Freaky Friday

Much like the 1976 classic (forget that Lindsay Lohan remake nonsense), there is a heightened sense of financial crisis today and the initial G20 statement does little to ease market anxiety.  Early gains in the major currencies against the dollar have largely been reversed, though sterling and the Australian dollar are holding on to modest gains just before the opening of the North American session.  European equities have been unable to sustain earliy upticks.  Price action on Friday's is often in line with underlying trends and it could be ugly even though hourly momentum indicators show stretched conditions. 

One sign of the financial stress is that the German 2-year yield has fallen to new record lows, below 35 bp for the first time.  With the US 2-year yield largely flat, the German move has resulted in a further shift in the 2-year differential.  At a 16 bp, the German premium is the smallest of the year.  There is in creased talk that the ECB will have to respond to the pressures in a way the new dollar swap lines/auction failed to do. 

Speculation today has focused on a rate cut from the ECB and at least one investment house is warning of the risk of a 50 bp move.  Yesterday the talk focused on a longer-dated refi operation (1-2 years) and the Federal Reserve lowering the interest rate on the currency swaps (that rate is now 100 bp on top of the 7-day OIS). 

The crisis is sparking shifting correlations.  Earlier in the week I noted how Irish bonds were highly correlated with Greek bonds and are now highly correlated with German bunds.  Look at gold.   From March through early July, the euro and godl were positively correlated (30-day rolling, percent change), since early July gold and the euro have been inversely correlated.  

Except for a brief period of time in April, the Swiss franc (not dollar-Swiss,but Swiss-dollar) has ben positively correlated with gold, hitting a high in Aug above 0.60 and now is less than 0.02.   The Australian dollar was positively correlated with the gold until late July, hitting a high near 0.75 in May.  It was inversely correlated until earlier this week and it has swung positive, albeit slightly, again. 

The knock-on effect of many emerging market central banks reportedly selling dollars to buy their own currencies may reduce the demand for US Treasuries from said central banks.  The Federal Reserve's custody holdings for foreign central banks has fallen from the $3.491 trillion peak to $3.468 trillion in yesterday's Fed report.  That is a $23 bln decline.   When the private sector is buying dollars, central banks do not have to.