Dollar Surrenders Yesterday's Gains

Currency in Crisis

Better than expected economic data from China and Europe is weighing on the dollar. The euro bounced smartly off the $1.3025 area seen in Asia. It appears to be stalling now near $1.3150 pending new incentives from the batch of US data (especially ADP and ISM). A modest new high on the day is possible, but yesterday's high near $1.3214 seems safe.

The official PMI reading from China is stronger than expected, back above 50. The EMU PMI as slightly better than the flash at 48.8, which is a 5 month high. The forward looking new orders was a 6 month high but still below 50. The UK and the Scandi bloc readings surprised on the upside and helped those respective currencies. Sweden' reading of 51.5 vs 48.9 in Dec and 49.5 consensus may be encouraging some participants to reconsider the chances of the Riksbank cutting when it meets on Feb 16.

Swtizerland bucked the general trend with a 47.3 headline reading, defying expectations for 51.4 and 49.1 in December. It is the fifth month below the 50 boom/bust line and new orders fell to 47.6 from 50.6. This is fanning some expectations that the SNB will soon show its hand and defend the CHF1.20 level (against the euro). The euro has been edging closer to that level and today recorded its lowest print since mid-September.

The dollar has fallen almost 3% against the yen since testing the 200-day moving average near JPY78.35 last Wednesday. It is now at its lowest level since the massive intervention on October 31. The verbal intervention is already on the rise, but material intervention is does not seem imminent. Intervention is more likely after the dollar falls below the record low near JPY75.35. Prime Minister Noda was clearly more of an interventionist than the prior regime.

However, the usual triggers, like disorderly or extreme one-sided market do not seem to be present. Implied volatility in the options markets as not a good predictor of the August or October intervention. A one-way market is usually seen as a large premium for yen calls over yen puts, but both against the dollar an euro, current market indications a relatively small premium.

In late July and October, prior to the past to intervention operations, there was a large run-up in the net long yen position futures market. That is also not happening no, with the net long yen long position having been trimmed for the past to weeks. Some observers suspect that US and European opposition to the intervention pose an obstacle to BOJ intervention, but it is difficult to test that hypothesis as the BOJ has intervened in the recent past knowing before hand that intervention would have to be unilateral.

In terms of success, the historic record of unilateral BOJ intervention is not reassuring. Yet the most compelling case for the intervention may rest on the counter-factual --how strong the yen would be if the BOJ did not intervene and the capital account as not recycled.

European bonds are generally firmer, including the periphery. The German bond auction was well received and Portugal bill auction went off without a hitch (lower yields even if small bid-cover ratio). Portugal and Ireland's 2-year notes are bucking the general trend with higher yields. Reports suggest that the Greek PSI may include a GDP-linked feature that could be worth 0.5-3%, allowing the IIF to consent to a lower coupon on the new bonds. Still, PSI agreement is modest step as it will allow the market's focus to shift to participation rate and whether it is really sufficient. ECB may still have to forgo profits on Greek bonds, national central banks may have to take a haircut, and Greek 2.0 may have to be bigger.

Merkel is on her way to China and despite her political and negotiating prowess, don't expect her to win meaningful concessions from her hosts in terms of bailout out funds for Europe (as opposed to the IMF) or faster currency appreciation, which ground to a halt in January.