Euro Firm, Consolidiative Tone Elsewhere

The euro made new highs since late November today. Investors have shrugged off the latest comments from Fitch that outlined potential triggers to credit downgrades of the periphery. In fact this has been a good week for peripheral bonds. Ten year yields have fallen 16-25 bp in Greece, Portugal and Spain. Ireland is the exception as its 10-year yield rose 10 bp.

For the record, the German 10-year yield is up 11 bp on the week. Meanwhile, it does not seem like European officials are any closer to carving out that comprehensive strategy that has been promised. Indeed the latest idea is that if Germany is balking at boosting the size of the EFSF, that perhaps the countries with less than triple-A credit should boost their contributions. It seems hardly practical that Italy and Spain for example can really afford to increase their external commitments.

That the German IFO hit a record high in December is not really news. The German economy is booming. The stock market hit 2 1/2 year highs earlier this week. Yet many misunderstand. Germany's strong growth is a symptom of Europe's challenges. German strong growth stands in sharp contrast to contraction or stagnation in the periphery and weak growth outside of a Germany and a couple of other countries.

Monetary policy is arguably too loose for Germany and too tight for most on the periphery. Most of the official focus has the debt dynamics, but less attention appears to be directed at the underlying problem, namely the deterioration of the competitiveness of countries on the periphery.

We continue to monitor the US-German 2-year interest rate differential as an important factor in the euro-dollar exchange rate. It has moved another 10 bp in Germany's favor this week and now stands near 68 b, its widest since January 2009. It had widened by 31 bp last week and was flat in the first week of the year. We find that while the level is important, the change in it is even more important.

The widening has helped fuel the near 4.5% rally in the euro over the past two weeks. The US-Japanese 2-year rate differential has been largest flat over the past two weeks. Net-net the dollar is flat against the yen. That puts euro-yen sharply higher on the week. In fact the cross is testing its 200-day moving average (~JPY112,32), which is it has not traded above since last January.

Today's UK retail sales data drives home the real problem policy makers face. Inflation numbers spook the market, but policy makers are constrained by the weakness of the economy. Stagflation ? It is not just that average earning growth is slow, but the PMI for services and construction is below the 50 boom/bust level, and the fiscal tightening will act as a strong headwind. The risks include a double dip to the economy. December retail sales were considerably weaker than expect, falling 0.8% rather than a 0.2% decline the consensus anticipated. Much of this was a decline in petrol. Excluding it, retail sales eased 0.3%.

Fuel purchases fell almost 6%. Of note, the deflator eased to 2.2% from 2.3%. The Jan report may be more important. It is not clear whether retail sales bounces back as the fuel purchases adjust and Dec purchases are pushed into the new year or wheather the rise in UK retail sales in late 2010 were aimed at get ahead of the VAT increase. Sterling, which often leads the euro, has not recovered form yesterday's slide, while euro sterling is flirting with its 100-day moving average (~GBP0.8535).