Dollar Bulls Return from New Years

There appear to be three main drivers in the foreign exchange market today. First, the failure of the euro yesterday near the upper end of its recent range is both the cause and effect of dealers expressing bearish sentiment by re-establishing short positions squeezed out in the thin holiday markets.

The convincing break of the $1.3250 area would likely signal a return toward the 200-day moving average (~$.13085) that had been toyed with in the second half of December.

Second, and the reason sentiment toward the euro remains so fragile is that investors expect more negative news from the region. In particular, yesterday's reports that the Swiss National Bank will not accept Irish bonds as collateral, may not seem so bad on the face of it as few Irish bonds are believed to be owned by Swiss banks, but it underscores the criticism of the ECB as becoming a "bad bank", insofar as it is accepting Greek and Irish bonds as collateral and buying their bonds (and Portugal's), which face additional downgrades and which investors seem to be abandoning. In this context, we note both that the Greek-German spread is at record highs near 975 bp and reports that a large US fixed income manager has stopped buying peripheral bonds.

Third, commodities are coming under pressure and may also helping spark in the commodity sensitive currencies, especially the dollar-bloc, but also in some emerging markets. Recall that since it became clear (late Aug) that the Fed would resume Treasury purchases and that the US economy was picking up from the dismal Q2 pace, commodities as measured by the CRB index, rose almost 30%. Two year highs were set on Monday, from whence the reversal began. From yesterday's close on the CRB, it should not be surprising to see another 3-5% pullback.

We have found that the euro-dollar exchange rate has tracked the 2-year spread between the US and Germany fairly closely in recent quarters. The premium Germany offers over the US has steadily fallen in recent weeks. On Dec 1 the premium was 34 bp. Today it is near 23 bp. To put this in a slightly larger context, just before QEII began, the German premium peaked on Oct 28 near 67 bp. The euro peaked a few days later.

During the holiday thin markets, dominated mostly by position squaring and portfolio adjustments, the exchange rate seemed to become less sensitive to the spread. Nevertheless, we expect it to re-establish itself and this would point to further dollar in the period ahead. At the longer-end of the curve, the story is consistent: US premium over Germany was near 18 bp on Dec 1 and now is near 42 bp.

A similar case can be made for the dollar against the yen. The premium the US offers over Japan has widened in recent weeks and this has not been reflected in the currency price action. The argument here is not that interest rate differentials dictates currency movement, but rather than they embody and reflect a number of consideration, including growth differentials, risk premia and sentiment, as well as the incentive structure for market participants. They are ignored at one's own peril.

In terms of economic data, two reports earlier today stand out. First, the UK reported an exceptionally weak construction sector PMI. AT 49.1, it contrasts with expectations of 50.9 and a Nov reading of 51.8. This is the worst reading since last Feb. Construction is only 10% of the UK GDP, but it has played an important role in the economic rebound. The market's tepid response may reflect 1) willingness the disappointment to poor weather especially given 2) that the relative strength of recent UK data had suggested some resiliency going into this year and the tax increases and spending cuts.

Second, the euro zone service sector PMI was a bit stronger than at 54.2 from the 53.7 flash and 53.4 Nov reading. The problem, of course, with thinking about the euro zone in aggregate is the powerful divergence taking place. True to form, German and French data was fine, but Italy disappointed with a 50.2 reading, barely above the 50 boom/bust level and Spain's contraction deepens with a 46.2 reading, a one year low.