FOMC Sets Dollar Tone

The minutes from the March FOMC meeting have continued to drive the dollar higher, except against the yen, and bonds and stocks lower.  Especially in the context of Bernanke's recent remarks, the, should we say less than dovish, tone to the minutes caught the market wrong footed.

The FOMC in essence tweaked its economic and inflation assessment higher than seemed evident in the FOMC statement following the meeting.  It will encourage many to come around to the view outlined here that the bar to QE3 is high and requires more than the status quo, but a deterioration in conditions. 

That said, the fact that the dollar rallied further even after it was confirmed that US March auto sales were weaker than expected warns that the FOMC/QE3 issue may trump the economic data, including today's ADP data and service sector ISM.  Or perhaps , better said, given those FOMC minutes, the market is likely to show an asymmetrical response to data:  shrugging off weak data and taking the dollar higher on strong data. 

The euro appears to have put in a double top on the daily bars and the measuring objective is near $1.3100.  Initial support may be seen in the $1.3130-40 area.  Sterling support is seen near $1.5850 and a break could signal a move to $1.5750-$1.5800.   The dollar is inside yesterday range against the yen.  support is seen near JPY81.50, though it is has held above JPY82.00. 

 The ECB has much to chew on today and it should be more evident in the press conference than the statement which is no doubt going to leave rates unchanged. The euro zone March PMI’s remain below the 50 boom/bust level. Unlike the manufacturing PMI, the service measure was a bit better than the flash reading at 49.2 compared with 48.7 and it is even slightly better than the 48.8 in February.

The stabilization of the area economy that the ECB had pointed to appears at risk and the data is consistent with a further contraction of the euro zone economy in Q1. While the German reading of 52.1 is an improvement over the flash 51.0 reading it is still down from 52.8 in Feb.

Moreover, the German service sector is under-developed compared to its manufacturing sector and this has been a source of criticism from the EC. Germany, like other countries, is reluctant to restructure. At the same time, the weaker than expected Fed factory orders (0.3% rather than the consensus 1.5% after a revised 1.8% decline in Jan)) warns that even Germany’s manufacturing sector has lost considerable momentum.

The ECB will also be aware of the backing up European interest rates. Part of the increase is the rise of US yields, dragging other bond markets with it, but part of the increase is also the resurfacing of pressures in the periphery. Not only has the Greek PSI not brought closure, but EC Commissioner Rhen acknowledged there may be need for some “bridge” to help Portugal return to the market. Pressure continues to build on Spain, where the first bond sale since the budget was a notable disappointment and Spanish equities continued to be trounced.

The ECB has halted its sovereign bond and covered bond purchases. Under what conditions will they resume? Draghi will also likely be asked about what appears to be a fragmentation of the collateral rules. Not only have some countries been allowed to liberalize their rules, but others, most notably the BBK, have been given the right to refuse bonds as collateral from countries receiving aid. The implications are troubling.

In contrast the UK completed its triffecta with its third stronger than expected PMI report today. The UK service CIPS rose to 55.3 from 53.8 in Feb. The consensus had forecast 53.4. The better than expected PMIs this week are consistent with an expansion of around 0.5% in Q1 after a 0.3% contraction in Q4 11 and contrasts with a likely contraction in the euro zone.

The data reinforces our sense that the doves (Miles and Posen) are unlikely to find more support for additional asset purchases at tomorrow MPC meeting. We expect the BOE to move to a wait-and-see mode after the current asset purchase program is complete next month.

On the other hand, Australia reported an unexpected trade deficit of A$480 mln (the consensus called for a bit more than A$1 bln surplus) and the January deficit was revised to A$917 mln from A$673 mln. Exports fell 2.1% after the 9.0% plunge in January. To state it baldly, there was simply no bounce back after the Lunar New Year distortion.

Following other soft data this week and the dovish official comments, there sense that a may cut is a done deal is increasing and the OIS has is nearly completely priced in. Given how sentiment swings, there is some risk that speculation increases of either a 50 bp move or a cut in both May and June. The next key support for the Australian dollar is near $1.02.