Monday Market Forces

The tick up in the flash euro zone composite PMI to 56.3 from 55.5 in December has not done the euro any favors with new session lows being recorded in quiet late morning turnover in London. We have emphasized in explaining the euro's recovery over the past two week to shifting interest rate expectations. Since the ECB meeting a number of ECB officials have played down the hawkish interpretation of Trichet's comments. The ECB President himself, in a Wall Street Journal, offers toned down rhetoric, recognizing that higher commodity prices are not feeding into wage increases. He clearly signaled a willingness to look past temporary jump in inflation. Note that German January CPI figures are due Thursday and a downside surprise at this juncture would likely have more impact that a small increase.

Yet there has hardly been a reaction in the Euribor futures strip or the Germany 2-year yield is essentially flat near its highest yield (~1.30%) in a year. In fact, the increase market rates adds an extra note of uncertainty in this week's ECB repo operations. There are 42 bln euro maturing of 3-month refi this week. There is some pressure for banks to reduce their dependence on the ECB for funding and some banks, including Spanish banks, appear to stepped up their use of reports and covered bond issuance, for example. Nevertheless, with the rise in market rates, ECB funding may look more attractive.

There is another consideration at work, and something that we may not have sufficiently appreciated. While we noted that there was some reports, later denied, that Greece might be allowed to borrow from the EFSF to repurchase its bonds in the market, which are trading at about a 30% discount to face value. Such proposal, even with Germany apparently continuing to oppose an increase in the size of of EFSF, it has prompted a powerful market reaction. Industry measures of euro zone credit default swaps, posted their biggest two week decline in over a year.

This is an even larger decline that seen last May when the EFSF was first announced. The cost of insuring Spanish and Italian sovereign exposure fell by nearly a quarter. The cost of insuring European banks posted their largest two-week decline in more than 2 years amid talk that EFSF may be used to more directly to recap banks, Some investors who were long these, apparently were short the CDS in the US and Japan to fund the trade and the unwinding has lifted those CDS prices.

Similarly, some upward pressure on German rates may be also traced to the unwinding of positions. This was evident in the currency futures positions as well. Data released at the end of last week, shows that as of January 18, the net speculative euro position swung from short 45k contracts to long 4k. This is the first time the net speculative position is long euros since mid-November. The net speculative sterling position also swung to the long side, though some what less dramatically (+5.7k vs -5.7k) for the first time since late-Nov.

The UK is the first high income country to report Q4 GDP. The consensus calls for a 0.5% quarter-over-quarter expansion, down from 0.7% in Q3 and the risk appears on the downside, given the sub-50 readings on the Dee service and construction PMI and the exceptionally poor weather in December. BOE minutes for the meeting earlier this month are released on Thursday and anything but a 7-1-1- vote as in November would elicit a market response.

Speculative long Swiss francs and yen were trimmed (also likely reflecting unwinding of short euro crosses positions), while Australian and Canadian dollar positions late changed.