Dollar Ends Week on a Whimper

Highlights
The US dollar is broadly lower in anticipation of a joint aid package for Ireland but experienced a quick jolt on the back of the China reserve hike news.  But as the markets digested the news, the hike in reserves is largely being shrugged off as a soft measure to tame inflation.  The euro continued to gain on the dollar, trading up to $1.373 highs while cable was boosted towards $1.61 as a result, but subsequently fell back to the $1.60 area.  Meanwhile, the dollar has given back some moderate gains on the yen as US yields drop and to a lesser degree investors seek refuge from the China reserve hike.  Otherwise, the Australian dollar, being the most sensitive to activity in China, is still down following the news after nearly reaching parity, again, early on in the session.  And due to the lack of economic data we will not be publishing an economic calendar. 

Global equity markets are mixed following a strong North American session with stocks down in Europe and moderately declining in Asia after China raised its reserve requirements to stem inflation. The MSCI Asia index is up 0.2% with positive gains in the Nikkei and Shanghai. The 0.9% gain in the Nikkei is led by outperformance in consumer services and health care with a 0.8% gain in the Shanghai index led by technology and health care.  Technology shares are up 5% on the day.  In Europe stocks declined with the Euro Stoxx 600 down 0.7% driven by a material loss in financials.  Meanwhile, the Dax and FTSE are both down marginally with the selling pressure on financials.

European sovereign bonds yields continued to moderate as a rescue package for Ireland’s banks appears to be in the works and may be announced as early as this weekend.  Irish 10-year yields are down 9bp yet Portuguese yields are up 1bp on the day.  Although many are concerned, we included, that once a resolution is put in place for Ireland that the burden of speculation may shift to Portugal.  While Portugal has no plans to sell more bonds this year, bond markets have continued to drive up yields over Portuguese budget concerns. Meanwhile, 10-year German yields are down 2bp with the 10-year US Treasury down 1bp.

Currency Markets

In an unsurprising move China raised its bank’s required reserves by 50bp, to be effective November 29. This is the fifth hike in reserve requirements this year, amongst other bank lending restrictions, while interest rates have been hiked once. The measures were taken as China continues to grapple with y/y inflation of 4.4% following, on a relative basis, the world’s largest stimulus package.  China’s problem with inflation is twofold.  One, the sharp rise in the cost of food, coupled with very low household incomes, means that food expenditures control nearly 70% of most folk’s budget.  So the nearly 18% gain in agriculture prices, measured by Bloomberg’s CMCI Agriculture index, has disproportionally impacted poorer countries and led to the rapid rise in inflation.  Reports suggest that China, beside rate hikes, is releasing some its reserves of grain in an attempt to quell the rise in food prices.  On the other hand to inoculate itself from the global financial crisis and the sharp contraction in global trade China enacted the world’s largest stimulus package, estimated around 15% of GDP.  This led to targeted lending and money creation, which in the course of a year nearly doubled the money supply.  As such, asset prices took off led by a sharp rise in the price of equity and housing.  Therefore the contractionary policy measures being pursued are expected to moderate output and allow China to ease some of the price pressures to make way for a soft landing.  At the same time, there is also a strong consensus that China’s PBoC will hike rates within the next couple of weeks, to follow up its October 19 quarter point rate hike, and there is speculation that the next move might be considerably more than 25bp given concerns that the PBoC might be falling behind the curve with regard to inflation as supply-side factors continue to drive up agriculture prices.

The US dollar is finishing the week on a soft tone after having seen the post-QEII gains extended at the start of the week.  The prospects of an Irish aid package continue to hang over the market like the sword of Damocles.   This has helped spur the dollar’s downside correction over the last couple of days after rallying for 8-9 consecutive sessions.  The initial target for the euro is near $1.3770, with a break spurring another cent advance.  Support is seen now in the $1.3650-70 area.  While European developments may be encouraging the dollar sales, the recent behavior of the 2-year spread between US and Germany and the 3-month risk reversals are also signalling a softer dollar environment.  Germany is offering 62 bp more than the US on the 2-year government obligations.  This is the most since Nov 3 when the FOMC announced QEII.  The market had been willing to pay a growing premium for euro puts over euro calls and it reached almost 2% in the middle of the week.  Yesterday it was reduced sharply and there is follow through today.  The premium is falling below its 20-day average for the first time since Oct 19.   The euro’s recovery is ironically leading to an under-performance by sterling against the dollar as the euro rebounds on the cross; recovering from a 5.5% slide against sterling since last Oct.   Support for cable is seen in the $1.6020-50 area.  The euro’s recovery against the Swiss franc allowed the dollar to test CHF1.0000 yesterday, its highest level since Sept 21.   Dollar support is now seen in the CHF0.9800-20 area.    Short-term interest rate differentials between the US and Japan have also moved against the dollar-yen since mid-week.  The JPY83.75 area looks to cap the greenback.  A break of support near JPY83.00 could see erosion toward JPY82.40 in short order.   With one of Australia’s largest mining companies announcing a A$8.4 bln investment (over 2.5 years) to expand iron ore production should ease concerns about the mining tax and blunt the impact of Chinese tightening.  The Australian dollar is encountering resistance in the $0.9900-20 area.  A convincing move through there brings parity back into view. 

German October producer price inflation accelerated to 4.3% y/y from 3.9% y/y, with prices up 0.4% m/m. The acceleration in the annual rate was stronger than the consensus which called for a y/y rise to 4.1%. Energy and food prices remain the main driving factor, but prices in other areas are also starting to nudge higher as previous energy price inflation start to pass through the product chain.  Nonetheless, rates remain moderate, but the gradual pick up highlights that inflation is not dead and that keeping rates too low for too long harbors inflation risks in the medium term.  Despite the positive tick in the data most investors are buying the rumor of a rescue package of Ireland.