Dollar Remains Soft, Recovery Looming (?)

The shift in interest rate expectations in the euro zone and UK continues to be a dominant force in the foreign exchange market. The euro poked briefly through the $1.35 level for the first time late November. Sterling is trying to extend its advancing streak to the ninth consecutive session and remains near yesterday's highs, which was its best level since mid-November. We think the market is getting too aggressive in bringing forward ECB and BOE rate hike expectations. At the same, however, there has been increased speculation around Asia's dollar sales. In recent days there has been much talk about Asian official demand for euros in particular. We suspect the market may be misunderstanding the seemingly supportive comments from Japanese and Chinese officials about the euro.

Official interest (including Russia) in the triple-A rated EFSF and EFSM bonds is not surprising. They do have to manage their massive reserve holdings. Moreover, it might not be about the euro zone but the tactical needs of Japanese and Chinese officials. Japanese officials are concerned about the strength of the yen. In fact, the rhetoric appears to have been stepped up in recent days. The financial crisis in Europe is one of the factors that may account for yen strength on the so-called safe haven appeal, which always strikes as as a bit ironic as Japan's debt/GDP ratio is well above the peripheral European countries.

A weak euro is also not in China's interest. The euro zone is China's largest export market and the euro plays some role in the basket used for its currency regime. China does not reveal the currency composition of its reserves, but it is widely thought that euro accounts for something on the magnitude of 25-30% of its $2.8 trillion reserves, making its exposure to the euro substantial.

At the end of last year there were reports suggesting that Greece was quietly trying to lobby private creditors (banks) to extend maturities on its debt in the same way the the IMF and EU are considering. This we suggested was a stealth restructuring. The reports were later denied. Today a German paper is reporting that Germany is proposing that Greece borrow from the EFSF to buy back its own bonds. We would have to recognize this too as an a path to restructuring. The report has been denied, as one would expect.

It is difficult to know the seriousness of trial balloons and claims. Ireland seems to moving in the other direction partly as a function of the different problems it confronts. Market participants continue to digest reports out late last week suggesting that Ireland's central bank has stepped up its emergency liquidity provision to Irish banks. At the end of December, the "other asset" line item of the central bank's balance sheet, which officials indicate is primarily lending to Irish banks, stood a little above 51 bln euros.

Recall in December, Irish banks borrowed 132 bln euros from the ECB, accounting for almost a quarter of ECB lending. The ECB had to authorize this Irish central bank's actions, but it is disturbing nonetheless. The fact that the Irish central bank lending so much to Irish banks suggests they may be running out of collateral acceptable to the ECB. Given the condition of Irish banks, it seems some fraction of this lending will turn become government debt.. Irish GDP is roughly $225 bln. The central bank has provided the banks with a sum a little more than 30% of GDP.

China Securities Journal appears to have "leaked" some of the slew of data that is to be reported tomorrow. Of particular note December CPI reportedly will ease to 4.6% from the more than two-year high reached in November at 5.1%. Yet there may be more than meets the eye, as this matches a news wire consensus. The same is essentially true of the "leaked" Q4 GDP put at 10.3% down from 10.6%. If confirmed, this may help reduce some investor anxiety over the pace of PBOC tightening. Yet new loan growth appears to have exploded in early January and this may still elicit orthodox and heterodox policy response.