Be Prepared to Buy into Potential Dollar Decline

There has been an obvious build up of expectations about the US jobs report today. The dramatic jump in the ADP estimate spark a large upward revision in expectations even though the short-comings of its estimate and its track record are well known. In part the optimism also reflects the recent string of data that has convinced even many of the cynics that the US economy has accelerated. Given the price action and the pendulum of market expectations the risk today is for disappointment.

The disappointment could lie in the difficulty to live up to some of the inflated expectation--talk of a 500k rise. While the US economy gaining traction, many observers have simply ignored the fact that the employment component of both the manufacturing and service sector ISM reports weakened. The risk is, as we noted here yesterday, of a "buy the rumor sell the fact" type of trading today.

Yet in the larger picture, to be clear, investor ought to see that potential pullback in the dollar as a new buying opportunity and/or opportunity to adjust exposures. The combination of growth differentials, mediated through interest rate differentials and relative returns, and Europe's debt woes will help fuel further dollar appreciation. By some market-based measures, the European crisis is worse than it was in the May 2010.

The immediate focus in Europe is three-fold. First, there are some reports suggesting that a Spanish caja may need to borrow from the government's aid fund (FROB). Private estimates suggest Spanish banks have another 80 bln euros of bad debt to recognize. On top of the federal and regional government borrowing, and bank borrowing, the FROB is expected to issue around 5 bln euros of bonds soon.

Second, is the sovereign supply next week from Portugal and Italy. The market does not seem to have much appetite for peripheral issuance. Portugal's 10-year bond yield has risen 54 basis points this week. Italian 10-year yields, on the other hand, have slipped 2 bp. The 7 bp the Spanish 10-year bond has risen this week have been registered today.

Third, there is a cloud of uncertainty of the status of creditors in Europe. Merkel was forced to back down from her ill-fated attempt last year to get private sector to participate in bail-outs (i.e., haircuts) to a compromise position of "only after 2013". But the proverbial cat is out of the bag. The moral hazard whereby creditors are guaranteed by tax payers money is coming to an end. Yesterday the EU proposed that bank regulators be granted powers to write down debt in future crisis. There had been some reports (that we cited earlier this week) that Greece was lobbying banks to extended maturities on Greek obligations in line with the extension that is likely from the IMF and EU. Subsequently the reports have been denied, but many, if not most observers look for Greek debt to be restructured at some point.

Some investors may be surprised how little the market has really paid attention to press reports playing up Chinese purchases of peripheral European debt. Previously it was the vice-premier, who is tipped to be the next premier in 2012, and today it was the Deputy Governor of the PBOC who appeared to have made supportive comments. So what ? The market is bigger than China. This means that unlikely maybe iron ore prices, China is a price taker not a price giver of say Portugese or Spanish or Greek bonds. If Bank A wants to sell its peripheral bond and the PBOC buys it, what difference does it make to that peripheral country or other holders of that same paper? Altering the holders of the debt also is not the same thing as addressing the unsustainable debt dynamics.

The amount of money being bandied about--around 10 bln euros-- is chump change for the PBOC, which saw its reserves jump $200 bln in Q3 10 alone. The disconnect that it points to though is the comments in the recent past about the risks China faced in holding US Treasuries? Are we really to believe that those same officials really believe that peripheral European bonds are less risk?