Busy Week Winds Down, Consolidation Main Feature

The foreign exchange market is finishing the busy week on a quiet note. This week, the US dollar has recovered against the major currencies, but the Australian and New Zealand dollars. The main driver was backing up US money market rates in response to an increase in the Fed funds forecast by Fed officials (25 bp 2015 and 50 bp in 2016). 

In addition, Yellen's attempt to clarify what a considerable period is in terms of the gap between when the asset purchases are completed and the first rate hike to around six months also spooked investors and helped lift the dollar.

Today will be an opportunity for Fed officials to weigh-in and react to what the market has done. There are four officials that speak today. Kocherlakota, who was the only dissent, could explain his concern about the asymmetry upon which the Fed appears to be embracing its inflation objective. Fisher is part of the hawk camp and probably does not personally disagree much with what Yellen said. Bullard is a non-voter, and this may leave it to Governor Stein as the most likely to help investors understand what Yellen meant.

We do not think Yellen meant to signal a hike as early as Q2 2015. Assuming Fischer and Brainard are confirmed, this will likely alter the "dot plot" in June, but this is too long to go without some verbal push back to the sharp backing up of US rates. However, the rub is that economic data is likely to improve from what has been seen at the start of the year.

At the same time, pressure is mounting on the ECB to take action. Next week, the euro area reports the flash PMIs and money supply and lending data, ahead of the preliminary March CPI on March 31. These will help shape expectations for the early April ECB meeting.  

The spring election season in Europe kicks off this weekend with the first round of municipal elections in France. Although the Socialists may hold on to Paris, the risk is that the Prime Minister's party is soundly trounced this weekend. Many will watch how the Le Pen's National Front does, which is running around twice the candidate they did in the last municipal elections as it gears up for the EU Parliamentary elections in May.

China and Russia remain very much at the center of investors' focus. The yuan moved by a little more than 1% from the fix, for the third consecutive session, but finished a little stronger on the day. For the week, the yuan depreciated by a what appears to be a modern record of 1.2%. The widening of the band to 2%, last weekend, appears to have permitted the yuan to explore fully the old 1% band. 

We note that 3-month implied volatility edged up to 2.6% from 2.45% at the end of last week. While some observers have suggested the CNY6.20 level was a key threshold for structured leveraged products, we suspect it is more a sliding range rather than a single trigger. The 2.7% rise in the Shanghai Composite today, the largest advance since last November, led by a 3.6% rise in financials bears out our point.

Russia's rating outlook has been changed to negative by both S&P and Fitch. More US and European sanctions have been implemented. While Obama has been authorized to implement economic sanctions, Europe, with closer trade ties is more reluctant at this stage. Reports suggest that senior Russian officials have informed the US officials that there is no intention on using military force in east Ukraine. There is some thought that the situation may stabilize in the coming days. 

Russian shares are lower today by about 2% near midday in London but are still up almost 5% on the week. The rouble itself is a bit weaker on the day, paring this week's gains to about 0.7%. To the extent there is strain, it is from the bond market, where the 10-year yield is up 25 bp today. This reverses this week's decline and puts the yield up about 10 bp on the week.

Canadian retail sales and consumer prices are the main economic highlights for the North American session. The Canadian dollar has lost over a 1% this week, weighed down by what appeared to be a divergence between a dovish Bank of Canada and a hawkish Federal Reserve. The market is likely to be more sensitive to a weakness in CPI than strength in retail sales. Old resistance for the US dollar near CAD1.12 now offers support. On the upside, a spike on the headline toward CAD1.1280-CAD1.1300 is possible.

Lastly, we note that the Federal Reserve custody holdings, which fell by almost $105 bln in the week ending March 12, jumped a little more than $32 bln the week ending March 19. While last week, it seemed understandable that Russia could have moved its reserves away from the Fed before US sanctions. However, the sharp rise this week is less understandable and may even cast doubts on the Russian hypothesis. We don't have a good explanation for the increase and suspect the settlement of the US auctions is not sufficient. Some have suggested that it could be China, who theoretically is selling yuan, but we are less convinced due to the scale. In any event, we will continue to monitor developments.