Marc To Market's blog

The US dollar saw its post-FOMC losses extended only against the euro as the perhaps the passable success of the Greek bond buy-back and bank supervision deal lent support to the single currency.  

Yet, even it succumbed to selling pressure in the European morning and returned to pre-FOMC levels near $1.3040.  Against most of the other majors, the dollar has been confined to yesterday's ranges.  This is somewhat reminiscent of the price action after QE3+ was announced on Sept 13, with the dollar bottoming either that day or the following day. 

Of course, we recognize that monetary policy is one of the factors the influence foreign exchange prices.  There are factors as well.  It seems that most investors and observers look at the same variables in their formal or informal models of currency determination, but differ on the coefficients, or weights that are given to the variables, which seem to change over time. 

The accumulation of reserves is primarily limited to developing countries.  There are two notable exceptions among the high income countries. Japan, which is traditionally willing to intervene in the foreign exchange market to curb the yen's strength.  The last intervention took place in Oct-Nov 2011, when the BOJ bought over $100 bln.  

The other exception is the Switzerland, where the SNB has capped the franc against the euro, leading to something on the magnitude of tripling their reserve holdings.  

The announcement that Sweden's Riksbank will boost its reserves drew our attention.  The Riksbank currently holds about $40 bln worth of currency reserves.  It will boost it by about 37% or around $15 bln (SEK100 bln).  The reasons behind its decision is interesting and reflective of more modern thinking about currency reserves. 

The US dollar and yen remain soft.  The news stream has encouraged the so-called risk-on trade.  The Greek debt buyback appears to have gone well enough that it will get dollop of aid.  Spain reportedly received 40 bln euros of bank aid.  There seems to be a potential compromise banking supervision in Europe.  On top of that, of course, the market expects the Federal Reserve to announce an expansion of its quantitative easing later today and keep the door open to further steps if necessary. 

The dollar made new eight month highs against the yen, just shy of the JPY83 level.  These dollar gains ahead of the FOMC meeting underscores one of our interpretative points that the old drivers of dollar-yen, like interest rate differentials and general risk appetite, have broken down, trumped by Mr Abe and his aggressive monetary and fiscal rhetoric.

Draghi's pledge to do what is necessary, within the ECB's mandate, to save the euro cleared reduced the extreme tail risk in the euro zone. Greece is about to receive a large dollop of aid so it can continue to keep its public sector creditors whole at the expense of domestic financial institutions. 

While the risk of a Grexit, which many thought was so imminent, has receded, euro skeptics have turned their attention to Spain and/or Italy.

The Target2 imbalances caused much consternation earlier this year as some economists focused on them as either signs that a transfer union was a fact on the ground, or alternatively, as a sign of the pending costs to Germany, which German politicians fail to acknowledge. 

This Great Graphic comes from the Brussels Blog at the London School of Economics, who in turn got it from Place De Luxembourg

Much ink has been spilled trying to decipher the true meaning, but we know that the Target2 imbalances are nothing more or less than a reflection of the intra-euro area current account imbalances.  Before the crisis those imbalances were financed largely by the private sector.  That was part of the financial integration process whereby creditors would recycle their surpluses by primarily buying bond in the debt countries.

News of greater political uncertainty in Italy and poor European data is spurring risk-off moves, with the dollar and yen firmer, emerging market currencies mostly softer, global equity markets lower and core bonds a bit firmer.  

Following much weaker than expected German industrial production figures last week has been followed in kind by disappointing French and Italian output figures today.  Italy reported a 1.1% decline.  The consensus was for a 0.2% decline and the Sept series was revised lower.   French output fell 0.7%.  The consensus was for a 0.3% increase.  Yet it is really the Italian political scene that is the key driver today with the benchmark 10-year yield up more than 30 bp, dragging up peripheral yields generally.  Italian shares have been particularly hard hit and a couple of banks were limit down and stopped trading.  

This week is the last before the holiday mood sets in.  We identify ten considerations that will drive the capital markets. 

News that the Greek bond buy scheme did not get sufficient takers to reach the 30 bln euro target set the commentariat ablaze.  This may prove to be a minor technicality as Greek banks initially offered 75% of the Greek bonds but were prepared to pitch them all if necessary to ensure EU aid is forthcoming, which is the source of their recapitalization funds.

The bigger story is the fall of the Monti technocrat government in Italy.  Berlusconi's PDL party pulled support by abstaining economic reform votes at the end of last week.   After a series of consultations with the Italian president, it appears that parliament will not be dissolved until two important pieces of legislation are approved, the 2013 budget and financial stability measures.  The former is needed for obvious domestic reasons.  The latter is needed to maintain credibility in  EMU; assuring its partners.

We have been tracking the deterioration of the US dollar's technical tone over the past three weeks.  That ended abruptly.  Weak euro area data, a more dovish than expected ECB, and heightened political uncertainty in Italy, saw the euro reverse lower after briefly moving above an eighteen month-old downtrend.   

The UK also cut its growth outlook, and poor data increases the likelihood that the BOE  may have to resume its gilt purchases in the new year, though consumer inflation expectations have ticked up recently.  

At the same time, there appears to be little progress on the US fiscal talks.  Whenever a top official signals this, the dollar seems to tick up on risk-off considerations, though with diminishing impact.  The stronger than expected November employment data is not sufficient to stay the Fed's hand and the FOMC will most likely expand the long-term assets purchased under QE3+ at its meeting that concludes on December 12.

The US dollar extended yesterday's gains and remain bid ahead of the November jobs report.   The deterioration of the economic and political situation in the euro area appears to be the single biggest factor behind the greenback's sharp recovery.   The dollar is little changed against the yen as the market grapples with the implication of the earthquake and tsunami.  

Asian equity markets were mostly higher with the MSCI Asia-Pacific Index was up about 0.25% and,. of note, the Shanghai Composite extended this week's recovery, gaining 1.6% to bring the weekly advance to 4.1%.  European bourses are bit heavier.    Spanish and Italian bonds remain under pressures, while Greek bond yields continue to fall as a the bond buy back offer expires today and the market anticipates a successful conclusion.  

We share five observations today. 

There has been much fanfare over the swap lines that China's central bank has established with numerous countries.

The Bank of England's Monetary Policy Committee meets Thursday.   There is an overwhelming consensus in the market that there will be no action taken--no rate cut or resumption of the gilt purchase program (QE) that was completed last month.  

More importantly, tomorrow the Chancellor of the Exchequer Osborne will make his Autumn Statement to parliament.  He will have to tread a narrow line.  Circumstances will force him to acknowledge that it is taking longer to recover from the financial crisis than the government had anticipated.  

The US dollar continues to trade heavily, with the euro and sterling edging to new multi-week highs and the yen consolidating its recent losses.  The main consideration appears to be the looming fiscal cliff, weaker data and the prospects for additional QE to be announced next week by the Federal Reserve.  

At the same time, tail risks emanating from euro area have diminished, even if the i's aren't dotted and the t's not crossed on  Greece's new program, or if the negotiations over bank supervision in Europe at today's EU finance minister meeting, are more protracted.