Week Begins With Global Equities Solidly Higher, Dollar Softer

The US dollar is mostly lower with little movement among the majors. The euro remains fairly subdued but recovered early session losses to break above Friday’s close. This week in Europe will be dominated by upcoming political events in Italy, Ireland and the EU summit – where EU leaders aim to agree to a limited EU treaty change in order to set up a permanent rescue mechanism for countries in financial duress. Meanwhile, cable continues to experience selling pressure following weaker-than-expected housing prices but most of the weakness is highlighted in the crosses with larger moves down versus the euro. The dollar has been well bid versus the yen amid the large swing in US yields with the 10-year Treasury now yielding 209bp above its JGB counterpart following recent firm US data and the extension of the Bush-era tax cuts. Elsewhere, the Australian dollar has been moderately higher buoyed by higher stocks and commodity prices with the AUD/JPY making a 3-week high as China refrained from raising interest rates, despite the headline print of 5.1%.

Global equity markets are solidly higher, surprised by the absence of a rate hike by China. The MSCI Asia Pacific index up 0.4%, after losing 0.3% last week while the Shanghai index up 2.8%. At the same time, the Nikkei is up 0.8% led by a 2.4% increase in energy and boosted by yen weakness. Meanwhile, European bourses extend gains for a sixth straight day with the Euro Stoxx 600 up 0.4% led by gain in energy. The FTSE and Dax are both up as well with UK stocks rising for a third day as merger and acquisition buoyed gains. The FTSE is up 0.8% with the Dax up 0.3%. Elsewhere, P&G raised its profit outlook, signaling a strong outlook for consumers, while GE raised its dividend payment.

Euro-zone spreads continue to rattle the markets led by Spanish 10-year government bonds, which declined for a six consecutive day before debt sales this week. The yield on the 10-year is up by 2bp followed by a 1bp increase in Italian 10-year yields. Tensions in the euro-zone periphery are also high ahead of Wednesday’s Irish Parliament vote on the EU/IMF rescue package, which the opposition party, Fine Gael, has said it will vote against the deal and seek renegotiation. At the same time, the German 10-year yield is flat while the US Treasury yield is up 3bp. Elsewhere, 10-year JGB yields are up 5 bps as global growth expectations reduce the demand for safe haven assets.

Currency Markets

Europe’s financial crisis has a political dimension, but vulnerability of Italy’s Berlusconi has little to do with the economic crisis. In fact, the 2011 deficit is expected to come in between 3.9% of GDP (government estimate) and 4.3% (EC estimate), which is considerably smaller than others on the periphery. Berlusconi’s problems are largely home grown. The debate in parliament today will be followed by a vote of confidence tomorrow. Even if Berlusconi loses the vote of confidence, it does not necessarily mean he will no longer be Prime Minister. Indeed President Napolitano would consult all the political parties, including Berlusconi’s, to see if a new government can be formed. Local accounts suggest the odds that Berlusconi heads a somewhat larger coalition to avoid elections in this challenging financial time may have increased in recent days. Over the past month, Italy’s 10-year premium over Germany has actually narrowed by a few basis points to about 160bp. However, some pressure is evident in the short-end. The Italian premium in the 2-year sector has increased by about 10 bp over the past month 136bp. On the whole, domestically-inspired political uncertainty in Italy is unlikely to be a significant market factor.

Rightmove said UK house prices fell for the second month to the lowest since January. The average asking price in England and Wales dropped 3% to 222,410 pounds ($351k) from a month earlier when they sank 3.2% percent. It’s the biggest consecutive monthly drop since Rightmove’s index began in 2002. The property website predicted that prices could fall as much as 5% in 2011. Likewise, UK PPI prices rose 0.9% m/m and were up 9.0% versus 8.2% in October. Imported materials added upward pressure, as a weaker sterling makes imported products more expensive and imported metal prices rose 22.8% y/y. Although the read-across from producer prices to consumer goods prices is variable over time, the current elevated factory gate price inflation is consistent with a continuation of high CPI goods price inflation, and above-target outturns for the overall CPI. That said, the likely pass-through from producers to consumers should force the BoE to remain torn between extending QE and its targeted inflation mandate, likely erring on the side of inflation reduction. This logic was in fact highlighted this morning by BoE official Bean who suggested that CPI is above the bank’s target for an uncomfortably long time and that the MPC intends to watch inflation like a hawk. This should keep sterling elevated as the outlook for QE continues to wane.

China reaffirmed the monetary policy shift to a prudent stance from the former "appropriately loose" one, via its Central Economic Work Conference on Sunday, which was chaired by President Hu Jintao. The statement came after November data showed Chinese CPI inflation at a worrisome 5.1% pace, up from 4.4% in October, and with the PBoC refraining to raise interest rates (so far). Rising inflation suggests that further tightening will be seen, but not as aggressive a path as seen in 2006-2007. Currency gains are likely to be used to limit imported price pressures. During the PBOC hikes in 2006-2007, CNY appreciation was quite significant and encompassed gains vs. USD of 1.5% in Q2 07, 1.3% in Q3 07, 2.8% in Q4 07, and the peak of 4.2% in Q1 08. In other words, the PBOC used a combination of rate hikes, reserve requirement hikes, and currency strength to help battle rising price pressures. That’s what we see happening in 2011 too. Markets have actually pared back CNY appreciation expectations after the surprise PBOC rate hike, with 12-month NDFs now pricing in 2.3% gain vs. close to 4% before PBOC first hiked rates in October. But overall, the current policy is a sign that currencies linked to China’s growth story will have further room to grow as China’s growth is expected to increase a 9% clip in 2011.

Upcoming Economic Releases

There are no data releases today in the US but at 8:30 EST 13:30 GMT Canada releases its 3Q capacity utilization rate which is expected to increase to 76.5% from 76% followed by October industrial production in Mexico which is expected to slow to 5.4% from 6.3%. Events: US Senate to vote on fiscal package at 3 PM / 20:00 GMT and BoC Carney speaks in Toronto.

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