Dollar Firm Ahead of Key Events

The US dollar is trading near its best levels for the week against the euro, Swiss franc and sterling ahead of ECB and BOE meetings, and US ADP and service ISM.  New market moving developments are scarce and the market has largely traded within the ranges set at the end of last week.  The Australian and Canadian dollars have seen some follow through gains in recent days, but this is the exception to the general rule.  

 News that funds for Spanish banks will not be available on July 9th as initially anticipated and may not be ready until July 20th, and Finland's insistence on collateral for Spanish access to EFSF/ESM, coupled with the new ECB collateral rules have undermined Spanish bonds, with the benchmark 10-year yield rising more than 20 bp and the 2-year yield up 25 bp, in a bearish curve flattening.  Italy's 2-year yield  is also up more than the 10-year, underscoring increased investor anxiety. 

Today also marks the first time Ireland has returned to the capital market for the first time since receiving aid by selling 500 mln euros of 3-month T-Bills.  The average yield was 1.8% and bid-cover was 2.8.  By comparison Italy pays 1.48% on its current 3-month bill.  Spain's 3-month bill yield is below 40 bp.   It is also noteworthy that for the first time in about 2-years, the Spanish 5-year credit default swap is above Ireland's. 

Separately, Ireland reported a another strong industrial production increase in May.   The 1.4% increase was fueled by 1.6% rise in manufacturing output.   The decline in unit labor costs in Ireland has boosted Irish competitiveness and should it be able to shift some of the costs of the bank aid to the EFSF/ESM, it would further lift the outlook for the once Celtic Tiger.  

Elsewhere in the euro zone, the contrast between Germany and the periphery was underscored at Merkel-Monti press conference yesterday.  The German finance ministry revised this year's deficit forecast to 0.5% from 1.0%, citing "favorable overall economic development", which seems like a self-serving explanation, especially given the loss of economic momentum in Q2 and the recent service PMI below 50      (though today's factory orders data was stronger than expected, rising 0.6% vs a flat expectation by the consensus, warning of strong output figures due tomorrow).  Instead, the lower interest rates in Germany, which must be understood as largely a function of the crisis in the periphery, can account for the bulk of the German savings that results in a lower deficit.  

Meanwhile, Monti 'fessed up to the fact that Italy's deficit will overshoot its 1.3% target and reach 2%.  This 2% can be achieved, it appears, only with additional savings.  Monti reportedly plans to announce another 4 bln euro in spending cuts, in an effort to stave off additional tax hikes.  Monti has seen his support rise in the polls.  Many link it to the summit, though Monti's call for a "spread shield"--some automatic intervention to support Italian bonds if the spread reached a certain pre-agreed level--was rebuffed.  Recall that on the eve of the summit, Monti put his labor reforms to parliament and tied to votes of confidence.  This and appearing to stand up to Germany may have generated these results more than substantive results for Italy from the summit.  

The recent string of UK data has been poor and if anything this increases the risk of a larger rather than a smaller move today.  Most are looking for GBP50 bln of gilt purchases.  The risk is for GBP75 bln and there is some risk (subjectively, maybe a 1 in 3 chance) of a rate cut.  

The ECB is likely to cut key rates 25 bp to 0.75% and this will likely entail a cut in the deposit rate.  Some talk of a 50 bp move, but this does not seem as likely.  Even at the end of last year, when Draghi was first making his mark and fairly aggressively so, he cut by 25 bp at two consecutive meetings. 

Lastly, note that China has been flooding the market with liquidity.  In the past, this has been a prelude to a cut in reserve requirements.  If it were to happen, this weekend is a likely time frame.