Turn Around Tuesday?

Corrective pressures grip the foreign exchange market today. The short-term momentum traders have been frustrated with the euro's inability to convincingly break above the $1.40 level and sterling's four attempts at $1.6350 appears to be the main impetus behind today's pullback. With today's losses, the euro has slipped through the post-Trichet's "strong vigilance" reference (~$1.3925). The next band of support is seen in the $1.3850-80 area. Net speculative long euro positions rose in the week through last Tuesday to 51.3k contracts, the upper end of positioning since the the crisis began, it likely understates positioning given the euro's surge following Trichet's rate hike signal.

Sterling has slipped to six day lows today. A break of $1.6150 now could see loss toward trend line support near $1.6070 (drawn off Feb 11, 16 and 25 lows). Today offers the first test of the dollar bearish sentiment in North America. Asian consolidation has been followed by European selling. On balance, we suspect the dollar bears remain in the driver's seat and that this pullback is largely technical in nature. The US-German 2-year yield captures, we think, main forces at work. At the end of last year the US 2-year yield was about 20 bp less than Germany. Now it is at 105 bp discount, having finished last week at 108 bp.

That said, we remain concerned about the political paralysis in Europe that will prevent a truly comprehensive plan to deal the European debt crisis at the self-imposed deadline of the March 24-25 summit. The IMF's European Dept head was also quoted on the news wires warning of market disappointment. The Franco-German competitive pact was clumsily delivered and pulled an end-run around the European Commission and Council. The competitive pact was the pre-condition to Germany accepting an extension of the aid programs after 2013. There was a strong push back against the proposed competitive pact.

The European Commission and Council (Van Rompuy and Barroso) appear to have have regained control of the process and are likely to propose as early as today and somewhat less diktat and provides for much national leeway and expression. One consequence is that it provides the basis for greater euro zone coordination outside of the EU, which is likely to annoy some in eastern and central Europe who are worried about new divisions in Europe.

At the same time, however, we are also concerned that German Chancellor Merkel will not be able to deliver German support for whatever agreement is reached. The government does not have a majority in the upper house and a couple days after two days after the summit, Merkel faces the most important state election--Baden-Wurttemberg, which the CDU has governed for more than half a century. Local issues, like the Stuttgart 21 railway station expansion have seen Green support rise toward 25%, which illustrates the uphill fight for the CDU/FDP.

Economic news is generally light in the first part of the week. The UK's BRC sales declined 0.4% in February after strong (tax induced?) sales in January. RICS measure of house prices were the least weak in around half a year. The BOE meets Thursday. Indicative derivative prices suggest the market is assessing about a 1 in 5 chance of a hike, while we suspect the odds are higher, it is not the most likely scenario.

France reported a slightly larger than expected January trade deficit. The French trade position has deteriorated. The 6 and 12-month moving averages are at their lowest level since late 2008. Until now the EMU and the Stability and Growth Pact have not recognized the importance of national imbalances within the euro zone, but this crisis is changing that. German manufacturing orders in January rose 2.9%, a bit better than expected, thought the Dec decline was revised to -3.6% from -3.,4%. Of note, domestic orders rose 4.5%, while foreign orders rose 1.6%. The government said that the trajectory is higher, but that big-ticket orders were below average in January.

Lastly, Japan reported a series of data, including money supply and January trade and current account data. The data were all largely in line with expectations. Dollar buying in Europe lifted the dollar toward the 20-day moving average, which comes in near JPY82.65. Additional dollar resistance is seen nearer JPY83.00.