Euro Eases Ahead of ECB Press Conference

The consoldiative tone in the euro appears to be more a function of caution ahead of Trichet's press conference following the ECB meeting. The January service PMI rose to 55.9 from 55.2 of the flash reading and 54.2 in Dec. Coupled with the strength of the manufacturing PMI earlier in the week, a broadening of the euro zone recovery would seem to be confirmed. However, the fact that Dec retail sales so badly disappointed (-0.6% vs consensus of +0.5%) warns of the continued sluggishness of domestic demand.

There are two main focal points for the market and neither is the economic data:

The ECB meeting and the EU summit. The important part of the ECB meeting is not what they do (nothing), but what Trichet says, especially regarding inflation, which has ticked up since his hawkish comments last month. At the same time, the rise in market rates above the refi rate has complicated the ECB's task of sterilizing its bond purchases.

Although it did not buy bonds in the most recent reporting period, it sterilization operations are for a week at a time and for only the third time since the operation began last May, the ECB failed to fully sterilize its stock of purchases. At the same time, wage demands in Germany are rising with the IG Metall and the chemical workers looking for 6-7% pay increases and this will play on ECB fears of second-round impact from higher inflation. Trichet has to tread a fine line.

Moreover, because of the second focal point--the EU summit--Trichet cannot afford to remove pressure on officials to address the debt crisis--so the ECB can be freed to pursue its mandate. The EFSF appears to be the center of discussions. The EFSF was initially intended to buy bonds, but Germany blocked this in part because of the lack of conditionality. Now there is an attempt to resurrect this function, but Germany is still balking. It is not clear what is a bargaining chit for Germany and what is a principled position.

France and Germany appear on opposite sides of the issue, but the French thrust of greater political governance appears to be being appropriated by Germany. German demands in exchange for greater support appears to include three key items: 1) changes in national laws, possibly constitutional amendments, that enshrine debt limits; 2) uniform corporate tax rates in a not very veiled criticism of Ireland; and 3) a EU wide minimum retirement age, in not very subtle criticism of Greece. Yet the idea that the current Stability and Growth Pact failed is misleading on two counts: Germany and France were the first to overshoot the deficit limits and faced fines, but politically maneuvered to block it. Arguably more important is that most observers simply have it backwards. The budget excesses did not cause the European crisis. The crisis caused the budget deficits to balloon.

It seems like ancient news that the UK economy contracted 0.5% in Q4 10. This week's PMI readings all jumped and more than expected. Today's service sector PMI jumped to 54.5 form 49.7 and well above the 51.3 consensus rounds out the week's reports. Since the end of last year, the implied yield of short-sterling futures have increased: 14 bp in the March contract, 30 in June and 50 in the Dec contract. The implied yield of the euribor futures strip has risen even more: March +20 bp, 42 in June and nearly 70 in Dec.

The contrast with the US is stark. The eurodollar futures strip is essentially flat since the end of last year. The dollar can rally while the Fed is engaged in QE2, with another 30-45 bp of effective easing still to come, if other major countries' policies are perceived to remain on hold and there is a safe haven bid emanating from the European debt crisis or as we saw at the end of last week, if there is a heightened fear that the political crisis in the Middle East (broadly conceived) will have important economic fallout.