Dollar Trades on Back Foot

from the BBH Currency Strategy Team

The US dollar is softer today after yesterday’s disappointing economic data releases stoked a drop in US bond yields. The euro remains choppy with conditions exacerbated by thin trading and gains capped by higher refinancing costs in todays Italian bond auction. Cable tested levels above $1.5400, but edged back down as movement keyed off fluctuations in the euro. The dollar bloc currencies are well supported heading into the New Year amid light speculative interest with demand for higher-yielding currencies increasing. Elsewhere, EUR/CHF traded in close proximity to record lows of 1.2450 after Swiss KOF leading indicator provided momentum and added to the general Swiss franc demand in to the year end.

German December CPI expected to remain stable at 1.5% y/y (HICP 1.6% y/y) but state data suggests an acceleration in annual rates. Inflation in five German states accelerated in December as prices surged in the final month of the year. Energy and food prices remain the main driving factors so far, but with the labor market improving markedly there is also some risk that underlying inflation pressures will creep higher as labor costs have already started to rise. With Germany’s economy growing at a much faster pace than its EMU peers ECB policy decisions are becoming harder to manage. As such, Germany may have to grapple with an inflation rate that is generally higher than it would likely prefer. If nominal yields fail to keep pace with inflation that would lead to lower real rates and may keep the euro under continued pressure.

Euro-zone November M3 money supply growth accelerated to 1.9% y/y, much higher than the consensus of 1.6%. The October rate was slightly revised down to 0.9% y/y from 1.0% y/y and the three months moving average accelerated to 1.3% from 1.0% (again, the latter a revision from 1.1%). This is still far below the ECB’s reference rate of 4.5% y/y, but the sharp acceleration is a reminder that inflation is not dead and that the ECB’s expansionary monetary policy is having an impact on money supply. Indeed, the renewed strength in money supply comes alongside a pick up in the ECB’s SMP asset purchases and reports that despite underlining and stressing its intentions to sterilize all government bonds bought to distinguish the emergency funding from QE, the CB has not covered its full quota with depos. This has left nearly EUR13bln sloshing around the system, which the ECB will try to mop up at its next auction.

Switzerland’s December KOF leading indicator was in line with consensus (coming in at 2.10) while the November reading was revised up a tad, to 2.13 from 2.12. This is the latest survey data to indicate that the Swiss economy continues to recover, albeit with growth momentum fading slightly. The KOF institute said on December 17 that it expects the SNB to raise rates in mid-2011, but only moderately due to the strong franc.

Peripheral bond yields are higher, led by a 10bp increase in Italian yields following Italy’s auction. Italy sold EUR3.5bln of zero 2012 bonds to yield 2.937%, up from a yield of 2.307% in last months auction. Italy also sold EUR8.5bln of 178 bills today, at a yield of 1.698%, up from 1.483% in last month’s auction. The weakness in peripheral bonds have led to a sharp increase in the cost of German and French CDS, with the cost of protection from default increasing more in Germany and France than the periphery over the past month. 10-year US Treasury yields are down 3bp while the 2-year is down 2bp. Meanwhile, the Philippine central bank kept rates unchanged at 4.0% and the PBOC raised the rediscount rate to 2.25% from 1.8%. The PBOC also raised one year interest rate on loans made to commercial banks by 52bp to 3.85%.

Global equities have shifted moderately higher in very quiet trade with European and Asian equities up on day. US index futures point to a modest open.

There are no US economic data releases today but German December CPI will be reported with no specific time announcement (1.5% expected). At 1:00 EST / 17:00 GMT the US will sell $29bln in 7-year notes. At 9:00 EST / 13:00 GMT Canada releases its Oct Teranet/National Bank HPI (-0.4% m/m expected , +6.1% y/y expected).