Waiting on the ECB

from the BBH Currency Strategy Team

Highlights

The US dollar is consolidating some it weekly losses versus some of the majors ahead of today’s ECB meeting and tomorrow’s jobs reports. The euro, however, maintains a firm tone as the recent string of better-than-expected economic data, coupled with the rise in commodities, suggests that the ECB will strike a more hawkish tone. However, with the euro underpinned by the anticipation of a more hawkish statement, it is more likely that the risks are skewed to the downside for the euro as the market is likely to be disappointed with the accompanying statement, given the still fragile situation in the peripheral banking system. After trading to a 13-month high, Sterling succumbed to some position squaring, with selling pressure in part fueled by weak-than-expected services PMI. The dollar is marginally lower against the yen, holding steady around ¥81.80, while the dollar firms against the Swiss franc as risk aversion abates.

Global equity markets are broadly higher, with risk appetite gradually returning after news of a possible Libyan peace plan. Asian stocks pared some of their weekly losses, with the MSCI Asia Pacific index advancing 0.7%. Elsewhere, South Korea’s Kospi index was among the best performers on the back of strong data (which reconfirms our view for a rate hike next week), while China’s bourses bucked the trend as the decline in PMI weighed on sentiment. European bourses pushed higher, buoyed by solid gains on Wall Street and large conglomerates beating profit estimates, with the Euro Stoxx 600 up 0.6%. The UK’s BSkyB rallied after News Corp won regulatory approval to take full control, boosting the FTSE. Oil prices continue to settle lower with WTI down 0.5%, while agriculture prices firm.

Global bond markets are under pressure as equities outperform amid positive earnings surprises, boosting overall sentiment. In Europe, Spain’s 5-year auction witnessed higher demand amid lower borrowing costs, while the German 2-year bund yield is at its highest rate since August 2009 ahead of today’s meeting. Elsewhere in Europe, short-dated gilts yields are flat following the weaker services print, while the 10-year yield is up 4bps as investor’s demand for safe-haven securities abate. Peripherals are mixed, with Portugal’s 10-year still sitting uncomfortably above the 7% threshold, although Spanish and Italian yields benefitted from a good result in today’s Spanish bond auction. US bonds are a tad softer, with the benchmark yields up 2bps, pushing the 10-year yield off its recent four-week lows.

Currency Markets

The ECB meeting and more importantly the press conference that follows is the main event of the session. The market generally expects Trichet to continue to sing from the hawkish hymn book. Although many observers have been critical of the July 2008 rate hike decision, Trichet has referred to it, almost as a badge of honor, demonstrating beyond reproach his anti-inflation credentials. Indicative prices suggest the market has discounted two quarter-point rate hikes this year. While the odds of a hike today are above zero, they are not much higher. The ECB still appears to have some preparation work to do. First, the ECB will likely lift its medium-term inflation outlook. Second, it may want to normalize money market operations, even though this is not a necessity. Yet, it seems that if conditions are beginning to warrant a rate hike, is unlimited amount of 3-month funding still needed? Moreover, with weak growth in money supply, arguably the monetarists at the ECB need not be in a hurry. Lastly, another argument against a hike is that the ECB may need to respond if the euro zone governments fail to present a compelling comprehensive plan to resolve the European debt crisis at the summit later this month. Fitch today noted that there are elevated expectations for that summit and, stating the obvious, disappointment could exacerbate the crisis. It warns that the ECB’s bond buying will likely continue and may need to be increased. This seems to imply that the EFSF is unlikely to be permitted to buy bonds. We suspect that without some indication of restructuring of at least Ireland and Greece’s debt, European officials will not deliver to the markets the kind of closure that is necessary to put the crisis behind it.

There is some risk that the ECB meeting produces a "buy the rumor, sell the fact" type of trading with market talk of large barrier structures in place in the $1.3900-50 band that appears to be deterring, or at least slowing, the euro. Also, once past the ECB meeting, the market will turn its attention to the last main event of the week: US jobs data. While a notoriously difficult number to forecast, the increase in small business hiring, the manufacturing ISM job component and the ADP estimate risks a robust report. This may also discourage short-term players from being aggressive dollar sellers today. The euro zone service PMI did not match the strength of the manufacturing reading. It slipped to 56.8 from the 57.2 flash reading, but is still above the 55.9 in January and the highest since Aug 09. The price component rose to 52.8 from 49.8 and is the highest since July 06. Of note, the disappointment in the headline came from softer French and German readings, but the periphery–Ireland and Spain and Italy–were unexpected strong. Ireland’s 55.1 reading is the highest in seven months. Spain’s move back above the 50 boom/bust level for the first time since July 2010 and Italy recovered above 50 (53.1) from 49.9 in January.

The UK service PMI also did not match the strength (record) of the manufacturing (and construction) PMI. The miss has jammed sterling back below $1.6300, where it had been building trying to build a foothold. However, bids emerged near $1.6260. There is additional support near $1.6220. The service PMI came in at 52.6 down from 54.5 in January and market expectations for 53.7. The service sector accounts for around 70% of the UK economy and so the disappointment may blunt the impact of the earlier reports. However, data should allow the MPC to feel more confident that the economy is not contracting. Markit, which conducts the PMI survey, opined that the data is consistent with 0.3% growth in Q1 rather than the 0.4% they previously said.

Upcoming Economic Releases

At 8:30 EST / 13:30 GMT the US reports Feb 26 initial jobless claims (395k expected vs. 391k prior) followed by Q4 nonfarm productivity (2.3% expected vs. 2.6% prior), followed by Feb’s ISM non manufacturing (59.3 expected vs. 59.4 prior) Events: Fed’s Kocherlakota (FOMC voter) speaks at 11:00 EST / 16:00 GMT followed by Lockhart (FOMC non-voter) at 12:15 EST / 17:15.