The More Considered Take

The US’s dollar’s slide that began in earnest in early September is set to continue. The prospects of QEII are deeply engrained. Some observers are emphasizing the sell-off in US Treasuries after the stronger Chicago PMI, but it seems the recovery was just as impressive. There seem to be two elements capture the forces at work.

First, the euro continues to track the US-German two-year spread. The spread has moved from a about 9 bp in Germany’s favor as recently as Sept 7 to 47 bp today. This is a new wide read since the end of last year. The spread seems important not simply because one has to pay more for the “privilege” of holding dollars, but also because that spread appears to reflect and encapsulate the various forces at work.

Second, and perhaps related is that the dollar’s weakness appear to be prompting intervention by a number of countries to slow the rise of their currency appreciation. This is not an issue of competitive devaluations as most currencies are appreciating against the dollar. In any event, the proceeds of the intervention are finding their way into US Treasuries. The Federal Reserve reports its custody holdings for foreign central banks every week. With yesterday’s report, we learn that custody holdings rose by about $32 bln in September to bring the Q3 figure to $132 bln. This is almost as much as custody holdings rose in Q1 and Q2 (~$142 bln). Asian and Middle East central bank in particular are thought to be taking some of the dollar proceeds and converting them into euros, diversifying the new inflow into reserves (not the existing stock).

These considerations are outweighing evidence that the Europe is slowing, in part because the slowing is not sufficient to prompt a policy response from Europe. ECB officials made it clear this week that they are going to continue to exit from the nontraditional measures adopted during the crisis. The low take-down at the ECB refi operations this week suggest that banks in aggregate are reducing their dependence on ECB financing. The peripheral countries remain in need, but the acute pressures are limited to Ireland and Portugal. And the fact that Greek bonds were the best performing in Europe in Q3 will not go unnoticed.

Spain, Ireland and Greece reported PMIs below the 50 boom/bust level. Greece’s 44.7 reading actually represents an improvement over August’s 43.6. However, both Spain and Ireland represent a clear slowing.

Germany’s 55.1 was a little weaker than the 55.3 flash reading and this speaks the pace of slowing in Germany. Germany is important because it is its strength that obscures the weakness when looking at the euro zone on the aggregate level. Its retail sales report today was particularly disappointing. The 0.2% decline in August contrasts with consensus forecasts of a 0.4% increase and the July series was revised to a 0.4% contraction from a 0.3% decline in initially reported.

On the other hand the French PMI of 56 was an improvement over the 55.4 flash reading and that helped lift the EMU reading to 53.7 from the 53.6 flash. This still represents a slowing from the 55.1 reading in August. The European Commission forecasts the euro zone economy to have grown 0.5% in Q3 after 1.0% (fastest in four years) in Q 2. Its Q4 forecast is for 0.3% growth.

Non-EMU PMIs are also interesting and play up existing trends. The UK PMI fell to 53.4, weaker than expected and the lowest in about 1 ½ years. Norway and Sweden reported stronger than expected PMIs, though the euro is outperforming both of their currencies today. Switzerland disappointed (59.7 vs 60.4 consensus) with weakness in employment and output especially evident.

Elsewhere China’s PMI was stronger than expected, but with two other PMI measures out earlier this week pointing to continued strength, today’s news does not seem like real news. But Austrlaia’s PMI fell to 47.3 is new news. It is the first sub-50 reading of the year and, after disappointing building approval data earlier, it is a closer call about a RBA hike next week.