Seven Thoughts to Start the New Week

Half way through the Asian business trip and unable to follow the nuances of the foreign exchange market, but from a high level here is what I am thinking about, well besides this:

1. Four central banks meet this week, the Fed, the BOJ, the SNB and the Norges Bank. None will take new action. The Fed may tweak its assessment of the economy a little, but the thrust of the statement will be the same.

After surprising the market with an expansion of its asset purchases and providing an inflation goal in mid-February, the BOJ is unlikely to do anything, but the press conference see new information about its intentions. The weakness of the yen, which reached a 10-month low against the dollar last week, off nearly 7% in the past three months, is likely to be welcomed by officials.

The central banks of both Switzerland and Norway share a common concern, the strength of the own currencies. Barring a crisis, the SNB will be loath to take action until a new chairman is named. Norwegian officials are likely to limit themselves to verbal intervention.

2. The triggering of the Greek credit default swaps is important. Many are focusing on the net figure, which is a modest $3.16 bln, according to reports, but the gross figure of almost $69 bln may be more indicative of the nature of the settlement process on March 19th. However, the Greece saga is not over, even if this chapter is. The fact that the one-year yield is over 1140% is more than just a function of illiquidity. One question investors are asking is if there is to be another aid package for Greece, will the private sector be asked to participate too?

Many will argue that because the CDS’s were ultimately triggered is a market-friendly development insofar as it preserves the integrity of the sovereign CDS market. In turn this may, even if only on the margin, encourage buyers of Spanish and Italian paper, for example, knowing that the insurance product is still legitimate. On the other hand, investors know that if euro zone allowed one of its members to default, it can let others, no matter how unique Greece may be.

3. The US economic data is not giving the doves anything to hang their hats on. Over the past six months, job growth in the US has been the strongest since 2006. This coupled with low interest rates and availability of credit have boosted auto sales to a 4-year high. Sales are rising faster than output and this bodes well for continued gains in manufacturing output. Manufacturing workers may not be a large component of the overall labor force, but it has been punching above its weight in job creation, accounting for almost one in five net new jobs created in January and one in a little more than 7 net new jobs in February.

The auto sales figures and the chain store sales point to the risk of outsized gains in retail sales when they are reported on Tuesday. The headline figure may also be inflated by higher gasoline prices, but the market will likely focus that the core measure that excludes autos, gasoline and building materials, used in GDP calculation and is likely to conclude that the signal is still strong.

4. In our explanation of the euro dollar exchange rate, we often find  the 2-year interest rate differential to embody many of the key forces that drive the investor behavior. The spread is at its widest level since mid-2010. The US pays about 16 bp more than Germany. As the premium Germany offered began to fall from last spring, we became more confident in our negative euro view. At first the driving force was the European debt crisis that saw investors park funds in the short end of the German curve.

However, more recently this has changed. It is the backing up of US rates that is responsible for the last widening of the spread. As recently as late January the US 2-year yield was near 20 bp. It now stands at 32 bp, the highest since last August. The German 2-year yield is essentially flat near the record low set in January of 13 bp. It finished last year at 14 bp.

5. China reported an unexpectedly large trade deficit over the weekend. The $31.5 bln deficit is the largest since at least 1989, according to Bloomberg data. The data still appears to have been skewed by the lunar new year. Imports fell sharply in January and rose sharply in February.

Nevertheless, the data will still be seen as good for investors on two grounds: First, China’s imports are other countries’ exports. Second, to the extent that China reported slower than expected industrial production, retail sales and inflation, Chinese officials are likely contemplating another easing of policy, which could be delivered in the coming weeks.

The unexpected surplus will give investors little reason to change their views that the RMB will be essentially flat this year. This is what the non-deliverable forward market has discounted. This is the signal from Chinese officials.

China says its exports to the US rose 22.6% from a year ago compared with 18.4% growth globally. At $19.4 bln they match China’s exports to Europe in February. China calculations show its imports from the US rose 43.4% year-over-year, to $11 bln. It is also noteworthy China imported its second largest monthly amount of copper and it imported record amount of crude oil for which it paid an average prices of $112.39 a barrel compared with almost $92.30 in January.

6. Few still appreciate the shift that has taken place in respect to Italy and Spain this year. At the end of last year, Italy was paying 200 bp more than Spain to borrow 10-year money. It now pays about 17 bp less. Nearly all of can be explained by the decline in the Italian yield, with a virtuous cycle of the ECB giving banks cheap money to buy government bonds, supporting prices, which in turn helps strengthen bank balance sheets. It cost less to insure Italian exposure than Spanish through the CDS market.

Monti still has to deliver labor market reforms, but his lame duck status makes these measures increasingly vulnerable to dilution. Yet, it is in the politicians' interest to let Monti determine the timing of the extraordinary IMF surveillance that Berlusconi agreed to in principle before being shown the door.

Spain appears headed for an important confrontation with the EU. Neither side can back down. Rajoy cannot reverse the unilateral aspect of his announcement that Spain would turn in a 5.8% budget deficit compared with the 4.4% agreed upon with the EU. The fiscal compact has just been signed and it promises greater fiscal discipline. If it backs down, it loses credibility and calls into question the fiscal compact itself.

7.The bottom end of the euro’s trading range comes in between $1.2980-$1.3000. This may still prove difficult to break, but repeated tests may absorb the euro demand. A convincing break though should be respected. It could be the neck line of a head and shoulders pattern that would suggest a test on $1.25. The 100-day moving average in the $1.3260 area and corresponds to the previous highs, should be enough to contain upticks.

Not only is the dollar sitting at ten month highs against the Japanese yen, but 2-year interest rate differentials are at 8-month highs. At the CME, the net speculative short yen futures position is the largest since last April. Provided JPY80.60 remains intact, the JPY85 area beckons as the next important target.

Sterling will struggle in the firm dollar environment. Moreover, even though last week’s disappointing industrial production data overstates the weakness, the fact of the matter is that is the BOE is more likely to do another round of gilt purchases before the Fed announces a QE3 or the ECB offers another LTRO. A break of $1.5640 area will look bad, but be patient and wait for the $1.5600 level to be broken for confirmation. If this happens, the objective is near $1.53.

The Australian dollar appears to be rolling over. Soft data encourages expectations of another RBA rate cut. Even after lightening up in recent weeks, the market still appears long Aussie. A break of $1.05 gives $1.04, but it is this latter area that must go to confirm a potentially important top. Take a look at Aussie against the Canadian dollar. A six month uptrend is being challenged in the CAD1.0450 area. A break could spur a 2% move.