Firm Dollar, Eventful Week

The US dollar is paring back some of its pre-weekend losses at the start of the new week. Tokyo markets on holiday today and many European centers closed for May Day tomorrow. Asia equities generally were firmer, while European bourses are lower, but modestly so, with the Dow Jones Stoxx 600 off about 0.25% near midday in London. Financials are performing in line with the overall markets and peripheral European bonds are steady to firmer.

There have been three economic reports in Europe to note: euro zone money supply, inflation and Spanish GDP. M3 rose a stronger than expected 3.2% (consensus 2.8%). This is probably a function of the LTRO, but loans to the private sector grew a mere 0.6%, warning that credit crunch conditions persist. April CPI was a touch firmer than expected at 2.6%, unchanged from March. Spain’s economy contracted by 0.3% in Q1, which was slightly better than the 0.4% contraction the consensus had forecast.

Two characteristics for the foreign exchange market stand out. The first is the general poor news stream and the anticipation of a further deterioration of conditions in Europe. The second is the broad ranges that continue to confine most of the major foreign currencies. The resilience of sterling in the face of its ongoing, though winding down, gilt purchases program, has been impressive, lifting it to multi-month highs against the dollar and euro, is an exception to this generalization. The nearly 4% appreciation of sterling on the BOE’s broad trade-weighted index likely offsets a good part of the easing from the gilt purchases.

Encouraged by the less dovish comments from the central bank, the Canadian dollar has also broken out of its trading range and is the other major exception to the current range bound feature of the foreign exchange market. The Canada is now perceived as the leading candidate to be the first to raise rates in the G7. In contrast, the Reserve Bank of Australia is widely expected to resume its easing cycle tomorrow. While we recognize a 25 bp move as the most likely, the risk of a 50 bp move is greater than standing pat given recent reports showing a more pronounced fall in price pressures than expected.

The ECB meets this week as well. The PMI reports will make for poor reading. Attention should focus on the forward looking new orders components. Yet, there is little, if any, chance that ECB follows the IMF’s advice and cuts interest rates. Draghi’s press conference, as is often the case, will be of greater interesting, especially after he endorsed a “growth pact” last week. The details of such are still somewhat elusive, but he will likely be questioned on it. Market participants will also be keen to see if the head of the central bank gives any hints about the possible policy response to future flare up of tensions.

There are two steps to address liquidity and ensure that current monetary policy is better transmitted and they are another LTRO and resumption of sovereign and covered bond purchases. The latter seems somewhat less odorous than the former for a majority of the ECB.

To address economic weakness the ECB has only one tool and that is interest rates. With the key rate set at a record low 1% (in a 0.25%-1.75% corridor). The bar to the next rate cut is higher than current conditions. The regional contraction would have to accelerate and/or be more prolonged. Moreover, if easier monetary policy fuels price pressures in the core (read Germany), the ECB’s challenges multiply.

With the completion of the BOE’s gilt purchases program in the coming weeks, we expect it to move to the sidelines, as have the Federal Reserve and ECB. That leaves only the BOJ of the major central banks still actively pursuing quantitative easing. It announced plans to expand its balance sheet by another JPY5 trillion and intends to buy proportionally more risk assets such as ETFs and J-REITS. The yen strengthened to nearly two month highs against the dollar and strengthened against the euro as well.

We have argued that politics will be a dominant market factor here in Q2 and of course this weekend’s elections in France and Greece are significant. The election outcomes are likely to be as much an effect as cause of a shift in the euro area agenda. Last week, a Japanese court found former DPJ leader Ozawa not guilty of financial violations. This may pose a new challenge to Prime Minister Noda efforts to raise the retail sales tax as well as deepen the fissures in the already fractious DPJ party.

The day after the ECB meeting and just ahead of the weekend the US will report its April employment data. The early (as in prior to the national ISM reports and the ADP survey) consensus is for about 170k rise in private sector payrolls after 121k rise in March. The flat weekly jobless claims and the seasonal adjustments warn of downside risks to the consensus. A weaker than expected employment report would likely encourage the reduction of risk that we think is prudent ahead of the weekend elections and would likely support the dollar, especially given the proximity to the lower end of its trading ranges.

Lastly we note that since China has widened the trading band against the dollar, it has not been explored and the 3-month implied yuan volatility is just above 2%, the lower end of where it has been for the past two years.  Over the weekend, China announced some reductions in tariffs.  This combined with the recent move on the trading band is likely to provide a more conducive backdrop to the Strategic Economic Dialog talks this week.