Markets Await China’s Next Move

Highlights
The US dollar is mostly lower as the market anticipates the data deluge from China this weekend (along with the preliminary 50bp hike in reserve requirement) and trading volumes narrow. The euro drifted moderately higher, as light sovereign demand has allowed the euro to test but not break the lower barrier of December’s $1.306 -1.3250 trading range. Meanwhile, cable is an outperformer in today’s session, marching to a 12-day high following producer price inflation measures that were in line with consensus. USD/JPY traded on an easier footing after exporter offers capped gains early on in the session yet head backed to the ¥83.50 range in tandem with the drop in US yields. Elsewhere, the Australian dollar recovered to a 3-day peak following the initial dip on the China reserve move and the USD/NOK was the largest mover on the day as Norwegian inflation numbers remained steady.

Global equity markets are higher, though Asian stocks continue to moderate following China’s 50bp hike in reserves. But Asian stocks still remain positive with MSCI Asia Pacific index up 0.06%. At the same time, the strength in the yen weighs on the Nikkei which is down 0.7%. The loss is led by a -1.3% loss and a nearly 1% loss in consumers following the weak consumer confidence figures. Meanwhile, European bourses are mixed but mostly positive with the Euro Stoxx 600 up 0.06% led a gain in consumer and loss in financials. The FTSE and Dax are headed in opposite directions with the former up down 0.05% (led by losses in financials), while the Dax is up 0.5% led by a nearly 2% gain in consumers.

Euro-zone spreads are up following the downgrade of Ireland’s debt and the review of 10 Portuguese banks stoking a 15bp rise in the Greek 10-year yield. As expected, following the review Portuguese banks 10-year yields are up 10bp. Additionally, Spanish yields are higher, with the 10-year yield up 10bp, amid concern government borrowing costs will rise at next week’s auctions (scheduled for 12/16). At the same time, the German 10-year yield is up 1bp with the price of bunds increasing steadily as the yields on the periphery continue to increase. Meanwhile, the 10-year JGB is down 9bp as signs of waning confidence in the economy boosted demand for safer assets.

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Currency Markets

China raised bank reserve requirements by 50bp, effective December 20. This is the sixth increase this year, two of which happened over the last month, and Beijing announced last Friday that it was shifting to a prudent monetary policy from a moderately loose one, thus signaling a hike of sorts. The PBoC is expected to follow this up with its second rate hike since October, perhaps as soon as this weekend. The official China Securities Journal said as much as this on Tuesday, saying that the central bank may move rates around the release date of November inflation data, which are due out tomorrow (Saturday). Inflation has become a problem for China. For one thing, despite the rapid GDP growth over the past decade, China is still a developing country with per capita GDP of nearly $4,000, according to the IMF. This means that the food consumes roughly 37% of consumer’s incomes and the run up in food prices has certainly been has exacerbated China’s inflation problem.

The Chinese government has utilized its food supply reserves to help moderate prices but the other pull on inflation is money supply growth and banking lending. Following the world’s largest stimulus package (measured as a percent of GDP) Chinese M2 money supply growth, along with banking loans, nearly doubled to 30% y/y growth in early 2009 from 15% in mid 2008. And following a gradual slowdown in mid 2009 to early 2010 liquidity and credit growth have started to increase at rates around 20% y/y. With China’s financial conditions improving and the economy growing near potential, excess liquidity poses a tough challenge at this stage of growth. Excess liquidity, in effect, may stoke asset bubbles. Meanwhile, the China Security Times cited an unnamed source saying November CPI will be only slightly higher than October’s 4.4%, though the market consensus is for 4.7%. October’s 4.4% inflation clip was the most since September 2008, and compares to a -1.8% y/y low point in July 2009. The PBoC raised rates in Oct, the first tightening since 2007, while Beijing has additionally been implementing various quantitative tightening initiatives with more to follow.

One of the most important developments in recent days has been the sharp backing up of global interest rates, spurred primarily by indications that contrary to expectations, US fiscal policy is in play again beyond simply preventing the expiration of the 2001 and 2003 tax cuts. While the rise in US rates has helped keep the dollar supported, we are concerned that two-year German rates have risen even faster than 2-year U.S. interest rates and that this may serve to dampen the ability for the dollar to extend gains against the euro significantly without continued poor news stream from Europe. This interest rate spread has tracked the euro-dollar exchange rate very closely throughout the year. The US-German 2-year yield differential is the most in Germany favor since before Thanksgiving. It is testing its 20-day average for the first time since Nov 21. Neither Fitch’s 3-notch downgrade of Ireland nor Moody’s review of 10 Portuguese banks for possible downgrade, nor Fitch’s downgrade today of several Irish banks and some of their bonds, including the guaranteed debt of several institutions have managed to keep the euro below the low seen before the release of the disappointing jobs data at the end of last week. Given that the news stream for Europe is not likely to improve markedly, the benefit for the wider interest rate differential may be more muted to limited to limiting the downside of the euro than truly lifting it significantly. Initial resistance in the euro is seen around $1.3300-$1.3325. It may take a move above $1.3350 really squeeze the euro bears.

Upcoming Economic Releases

At 8:30 EST / 13:30 GMT the US releases November’s import prices. The m/m figure is expected to decrease to 0.8% from 0.9% in October. The y/y is expected to fall as well to 2.8% from 3.6%. Next, the US reports December’s UoM confidence number which is expected to increase to 72.5 from 71.6 in November. In Canada, October’s international trade balance is expected to narrow to –C$2.1bln from –C$2.5bln in September. Meanwhile, Mexico’s fixed investment is expected to increase to 5% from 4.8%. Events:Volcker Speaks on panel at 9:00 EST / 14:00 GMT.

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