It is just possible that the worm is slowly turning for the single currency. After a possible double bottom on Wednesday at 1.2660, the single currency has climbed ever so gradually. Those extraordinary difficulties that many European banks had obtaining dollar funding late last year have eased to some degree, with the 3mth cross currency EUR/USD basis swap now down to -85bp from near -160bp late in November. Traders are carrying record short positions in the single currency, while money managers, sovereign wealth funds and retail investors have been avoiding the euro and/or reducing exposure to it for months. As such, there is huge potential for a short-covering rally on merely a whiff of good news. EUR/CHF is inching towards the 1.20 level which the SNB has vowed to vigorously defend. Both Italian and Spanish bond yields have fallen very sharply over the last few weeks, and yesterday’s auctions went well. The fiscal compact appears to have more teeth than many suspected when it was first announced last month. Both the UK and Switzerland might just be heading back into recession, which makes investors more reluctant to park money there; in recent days, EUR/GBP has started to head higher. Perhaps the euro will defy the doomsters and reach 1.30 before too long.
Draghi deserves some praise. ECB President Mario Draghi continues to gain some deserved praise from both the forex and bond markets for his bold initiative to conduct an unlimited 3yr LTRO. With some justification, Draghi claims that it has helped to unclog some of the financial plumbing that was threatening to wreak Armageddon on many European banks which otherwise were being denied access to liquidity by the rest of the planet. However, his assertion that funds borrowed from the ECB are not being re-deposited is contrary to the evidence which suggests that the bulk of it is, for now at least, residing back at the ECB. Also providing the euro with a minor boost was his suggestion that there were tentative signs of recovery, although the backdrop is still highly uncertain. Separately, Draghi again applauded the progress being made in both Italy and Spain regarding fiscal austerity and structural reform, stating that markets were already buoyed by the steps taken. The ECB President also expressed encouragement on the question of the fiscal compact; he hopes that it will be signed by the end of the month. Draghi is clearly a different proposition to Trichet. His approach is refreshing, thorough, and brave. Given Europe’s economic sclerosis, he needs to be.
More Fed QE still on the table. Notwithstanding recent signs that the US economy is actually fairly robust, it is clear that a number of Fed officials want to keep the option of implementing further QE firmly on the table. The Fed’s über-dove, Chicago Fed President Charles Evans, is not convinced the economy is in the clear, claiming that the recent improvement is only modest and that ‘substantial’ accommodation is still required. Some other senior Fed officials, such as New York Fed President McDonough and Boston Fed President Rosengren, are similarly disposed towards further consideration of quantitative easing. In contrast, über-hawk Charles Plosser continues to sound off on the risk of higher inflation, while Richmond Fed President Lacker is more worried that the Fed’s QE program compromises their independence. Of interest, Plosser does not get to vote on Fed policy this year, while two Fed Presidents who do get to vote in 2012, Sandra Pianalto and Dennis Lockhart, both seem inclined to support more asset purchases. It could be contended that dollar investors are far too sanguine that QE3 will not be needed and/or implemented.
Problems for the pound. Many of the UK’s major retailers have been providing updates on Christmas sales over the last few days and, for the most part, it confirms what most already suspected, namely that the British consumer remains extremely hesitant. Tesco suffered a 2.3% decline in UK like-for-like sales in the six weeks ended January 7th, much worse than expected – the share price of Tesco fell by more than 13% at one stage yesterday. Last week, Visa reported that UK retail sales fell by 1% in the month, a very poor outcome for the most critical month of the year for retailers. Separately, industrial production fell by another 0.6% in November, after a 1% decline in the previous month. Even if production jumped by 1% in December, for Q4 as a whole production would still be 1% lower than Q3, which on its own could chop up to 0.2 percentage points from GDP. Because of the incredibly mild weather, utilities’ output fell sharply in November (by more than 2%), an outcome likely repeated last month as the weather was again remarkably warm. The (unsurprising) revelation that festive season sales were very soft is not doing the pound any favours. Cable fell below 1.53 for a time yesterday whereas a week ago it was threatening 1.57. The pound is also underperforming the euro – EUR/GBP is now well above 0.83. With the Chancellor admitting to MPs that an extra GBP 10bln may need to be provided to the IMF despite the UK’s desperate fiscal plight, it is little wonder that the currency is under pressure.
Chinese inflation to fall further. The decline in Chinese inflation last month (from 4.2% YoY to 4.1%) may have been modest but it represents the fifth consecutive month that prices growth has slowed. Furthermore, we can be fairly confident that there is more to come, based on the base effects from last year’s sharp increase, the recent softening of food prices and the easing of domestic conditions. Food prices are still running at 9.1% YoY, but this is down sharply from the large double-digit gains seen in the middle of last year. Also of interest overnight was a further weakening in auto sales’ growth, up 4.6% YoY in December. Part of the explanation for weaker demand is due to the ending of subsidies but nevertheless it reaffirms that there is some moderation in consumer and business spending. Hopes for some further policy action, either on interest rates or bank reserve requirements, remain very much alive. However, at the same time any relaxation is likely to be gradual. The slowdown in lending, especially to the property sector, was a key objective of policy last year and thus far the measures taken have proved successful. The yuan remains modestly weaker so far this year, although it’s notable that the disparity between on-shore and off-shore rates (as wide as 2% towards the end of last year) has narrowed in the past few sessions.