Euro Races Higher

Currency in Crisis

The euro is racing higher after initially gapping lower in Asia on indications that the private sector involvement in Greece had hit another stumbling block ahead of today's EU finance minister summit.  It has moved above the $1.30 area in the European morning, for the first time since January 4.  There are a few consideration prompting the continuation of the short-covering advance that began last week. 

First, there are reports that Germany and France are seeking to relax bank capital rules to avoid worsening the credit crunch.  Second, the Financial Times reports that some money market funds have begun returning to European bank paper.  The report indicates that French and Spanish paper up to a month in duration is being purchased. 

Longer dated paper in the Scandi, Dutch and UK banks is also being bought.  Third, Germany and France also appear to be stepping back from the aggressive stance regarding the financial transaction tax and instead as looking to ensure UK participation by adopting the UK's stamp tax on securities transactions.  Fourth, financials are again leading the European equities higher.  The bank index of the Dow Jones Stoxx 600 is at 3-month highs, up over 20% since early January. 

Reluctant at first, the market is recognizing the significance of the ECB's 3-year financing, even though overnight deposits at the ECB remain near record levels.   The LTRO may support the sovereign debt market marginally, but more importantly, it appears to be supporting bank debt.  European banks have not been issuing secured senior debt, but have been issuing largely levels of covered bonds, which the ECB is also buying in the secondary market. 

The Greek PSI negotiations have also been about brinkmanship tactics and both sides seek the best possible deal and that force each to push the edge of the envelop.   The key is not the notional haircut of 50%, but rather the impact on net present value.  The media continues to play up the coupon of the new bonds as the key sticking point, but there are numerous moving parts. 

A lower yield on the new bonds can be offset by a slower increase in the graduating coupon, or a longer grace period before the principle is serviced, or a smaller cash inducement.   There is also more talk that the ECB could sell its Greek bond holdings back to the Greek government (for funds lent to it by the EFSF) at cost, allowing a further decline in Greece's outstanding debt. 

It had been hoped that some agreement would be presented to the European finance minister meeting today.  However, now it is hoped that an agreement can be reached for next week's heads of state summit.  Brinkmanship tactics will continue. 

In terms of sovereign supply, this week features mostly bill sales and an Italian inflation-linked bond.  Supply should not be a major factor.  Instead, the main focus is likely on the Fed and BOE.  The Federal Reserve two-day meeting will break new ground in terms of transparency as the Fed steps up its communication by providing for detail forecasts, including of the expected trajectory of policy rates.  The Fed has indicated no change in the Fed Funds target until mid-2013.  On Wednesday, the Fed will likely confirm a recent NY Fed survey of primary dealers that indicate the first hike does not take place until at least the middle of 2014. 

The BOE does not meet this week, but the minutes from the recent meeting will be scrutinized for insight into what happens next month when the current gilt purchase program is completed.  The UK is the first of the G7 to report Q4 GDP.  On Wednesday, at the same time the minutes are released, the UK is expected to report Q4 GDP contracted 0.1% after a 0.6% increase in Q3.  This, coupled with an expected continued easing of inflation pressures, will likely set the stage for another GBP50-75 bln of gilt purchase. 

Assuming the euro can establish a foothold above $1.30, the net target is near $1.3075-80.  Support is seen near $1.2850.  We note that volatility has come off as the euro has pushed higher.  Sterling is lagging behind the euro.  Against the dollar it is testing the $1.5600 area and above there is he $1.5670 area.   

The lunar new year is closing some Asian centers, but Japan was open, not that it did the yen any favors.  The greenback has been confined about a 20 tick range.  The net consequence of this is to lift the euro back to JPY100 and on the margins seems to diminish the likelihood of near-term BOJ intervention on the cross, which has been seemingly threatened.