Understanding the FX Drivers

Many investors are concluding that the Federal Reserve will lag not only many emerging markets, but also a wider number of European countries. Yesterday’s PMIs drive home the point that growth at the start of the New Year is accelerating. This helps embolden the risk appetite at the same time that the market is being told by European officials that they are serious this time about arresting the debt crisis in the periphery of Europe.

News that Egyptian President Mubarak will step down in September has seen the army call for the end to the protests. It is too early to tell whether the army, which is highly respected in Egypt, will succeed or whether the protesters will feel emboldened by Mubarak’s decision. Provided there is not significant impact on oil prices, the market appears willing to look past these largely political events.

Taken together, the safe haven appear for the greenback has faded, the divergence between Fed policy and perceptions of the trajectory of policy in Europe keeps the greenback under pressures and underpins the appetite for risk assets.

There have been numerous trial balloons emanating from Europe of alternative ways to stem the debt crisis in the periphery. A general plan appears to be taking shape and the market will likely hear more in the coming days. Our argument has been that anything shy of debt restructuring is unlikely to offer more than temporary relief. Our understanding of the “comprehensive” plan includes a number of elements of restructuring that reduces the debt burden.

These include an extension of IMF/EU debt to near double current maturities. Market talk of a 30-year extension seems over the top. Second, the interest rate charged Ireland and Greece would be reduced. For example, the EFSF raised money last week at about 2.85% and Ireland would be charged about 5.85%. The leading opposition parties in Ireland are promising to renegotiate the terms of the EU/IMF loans and they appear likely to find a more receptive audience.

Third, it is not exactly clear yet, but something on the magnitude of 50 bln euros worth of bonds (Greece and Ireland presumably) may be bought directly by the EFSF or by Greece (and Ireland) to buy back their own bonds either from the ECB or the secondary market at a discount.

Fourth, there is great consideration being given to the possibility of a Brady Plan like scheme that would exchange existing bonds for new EFSF issued bonds with longer duration and higher rating. It would offer the exchange at market prices, which implies haircuts.

Two important discrepancies have surfaced between the developed and emerging markets. First, the PMI reports yesterday show the developed countries recoveries appear to be accelerating just as several emerging markets, including China, seemed to begin moderating. Second, those emerging market countries perceived to be behind the inflation curve have been punished, more increase in the cost of capital than necessarily in the foreign exchange market, but some, like South Africa and Turkey have seen their currencies weaken as well. However, among the developed countries, those experiencing inflation are being reward with higher currencies. Sterling and the euro are clear beneficiaries of this.

There is much anticipation of more hawkish comments from ECB President Trichet at tomorrow’s press conference given the additional rise in Jan CPI (now 2.4% on the flash report), the continued rise in Dec PPI (flash report today at 0.8% m/m and 5.3% yoy from 0.3%/4.5% in Nov) and strong wage demands from German chemical workers (7%) and IG Metall (6%). However, inability of the ECB to sterilize bond purchases this week stems from fact that key market rates (EONIA) is well above the rate the ECB pays on its one-week term deposits. Risk is that Trichet tries to calm the market down or face more potential disruptions in the transmission of monetary policy.