Dollar Strong on Continued Concerns over European Debt

Highlights

The US dollar has begun the new month off on strong footing against both and emerging market currencies.  The yen is the sole exception.  There are three drivers today.  The first is economic data from China and Europe that play on fears that the financial turmoil is taking a toll on the real economies.  The second is continued concerns about European debt situation, with some speculation spread to France today.  Third, political leadership is severely challenged.  Japanese Prime Minister Hatayama is apparently considering stepping down and the President of Germany Koehler resigned yesterday and the deputy CDU leaders Roland Koch, and premier of the state of Hesse resigned last week.  The net consequence is that the euro has been driven to a new low (since April 2006) and is now in the middle of the life-time range.  No currency seems unaffected by the rise of risk aversion.  Even the Canadian dollar, which one would expect to be supported ahead of the central bank meeting that is widely expected to result in the first rate hike for a G7 country, is under pressure today. 

This continues to be a poor environment for global equities.  The MSCI Asia Pacific Index slipped 0.8%.  News that China’s PMI fell to 53.9 from 55.7 in April, a somewhat larger than expected decline took its toll on commodity and share prices.  European bourses are down even more, with most markets off at least 2%.  Financials are among the weakest sectors not only in Spain, Italy, Portugal and Ireland, but also Germany and France.   Weak commodity prices are weighing on basic materials and oil and gas shares as well.    US indices are called around 1.5% lower. 

Flight to safety is evident in the fixed income market.  US Treasuries and German bunds are out performing, with 10-year yields off 5 bp.   Peripheral European spreads are wider over Germany.  So is the premium that France pays over Germany (3 bp wider today—a third of the year to day widening).   Separately, Chinese money market rates rose to 19-month highs today (key seven day repo rate jumped 69 bp to 3.2%).  However, this is unlikely to be a harbinger of an official rate hike.  Part of the pressure should ease after tomorrow’s CNY40 bln (~$5.9 bln) convertible note issuance by the Bank of China.  Another part of the pressure is coming form the PBOC’s attempt to drain liquidity from the banking system.  Today it sold half amount of T-bills it did a week ago (CNY15 bln) but at about an 8 bp higher yield (2.0096%).  Lastly, as widely expected the Reserve Bank of Australia kept rates steady at 4.25% and the statement suggested a more neutral stance. 

Currency Markets

The euro is plagued by two things:  what the market knows and what the market suspects.  What the market knows has increased today with the euro zone manufacturing PMI readings for May.  While readings remain above the 50 boom/bust level, the pace of activity slowed.  For the euro zone as a whole the headline pace slowed to 55.8 from 57.6 in April.  Separately, the region’s unemployment rate rose to a 12-year high of 10.1% in April, though Germany reported a decline to 7.7% (from 7.8% as the unemployment queues fell 45k, more than twice the consensus expectation.  This plays on fears that the fiscal consolidation in Europe will slow growth.  The market also learned from the EMU’s stability report that European banks may have to write down another 195 bln euros in the 2010-2011 period.

What the market suspects is that European officials are still behind the curve.  Since announcing and arguably exaggerating the 750 bln euro package (exaggerated on the grounds that the 250 bln euros from the IMF are theoretical and IMF assistance has not been requested by any member outside Greece), and delivery mechanism and conditions have not been established.  Moreover, details from the term deposits at the ECB suggest it is only reluctantly buying European bonds.  The term deposits are the way in which the ECB is sterilizing the purchases.  Judging from this, it appears that the ECB bought 16.5 bln euros in the first week of the program, 109.5 bln euros the second week, and 8.5 bln last week, for a total of about 45.5 bln euros.  Reports suggest that every morning the ECB’s Market Operations Committee meets at the ECB and a decision is made and then the ECB with the national central banks coordinate their purchases.  Both of the leading candidates to replace Trichet at the end of his term next year, Weber and Darghi advocate a quick end of the purchases.  The heightened pressure in the European debt markets suggest it will still be involved.  There are some reports (e.g. Spiegel Online) that suggest German banks made a ‘voluntary’ commitment to the Finance Ministry not to sell Greek bond holdings, while there is concern in Germany that French banks have been eager to sell their Greek bonds to the ECB.

The Bank of Canada meets today.  All of the primary dealers in a Reuters poll expect a 25 bp rate hike today, the first in the cycle and the first from a G7 country.  A Bloomberg survey found 25 of 27 respondents expect a hike today.  Yesterday’ stronger than expected Q1 GDP data (6.1% annualized pace) and the record April jobs gains underscore the strength of the Canadian economy.    The setback in the Canadian dollar, which has slid more than 5% in the last six weeks, may mitigate one obstacle to a rate hike (namely currency strength).  The main weight on the Canadian dollar appears to be emanating from unwinding risk on trades and the pullback in commodity prices, rather than something Canadian specific.  We continue to favor the Canadian dollar for medium term investors.  A rate hike today by the BOC, though may also help another currency, the Swedish krona, albeit indirectly.  Here is the logic.  Sweden’s economy is chugging along.  Bucking the trend of softer PMI readings, Sweden’s manufacturing PMI rose to 66 from 64 in April (the consensus was for a decline to 62.3).  The Riksbank’s stability report underscored the relative health of the Swedish banking system.  The Riksbank meets on July 2.  Although Sweden is of course more integrated into Europe than Canada, if European financial crisis does not prevent the BOC from hiking, it may not stop the Riksbank either.    Long Swedish krona against sterling looks attractive from the technical and fundamental vantage point, though the UK did report a better than expected manufacturing CIPS (58 vs 57.9 consensus).

Upcoming Economic Releases
The US reports May manufacturing ISM at 10:00 EST/14:00 GMT.  A modest pullback from the 60.4 April reading is expected.  At the same time, April construction spending is released.  A 0.1% rise is expected after a 0.2% gain in March.  The Dallas Fed’s manufacturing report is out 30 minutes later.  The Bank of Canada’s decision is at 9:00 EST/13:00 GMT.