Dollar and Yen Remain Soft

The US dollar and yen remain soft.  The news stream has encouraged the so-called risk-on trade.  The Greek debt buyback appears to have gone well enough that it will get dollop of aid.  Spain reportedly received 40 bln euros of bank aid.  There seems to be a potential compromise banking supervision in Europe.  On top of that, of course, the market expects the Federal Reserve to announce an expansion of its quantitative easing later today and keep the door open to further steps if necessary. 

The dollar made new eight month highs against the yen, just shy of the JPY83 level.  These dollar gains ahead of the FOMC meeting underscores one of our interpretative points that the old drivers of dollar-yen, like interest rate differentials and general risk appetite, have broken down, trumped by Mr Abe and his aggressive monetary and fiscal rhetoric. 

We would discount speculation of covert intervention and instead point to polls showing that not only will the LDP win this weekend's election,  but it is within striking distance of securing a 2/3 majority (of the 480 seats in lower chamber of the Diet).  We note that although the October core machinery orders recovered after falling sharply in August and September, the 2.6% rise was less than expected and this reinforces speculation that the BOJ can expand its asset purchase program as early as next week--which would be the third expansion in four months--and this is before the new government implements its changes.

The euro's recovery from the $1.2880 low at the start of the week is impressive.  Developments are conspiring to keep the tail risks at bay.  It may not have been very pretty, and the burden fell on Greek banks, but the bond buy back has been sufficiently successful.  Greek bonds have continued to rally, with the10-year yield off another 62 bp to 12.58%, seemingly rewarding those investors most who did not participate (rewarding defectors in game theory), which now appear to be only officials and foreigners.  Spain received the funds for its bank recapitalization scheme.  As part of the conditionality, look for the troubled banks to sell non-core assets (including corporate holdings) and close branches, laying of employees.  In addition, they will transfer assets to the "bad bank".  The mechanism was established in haste and the pricing of the "toxic assets" seems problematic and something that may come back to bite.  

Turning to Italy, the market seems to find solace in the idea that Berlusconi may not win and Italian yields are down for the second consecutive session, though that 4.66% the benchmark 10-year yield is above last week's close of 4.51%.  A poll in La Stampa today shows that given the choice between Monti, Berlusconi and Bersani (leader of the PD), Monti is favored by 47%.  However, Berlusconi polls 24% compared with Bersani's 20%.  And Monti has been cagey about whether he will run, though he has denied such intentions in the past.  Bersani advised against, but of course that is narrow self-interest. Look for this issue to become more salient. 

The UK's labor report was stronger than expected and this is helping sterling keep pace with the euro's advance.  The claimant count fell 3k, whereas the consensus expected a 7k increase and the Oct count was revised slightly lower.  Unemployment was unchanged at 4.8%.  The fact that the UK's employment data has held up better than the economy raises questions about productivity that will be a key discussion and research point. 

The key event of the North American session is the outcome of the FOMC meeting.  The Fed's communication is sufficiently transparent that nearly every one expects an expansion of QE3+ today as purchases being conducted under Operation Twist get replaced by outright purchases.  New economic forecasts and a Bernanke press conference will also be featured.  While it is possible the Fed announces that it will increase QE by $45 bln a month, which is to roll the entire long-term Twist purchases into QE, which would more than double its size and much more on a duration adjusted basis.  We suspect there is a greater than appreciated risk that the Fed does not double up, but instead increases QE more modestly by $20-$25 bln a month and keeps the bar low for expanding it further. 

Lastly we note that since QE3 was announced, the dollar is broadly mixed, but slightly higher overall.  Many key commodity prices, including gold and and oil are lower.  The S&P 500 is slightly lower. The 10-year Treasury yield is a few basis points lower.