Monday Morning Quarterback

Tom Brady playing for University of Michigan,
who has the most all time wins and highest winning
percentage in college football history

There are several developments in the foreign exchange market that are worth reviewing at the start of the week. The US dollar’s underlying tone remains firm after recovering in the second half of last week. Ahead of the EU Summit, Europe seems divided. Germany’s Merkel is keen to dampen expectations that the summit will agree on an aid package for Greece, while EC President Barroso is pressing for some kind of mechanism to be presented. Sterling trades heavily ahead of Wed budget presentation. It has spent most of the European morning below $1.50. It has shed 4.5 cents since the high recorded in the middle of last week. For its part, the euro briefly traded below $1.35 before bouncing to almost $1.3550. The risk is on the downside. Tokyo markets were closed for the spring equinox; allowing the dollar-yen to languish in uneventful range activity.

Euro zone: The key focus is the EU Summit on Wed-Thur this week. Last week’s indication by Germany that it may be warming to the idea of a larger role for the IMF, the euro has been unable to sustain even modest upticks. Greece has large bond maturities and coupon payments in April and May. It needs to sell more bonds, but market conditions are not that favorable at the moment. Greece has been clear. It is not yet asking for funds, but is seeking some mechanism that could lower its interest rates. If such a mechanism is not forthcoming, Greece has made it clear it can still go to the IMF. France’s Sarkozy may not like that, just as much for political reasons (IMF head Strauss-Kahn may run against him in 2012 and the weekend elections that saw Sarkozy’s party hold on to only 1 of 22 councils) as well as a loss of face for EMU. ECB’s Trichet may also be opposed to a larger role for the IMF. Yet it does not appear to be their call. Separately, the Franco-German pillar upon which EMU rests, showed some tensions as well, with France’s Lagarde have raised questions bout German wage policy as a contributor to the region’s imbalances. German officials are right to resist efforts to dilute German productivity, but the real issue seems to be about strengthening domestic demand.

Sterling: The short-covering advance that lifted sterling from $1.4784 on March 1 to $1.5382 in the middle of last week has run out of steam. The ostensible cause was heightened concern that the economy may falter. The CBI offered a much more downbeat economic assessment and still seeks a credible plan to balance the budget by 2015/16, two years earlier than currently targeted. The Brown government continues to advocate securing the recovery first and then address the fiscal side. The Tories and others seem to be pressing for fiscal reform as a precondition for an economic recovery.

Swiss franc: Comments by new SNB member Danthine last Thursday has put the Swiss franc into play. He indicated that interest rates would have to normalize and the Swiss franc again be driven by market forces. This does not seem to be a shift in policy, yet officials have not protested the market’s reaction. The euro has slumped a bit more than 2% against the Swiss franc since the middle of March, about what it had lost over the previous 8 weeks or so. Today it is just above the all time low recorded in Oct 08 near CHF1.4315.

Canadian dollar: Strong Jan retail sales (0.7% month-over-month, with a 1.8% rise excluding autos, and the Dec series was revised to 0.5% from 0.4%) coupled with a larger than expected rise in Feb CPI (core +0.7% vs 0.3% consensus) helped pushed the Canadian dollar close to parity against the US dollar. However, the renewed strength of the greenback saw the Canadian dollar pullback. The US dollar recorded a potential key reversal day—having made new lows for the move and then rallied to close above the previous day’s high--. Initial resistance is seen near CAD1.0200-CAD1.0225. The data strengthens the market conviction that the Bank of Canada is likely to raise rates before the Federal Reserve. A move early in the third quarter seems increasingly likely, but the market may have gotten ahead of itself in terms of the magnitude of tightening being priced in.

US Interest Rates: Short-term US interest rates continue to creep up. Three-month LIBOR is at its highest level since early Nov 2009. The yield on the 2-year note has risen for three weeks and now is near the highest level since early Jan. The general collateral rate in the Treasury’s overnight repos—the interest rate paid on cash loans, backed by a basket of government debt—rose to 26 bp before the weekend. There are several factors behind the rise rates. Some are technical, like the March 15 corporate tax payment. Many observers are still attributing a significant role to the Treasury’s Supplemental Financing Program ($200 bln of T-bills issued for the Fed). This is said to be causing a backing up in bill rates, which in turn pulls up rates in the repo market and is transmitted to the interbank market. Some observers are noting the more restricted list of foreign counterparties for GSE repos. There are also reports are strong dollar demand from European banks. There is some concern that there is a large amount of collateral in the bill market and is also serving to push up rates. Finally, given that the Federal Reserve is winding down several liquidity measures at the end of the month, there continues to be some thought that it could also raise the discount rate again, which would widen the spread between the Fed funds rate and that discount rate to 75 bp, 25 bp less than prevailed before the crisis. While a discount rate hike is part of the efforts to manage liquidity, it is seen as a precursor to an official rate hike.