Three Observations to Start the Week

There was a brief attempt in early Asia to extend the US dollar's pre-weekend decline, but this proved limited and buying reemerging especially in Europe.  Concerns about the extent of private sector involvement in Spanish aid seems to be the main talking point and is more evident in the equity market, where financials are the weakest sector (off more than 1% near midday), than in the sovereign bond market, where yields are slightly higher and the sovereign credit default swap is a few points lower. 

The euro has moved within 20 ticks of the two year low against the dollar seen before the reversal on Friday, and also continues to be sold on the crosses.  The dollar's heavy tone against the yen is a notable exception to the general greenback strength.  The dollar has dipped below JPY79 for the first time in nearly a month.  Additional chart support is seen near JPY78.60. 


In what could be a quiet mid-summer week in the foreign exchange market, there are three issues that stand out:  Bernanke's semi-annual testimony, the European finance ministers meeting and heightened geopolitical tensions.

Bernanke's testimony before Congress will be scrutinized for hints about new asset purchases. Surveys suggest a majority of primary dealers continue to expect QE3 to be announced and simply pushed back the timing from the spring to the summer and now September is seen as the next likely window.  

Many observers also play down the impact that the first two rounds, but continue to believe the Fed will continue this course.   Instead, some officials are looking for alternatives.  As the FOMC minutes put it: "several participants commented that it would be desirable to explore the possibility of developing new tools to promote more accommodative financial conditions and thereby support a stronger economic recovery."  

In response to a question at the post-FOMC press conference, Bernanke indicated that the UK "funding for lending" program was the type of program that the Fed will look at.   Yet before the UK's program, earlier in the financial crisis, the Fed had the Term Auction Facility.  Leaving aside the mechanics, the UK's innovation lies in providing incentives to banks to make new loans to the private sector. The Fed could also reactivate another facility that made loans to banks using newly minted asset-backed securities as collateral. 

The European finance ministers meet at the end of the week.  The goal is modest.  Approve the terms of the aid to Spanish banks.  The details have largely been leaked.   It is not a game changer.  The market will continue to fear that Bundesbank President Weidmann is correct when he suggested that Spain's problems are much larger than its banks and it should seek a full aid program.  

There are a number of issues below the surface that will continue to fester after this week's finance ministers' meeting the last until September and reports indicate it is some acrimonious that there might not even be a physical meeting, but a video conference instead. 

These issues include:  Is there a plan B if the German Constitutional Court rules against ESM on Sept 12?  What to do about Greece, which reportedly has missed 210 of the 300 targets agreed upon (and needs funds to pay for a maturing bond the ECB holds)? How much does Cyprus need? Won't Portugal need a second aid package, especially in light of its Constitutional Court ruling against some public sector pay cuts (the non-payment of summer and Xmas bonus payments was discriminatory because it did not apply to the private sector as well)?  Does Slovenia need assistance?  Will Ireland be able to return to the capital markets in H2 13 as planned if the bank debt is not removed from the government's balance sheet ?  

In terms of geopolitical risks, the Syrian and Iranian situations are well known, but what seems to be less appreciated is the flare up of tensions in the South and East China Seas.  The Chinese frigate that ran aground  on a shoal near the Philippines was refloated over the weekend and this helped to avoid a more intense crisis.  However, the unresolved territorial dispute was evident at the recent ASEAN summit, which for the first time in 45 years failed to agree on a statement, reportedly because of this precise issue.   

The tensions in the East China Sea remain at a high level.  Ishihara, the governor of Tokyo is delivering Prime Minister Noda a fait accompli.  Noda cannot distance himself from Ishirara's offer for Tokyo to  buy the disputed Senkaka Islands, or what the Chinese call the Diaoyu. Noda appears to have exhausted his political resources in securing passage of the controversial increase in the retail sales tax.  Some observers do not expect him to remain prime minister for more than a few more months.  

In any event, the potential nationalization of the islands, elicited a strong reaction by Chinese officials.  The Japanese ambassador to China  warned that the sale of the islands could spark an extremely grave crisis and has been recalled home for further consultation.  In the middle of last week, Japan protests China state fisheries patrol vessels in the disputed waters. 

There are various forces at play that seem to prevent Chinese officials from being able to back down very much.  Any compromise now, China officials seem to recognize, will weaken their negotiating hand in the other numerous unresolved territorial disputes.  In the middle of a transition period in China is a difficult time to show anything that can be interpreted as weakness in pursuing national interest.   Recall the dispute over this area led to a souring of Japanese-Chinese relations in 2010.