Dollar Bid on Tapering Thoughts and Disinflation in Europe

Armistice Day in Europe and Veterans' Day in the US yesterday denied investors an overall theme, but today the drivers are clear: rising long-term US interest rates are taking place amid falling price pressure in Europe.

On its own, the former has helped lifted the dollar to nine week highs against the yen, stopping just shy of the JPY100 level. While that level may hold some psychological significance, note that the September high was set nearer JPY100.60 (September 11). The premium the US government pays over Japan for 10-year borrowings is at 218 bp today.   The spread peaked in near 222 bp on September 10. 

Five European countries reported soft inflation figures today.  These include Germany, Italy, Portugal, the UK and Sweden.  These reports have generally weighed on the respective currencies today.   The traditional way in which European countries regained competitiveness lost to Germany economic prowess, if not the mercantilist tendencies of its ordo-liberalism, was through devaluation.  Monetary union denies participating members this path.     The path now is seen through internal devaluation, which is tantamount to having lower inflation than Germany.  This is no mean feat as Germany reported Oct CPI was 1.2% above a year ago.  

This requires other countries to have even lower inflation, which forces a flirtation with deflation, a decline in the general price level, and ruinous for debtors (and therefore creditors).    Italy today reported Oct CPI at 0.8%.    Like Greece and Spain, Portugal reported its year-over-year CPI has fallen into negative territory.  The unchanged monthly reading in October saw the year-over-year rate fall to -0.2%, though the EU harmonized measure shows the year-over-year rate at 0 down form 0.3%. 

Sweden slipped back into outright deflation in October, with its CPI standing at -0.1% year-over-year.   Recall that from Nov 2012 through June 2013, Sweden did not report a year-over-year positive CPI.  In Q3 CPI was 0.1% .  Its core rate is still positive at 0.6%, slightly above the lows seen since the financial crisis.    The euro firmed to new highs for the year against the krona (just above SEK8.90).  The high from last year comes in near SEK9.17.    The euro has also extended its recent gains against the Norwegian krone, pushing above NOK8.32 today.   The euro closed October near NOK8.055. 

Of the high income countries, the UK has stood out with its stubbornly high inflation.  Base effects and the 7.5% rise of sterling on the BOE's broad trade-weighted index over the past 18 months, was expected to see price pressures ease.  The UK reported headline CPI fell to 2.2% from 2.7% in September.  Economists had expected a smaller decline to 2.5%.  The biggest pressures on the year-over-year rate stemmed from transportation and education.  This is a four-year low for UK inflation.  It has not been this close to its target since 2009.  The core rate fell to 1.7% from 2.2%, which also represents a four-year low. 

The price action is technically significant.  Sterling has been sold through the mid-October lows, which served as a neck line to a double top set near $1.6260.    The measuring objective of the pattern is near $1.5520, which corresponds to a 61.8% retracement of the 14.5 cent rally off the July lows.   It is also near the 200-day moving average ($1.5495).  First, sterling needs to finish the North American session below the neckline, which is just below $1.59.  

Note too some participants are linking the sell-off in sterling to the M&A in the pharma space.  The UK's Shire has reportedly agreed to buy the US-based ViroPharma for $50 a share in cash (~$4.2 bln), which is a little more than 25% of last week's closing price.   We typically are skeptical of the general impact of much cross-border M&A impact foreign exchange prices (often the funds are raised through borrowing the currency rather than buying it, for example), but we have to be open possibility that any one transaction, especially a cash deal, may have impact directly or indirectly. 

For its part, the euro remains within yesterday's trading range against the dollar, which was within last Friday's, which itself was within last Thursday's broad range established by the ECB's surprise rate cut and the stronger than expected preliminary Q3 US GDP.    Although we have argued that the refi rate cut will be ineffective in addressing the threat posed by deflation, slowing money supply growth, continued contraction in lending to households and businesses, and the decline in excess liquidity in the banking system.  

However, we do recognize that Italy's auction of 1-year bills today, the first auction after the ECB's rate cut, saw yield sip to record lows of 0.688%  and the bid-cover was slightly better at 1.80 than last month (1.72).    However, do not jump to the conclusion that this is representative of the country's funding costs, after all, he average maturity of the government debt is closer to 7-years and there yields appear to be bottoming, after falling about 70 bp since the Fed decided not to taper in September.