Drivers Tighten Grip

The latest developments are serving to strengthen existing forces driving the foreign exchange market and producing a clear divergence of performances against the US dollar.  

The firmness in the US 10-year yield near 2%, the lack of much push back from G7 officials about the yen's weakness,a nd soft Japanese economic data (unexpected rise in unemployment and larger than expected decline in household spending) provided the latest incentives to  encourage the push the dollar to new highs against the yen to JPY92.30.  

The euro is posting strong gains that began in Asia even before the favorable euro area economic data and is poised to challenge the $1.37 area.   The PMI data supports ideas that the worst of the recent economic downturn is over.  The final manufacturing PMI was reported at 47.9, which compares with the 47,5 flash reading and 46.1 reading in Dec.  This is the highest in nearly a year. 

 

There are a few high-level take aways.  First, the Germany recovery appears to be gaining momentum at the start of Q1.  The manufacturing PMI rose to 49.8 from the 48.8 flash.  Output and orders are back above the 50 boom/bust level.  Second, the weakness of the French economy and its divergence from Germany, which we think is a critical development in the euro area, continued.  France confirmed its 42.9 flash reading, a four month low.   Third, while Italy and Spain readings remain below 50, they are at there highest levels (47.8 and 46.1 respectively) since mid-2011.  Fourth, Ireland surprised on the downside, slipping to 49.5 from 50.9 in December and is worth monitoring to see if it is signaling a broader economic weakness.  

The euro area also reported an unchanged unemployment rate for December at 11.7%, after the Nov figure was revised down.  The consensus had been for an increase to 11.9%.   Taken together with the PMI data,  the market may conclude that the ECB is unlikely to  lean against the passive tightening of financial conditions that has seen Euribor rise around 25 bp since early December.  That passive tightening continued as the ECB announced that banks will return another 3.5 bln euros from the LTRO. 

Another theme that the market has been following is the weakness of the UK economy and sterling's move out of the euro-orbit to some extent.  The CIPS manufacturing survey was disappointing and the Dec report was revised lower.  The Jan reading of 50.8  compares with 51.2 in Dec, which was revised from 51.4.  Sterling fell to session lows on the news, just above $1.58.  However, we suspect the market may be a bit too negative.  It is the first back-to-back reading above 50 since March-April last year. Output itself rose to 54.2 from 53.4, which is the highest since Nov 2011.  New orders rose for the third consecutive month.  

A case can be made that the weakness in Q4 GDP was also a bit of a fluke (like the US, though for different reasons).  For example, without the closure of two North Sea oil platforms, GDP would have been positive.  The talk of a triple-dip seems a to misconstrue the recoveries.  The UK economy has not recovered.  US and German GDP, in contrast, is above pre-crisis levels.  That is not true of the UK.  The economy is broadly stagnant in a trough.  The government insists on its austerity agenda and the BOE is currently saying that there is little more than it can do. 

Doubts about the recovery of the Chinese economy were sparked by a unexpected decline in the official PMI and this contributed to the extension of the Australian dollar to new lows for the year near $1.0360. 

The US jobs and PMI will be the economic highlights of the North American session.  In some ways, given the Fed's commitment on QE3+, the data needs to be significantly different from expectations to alter the forces at work.    US jobs growth is expected to be steady around the 3 and 6 month averages of 150-160k, which is shy of the 200k thought to be needed/desired.  The US manufacturing sector remains a bright spot of the economy and this should be reflected in the ISM reading.  The consensus is for a 50.6 reading after a revised 50.2 in December.