Interest Rates Drive Divergence in FX
The euro has raced higher, with the $1.35 level convincingly breached and the option structure rumored to be struck near $1.3550 taken out. The US dollar has moved to new highs against the Japanese yen near JPY91.40. Beneath both lay interest rate considerations.
There is more evidence today that a tightening of euro area financial conditions is underway. This has been a developing story, but two more pieces of the puzzle fell into place today. First, the ECB itself reported that banks in the area tightened credit standards further in Q4. This was especially true for residential mortgages and consumer credit. Overall, loans to households and businesses fell for the eighth consecutive month in December. There are both supply and demand considerations are work. The ECB recognized new regulation and capital requirements contribute to the tightening of credit standards. Weaker corporate demand for M&A, inventories and working capital was also noted.
Second, after last week's revelation that European banks were going to pay down around a quarter of the first 3-year LTRO, there had been some concern that some of that long term borrowing would be replaced by 3-month refil operations. This did not happen in the first 3-month repo operation. Banks borrowed 3.7 bln euros compared with the last 3-month operation in mid-Dec that saw banks take down 15 bln euro and the Nov operation in which 7.4 bln euros was taken.
The net consequence of this is to push Germany 2-year rates above similar US rates. Two months ago, the US was offering around 30 bp more than Germany; today 1-2 basis points less. The March Euribor futures are consolidating the roughly 25 bp implied tightening since early December. The passive tightening is likely to be a key issue at Draghi's press conference next week.
Meanwhile, the US 10-year yield is pushing through 2%. It is up about 17 bp over the past week. The 10-year JGB yield is up 4 bp in the same period. The US 10-year premium over Japan has widening to about 125 bp, the most since last April. The 2-year interest rate differential is near its best level in three months.
The dollar-bloc itself continues to under-perform. Some suggest that this is part of the unwinding of safe haven plays, with the Australian and Canadian dollars having been previously favored. This may be true, but it is not being reflected in the futures positioning. The gross long Australian dollar futures position is near record highs and has risen for four consecutive weeks. The gross long Canadian dollar positions have been trending lower since mid Sept. Note too in Canada's case, soft economic data, low inflation readings and a less hawkish central bank also appears to be playing a role. The outcome of the Reserve Bank of New Zealand meeting will be known late in the North American afternoon. It is widely expected to keep rates steady, but retain a tightening bias.
It is a busy day in the US, with the ADP estimate of private sector employment, the first look at Q4 GDP and, last but not least, the FOMC statement. While there is some headline risk associated with each, in general they are unlikely to change the underlying trends. Jobs growth in the US remains steady but slow. US GDP is expected to have slowed considerably from 3.1% pace in Q3. Drags from inventory, trade and defense spending are expected. However, the impact of behavior meant to game the system and beat the tax increases, like special or early dividend payments and early bonuses, may have boosted income.
The FOMC economic assessment is unlikely to change substantively, though the easing of some international headwinds may be noted. At the last meeting, the FOMC tied the low interest rates to certain macro-economic conditions (6.5% unemployment an/or 2.5% inflation). There is not such guidance on the Fed's asset purchases. It seems too early in the evolution of the Fed's thinking for it to provide such guidance now. With price pressures not problematic and now significant increase in the pace of job creation, QE3+ will continue through the year, we expect.
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