Foreign Currencies Mostly Higher on Short-Covering

The US dollar is broadly lower, though mostly within yesterday’s trading ranges, as the market adjusts positions in light of the European agreement on support for Greece. This is the main market development. However, it does not appear sufficient to really reverse the negative sentiment toward the euro. Resistance in the $1.3425-50 area needs to be overcome to spur another wave of position adjustment. A similar resistance area for sterling is seen near $1.4900-25. be disappointed. The most likely scenario is further consolidation in a choppy North American session.

Meanwhile the dollar has been confined to fairly narrow trading ranges against the Japanese yen. Dollar support is seen near JPY92.00. The approaching month-end, quarter-end and fiscal year-end may discourage participation. Yet, further out—a week from now—the market is looking for a strong US employment report, with such expectations further fanned by news yesterday that weekly jobless claims fell to their lowest level since December 2008.

There is a sigh of relief that European officials are not committing joint suicide and have managed to take step away from the proverbial abyss. However, that sigh may not last very long. Despite the news, the market knows very little now that it did not know yesterday.

What we do know is that should Greece be locked out of the capital markets, the IMF and Europe (on a 1/3 and 2/3 basis) will provide funds at market interest rates. The decision will require unanimity in among the euro zone members, which still give Germany a veto. The bilateral assistance will be proportionate to the funding of the ECB, which ensures that Germany will provide the most. The pledge of “determined and coordinated action” have did not come with a specific price tag. Nevertheless, the key stakeholders, including Greece and ECB President Trichet gave the deal their blessings. The price action seems to belie concerns that previously was the conventional wisdom—that a substantive role for the IMF would damage the euro.

The recent pattern has been for Greek officials to take advantage of relaxation of market tensions to try to sell more debt. It should not be surprising to see Greece come to the market in early April. As is widely appreciated, Greece has significant debt maturities in the April and May period. There is also a German state election in early May, and it could limit Merkel’s degrees of freedom. Moreover, as Portugal’s downgrade this week reminds us, Greece’s problems are not really unique and the pressure on the weaker credits in Europe may resume especially if global interest rates continue to rise.

Although the Europe/IMF deal will grab the limelight, arguably the more substantive step was yesterday’s reversal by Trichet on the ECB’s collateral rules. The extension of the relaxed collateral rules is an important, even if lower quality paper gets a bigger haircut. The size of the haircuts will be the main market focus of the next ECB meeting on April 8th. This relaxed collateral rules, some argue, is tantamount to some easing of monetary policy. While we are not necessarily convinced by those arguments, it does seem clear such a monetary move by the ECB has fiscal implications, contrary to the official denials. It is supportive of Greek bonds and Greek banks, which hold about half of the Greek government bonds.

Meanwhile, the deflation’s grip on Japan continues. Headline CPI in February was 1.1% below year ago levels, the same pace as recorded in January. Ex fresh food and ex food and energy showed a small abatement as did Tokyo’s March figures. This follows yesterday report of a slightly larger than expected decline in corporate service prices.

The Bank of Japan expects deflation to persist through the next fiscal year. If there was any glimmer of hope in today’s CPI report it is that the number of items that are experiencing falling prices fell for the first time in February in almost a1 ½ years. Of the 525 items tracked by the CPI basket, 335 fell in February compared with January when prices for 342 items fell.

In addition to the European drama, the other main feature of this week action has been the sharp backing up of US interest rates. The proximate cause was the weak auction receptions, but we have been tracking the rising money market rates as well. The US 2-year yield has risen 9 bp this week, while European two year yields are mostly lower. The US 2-year yield has risen and is remaining above similar German yields for the first time in almost 3 years.

The US 10-year yield rose 17 bp, while European bonds were up no more than half as much. The rise is mostly a function of real yields as inflation expectations, judging from the 5-yr/5-yr forward, remains in the lower half of the range that has prevailed for the past six months or so. Moreover, despite the soft auctions, foreign central bank boosted their holdings at their custody account with the Federal Reserve by almost $16 bln to hold over $3 trillion there. Over time, we expect rising US interest rates to help support the dollar.