Dollar Down for a Second Day Ahead of FOMC Meeting

Highlights
The US dollar is mostly lower for the second day in a row ahead of the Fed’s meeting this afternoon. The euro maintained a supportive tone after the German ZEW release, which showed improving consumer confidence, but buying pressure stalled out around $1.350. The euro looks over extended on the hourlies yet may have room to run higher if the Fed reasserts its commitment to purchasing $600bln, citing the weakness in inflation and spare capacity weighing on unemployment. Meanwhile, cable trade higher following the release of higher-than–expected inflation but subsequently fell back amid reports of a good UK clearer sell order. The dollar dropped below yesterday’s close against the yen to hit a 5-day low of ¥82.83 but may see the range tighten up ahead of Japan’s Tankan report. The New Zealand dollar slipped back after retail sales dropped the most since 1997. Elsewhere, SEK and NOK remain well bid ahead of central bank meetings that will likely see the Riksbank hike by 0.25 with a small chance of a hike (18%) by the Norges Bank.

Global equity markets are mixed with a continued rally in Asian markets and a softening tone in Europe. The MSCI Asia Pacific index up nearly 1% boosted by raw material producers amid commodity price gains. At the same time, the Nikkei is up 0.2% led by outperformance in energy while the Shanghai index was up 0.1%. On the other, European bourses are flat with the Euro Stoxx 600 down 0.2%. Otherwise, the FTSE is little changed, following the longest stretch of gains for the index since September, while the Dax fell after reaching its highest level since May 2008.

S&P cut the Belgian ratings outlook to negative from stable while the outlook on its AA+ credit rating was lowered to negative as well. The agency sees risk to the government’s 2011 GDP and fiscal targets. The 10-year yield on Belgium’s debt climbed by 4bp but has not had a drastic change on the yield in other periphery countries. In fact, Spanish government bonds are holding up fairly well after Spain saw decent demand for its T-bills, albeit at a higher yield. Spain’s 10-year is up 7bp while Greece and Portugal’s yields are both up 8bp. At the same time, the German 10-year yield is down 1bp while the US Treasury yield is up 2bp. And despite the higher-than-expected inflation numbers, UK Gilts are holding firm up on 1bp at the 10-year tenor. And finally, Berlusconi won a confidence motion in the Italian senate.

Currency Markets

The US dollar’s pullback has been attributed to three main factors. First, some are placing emphasis on Moody’s warning that the Obama- Republican fiscal compromise increases the likelihood of a negative outlook within two years. While this is potentially worrisome, the market most directly impacted would be the Treasury market and it rallied after the Moody’s announcement. If the Treasury market did not respond, this does not seem like a very satisfying explanation. Second there is some speculation that at today’s meeting, the FOMC may decide to step up its bond purchases to protest the recent dramatic rise in rates. To the extent that this has indeed been weighing on the greenback, we suspect it will be lifted as the Fed has only begun its bond purchases. It could have chosen to increase the pace of purchases, but it did not. It seems highly unlikely that the Fed will change its asset purchase program in any substantial way at this juncture. Moreover, the Fed’s statement from last month as whole is unlikely to deviate very much from last month. Core inflation remains soft and while the data has come in better than expected, clearly it has not been sufficient to bring down the critical unemployment rate. Third, some observers have played up the possibility that European officials announce some new initiative at the summit at the end of the week. Yet the market may be getting ahead of itself.

The latest is that the EFSF itself could buy sovereign bonds. This is highly unlikely. The EFSF does not have money. It has guarantees. The EU Summit is likely to devote its energies to finalizing plans for the European Stability Mechanism, which is to replace the EFSF after 2013, and discuss the modifications of treaties that could avoid national referendum. At most, the ECB could see its capital increase. Reuters reports suggest some at the ECB may be concerned about loses due to the risk of loss due to its sovereign bond purchases. The ECB’s capital base is reportedly stands just below €6bln. Its assets are about €1.925 trillion, which produces a gearing (leverage), if such a thing is a meaningful metric for central banks, of 331x. To the extent that these three factors individually or collectively sparked the selling pressure on the dollar, look for their influence to be transitory in nature.

This morning’s European data has been mixed with the December German ZEW confidence outperforming while October euro-zone production was weaker-than-expected. The December ZEW survey jumped to 4.3 from 1.8 in November, after the dip in October and September. The reading for the current situation rose to a very strong 82.6 from 81.5. This compares to -51.9 at the end of Q1, which highlights the remarkable improvement the economy has seen this year. Germany has helped power an expansion as companies stepped up investment and hiring, encouraging consumer spending. A pickup in German spending is vital to rebalancing the euro-zone economy, which places the periphery at a competitive disadvantage, as the periphery’s average inflation adjusted exchange rate is nearly 6% higher than that of Germany. The IFO institute earlier lifted its growth forecast to 3.7% and, of course, German will be the key driver of euro-zone growth which is expected to be 2% in the fourth quarter, according to the consensus. On the other hand, euro-zone industrial production rebounded from last month but grew less than expected. Still, the picture of Europe is of a two tier economy with the core countries, notably Germany, being the main driver but bogged down by the weakness in the periphery.

Upcoming Economic Releases

At 8:30 EST / 13:30 GMT the US releases November’s advanced retail sales. Retail sales less autos are expected to increase m/m by 0.6% from 0.4% in October. Advanced retail sales are expected to decrease to 0.6% from 1.2%. Meanwhile, m/m PPI prices are expected to increase to 0.6% from 0.4% with core PPI increasing 0.2% from -0.6% in October. Business inventories are expected to increase to 1% from 0.9%. Events: FOMC rate decision at 2:15 EST / 19:15 GMT.