Key Points For MLK Holiday Markets

The US dollar is mixed against the major currencies, but the key development is the sharp drop in the euro as last week's lofty expectations are scaled back. German officials still seem to be balking pressure to increase the EFSF. The euro's decline brought it within a whisker of the 38.2% retracement of last week's gains (found near $1.3230). European players have generally been buying the euro allowing its to claw back some of the steep losses registered in Asia.

Unable to resurface above the JPY83.00 area, the greenback slipped back toward the pre-weekend lows near JPY82.40. The BOJ cut its economics assessment of 7 of 9 regions. The dollar is likely to find support in the JPY82.00-30 area.

Sterling is flirting with the $1.5900 area, helped by cross-rates gains as well. Cable is at its best level since mid-December. The first increase in Rightmove's house price index may be encouraging some buying. Momentum indicators warn sterling may be getting stretched, suggesting no need to chase it.

Global equity markets are heavy. The MSCI Asia-Pacific Index was off 0.3%, after reaching 2 1/2 year highs last week. China's Shanghai dropped 3%, its biggest loss in a couple of months following the fourth hike in reserve requirements in two months. Korea, which as been the early favorite of foreign investors in emerging Asia took some profits, helping to push the Kospi 0.4% lower. European bourses are lower. Financials and basic materials are the largest drags, while health care and utilities are stronger.

Japanese government bonds were lower as the market appears to be building a concession ahead of this week's supply JPY3.5 trillion (~$42 bln). European peripheral bonds are mostly lower, with spreads widening. Ironically, Greek 10-year bonds are an exception and yields are 11 bp lower.

Spain's bill auction tomorrow is likely to go fine, if by fine it is understood that higher yields will attract buyers. Spain is also indicating that bond auctions scheduled for later this month may be sold via a syndicate. Irish bonds are under a bit of pressure. The foreign minister (Martin) is challenging the prime minister (Cowen) in a secret ballot tomorrow. Cowen is likely to persevere tomorrow, but Martin is likely to eventually become the next Fianna Fail leader. The national election looks likely to be held in late March.

A brief word on drivers: There has been a big shift in interest rate expectations. There a many ways to illustrate this. Consider that since the start of the year, the implied yield on the June short-sterling and June Euribor futures contract have risen by around 25 bp since the start of the year, while the US comparable yield is unchanged. On Jan 5, the US 2-year Treasury yield was about 20 bp lower than Germany. The discount widened sharply last week and near 60 bp. In the past five sessions, the US 2-year yield is up a single basis point. Germany's 2-year yield is 25 bp higher and the UK's 2-year yield is 10 bp higher.

Stickiness of prices in the UK and the hawkish tone of ECB President Trichet explains part of the equation. At the same time, we note that the recent string of economic data in the US, especially the trade and inventory data warns that Q4 10 growth in the US is likely somewhat less than the 3.5% pace that had seemed likely. Judging from the Fed funds futures strip the market has pushed out expectations for the first hike well into 2012 from late 2011.

The heads of state meeting between the US and China begins tomorrow. There is much jockeying for position. Hu has made himself available for written questions from the Wall Street Journal and the Washington Post. Although no break through agreement is likely on the yuan, note that it has appreciated 0.62% last week, with the dollar moving move CNY6.60. Plenty of fodder for pundits. Where Chinese officials go, commercial deals follow, but broader agreements will likely remain elusive. Transition of power is to take place in China next year. It could also take place in the US.