italy paying a EMU-era record premium over Germany and the French premium widened to 119 bp, within half a basis point of the Oct 24 record high.