FX Forces: Rate Expectations and Petrodollar Recycling

There are two main drivers of the US dollar presently: divergent interest rate expectations and the recycling of petrodollars. Developments over the past 24 hours reinforce those drivers. The higher euro zone manufacturing PMI readings yesterday have been followed by news of a larger than expected jump in Jan producer prices. The 1.5% m/m increase was half again as much as the consensus forecast and lifts the year-over-year rate to 6.1%, the fastest since Sept 08.

The ECB meets tomorrow. The market appears to be pricing in two 25 bp rate hikes this year. However before hiking rates, the ECB will likely end its provision of unlimited 3-month funds. Recall it had been moving in this direction before the Irish crisis last November. In contrast, Fed Chairman Bernanke was fairly clear yesterday, while the recovery appears to be strengthening, employment growth has been frustratingly slow and the rally in commodity prices may provide only a temporary lift to prices, but inflation expectations remain anchored. Some argue that the Fed is slipping behind the curve, but this assumes that both central banks are dealing with the same conditions.

If the ECB had US CPI levels, rate hike expectations would likely be profoundly different. US CPI is up 1.6% year-over-year, while the euro zone CPI is up 2.3%. The difference between US and German 2-year interest rate, which touched its highest level yesterday since early 2009, can be nearly entirely accounted for by the inflation differential.

In addition to the talk of Middle East demand for euros, ostensibly to maintain the reserve allocation in light of the higher oil prices, there is another interesting element of the story. Earlier this week, Spanish Prime Minister Zapatero was in Qatar and the emirate promised to invest ~3 bln euros in Spain, which included reports to 300 mln in Spanish banks. As I have noted the correlation between Spanish and Portuguese bonds as broken down since the end of last year.

There is a general sense that Spain has beaten back the wolf at the door, for now. Portugal and Germany meet today. Earlier today, S&P reaffirmed its negative outlook for both Portugal and Greece. Portugal is reluctant to take the path led by Greece and Ireland. Their aid package have not succeeded in stabilizing interest rates. My base line expectation, assuming rational actors, is that Germany (and France) use brinkmanship tactics and refuse to compromise at the March 11 summit, with a resolution only possible at the last minute at the March 24-25 summit and an agreement will also provide assistance to Portugal.

I think the strength of UK economic data, within the context of high inflation readings, coupled with the penchant for the BOE to surprise the market, increases the risk of a rate hike at the March 10 MPC meeting. Indicative prices suggest the market has discounted only about a 1 in 6 chance of a hike. I suspect the odds are considerably higher. The latest string of data will likely strengthen the hawks hands. Yesterday's record high manufacturing PMI reading has been followed by a stronger than expected construction PMI. The 56.5 reading was driven by the growth of new business compares with 52.8 consensus forecast after a 53.7 reading in January. It is the strongest construction PMI since last June. The PMI for services, which accounts for a much larger part of the economy, will be reported tomorrow. The risk seems to be that the market has underestimated the recovery from the 0.6% contraction in Q4 GDP.

Barring a significant negative surprise tomorrow, I suspect as more of the market comes around to our view that sterling will be underpinned. A move above $1.6330 could signal a move toward $1.6460, the high from Jan 2010.