WISE MONEY

Developments in US monetary policy last night make it unlikely that the Greenback is going to see much improvement over the coming months; at least until there are more positive signs of a US economic recovery.The US news has lead to a general rebound of exchanges around the world following heavy losses last week and early this week on fears there could be a new recession due to the euro zone and US debt problems.

Markets in London and Paris are up1.8% in opening trade, as shares in Frankfurt jumped over 2%.

The Dublin market had gained 1.9% in the first few minutes of trade.

Overnight Asian stocks fought back some recent lost ground, following a rebound in US shares, after the Federal Reserve’s unprecedented pledge on rates.

Tokyo’s Nikkei index closed 1% higher, while markets in Australia rose by 2.6% and shares in Hong Kong finished 2.3% higher.

The single European currency has been given a let off following the judgment of the ECB to purchase Spanish and Italian bonds – even though this will be short lived.

Sometime in the future EU officials will need to make tough decisions about the Euro’s future but the European Central Bank decision has given them some breathing space.

This will likely reinforce the support levels for the Euro against the major currencies for the next 2-3 months.

Finally, Sterling has enjoyed a rare period of stability, if not demand, whilst pressure mounts on the Dollar and Euro, with Gilt yields falling on an almost daily basis as overseas investors rush to buy the perceived safe haven Government bonds (still AAA …..).

The outlook for Sterling is less clear however, especially given the recent evidence weak outlook for the UK recovery and continued civil unrest.

So where does that leave the market?

Well, buying Swiss Francs and Yen primarily, with both currencies continuing to appreciate despite the best efforts of the respective Central Banks to curtail the move – the Yen is now just stronger than prior to the BoJ intervention last week, whilst the Swissy has made considerably gains since the SNB tried to hold the EUR/CHF at 1.1000.

Gold has also maintained its strong run ….

Following the carnage from both sides of the Pond last week, the money markets will aim for some form of restoration and degree of normality in the early sessions of trading this week.  This could prove difficult, following continued worries about global economic growth, concerns over the eurozone debt crisis and finally late on Friday the downgrade of the US sovereign credit.

This all comes at a time when many top policy makers are on vacation and market liquidity is thin during the summer holiday period.

It was hardly a huge surprise when the US lost its top AAA rating last week.

S&P had been warning the US for several months about a possible downgrade and when the smaller than hoped for $2.1 trillion cuts in the US fiscal deficit were announced, this left the rating agency little choice.

Some consolation will be taken from the fact that the other two main ratings agencies Moody’s and Fitch have so far maintained the top tier rating for the US, although Fitch will be reviewing this before the end of the month.

Inevitably comparisons to 2008 are being made, however there is fundamental difference this time around.

While in 2008 policy makers were able to turn on the financial and monetary taps, the financial clout of governments is now in question.

There is little room for manoeuvre on government spending in western economies as this has now been totally used up, while interest rates are already at an all time low.

One could argue the US Federal Reserve can embark on another round of asset purchases but the effectiveness of more QE is very limited.

Confidence is pretty low right now so what light if any is at the end of tunnel?

EU officials had hoped that their agreement to provide a second bailout for Greece and beef up the EFSF bailout fund would have stemmed the bleeding but given the failure to prevent the spreading of contagion to Italy and Spain it is difficult to see what else they can do to stem the crisis.

One could compare the EU attempts to sticking a plaster on a fatal wound.

Although it is unlikely that the eurozone will disintegrate (more for political rather than economic reasons) there may have to be sizeable fiscal transfers from the richer countries to the more highly indebted eurozone countries otherwise the whole of the region could fall down the plug hole.

After dipping briefly  under 1.60 over the past week, the Sterling-Dollar pair snapped back sharply in late trading last night as firstly Fed Chairman Ben Bernanke refused to rule out further QE and secondly, after threatening to do so last month, Moody’s placed the US on review for a downgrade of its credit rating. Although Mr Bernanke did not outline much more than the market already knew from the minutes from the last Fed meeting, the fact that the words came from his mouth and not in text seemed enough of a reason for traders to sell the Dollar off against the Euro and Sterling, with cable jumping one and a half cents in quick time.

The potential ratings downgrade came as US President Barack Obama walked out of budget talks, raising the fear that a deal on raising the US debt ceiling before the US Government runs out of money is looking increasingly unlikely.

Later today US retail sales are due, and will probably show a modest decline, as retail sales ten to do over the summer months.

On Friday we also have the US CPI number and the U of Michigan confidence survey.

With EU banking stress tests due late on Friday evening, we’ve had the first indication that some of the banks are struggling to pass.

German public sector bank Helaba is rumoured to have pulled out, giving regulators a real headache the day before the results are due.

The key point in doing a second round of stress tests was their credibility, and the fact that it would cover all systemically important EU banks.

If Helaba pulling out marks the first of several banks following suit, the whole purpose of the project, namely to restore confidence in the European banking system will be undermined.

After the market volatility in Italian bonds and bank shares, this morning’s Italian Debt auction takes on more significance.

With many economists suggesting Italy is too big to fail, any sign of weakness will be magnified hugely.

Speculation is mounting that the ECB or Italian central bank may buy some of the bonds to signal to the market that demand is high and to keep yields suppressed.

As we know with Greece, Ireland and Portugal when the cost of insuring the bonds raises above 400 basis points bad things start to happen; both Spain and Italy remain around 300.

Even with all the negative Euro news, the news from the US yesterday evening has pulled the Euro higher against both Sterling and the Dollar.

The Fed announcement did little to move currency markets during trading but there was a negative tone to stocks and commodities.The Fed did not show any interest in a third round of QE when this ends in June, but will maintain its balance sheet at around $,2800 billion.

The major worry for markets remains the length and severity of the existing ‘soft patch’ in the economy.

Bernanke believes it will be temporary but the fall in equity markets over recent weeks suggests that there has been a deviation between stock market expectations and reality.

The Greenback may in fact be hitting a medium term bottom with the fact that the Fed is not considering additional QE.

The negative Fed stance combined with a vigilant reaction to the Greek government’s passing of a confidence motion suggests that markets will remain watchful over the near term.

Without a doubt, comments by the Greek opposition that they will not support further austerity measures ruined any hopes of agreement and will add another obstacle towards an easing in Greek tensions.

The continued bickering between EU officials over private sector participation in any debt rollover in addition to uncertainty over how ratings agencies will respond, threatens to keep sentiment under pressure.

The EUR has remained surprisingly resilient but its muted reaction to the passage of the confidence motion has given way to some weakness and the currency remains a sell on rallies.

Sterling suffered yesterday, weighed heavily by the relatively dovish Bank of England MPC minutes in which some members were even discussing further QE.

The currency faces its toughest battle for months as it breaks through key psychological 1.60 level and currently stands 1.5987 and GBPEUR:1.1223.

The US’s Federal Reserve Board Chairman Ben Bernanke hinted in a speech last night that there are no current plans for further monetary quantitative easing.

He also said that he is satisfied that the economic conditions in the US remain positive for growth, even in light of the recent weak employment and manufacturing data over the past few weeks.

Mr Bernanke continued to suggest the US economy is producing well below its potential but the current weak data flow is a “soft patch” and there would be a pick up in activity in the second half of 2011.

US stock markets immediately reversed small gains once the Fed Chairman began his talk and finished down on the day.

The US Dollar also strengthened on the news and looks set to continue that path today with Bourses in Europe opening the day down and the risk-on risk-off see saw continuing to play out across the markets.

With the ECB not likely to raise rates this Thursday, the closely watched press conference by ECB President Jean-Claude Trichet becomes the potential market mover.

The market seems to be suggesting there is a high probability that Mr Trichet will indicate a rate increase in July.

In the strange world of Central Bank communication, he will not say this directly but indicate this by mentioning “vigilance” when talking about the Banks stance towards inflation.

Given the size of the move in the Euro against the Pound and Dollar there seems to be a big chance that the market will be disappointed.

Yesterday we heard the particulars of recent the UK’s MPC and the US’s FOMC meetings and we also had euro ratings action from Moody’s, with very little resulting movement.The Pound dropped slightly following poorer than expected UK employment data but only lost ground following hard fought gains from Monday and Tuesday.

The main points from May’s MPC meeting were as expected and indicated no change in voting from April’s outcome.

However, the meat on the bones was always going to be the interesting facet, and so it proved.

The minutes suggest that the majority of members on the committee remain in no hurry to raise interest rates and although it is apparent that a wide division in views still exists, it is obvious that more members remain concerned about the downside risks to growth than about the dangers of stubbornly high inflation.

Moreover with the most hawkish member, Andrew Sentance, now set to be replaced by Ben Broadhurst, who seems to have a more balanced view on the economy, the make-up of the MPC would seem to be moving even further towards unchanged policy.

As a result, interest rates in the UK appear set to remain at the current low levels until the Autumn at least, with the November meeting now touted as the favourite for a tightening of policy.

The FOMC minutes, like those of the MPC, produced nothing earth shattering as the Fed Chairman, Ben Bernanke, had already prepared the market for a less dovish stance in his first press conference although again, the detail, when you dug down, was more revealing.

Markets were surprised by the extent of the discussions concerning exit strategies with officials outlining several guiding principals for the process of normalising monetary policy.

It was also clear that the majority of voting members favour raising interest rates prior to any asset sales as a means of tightening liquidity conditions.

Moody’s were also active, downgrading by 1-notch the credit ratings of the 6 largest Danish banks on fears of declining financial resilience.

None of this dented the Euro’s continued strength however with Asian markets preferring to focus on a report in The Times of China’s continued appetite for Eurozone sovereign debt as a means to diversify its foreign currency reserves away from the Dollar.

We have several American data releases on the menu this week but possibly the most significant for the US Dollar exchange rate will be the minutes of last months FOMC meeting. Coupled with speeches by Fed officials including Bernanke, investors will be watching carefully for clues to Fed policy post the end of QE2.

The Fed’s attitude at this point will be the major factor of whether the Dollar can maintain its rally over the next few weeks.

The lack of encouragement in US bond yields suggests that USD drive could slow, with markets likely to shift into wide ranges over coming weeks.

One should also consider which currencies will suffer more in the event of further USD gains.

The relationship linking the USD index and EUR/USD is extremely strong signifying that the USD gains are mainly a result of the single European currencies woes.

Apart from the EUR, GBP, AUD and CAD are the most susceptible major currencies to USD strength as many emerging market currencies including ZAR, TRY, SGD, THB, IDR, and MXN, are all highly susceptible to the impact of a stronger USD.

Japanese officials have been avoiding further forex interference blaming the drop in USD/JPY over recent weeks on general USD weakness in spite of the move towards 80.

However, this stance is not really backed up by correlation analysis which shows that there is only a very low sensitivity of USD/JPY to general USD moves over recent months.

One explanation for the strength of the JPY is strong flows of portfolio capital into Japan, with both bond and equity markets registering net inflows over the past four straight weeks.

No sooner had the ECB president given his monthly press conference last Thursday than the Euro promptly lost five cents against Dollar and three against Sterling in a frenetic two days of trading going into the weekend. The Euro has continued where it left of last week, on the back foot, as more concerns over another round of financing, or a more likely debt restructuring of Greece hit the papers on Monday.

It is set to be a busy week on the data front in Europe with German CPI and GDP data due, as well as Eurozone wide GDP on Friday.

We wait to see if Mr Trichet’s manipulation of the Euro was a prophetic move in light of weak data or if the well oiled German machine continues to perform strongly.

My guess would be the former considering the size and speed of the move.

The big US jobs number on Friday saw a decent increase in the number of jobs created, 244K against a forecast of 185K.

For the size of the miss on estimates the move in the Dollar was rather muted. This is probably a case of two opposite forces cancelling each other out.

On the one side the US now seems to be creating enough jobs to secure the economic recovery, on the other the data probably gives Chairman Bernanke enough of an argument to keep interest rates low for a considerable time period.

Sterling remains vulnerable to an upturn in risk appetite especially given the diminishing likelihood of a UK rate rise at the May MPC meeting following yesterday’s inflation figures. The headline YoY number was reported as +4.00% in March against expectations of a +4.4% outcome.

This trend will encourage the view persistently expressed by Mervyn King and most of his BoE colleagues on the committee, that the recent spike in inflation was just that.

He has argued for several meetings that the MPC putting rates up as a counter to a sharp rise in imported inflation, when the spike is expected to correct itself quite quickly, is a pointless exercise.

This opinion looks more likely to be borne out following yesterday’s data, but could easily prove to be a 2-edged sword for Sterling.

The reduced prospect of interest rate rises in the UK combined with higher yields elsewhere leaves the Pound extremely susceptible to further declines against the Euro and commodity focused currencies.

The much reduced UK trade deficit was a bright spot, but the implication derived from the numbers is that the pick up in exports was as a result of the weaker Pound; a scenario that has been touted by both the BoE and the Chancellor, which again suggests little enthusiasm for any recovery in Sterling for the time being.

Yesterday, it was the turn of a Fed hawk, the Dallas President Richard Fisher, to air his views on current policy.

In an article published by a German newspaper this morning, he was quoted as saying that the Fed risks having maintained a monetary policy that is too expansive adding that, ‘It can now hardly be disputed that US businesses have enough financial fuel in the tank to grow and create jobs’.

He said that the Central Bank did what was needed when financial panic broke out back in 2008, but that the situation was much different.

Debate at upcoming FOMC meetings will become more intense with both doves and hawks seeking to sway Bernanke’s thinking their way.

The straw that finally broke Portugal’s back was the €10bn shortfall in cash required to see them through until after the June election.Jose Socrates the interim PM finally accepted the “inevitable” in seeking EU funding.

Yesterday’s sale of €1bln debt reached a worrying 5.1% for six month bonds an unsustainable level according to the government.

The cost of the bailout will reach similar levels to that or Ireland with around €85 bln with the UK picking up the tab for 13%.

So far the Euro has been relentless currently 1.4287 against the Greenback and 0.8753 against Sterling ahead of the rates decisions later.

The US are not grabbing the headlines today but their fundamental issues will not go away.

Despite strong growth in the economy and reducing unemployment, there remains a general reticence in buying Dollars with combination of a general risk recovery and the occasional weak data release (i.e. Tuesday’s disappointing non-manufacturing ISM number) negating the currency’s appeal as a recovery currency.

The fact that the country is also heading towards a Government shutdown (this Friday) as the debt ceiling limit approaches, adds to the uncertainty and keeps investors away from the Greenback.

The Euro Dollar pair breezed through the 1.4250 resistance level and will now eye resistance in the region of 1.4500.

The news last night that Portugal formally went ‘cap in hand’ to the European Union (EU) was no shock coupled with strong German factory orders gave further hold up to the EUR.