Dollar Finishes the Month Softly

After a soft start in Asia, the euro has rallied to approach the year's high set February 2 just above $1.3860. The ECB rhetoric ahead of the meeting later this week is expected to reiterate the hawkish tone seen in recent weeks, the euro seems particularly vulnerable to negative news that is mounting, though momentum and technical players have their sights set on $1.40.

First, the Jan euro zone CPI came in at 2.3%, off slightly from the 2.4% flash reading. While still the highest since Oct 08, it is not as bad as feared.

Second, overnight borrowing from the ECB reached a new 20 month high on Friday, according to data released earlier today. The 17.1 bln euro borrowing at a punitive rate of 1.75% compares with overnight borrowing of 2.21 bln on Thurs. The recent surge has been linked to Irish banks shifting from longer-term facilities to overnight borrowing as they sold their deposits, but thus far the surge on Friday is unexpected.

Third, the Irish vote itself was in line with expectations and the Fine Gael are expected to head up a new coalition government with Labour. The two pledges that are important for investors are the to renegotiate the terms of the EU/IMF aid packages, really more the former than the latter, and seek some burden sharing with some senior bank bondholders.

Fourth, it is not just Irish politics, but the shifting landscape of German politics as well may be a policy constraint. There are three German state elections this month. Merkel's coalition is a shrinking minority in the upper house. In addition, newswires report that the euro-skeptic True Finns party is in the ascendancy ahead of the April 17 vote. Separately, note the Beligian provincial election later this week may also complicate its political situation.

Fifth, while the Portuguese government is still deploying denial tactics, pressure is building on the country to seek assistance. As we have noted, the 10-year yield remains at elevated levels and above what are regarded as sustainable. With the EFSF in flux and the terms unclear, at the very least Portugal needs to wait until the end of next month (March 24-25 summit). Portugal will sell 0.75-1.5 bln euro of 6-12 month bills on Wed and try again to buy back existing bonds that mature shortly. The earlier attempt produced lackluster results.

Meanwhile, the net speculative position at the IMM rose by more than a third to 45.6k. Since late 2008, the largest long position was about 51k.

Japan offered mixed economic data. January retail sales rose 0.1%, whereas the market had forecast a decline of over 1%. Industrial output rose 2.4%, the third consecutive month, but was nearly half the gain the consensus had expected. Moreover, the expectations for Feb were soft at 0.1%.

Yet it is not so much economic data that appears to be driving the yen. There seems to be a tug-of-war. Speculative traders, using the IMM for a proxy, are building a large short yen position. Net short yen positions grew by 50% over the past reporting period to 27.7k from 18.5k. Recall, speculators had been net long yen, until the middle of the month. However, at the same time specs have gone short yen, real money has poured in. In the first half of February, foreign investors bought JPY495 bln of Japanese assets on top of the record JPY5.28 trillion in January. The Nikkei's 3.8% rise this month is the best among the G7. The dollar has established a 3-day base near JPY81.60. The JPY82.50 area marks the upper end of the 3-day range, which looks likely to remain intact over the near-term.