EURO ‘Caught in a Trap’

FYC said it best ‘we’re caught in a trap’. These ranges are tedious as FX traders now become commodity and equity experts in training, and that’s even with the Euro-zone Producer prices posting the sharpest gain in three decades this morning (+1.5%). It’s the latest sign that inflationary pressures continue to build in the region and supportive of stronger rhetoric from Trichet at his press conference tomorrow. This morning, ADP will try to set the stage for Friday’s NFP as it’s the only notable piece of data to be released. For Bernanke, hit the rewind button, press play and then pause. With the NFP release on Friday and the ECB meeting tomorrow the market should expect data to have limited impact. However, surprises are welcome.

The US$ is mixed in the O/N trading session. Currently, it is higher against 10 of the 16 actively traded currencies in a ‘subdued’ O/N session.

US data continues to record healthy surprises, despite what Bernanke is afraid of. Yesterday, January ISM numbers in the US expanded at its fastest pace in seven-years (61.4 vs. 60.8), as factories added workers and pumped up production, continuing the momentum for their expansion. It was a similar story in Europe, manufacturing expanded at the fastest pace in a decade, while the rate of growth in China was the slowest in six-months. The surge in the employment index may be suggesting that the recovery is sustainable and should prove positive for NFP. The report also revealed that operators face a big jump in raw material prices. Even with oil hovering close to $100 a barrel, indicators tracking inflation at the consumer level have been benign. Bernanke raised his concerns that higher gas prices might hurt consumers and business spending. However, he does expect inflation to remain a temporary blip. Big picture, Middle-East contagion fundamentally is expected to overhang the global economies for some time.

US construction spending fell for a second consecutive month in January (-0.7% vs. -1.6%). Despite the weakness in the housing sector, residential project outlays increased last month (+5.5%), unlike non-residential projects which fell (-3.3%). Builders have had trouble getting finance for various projects. Even with the tighter credit conditions, demand for credit in some places remains weak. Digging deeper, private sector construction spending fell -1.2%, public sector increased +0.1%, even Federal spending was up +9.1%, while state and local governments spending fell -0.9%. They continue to wrestle balancing their books.

Bernanke commented yesterday that he will not be tightening monetary policy until he is more confident that US recovery can stand on its own. ‘Once we see the economy is in a self sustaining recovery and employment is beginning to improve and labor markets are improving and inflation is stable and approaching +2% or so….at that point we will begin withdrawing’. That being said, he is aware of the risk that the Fed will act too slowly and allow inflation to get controlled. What he said was very much in line with market expectation.

The USD$ is lower against the EUR +0.14%, GBP +0.11% and CHF +0.23% and higher against JPY -0.08%. The commodity currencies are weaker this morning, CAD -0.15% and AUD -0.10%. It was expected. The BoC held rates steady yesterday at +1%. The danger was that Governor Carney would try to talk down the currency’s rise. In their communiqué, the BoC expressed its concern about the strength of the loonie ‘the export sector continues to face considerable challenges from the effects of the persistent strength in the Canadian dollar and Canada’s poor relative productivity performance’. The new reality is a Canadian dollar at or close to parity as the economy adjusts to this paradigm. Without commodity prices aggressively rising yesterday the CAD would have probably underperformed even more. The market has preferred been long this currency for both risk averse and commodity supporting reasons. The swap market is looking at about a +56% probability of a +25% hike from the BoC in May, down from +66% the day before, to a rate hike being fully priced in for the July meeting. That being said, Governor Carney is in no rush to raise interest rates, stressing as before that ‘any further reduction in monetary policy stimulus would need to be considered carefully’. If the Bank really was contemplating an early rate hike, would we not expect the forward looking guidance to be altered? (0.9750)

The AUD is a tad weaker in the O/N session as global bourses see red and on slightly weaker than expected fourth quarter GDP growth of +2.7%, y/y (+2.8% expected). However, Australian fundamentals continue to support a higher policy rate environment, and a currency appreciating medium term. Analysts note that the Australian economy finished last year with ‘strong’ momentum and despite severe flooding affecting first quarter 2011 GDP growth, futures dealers anticipate a solid uplift in growth for the first half of the year. The RBA, this week, has noted that mildly restrictive rates are appropriate. The futures market is pricing in further modest tightening starting in third quarter as the data strengthens and the threat to inflation rises along with commodity prices and higher wage growth. Commodity prices continue to provide support on pull backs. Next question, is this growth sustainable in a higher oil price environment? Expect the RBNZ actions to weigh on Governor Stevens monetary policy thinking.

Crude is higher in the O/N session ($100.09 +46c). Crude prices remain elevated on Middle-East geopolitical concerns and this despite the Saudis offering to make up for supplies lost. Oil looks set to surpass its 30-month high of last week on concerns of further supply disruptions. ‘While there’s a risk of contagion, of this spreading to Iran or Saudi Arabia, the market is going to see prices elevated from these levels’. The IEA’s chief economist said that ‘higher oil prices pose a danger for a global economic recovery’. Last week’s EIA report again has provided some support for the US crude market on pull backs. The report showed a smaller-than-expected increase in supplies. Crude inventories rose by +800k barrels vs. an expected increase of +1.4m. Even worse was the gas inventory headline declining -2.8m, analysts had been expecting an increase of +950k barrels. Stocks of distillates (heating oil and diesel) fell -1.3m barrels, which was very much inline with expectations. Concerns about the Middle-East and production problems in the North Sea are boosting Brent relative to WTI and pushing the spread to a record premium. With supply the number one concern, the commodity will remain bid because of the contagion concerns.

Like most commodities, gold is heading for its longest rally in six-months, as mounting tensions in North Africa and the Middle East boost demand for a ‘safe haven’. Last week the commodity was up +1% and is on course to replicate that appreciation. The yellow metal continues to be supported by geopolitical factors and inflation threats. Prices have risen nearly +7% this month, as protests in favor of democratic reform in North Africa turned bloody. Investors have grown increasingly uneasy that the crisis could spread. Even hawkish global rhetoric has managed to give the yellow metal a leg up in February. Consumer prices are also boosting the demand for the precious metal as a hedge against global inflation. Last week, the market witnessed Chinese’s inflation accelerating the most in six years, and UK consumer prices the most in two years. Even US data is showing that their inflation numbers are edging higher. The commodity is being used as a store of value. The asset class is expected to remain better bid on speculation that currency volatility will boost demand for a safe heaven investment once the Euro contagion fears raise its ugly head again over the coming weeks during the Euro-periphery refunding season ($1,430 -6c).

The Nikkei closed at 10,492 down-261. The DAX index in Europe was at 7,139 down-83; the FTSE (UK) currently is 5,872 down-63. The early call for the open of key US indices is lower. The US 10-year backed up 1bp yesterday (3.45%) and eased 3bp in the O/N session (3.42%). Geopolitical pressures continue to support treasuries despite the uptick in global inflation numbers. Treasuries were little changed yesterday even after Bernanke recognized inflation gains from higher commodity prices and a stronger ISM manufacturing report. He acknowledged that the risk of deflation and the downside risks to the economy have subsided. This may suggest he will not need to do more on the accommodation side. The Fed will stay on course to complete $600b buying program through June in a bid to reduce the unemployment rate. Event risk remains the order of the day despite more encouraging global economic data.

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