Foreign Exchange Fever

There were big moves in the foreign exchange market on Monday, but little in the way of fresh developments.  The euro bounced smartly off the 1.4300 area and was back above the $1.44 area by midday in North America.  This despite S&P slash of Greece's sovereign rating to CCC from B and a blowing out of peripheral spreads against Germany and new highs in credit default swaps.  LCH Clearnet, a major platform, raised the margin for Portuguese and Irish bonds to 65% and 75% respectively.  

Nor has there been any resolution of the stand-off as it were among European officials.  This is much more than Germany vs the ECB, as many commentators suggest.  Rather, Germany can count on the support from Finland, Austria and the Netherlands.  On the ECB's side is France, EU and most of the finance ministers.

At the same time, there has been more leakage of the periphery woes to Spain.  The premium Spain is paying over Germany widened 30 bp over the past week and 33 bp over the past month.  This effectively unwinds the improvement this year and is now little changed (4 bp wider) year-to-date.  There have been some reports suggesting that Prime Minister Zapatero, who has already indicated he will not run again, may call for early elections--late this year rather than next spring, ostensibly because the Socialists, he thinks, can do better.  Meanwhile, as the dust settles on the the recent elections, larger deficit figures are bigger reported by the new local and regional governments,   

The premium Italy pays over Germany also has grown in recent days.  Fourteen basis points over the past week to be precise and 27 over the past month.  Year-to-date the spreads is little changed.  Prime Minister Burlusconi lost recent local elections and now the referendum have gone against him too.  The referendum sought to overturn his policies in four areas and the turnout was sufficient to make it the first binding referendum since 1995.  The fiscal implication is not favorable as one of the government's measures that was overturned was the privatization of city water facilities.  

The euro peaked near the middle of last week just below $1.47.  The $1.4450 area represents a 38.2% retracement of the subsequent losses.  A move above $1.4550, the 61.8% retracement is likely needed not just to re-test the $1.47 area but to retest the year's high just below $1.50.  

The price action pattern is familiar.  Frequently, Friday's seem to be a move in the direction of the underlying trend and Monday sees a little follow through before consolidation/correction.  However, the magnitude of the euro's recover (and sterling) on Monday was more than I had expected.  

The near-term outlook may be driven by Tuesday's US retail sales report.  The headline will be weak.  It may be the first decline in nearly a year.  However, the details, and in particular the "core", which excludes gasoline, autos and building materials, and is used to calculate GDP, may show the American consumer is still resilient. Those non-core components are picked up by the Commerce Dept elsewhere as inputs into GDP calculations.   

Japan reported much worse than expected core machinery tools and this comes at an important moment in BOJ policy making.  It concludes its policy meeting on Tuesday.  Prior to the poor orders data, where was some suspicion that it could revise up its economic assessment suggesting the reconstruction efforts had begun.  On the other hand, the IMF has called on the BOJ to extend its asset purchase program.  While the threat of intervention is minor, the dollar will likely continue finding support around JPY80.  

Chinese loan growth slowed in May to CNY558 bln from CNY630 a year ago.  This was about 15% below market expectations and loans in the first five months are off about 12% year-over-year.  This is seen as a sign of the effectiveness of policy to engineer a soft landing.  The 12-month non-deliverable forward is pricing in about a 1.4% appreciation over the next year.  This seems to low.  That said, there is some risk that China essentially pauses in the appreciation path and widens the 0.5% band to 1.0%.  It does not fully explore the 0.5% bond (in the vast majority of sessions) and would be therefore of little cost and appease some critics.