To Key Issues Today: ECB Intentions and US Jobs

Currency market participants are focused on two things today. The first is the implication of ECB's Trichet comments yesterday. The reference to "strong vigilance" and explicit refusal to indicate that "rates are appropriate" are understood as powerful signals of the ECB's intent to raise rates as early as next month. A Reuters poll found 39 of 49 expect the ECB to raise rates a quarter of a point at its next meeting in early April. While it is difficult to deny the ECB's hawkishness, my reservation lies with the key EU summit on March 24-25. The ECB has, like the Federal Reserve, drawn a distinction between liquidity provisions and monetary policy (interest rate policy), but the ECB had to backtrack at the end of last year, due primarily to the Irish crisis, from ending its three-month liquidity facility. It now says that facility will last through Q2, under which banks can borrow unlimited funds at a fixed rate (presently 1%).

While there can be no doubt Trichet was sending a signal to market participants, he seemed to also be sending a message to European governments. They need to address the debt crisis and the ECB's ability to pursue an independent monetary policy cannot be put at risk. The market has done a great deal of the heavy lifting for the ECB already in pushing up market rates, so it matters little now whether the hike is in April or May. Monetary conditions may be too loose for the German economy and a few others, but they are arguably too tight in the periphery and the ECB's hawkishness reinforces our view that Portugal will need international assistance. The market's sentiment will be tested next week as Portugal holds its second bond auction of the year next week (March 9) with 750 mln to 1 bln euro 2-year bonds. Yesterday, the 2-year yield rose through 6% to its highest level since last May.

Meanwhile the center-right euro zone leaders meet today to coordinate positions ahead of next week's summit. Our base line view is that Germany (and France) will use brinkmanship tactics, which means no agreement until the very last moment. It will likely be seen, though, from today's meeting that Irish pleas for lower rates on their assistance package will get little sympathy. The ECB's hawkishness puts more pressure on European officials to reach a comprehensive agreement just as political considerations (new government in Ireland, Merkel's CDU/FDP coalition facing state elections, Dutch government weakened in recent elections and a national election in Finland next month) make such an agreement more difficult.

The second important focus is on the US jobs data. It is arguably the single most important US economic report of the month and also among the most difficult to forecast. State governments likely continued to reduce headcount and since last year's census obfuscation, the market has focused on private sector payrolls. The consensus is for around 200k increase. I am concerned that such a number would be the highest since last April, but still be ultimately disappointing. Here is why: Private sector payrolls rose an average of almost 140k in Q4 10. In order to maintain that average here in Q1 11, given the 50k rise in January, the February increase needs to be closer to 240k, pending of course the revisions.

At the same time, the payback for the weather-induced weakness in January suggests the details of the report, like weekly hourly, should also bounce back. One critical transmission mechanism through which strong data is currency positive is through the interest rate channel. Given the ECB's signal and the Fed's commitment to continue to ease monetary policy through the unconventional means of Treasury purchases warns that this transmission mechanism is currently not work or at least not working very effectively.