Not Too Late for Turn Around Tuesday

The US dollar is turning in a mixed performance today.  It is firmer against the dollar-bloc and is at the highs for the year against the yen.  It is mostly firmer against emerging market currencies, but is modestly softer against the euro and sterling.  

Many observers will  posit the euro's resilience today to the flash PMI reading for January where both the manufacturing and service sector readings were above expectations.  The flash manufacturing diffusion index stood at 48.7 vs 47.3 consensus and 46.9 in December.  The service sector index is at 50.5 vs  49.0 consensus and 48.3 in December.  

Yet in the forward looking components like new orders remain weak.  German new manufacturing orders continue to contract at 48.5 and new business in services fell to 50.1 from 50.9.  In France the new order/business sub-indices both continued their multi-month contraction.   

Separately, but not totally unrelated Siemens earnings disappointment and economic assessment is more somber than some of the recent talk that the worst is past in terms of the euro zone economy.   The euro's resilience appears to be largely a function of positioning and continues to appear to be a technical correction, despite attempts to link it with a fundamental shift.  Sometimes the news explains the price action, but now it seems the other way around, the price action explains the news. 

There have been three key developments in the euro zone debt crisis.  First late yesterday the EU finance ministers formally sided with the IMF, Germany and Greece in negotiations with the private sector that their debt forgiveness should be greater.  The IIF says its last best offer is for a low 4% coupon on the new bonds.  Officials want something around 100 bp lower.   

The brinkmanship tactics are only effective if one can demonstrate one's willingness to walk away, but in the case of Greece, it is not so clear.  European officials want to avoid a credit event, a non-voluntary default for fear of a Lehman-like event, a contagion that undermines and already vulnerable Spain, Italy and even France. 

The private sector investors, on the other hand, might not recover (barring CDS or some other hedge) the 35% of so that the voluntary deal would net them on a NPV basis.  Negotiations continue and a result is now seen unlikely for several weeks. 

Second, a new issue has emerged that again threatens to put a wedge in between Germany and France.  It is whether the ESM should be topped up.  Germany says no.  France, Italy, Spain, Portugal and the IMF says yes.   Germany does appear open to re-examine the case in March. 

The ESM appears to be a second front for which there are preliminary signs of a backlash against the German austerity regime.  The first front may be in the increased pressure on Germany to offset some of the region's tightening, or to slow its own fiscal adjustment.  

Third, pressure on Portugal is being overshadowed by Greek and EU developments.    The bond market may not be the best place to monitor the pressure on Portugal as the ECB's hand may distort the market.  The 5-year CDS, in contrast, is at new record highs, suggesting that private sector investors are getting increasingly concerned that Portugal is on the same path as Greece.  Not only will a second aid package be required, but the recognition that debt restructuring may be necessary is increasing. 

The yen is independently soft today.  The BOJ concluded its two day meeting.  It downgraded its assessment of the Japanese economy for the third consecutive meeting.  It now projects that the economy contracted 0.4% in FY11 (which end at March 31) rather tna expand 0.3% as it thought in October. 

Separately, note that the Japanese cabinet, which has endorsed PM Noda's push to double the retail sales tax (in two stages in the coming years) forecasts that even with the hike to 10% in the sales tax, Japan would still not be running a primary budget surplus in FY2020.  

The dollar gained to JPY77.40, but appears to be running out of steam.  The yen's softness against the dollar appears to be largely a function of cross rate adjustments, that might ultimately steam from the euro's recovery.