Fear Overwhelms Everythng, Drives Dollar Higher

There driver of the capital markets today has a name:  Fear.  It has overwhelmed nearly every other consideration and is driving the dollar higher against all the major and emerging market currencies.  

Even the Japanese yen is not match today.  Despite narrow interest rate differentials and heightened anxiety, the dollar is trading at its best level against the yen since May 3.  In fact, although the euro is at the epicenter, and made new lows for the move as it approaches the year's low set in January near $1.2625, it is gaining modestly today against both sterling and the yen.

Talk of a Greek exit continue to run high and contingency plans are being developed.  They underscore complication and the likely costs involved.  There won't be any winners.  Greece will be plunged into an economic and political nightmare that may even make Argentina's experience look like a tea party.  

We have noted the geo-strategic importance of Greece as well, and note today that a recent poll of 60 important policy makers by the Atlantic Council and Foreign Policy magazine found that Greece was picked by the most (18) as their pick to be ejected from NATO (ostensibly over treatment of Macedonia and Turkey).    The direct costs of a complete unilateral moratorium on the rest of Europe is at least 400 bln euros and this does not take into account contagion and other knock-on effects.  

The odds of a country leaving the euro zone continues to edge higher on the www.intrade platform.  At pixel time, the odds stand at 42%, 60.8% and 65% respectively for the end of 2012, 2013 and 2014.  The 2012 odds are approaching twice the level that prevailed prior to the election.  

Spanish and Italian bond yields now are well above 6%. Germany and France found little difficulty in selling their bonds today.  A few German auctions recently were under-subscribed, but not so today with strong safe haven bids.   Economic data from the euro zone can be lost in the fear-driven market and participants barely noticed that EMU CPI edged lower in April to 2.6% from 2.7% in March.    

Talk of an emergency ECB meeting appears to have fallen wide of the mark.  Note that yesterday IMF's Lagarde reiterated the institution's view that the ECB can cut rates.  While a rate cut next month cannot be ruled out entirely, it is important to understand that the ECB draws an important distinction, as does the Federal Reserve, between liquidity provisions as such and monetary policy.  The latter is about interest rates.  The former is about quantities.  

The first step from the ECB to address the current flare up is not a rate cut, after all Q1 GDP reported yesterday was flat, while the ECB was likely prepared for a modest contraction.  Rather the first line of defense would be a resumption of its sovereign bond purchases.  While there is talk of another LTRO, that also seems quite a bit less likely than sovereign bond purchases.  

While EMU's future, or lack thereof, is once against the overwhelming focus in the market, sterling's decline in recent days is noteworthy.  Sterling began the week above $1.61 and today broke below $1.59.  

We never really liked the M&A story cited by some banks to explain sterling strength.  While we acknowledge some related demand around some announcements, there is a difference between that and real flows.  We have pointed out that often in M&A transactions real flows lag the announcement by months, if not quarters and often corporate Treasuries will not buy the target currency but borrow it.   

In any event, the bloom is off the rose.  The asymmetrical response to data today suggest stale longs are being forced to exit.  First the UK reported better than expected jobs data.  Although the unemployment rate was unchanged at 4.9%, the jobless claims fell by almost 14k, whereas the market had been looking for an increase.  Sterling did not gain any traction on the report.  The wage component of the employment report has an extra month lag and covers the month of March and wage pressure continued to evaporate. 

Secondly, the BOE issued its inflation report.  It was dovish--there is no doubt- and sterling was sold on the news, triggering more stops, and recorded its sub-$1.59 print in reaction.  

Less than a fortnight ago, the BOE decided to let its asset purchase scheme end without renewing it.  The dovish inflation report may spur speculation that it will resume shortly.  Yet one cannot help but suspect that the MPC had a good sense of what was going to be in the inflation report at the MPC meeting and it alone won't change official views.  

Moreover, as we have noted before, despite what economic theory may say, in practice, those countries that have pursued some form of quantitative easing, from Japan and Switzerland the US and UK, have not, for the most part, experienced currency depreciation as a result.  More importantly, sterling was the only top tier currency that speculative players had built up a net long position in the futures market.  Sterling's slide appears to be stale longs being forced to the sidelines.