Dollar Firmer on Eurozone Debt Concerns

Highlights
The US dollar is enjoying a firmer tone, but has remained confined to its pre-weekend trading ranges.  The euro is the hardest hit and although Nobel prize-winning economist Stiglitz pressed his pessimistic outlook for the euro zone and especially Spain, the market reaction outside of foreign exchange has been quite limited.  Talk of a hostile bid for a US pharmaceutical company for an estimated $18.5 bln might be a more important factor.  That said, the Swiss franc and yen are holding in the best, which may speak to risk-aversion in the foreign exchange market.  Emerging market currencies are also lower.  There may be some disappointment that Dimla Rousseff’s victory was by an insufficient margin to prevent a run-off round at the end of the month.  This could see the high flying Brazil real ease back after a strong pre-election advance. 

Asian stocks climbed on optimism regional economic growth will support corporate profits, although many of the overnight gains were given back over concerns of Chinese housing.  The MSCI Asia Index, for example, climbed to its highest level in 5 months, rising by 0.5%, subsequently falling back.  The leading gainer in the region was Shanghai’s composite, up 1.7%, while benchmarks in Hong Kong, Taiwan, India, Australia and Singapore all gained. In contrast Japan’s Nikkei slipped back 0.3% as banks suffered.  European stocks fell for a sixth day, led by a retreat in basic materials and oil & gas.  By midday in London the Stoxx Europe 600 Index sank 0.5% amid concerns the economy is slowing as Europe’s sovereign-debt crisis curbs growth. 

Japanese bonds climbed amid stock declines and ahead of the BOJ policy meeting which many expect to result in further monetary easing. 10-year JGB yields dropped 2 basis points to 0.935%. 5-year yields fell to 0.24%, the lowest level since June 2003.  German 10-year government bonds snapped two days of declines as renewed concern that highly indebted nations may struggle to finance their deficits.  The German 10-year yield, for example, fell by 4bps, though the statement made by Joseph Stiglitz of the euro’s imminent demise was largely shrugged off by the periphery.  In fact, the 10-year yield on Greek debt fell by 15 bps, Ireland by 10 bps and Portugal 3 bps.  In the US Treasuries gained, with 10-year yields down 4bps to 2.46% and 2-year yields down 1bps to 0.40.

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Currency Markets

The key question today is whether the setback in the euro, after a marginal new high was recorded in early Asia above $1.3800, or if it is the start of a more sustained correction.  Since September 10, the euro has advanced more than 9%.  In the three weeks since then, the euro has fallen one day in each week. The Commitment of Traders data released late Friday showed a large jump in net speculative longs.  Recall that since from December last year through most of September, the net speculative position at the IMM has been short euros.  At the end of September, the net position had swung long and last week, it jumped from almost 5100 contracts to 35.3k, which is the highest since last October.  Our analysis has placed an emphasis on interest rate differentials.  This continues to work in the euro’s favor.  Last week, euro zone banks chose not to roll over roughly 80 bln euro financing despite the ECB’s readiness to provide an unlimited amount of 3-month money.  Three-month Eonia stands at 71 bp today compared with 55 bp last week.  Six month Eonia stands near 74 bp from 59 a week ago.   The short-end spread is at new wide for the year today.  The Dec 10 Euroibor vs Dec Eurodollar spread now stands near 72 bp from.  The June 11 spread is also at new widening for the year.  The two-year US-German spread widened to almost 44 bp in Germany’s favor before the weekend, which is the high since last December and is near 42 bp today.    In addition to these interest rate developments, we note that the hourly RSI (14 period) is at its lowest level since this leg of the euro rally began on September 10.   We are inclined then to view this euro pullback as a new opportunity to buy the euro.

There are varied voices from the Federal Reserve in recent days and the media has been playing up these differences.  However, too often it seems, that not enough attention is paid to who actually is a voting member of the FOMC and who is not.  Several of those who seem to be reluctant about embarking on a new long-term asset purchase operation, like Dallas’ Fed’s Fisher and Philadelphia Fed’s Plosser are not voting members.  In this context, we would place emphasis on NY Fed’s Dudley’s speech before the weekend.  As the vice chairman of the FOMC his view is likely to be reflecting the emerging consensus.  The key part of his message was he favors additional measures “unless the economic outlook evolves in a way that makes me more confident that we will see better outcome for both employment and inflation.”    Dudley also seemed to speak for an emerging consensus was he suggested that inaction is unacceptable when the tools exist that could help alter expectations and economic outcomes.   On the other hand, the Us debt market has already responded quite favorably to the Bernanke’s Jackson Hole speech and the FOMC statement last month and, making conservative assumptions, it would appear that as much as half of the impact 25 bp of 50 that many expect may have already been discounted. 

In the UK, the construction PMI rose to 53.8 in September from a recent low in August of 52.1.  Yet the headline figure was largely above consensus which expected the index to drop to 51.4.  The headline figure marked the first m/m rise since after May after falling from a recent peak in the spring of 58.5 to last month’s recent nadir.  Despite the upbeat news, the outlook for the construction sector remains extremely challenging.  As today’s survey suggests, the recent worsening in consumer sentiment suggests that housing activity is weakening. This is exasperated by the ongoing tightness in the credit markets.  In addition, in the coming months the outlook for construction remains bleak as the UK government is slated to cut government expenditures which may lead to a cancellation of civil engineering projects.  All in all this will be weighed by the MPC members this week as the string of weak data, coupled with the dovish comments from Adam Posen, may be signals that the MPC will follow the Fed’s lead on QE2.  Indeed, any policy that focuses on tighter fiscal and weaker monetary may lead to further sterling weakness.

Upcoming Economic Releases
At 10:00 EST / 14:00 the US reports Factory Orders for the month of August.  The consensus is for a 0.4% drop from a 0.1% increase in July.  In addition, Pending Homes Sales for the month of August which are expected drop from last month.  There are no major reports in Canada but Mexico releases its Consumer Confidence numbers for the month of September at 10:00 EST / 14:00.   And finally, the Fed’s Sack speaks at 11:30 EST / 15:30 followed by Bernanke’s speech on fiscal sustainability   at 3:00 pm EST/ 19:00 GMT.

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