Key Drivers in Foreign Exchange Market

 With fresh developments light on the ground today, it may be worthwhile to take a step back and re-examine the key drivers of the foreign exchange market.

Last week saw the emergence of a new factor that seemed to eclipse or at least mitigate the impact of the other drivers. Previously problems in deficit issues in Europe and efforts by China to tighten lending conditions were the dominant issues, but last week, the combination of President Obama’s new proposal regarding banking activity coupled with the heightened doubts over Bernanke’s re-confirmation sent shock waves through the capital markets in general and seemed to stop a dollar rally cold. Obama’s new proposals are still regarded as a bit vague (e.g. what kind of proprietary trading, outside of owning of hedge funds and private equity firms, does the Volcker Rule seek to ban) and appears to break from the coordinated international approach that seemed to emphasis the capital requirement tools. The proposed new tax on large banks may encourage some like the UK and France to push again for some kind of financial transaction tax (like the Tobin Tax).

Meanwhile, over the weekend there was some effort to rally the wagons around Bernanke and as we judged on Friday, despite a couple of high profile defections, Bernanke’s nomination will likely be re-confirmed. Note the www.intrade.com puts the odds of the re-confirmation near 90% after having dropped to 65% before the weekend. This week could see the FOMC rally behind the Chairman by formally naming Bernanke chair of the FOMC and with no dissents from the two-day meeting, where the statement is unlikely to deviate much from the last statement. The economic highlight of the week may be the first look at Q4 GDP. Estimates have crept up and now are near 4.6%, though talk of a 5-handle is also increasing.

China has surprised the markets by taking preliminary steps to tighten monetary conditions in recent weeks. The problem Chinese policy makers are trying to address is not economy-wide, but appears largely limited to the financial sector. This is why, contrary to pre-weekend speculation, we did not think the PBOC was going to hike rates this past weekend. Bank loans appear to have exploded in the first couple weeks of the New Year. Some estimates place them as high as CNY1.1 trillion, nearly three times greater than all of December and compares with the year’s target of about CNY7.5 trillion. Chinese bank loans tend to be strong at the start of the year, but Chinese officials are concerned the rash of new loans could fuel bubble conditions and inflation. We also note that Chinese relations with the US and Europe have soured in recent weeks—with the cyber attacks on Google and others, shortly after the Rio Tinto controversy and China’s reportedly obstructionist posture at Copenhagen. Calls on China to allow its currency to appreciate are likely to be seen ahead of and from the G7 meeting next week and from the IMF

Debt and deficits continue to be a dominate concern in Europe. Greece continues to act as the lightening rod of such concerns. Most officials are touting a tough line of no external help for Greece, but pressure is evident on other weak credits in the region. And there does not appear to be any near-term solution, though the level of anxiety cannot be sustained long. The recent weakness in the euro must be seen as a welcome development. Meanwhile, US Q4 09 and Q1 10 growth figures are likely to offer a stark contrast with the euro zone and may see interest rate spreads move in a more dollar supportive direction. The UK is expected tomorrow to report its first quarterly expansion since Q1 08 (0.4% expected), but the details will likely underscore the vulnerability of the growth prospects going forward.