The Dollar Slips More, but Weights are Transitory

The US dollar's pullback has been attributed to three main factors. First, some are placing emphasis on Moody's warning that the Obama- Republican fiscal compromise increases the likelihood of a negative outlook within two years. While this is potentially worrisome, the market most directly impacted would be the Treasury market and it rallied after the Moody's announcement. If the Treasury market did not respond, this does not seem like a very satisfying explanation.

Second there is some speculation that at today's meeting, the FOMC may decide to step up its bond purchases to protest the recent dramatic rise in rates. To the extent that this has indeed been weighing on the greenback, we suspect it will be lifted as the Fed has only begun its bond purchases. It could have chosen to increase the pace of purchases, but it did not. It seems highly unlikely that the Fed will change its asset purchase program in any substantial way at this juncture. Moreover, the Fed's statement from last month as whole is unlikely to deviate very much from last month. Core inflation remains soft and while the data has come in better than expected, clearly it has not been sufficient to bring down the critical unemployment rate.

Third, some observers have played up the possibility that European officials announce some new initiative at the summit at the end of the week. Yet the market may be getting ahead of itself. The latest is that the EFSF itself could buy sovereign bonds. This is highly unlikely. The EFSF does not have money. It has guarantees. The EU Summit is likely to devote its energies to finalizing plans for the European Stability Mechanism, which is to replace the EFSF after 2013 and discuss the modifications of treaties that could avoid national referendum.

At most, the ECB could see its capital increase. Reuters reports suggest some at the ECB may be concerned about loses due to the risk of loss due to its sovereign bond purchases. The ECB's capital base is reportedly stands just below 6 bln euros. Its assets are about 1.925 trillion euros, which produces a gearing (leverage), if such a thing is a meaningful metric for central banks, of 331x. To the extent that these three factors individually or collectively sparked the selling pressure on the dollar, look for their influence to be transitory in nature.

Spanish and Belgian bill auctions were adequately received, though Spain was forced to pay about 100 bp more than it did a month ago. In Belgium the 3-month bill yield rose a modest 10 bp, but the yield on the 12-month paper rose 70 bp. Then S&P downgrade Belgium's outlook to negative from stable. THat may have helped pull the euro away from the $1.35 high.

Meanwhile, Berluscoin passed the vote of confidence in the Senate, where he enjoys a majority. It is in the lower chamber that will be decided shortly. Even if he loses that vote, I am not so sure that the oppostion can agree on an alternative. It seems most likely now Berlusconi will lead the new government whcih may have larger and more fractious coalition.

UL CPI came in a bit on the high side of expectations but does not seem like a market factor. Gilts are little changed. German ZEW surey was also released. Sentiment was better than expected but the assessment of current conditions did not improve as much as expected. Regardless, German growth has been exceptional this year and the relative strength is notable. Euro zone industrial output rose 0.7% in Oct, which is about half as much as expected. France, Italy, and Ireland all contracted, while Spain incresed by 0.1%. Germany IP rose 2.9% in Oct.