Trichet Holds Key

The US dollar is largely within yesterday's trading ranges against the major currencies ahead of Trichet's press conference.  The big moves are in the antipodean currencies where softer than expected employment data has weighed on the Australian dollar, while a somewhat more confident New Zealand central bank sent the kiwi more than 1% higher.  It has enjoyed some extra play recently amid talk of it being added to reserves. 

Before turning to the ECB, consider the environment in which it is meeting.  The credit default swaps of the peripheral countries have set new record highs today as the risk of a credit event have appeared to increase following the letter, leaked to the press, by the German finance minister, calling for substantial private sector participation--beyond the Vienna Initiative-like approach.

The ECB has been opposed, but its position has been evolving, or perhaps the language has.  First, it rejected any talk of restructuring.  Then it seemed to accept some version of voluntary rolling over of debt, and then a debt exchange that would not trigger a credit event.  It says  too that it would not accept reconstructed bonds as collateral. 

At the same time, as noted previously, the ECB stands accused of being a bad bank--that is acquiring toxic assets--even if confusion over the mechanics of how the ECB operates to say conduct its liquidity operations led to some exaggerations in the press and blogosphere.   It holds an estimated 40-50 bln euros of Greek bonds  (bought at discounts) and holds collateral of questionable value on loans to questionable Greek banks. 

This will be the ECB's first opportunity to respond to Schuable's letter, which was addressed to the it as well as others.    His first response is likely to use the word cues to signal a 25 bp rate hike next month.  This will likely be supported by new staff forecasts projecting more inflation and growth this year than the earlier forecasts.  The uptick in the inflation forecast will likely signal the ECB's concern that it will be closer to 3% than 2%.  

If Trichet does not signal a rate hike, given the short-term market positioning, the euro likely has more downside potential than upside potential if he confirms widely discounted expectations of such a signal. 

The fact that the the peripheral debt markets remain under pressure and not just Greece is important.    A default or restructuring by Greece increases the risk that Portugal and Ireland will share the fate.  Ironically, a downgrade of Greece at this juncture may have little impact, but a change in the credit treatment there could trigger downgrades in the other two. 

This is also a point made previously here too that if Greece were to drop out of EMU as some observers are proposing, it would increase the risk premium for the remaining countries not lower it.  This is due to the understanding that what happens to Greece could happen to others.    This may sound perverse, but the logic seems more compelling than Greece leaving the euro zone is some kind of panacea. 

There have been two main forces vying for the market's attention.  The divergent trajectories of monetary policy and the European debt crisis.  The euro has been fairly resilient to the new heightened pressures in the periphery, reflected increased risk of a near-term restructuring.     A break of $1.4550 may signal the end of that resilience.   On the upside, barriers believed to be struck near $1.47 mark the upper end of the recent range.