Three Revealing Developments

I am on vacation, but I have a television interview later today and as I was reviewing what happened today and three things strike me as noteworthy.  

First, China had its second failed auction this month today.  It sold about 80% of the 3-month bills as it wanted to.  The 7-day repo rate, which is similar to our Fed funds rate insofar as it shows the liquidity of the interbank market, has doubled in the past couple of weeks to almost 5.7%--a 3yr high..  The 3m bills that the government was selling yielded 3.68%.

Second, the ECB experienced a failed auction.  Its auction was were 7-day term deposits--yes--it was taking extra liquidity away from the market, equal to its recent bond purchases--which doubled in the most recent week from the prior week--.  It sought to drain73.5 bln euro, but only drained 60.8 bln.  This is not necessarily a big deal. So 13 bln more euros are sloshing around the system...for a week and then the ECB will try again.  I wrote a piece here the first time this happened and suggested that the key level to watch is around 80 bln euros which is around the most that is often bid for.  Over time, this is going to see the ECB slip into quantitative easing...That is to say its bond purchases could have greater leakage into money supply. Note that unlikel the Fed, BOJ and BOE, the ECB has an open-ended purchase plan.   

This brings me the what I think is the third key development. Interest rate differential between the US and Germany.  I have focused on the 2-year because it has done an incredible job of tracking the euro dollar exchange rate for several quarters now.  It has moved in a big way to the US favor.  This is a result of a decline in German rates, largely it appears on safe haven appeal and the sharp backing up of US rates.  The US two-year yield is at 6 month highs.  

My guess, and that is what I will say in the interview,  this captures the main three forces I expect in 2011.  European crisis growing.  US economy recovering.  China tapping on the monetary breaks to combat inflation, which does not appear to be so much as function of economic bottlenecks as excess money supply growth and excess lending.  This keeps me dollar bullish into the new year.