Euro, Swiss franc, Fed Update

There is no significant driver of the foreign exchange market today. The tone is less tense than it has been in recent days, but there still does not appear to be closure and calm seems fragile.

While the euro, for example, has risen above yesterday’s highs, those gains were recorded in early Asia and Europe has need managed to get the euro above $1.2350. This $1.2350-$1.2400 area is a resistance band that the euro may have difficulty taking out in North America today. However, while euro shorts are dominate, the downside momentum has stalled, leaving some of the late euro shorts in week hands. The price action suggests some kind of consolidation is at hand. The issue is whether the consolidation is a brief respite in the euro’s slide or will it transform into a bona fide correction. Confirmation of a near-term bottoming pattern in the euro requires gains through the resistance band identified. Such a move could signal a move toward $1.2600. Given the deep-seated euro bearishness, and still concerns about the viability of the euro zone over anything but the shortest of terms, the core euro shorts will be patient.

Perhaps one of the factors giving the market a pause today is the fear of some kind of policy response. LIBOR remains elevated and strains are still evident as banks in Europe and Asia try to secure dollar funding. To secure the dollar funding, some operators are using the forward currency market, where they sell and buy euro forwards. There had been talk that in order to help facilitate the funding the Federal Reserve would lower the 100 bp premium over the overnight index swap in it provides the dollars to foreign central banks. However, comments by Fed Chief Bernanke, which did not address the topic specifically, were seen to dampen such speculation.

Meanwhile there are rumors that the Swiss National Bank could re-impose a negative rate to CHF deposits to discourage speculation in the franc. We are skeptical. First, the Swedish central bank has set a negative deposit rate (-25 bp) and this has not prevented the krona from appreciating. Apparently from an operational point of view it is difficult for the Riksbank to really impose a negative interest rate. Second, while the Switzerland may be a bit of a safe haven for funds fleeing the euro zone, there seems to be more to the Swiss franc’s rise. Some believe that one pressure is coming from the Swiss banks themselves repatriating funds. Also some demand for the franc may be related to the unwinding of the use of the Swiss franc for mortgages and other consumer activity in eastern and central Europe.

News late yesterday that three Federal Reserve presidents favored a discount rate hike last month should not be all that surprising. The minutes from the FOMC meeting (released last week) indicated that there was some call for a discount rate hike. The presidents of the Kansas City, St. Louis and Dallas Feds were outvoted by the other nine presidents. When the vote took place (April 15-22) the tensions in the capital markets was already evident but still mild compared to what has been experienced subsequently.

To be sure there is no direct policy implication if the discount rate hike would have taken place. It is part of the normalization process that will re-impose the more normal spread between the Fed funds rate and the discount rate. It is interesting to note that discount window borrowings are near there lowest level since late 2008 and off some 95% from their peak in Oct 08 around $110 bln. At the same time, the vote may reflect a deeper split at the Fed.

The market has all but given up ideas of a near-term adjustment in the Chinese yuan, which many including the NY Times has suggested was imminent several weeks ago. The three-month non-deliverable forward is practically flat and the 12-month NDF is pricing in about a 0.6% appreciation compared with 3.2% at the start of the month. In fact, the on-shore and off-shore (NDF) prices have largely converged.

The PBOC may have drained too much liquidity from the banking system. Money market rates have risen for the third consecutive session and now are the highest in three months. The 7-day repo rate rose 24 bp to 2.16% and this in turn may have weighed on stock prices. Last week the PBOC sold CNY120 bln (~$17.6 bln) of 3-year bonds. This is eight times larger than last month’s offering.