Euro Pops to Start Week

In a Tokyo-less Asian session, the dollar had begun the week bid, but quickly reversed in early Europe, which saw the euro rise more than a cent off the $1.2666 low.  It was largely a short-covering bounce, but as North American players take their posts, it is running out of steam, unable to take out the $1.28 level , which would and trigger another round of short covering.  Sentiment toward the single currency is still overwhelmingly bearish, but there seems to be a growing sense that it may have come too far too fast. 

Given the extended positioning and sentiment, the market is vulnerable to a larger correction.  Support for the euro is seen in the $1.2720-40, provided this area holds, short-term momentum traders may begin trimming positions.   The euro has not taken out the previous day's high since Jan 3 (and that might say more about the fact that markets were largely closed on Jan 2).  Friday's high was near $1.2813. 

The short-term speculative market had begun using the euro as a funding currency.  As it amassed a larger and larger short euro position, it began reducing its short position in some currencies, like sterling  and actually going outright long some, like yen and Australian dollar.  

The euro has fallen for five consecutive weeks, the longest losing  streak since mid-2010, hitting a 16-month low in the process.  It was at record lows against the Australian dollar and 11 year lows against the yen and 15 month lows against sterling.  A euro recovery is likely to be felt on the crosses, not just against the dollar. 

Leaving aside the high frequency data that showed a 0.6% decline in German industrial production, but a larger than expected trade surplus of 15.1 bln euros, on the back of an increase in exports and a decrease in imports, a smaller than expected French trade deficit and a small tick up in the EMU sentiment indicator, the focus is on Merkel and Sarkozy meeting and the subsequent press conference. 

Many cynics dismiss such meetings as political theatre and point to what they argue has been a dismal failure of numerous summits to resolve the European debt crisis.  While there may be elements of truth here, there is something profound taking place.  The scaffolding for a fiscal union is being built, albeit frustratingly slow and not without occasional setbacks. 

Last week, the EC let it be known that it did not agree that Belgium's 2012 budget deficit would be kept below 3% of GDP as agreed.  The EC is reviewing five EU budgets (Belgium, Malta, Cyprus, Poland and Hungary) and will announce the formal results on Wednesday.   The EU Economic and Monetary Commission Rehn appeared to give Belgium the option of making another 2 bln in savings or institute spending freeze until the government's own budget review was completed in February.  Over the weekend Belgium decided on an administrative suspension of spending.  It appears that the measure will sufficient for the EC.   Belgium yields and CDS eased today. 

That European financial markets are still dysfunctional is evident in not only the high levels of overnight deposits with the ECB, but also by the negative yields in bill markets.  Today the Bundsebank auctioned six month bills that had a negative yields (-1.2 bp) for the first time (in the primary market).   In the secondary market, German paper up to 1 year offers a negative yield.    Dutch 3 and 6 month bills sport negative yields. 

Italy and Spanish bond auctions at the end of the week (trying to raise around 7.5 bln and 5.0 bln euros respectively) keeps the new periphery in the spotlight, but the old periphery will still command attention.  Note that Der Speigel report that the IMF is getting more skeptical on Greek reforms has been widely picked up and press reports elsewhere play up the need for the PSI to have more than a 50% haircut. 

The Troika visits Dublin tomorrow to prepare for another tranche of aid.  Portugal port workers start a five day strike.  While some observers are emphasizing the impact on exports, given the country's trade deficit, the strike may result in a smaller imbalance.  The central bank of Portugal today indicated that its banks stepped up their borrowings from the ECB to 46 bln euros in Decfrom 45.7 bln in Nov.  The record was in Aug 2010 just above 49 bln euros. 

In the old periphery, the changing tactics of the Hungarian government helped pave the way for a successful auction today.  The government sold six week bills and the sale was over-subscribed, after a couple recent dismal failures.  The cost was higher yields--7.77% up from 7.24% in November.  

China reported stronger than expected new loans in December and robust gains in money supply.  These figures illustrate that thrust of policy back toward growth has already begun.  China reports a slew of economic data this week and it is generally expected to show a modest moderation in activity,while inflation is expected to ease to 4.0% from 4.2%.