Dollar Firms, Uncertainty Increases

Highlights
The US dollar is trading with a firm tone against nearly all the majors as weakness across equity markets and commodities drive risk appetite and markets await the outcome from today’s EuroGroup meeting, where hopes for aid to Ireland are rising .  The euro continues to weaken versus the greenback, sliding down to $1.36 area despite the stronger-than-expected confidence numbers.  Sterling gave back most of today’s gains, after an initial rally following the strong-than-expected inflation numbers stalled out around $1.6. The dollar continues to strengthen versus the yen now beginning to test levels not seen since late September.  Elsewhere, China tightening fears fueled safe haven trading after it had a ripple on global markets after the SSEC dropped almost 4%, in addition to the new restrictions placed on hot money flow disguised as foreign direct investment, stoking a large selloff in the dollar bloc.

Global equity markets are mostly weaker, led by losses in Asia, as South Korea’s rate hike signals that more EM central banks are raising interest rates to combat inflation.  The MSCI Asia index is down 0.6% with stocks weaker in Japan and China.  The 0.3% drop in the Nikkei is led by a 1.3% loss in utilities, though consumer services are up 1.6%.  The Shanghai is down nearly 4% led by 6% losses in materials and energy.  In Europe, the equity retreat led by a 1.3% loss in the FTSE as a 3% loss in telecommunications weighs on the index.  At the same time the Dax is down 0.5% led by 1.1% loss yet with positive gains from tech and health care.  Overall, the Euro Stoxx 600 is down by 1.1%

European sovereign bonds yields are mostly up, led by Ireland, after initially falling on hopes for a deal on EU aid for Ireland at today’s EuroGroup meeting.  But yields are now rising again, as Ireland continues to maintain that it doesn’t need aid and is seeking help only for the banking sector. Namely, Ireland’s 10-year yield is up 17bp on the back of the news with Greece’s yield up 6bp following this morning’s bill auction.  And Spanish yields are mostly flat following this morning’s €5bln auction, where Spain missed its maximum target by €500mln. Meanwhile, the yield on 10-year German bunds is flat with 10-year gilt yields down 3bp.  The yield on the Japanese 10-year is down 1bp, at the same time, as the US 10-year yields are down 5bps.

Currency Markets

Ireland continues to discuss a possible aid package at the EuroGroup meeting. PM Cowen signaled in an interview yesterday evening that the government will discuss measures to help the Irish banking system with funds from the EU emergency fund. Cowen insisted that the government does not need external help but, namely, he is concerned about the health of the private sector banking institutions.  He suggests that an aid package is not necessary for the government since its obligations are met until mid 2011 but would need the money in case the banking system needed additional assistance. Despite this insistence, technically, there is no difference, as the emergency fund cannot lend to banks directly and it will have to be Ireland that has to apply for funding. Pressure on the country to go to the EU has been mounting amid renewed market tension and possible contagion effects with the ECB threatening Irish funding and a continued rise in bond yields, which means rising refinancing costs are not having an immediate impact.  In the short-run it appears that a bailout package may be imminent but, in our view, would only be a band-aid solution as investors would surely focus attention on other “weak” periphery members.

A little more than a year ago the PBOC governor proposed a supra-national reserve asset, like the IMF’s Special Drawing Rights (SDRs) to supplant the role of the US dollar.  While the proposal does not appear to be the basis of recent G20 discussions, the topic continues to capture the imagination of market participants.  Every five years the IMF reviews the composition and weights of the SDR.  Late yesterday the IMF announced its adjustments.  China’s yuan, despite efforts to internationalize its use, remains inconvertible and it may be disappointing to some, but perfectly understandable that the yuan is not included in the SDR basket.  The dollar’s weight in the SDR was cut to 41.9% from 44%.  Some will see this as a further sign of the declining significance of the dollar.  Yet that might not be the real signal.  Taking a longer term view, for example, the dollar’s weight in the SDR in 1996 was 39% .  The Deutschemark and French together had a weighting of 32%.  The euro’s weighting was increased to 37.4% starting next year from 34%.   Initially (2001) the euro’s weighting was less than the combined DEM and FRF weighting and ever since every 5-year evaluation has seen an increase in the euro weighting.  However, as we have pointed out, when looking at the IMF’s reserve data (COFER), to the extent there has been a meaningful shift, it seems that it is not so much at the dollar’s expense as it is at the yen’s.  The yen’s weighting in the SDR was cut to 9.4% from 11%.  In 1996 it was 18%.  Sterling weighting remains essentially unchanged at 11.3% from 11%.  In 1996, it was also at 11%.

After several months of a downshifting in US Treasuries, where from April until July foreign purchases averaged $38bln, the foreign purchases of Treasuries in August skyrocketed.  There was an additional improvement in both private and official flows, although some of this was due to July month-end auctions settling in August.  Meanwhile, the demand for agency debt and corporate bonds and stocks continued to plummet.  On the other hand robust USD buying from central banks continued, suggesting that underlying structural demand for USD instruments remains steady.  Namely, China increased its treasury holdings to $868bln in August from $846bln in July, while increasing its purchases of bills by nearly 200% to $15bln from $6bln with Japan increasing its purchases at nearly the same magnitude.   There may have also been central bank buying through UK based banks as the $74bln is the largest absolute increase in over 20 years.  Given high uncertainty about the outlook for the dollar in the face of QEII we think this report will be important  in determining structural demand for the dollar, although it is back-ward looking. 

Upcoming Economic Releases

At 08:30 EST / 12:30 GMT the US reports October’s producer prices which are expected to increase on most levels.  The consensus for the m/m is to increase to 0.8% from 0.4% in September with the core figures expected to remain unchanged at 0.1%. After the producer prices will be the September TIC data.  October industrial production is then expected to increase to 0.3% from a 0.2% decline in September while capacity utilization is expected to increase marginally. Events:Treasury’s Brainard and Fed’s Lockhart (non-voter) speak in the afternoon.