Rule of Alteration in Play Today for Euro vs. US Dollar

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Highlights

The US dollar and yen are trading with a firmer tone against the major and emerging market currencies.  But the markets still appear to be consolidating and we expect the “rule of alternation” to remain in play meaning that the top side of the euro’s range was tested yesterday and the bottom side around $1.3500 is likely to be tested today in the absence of any key news.  The pound has been rocked by weak data (retail sales, housing data and a worse than expected trade deficit despite the pound’s slide in recent months) and another warning from Fitch that the country is not moving fast enough to address its structural imbalances.  (Fitch also warned Portugal and Spain to put their houses in order.)  That said, the pound is oversold around the $1.4940 support area and amidst talk of M&A related demand for pounds against the Scandinavian currencies.  The Swedish krona is now the worst performer on the day amidst cross related selling and after Moody’s warned the outlook for the Swedish banking system is improving but remains negative. 

Global equity markets are mixed.  The MSCI Asia-Pacific index was barely changed, gaining just 0.1% after reaching a six-week high yesterday.  Japan’s Nikkei was also relatively unchanged, down just 0.2%.  Materials related shares were amongst the hardest hit as gold slipped after China’s Yi Gang, the Director of SAFE, said gold was unlikely to become a primary investment for China’s reserves but noted that given the size of the country’s reserves, the US Treasury market is “an important one to [China]”.  The comments are not overly surprising despite recent rumors China could buy gold from the IMF.  China’s gold holdings make up a very small proportion of the country’s almost $3 tln of reserves.   European bourses have given up early gains with the key bourses down about -0.7% while early indications suggest US markets may open lower.

Global sovereign bonds are firmer.  In Europe, the German and French 10-year bond yields are down 4 bp.  The comparable Greek yield is down 5 bp despite differences of opinion over the German Finance Minister’s proposal yesterday to establish a European Monetary Fund with some officials unwilling to change the rules at this juncture.  That suggests formation of an EMF would come too late to help address current problems in the euro area.  Spanish and Portuguese yields are flat with Fitch warning of a downgrade in Portugal if consolidation is insufficient and that Spain is vulnerable given an inflexible labor market that could prolong a recovery and reduce tax revenue.  At the same time, Fitch said a European sovereign default would not cause a break-up of the euro zone and said the US had no short or medium term problems.  US 10-year Treasury yields are down 4 bp.

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Sterling has come under renewed pressure after a mini perfect storm consisting of weaker than expected data (retail sales, housing and trade), new opinion polls and further warnings from Fitch and Moody’s.  Fitch indicated the UK has a serious row to hoe and that the authorities are not moving fast enough in addressing the deficit.  Last week, Fitch warned the UK is the most vulnerable of the AAA rated countries to financial crisis and should trim its budget deficit more sharply in the next four years.  Today’s warning from Moody’s focused on the UK banks and lenders.  Moody’s said those lenders that have not improved their financial position could be downgraded as government support is withdrawn.  The rating agency had taken the UK government’s GBP1 tln ($1.5 tln) of assistance into account in rating banks but will cease this practice as the money is withdrawn.  The announcements came after the UK released a much weaker than expected housing report from RICs (with real estate agents saying house prices had risen vs. those saying they fell at 17%, vs. 30% exp and down from 31% in Jan) and Feb BRC retail sales monitor confirming a sluggish consumer sector (up 2.2% y/y but from an extremely low Jan 09 base, so far from impressive.)  That was coupled with a widening of the trade deficit despite the weakness of the pound.  The deficit was £7.98bn in Jan (vs -£7bn previously and vs -£7bn expected) while the non-EU trade gap widened to -£3.8bn (from -£2.6bn). This was the worse trade performance since Aug 08 and resulted from a 6.7% monthly drop in exports while imports were down 1.6%. The slump in exports is disappointing at a time of sterling weakness but one should not forget that the UK main trading partner (the euro zone) recovery is extremely sluggish and a weaker currency will do little in the near-term if external demand is very weak to start with. Coupled with the negative adverse effects that the poor Q110 weather will have on GDP growth, the highly disappointing trade figures underline a further drag on economic activity.  It looks increasingly likely that Q1 GDP (due on April 23rd) will be very weak – an unfortunate timing for Chancellor Brown ahead of the May 6th general elections. In this context, some would argue that the case to call the elections before April 23rd is growing by the day.  Note that the most recent Populus poll of 100 key seats shows both Labour and the Tories at 38%.  On the downside for PM Brown, a YouGov poll puts the Tories at 39% with Labour at 34% while the LibDems, which according to leader Clegg, won’t form a coalition with Labour if Brown runs the party, have 16%.  

The Federal Reserve continued its slow but steady march preparing the normalization of monetary policy.  Yesterday, it announced it would expand the counterparties it would use for the reverse repos (which are one of the tools the Fed has indicated it will use to neutralize the excess reserves before it raises rates) to include large money market mutual funds.  Usually the Fed’s activity is focused on the primary dealer community.  Like the earlier steps, there is no policy implication per se, but taken together, would seem to reflect a central bank committed to this process and continuing to "get its ducks lined up" so that it is prepared for the eventual rate hike.  The Fed also indicated that it would use a range of instruments in its reverse repo operations, including Treasuries of course, but also mortgage-backed securities and agency bonds.  Several large money market mutual funds seemed eager to participate, according to news wire accounts.   The Fed’s long-term asset purchase program winds down this month.  It is interesting to note that despite the supply and the absence of the Fed’s buying, the US 10-year yield is off 15 bp this year.  And even though the Fed’s buying of agency securities has slowed, the yields on Fannie Mae and Freddie Mac mortgage securities appears to be the tightest on record compared to Treasuries.

Upcoming Economic Releases

There are no key US or Canadian data releases today.  The Fed’s Evans speaks at 9:30AM EDT/14:30 GMT.

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The preceding is a post by Marc Chandler, global head of Brown Brother Harriman’s top ranked Currency Strategy Team. For more of BBH’s currency views, please visit the BBH FX website here.

This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only.  This communication should not be relied upon as financial, investment, tax or legal advice.  This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency.  This information may not be suitable for all investors depending on their financial sophistication and investment objectives.  The services of an appropriate professional should be sought in connection with such matters.  The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own currencies in the subject of this communication and/or may make purchases or sales while this communication is in circulation.

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