Rumor Bought, Fact Sold, and Other FX Developments

The euro extended its recovery in early Europe but reversed course after the lukewarm Italian bond auction.  Italy raised the funds it sought and yields did fall at the shorter term auction, but increase at the longer term and the bid-covers were on the low side.   

In some ways, this is the best Italy might be able to hope for given that the market has been warned by Fitch to expect a multiple step downgrade before the end of the month.  Given the drop in yields yesterday. Italy's Treasury cannot be disappointed either. 

Although I think I recognized early the importance of the 3-year LTRO, the news reports embellishing on Draghi's comments yesterday, suggesting that somehow the debt crisis is over are over the top.  Draghi's idea itself that there are tentative signs of GDP stabilization seems also a bit of a stretch.  One month PMI is an anecdote not evidence.   If the euro zone economy is contracting in Q1, the stream of evidence for it will continue well into May and that is even if the economy turns up in Q2, which is not clear.   The economic risks seem all on the downside. 

Initial support for the euro is seen near $1.2760 on hourly bar charts and then there is the previous band of resistance $1.2720-40 that may now act as support.  Barring break of this lower area, the euro is snapping a five week losing streak, though it still failed to rise above the previous week high.   

Other major currencies are little changed on the day, but the euro is also coming off on the crosses.  One of the remarkable developments that has gone largely uncommented up is that German 2-year yields poised to fall below Japan's 2-year rates. 

Perhaps lost in turn of the year, but the trend seen in custody holdings at the Federal Reserve continues into the new year.  Custody holdings have been trending lower.  Comparing the weekly average figures with the period ending figures warns that the decline will continue in next week's Fed report. 

Recall what larger picture looks like.   Treasuries holdings in the Fed's custodial account for foreign central banks peaked at the end of last August near $2.757 trillion.  In the following 10 weeks those holdings fell by about $82 bln, an apparently unprecedented streak and draw down.   Although we can't know for sure the rise November seemed to be timed with the record large BOJ intervention on Oct 31.  

Custody holdings of Treasuries resumed their decline in early December and have now fallen $68 bln in the past six weeks, a faster pace than the earlier period.  Note that over this period, the dollar generally trended higher.  This is important because it suggest central banks were reducing their Treasury holdings as the private sector increased its dollar demand. 

The custody data does not match up perfectly with the TIC data, but two do move generally in line with each other and for good reason:    a large part of official Treasury holdings are kept at the Federal Reserve.  At the end of October, the latest Treasury data, foreign officials held $3.239 trillion of Treasuries.  At the end of Oct, custody holdings of Treasuires were $2.675 bln, or almost 83%.  The decline in custody holdings with the concurrent rise in the dollar suggest the composition of flows into the US may changed.    

Separately, China reported its first quarterly decline in reserve holdings since the Asian financial crisis in 1998.  In Q4 China's reserves fell $20.6 bln.  Most observers will attribute this to the decline in the trade surplus and reduced speculative flows.  Yet these probably were of secondary importance compared with valuation. 

Consider the simply thought experiment.  Assume China has 25% of its $3.2 trillion reserves in euros.  That is $800 bln.  In Q4, the euro declined 3.2%.  That is worth around $25 bln to China.