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.

This coupled with market positioning may underpin the dollar. There was a large jump in dollar short positions in the futures market in the most recent reporting week through Feb 1. The net speculative euro longs, for example, jump by 75% to almost 40k contracts, the most extreme positioning since last Nov. To further appreciate the positioning note that for three years, the net speculative position has not exceeded 50k contracts. Net long sterling positions nearly tripled to 22.6k contracts, also the most since last Nov, which was the highest since early 2008. For the record, most of the the other currency futures positioning was little changed, the main exception was the 33% jump in Australian dollar longs.

The weaker than expected December German manufacturing orders (-3.4% vs -1.5% expectations) did the euro no favors, but the data needs to be placed in the context of the incredible strength in recent months. In November manufacturing orders rose 5.2%. The year-over-year gain of 19.7% is still impressive. That said, most economists expect the German economy to cool from last year's 3.6% year-over-year pace.

The Feb 4 Summit ended with more apparent disagreement than agreement. Even several countries often sympathetic to Germany dissented over efforts to drop the indexing of wages and encroachment sovereignty. There did not seem to be an agreement on the EFSF and its resources. However, there will be another meeting in early March and this may help to prevent a complete reversal of sentiment.

The Irish elections later this month may also force Europe's hand. Polls show the the Fine Gael and Labour will form a coalition government, but that more strident voices are likely to move to the fore. The new government may feel emboldened to force through a restructuring unless there are some concessions from the EU. At 5.85%, which is what it is currently expected to pay on EFSF funds (3.6 bln euro transfer has reportedly been made today), is punitive and onerous, given that this will not help the country stabilize its important debt/GDP ratio. Separately, note that the EU/IMF begin Greece's check-up ahead of the delivery of its fourth tranche of funds.

Late Friday, the US Treasury issued its report on the foreign exchange market. It again refrained from citing China as a "manipulator" in the currency market. What is especially noteworthy is that in the US Treasury's assessment it acknowledged that increase in inflation in China is causing a real appreciation of the yuan that is significantly faster than small nominal rate. While it is clearly not satisfied, it recognizes that the annual rate is now closer to 10%. Some in the US Congress may not be appeased and may still press their case. At the same time, citing China is not the "nuclear option" some have suggested. Remember China has been cited in the past (mid-1990s) and it the required action is bilateral talks with the US and it may allow companies to seek redress, making it easier to argue that the yuan gives an unfair advantage.

More generally speaking the US seems more comfortable with the actions Brazil has taken than some Asian countries, like South Korea. Brazil is running a current account deficit and its currency has appreciated to near what many economists would regard as fair value. Current account surplus countries, which continue to block currency appreciation are seen as greater obstacles to re-balancing efforts. That said, we note that the Taiwanese dollar and the Malaysian ringgit are near multi-year highs against the US dollar. Note that while the Financial Times lead story over the weekend was the large flows out of emerging market equity funds, foreign investors continue to pour money into Taiwanese shares (~$3.4 bln in January alone)