The FX Winner

The USD had a mixed overnight despite downgrades in Q1 GDP forecasts and a rally in US treasuries; CHF, JPY, and EUR were the biggest gainers in G10. US trade data was weak; and the monthly budget statement showed a widening deficit. While the trade balance narrowed in February, it does not support a positive contribution to Q1 growth.

Economists have revised their US GDP forecasts for Q1 downward.  The trade numbers follow an IMF growth warning and an IEA report of a slowdown in oil demand growth. The IMF call for action on the US deficit comes ahead of an Obama speech today, where he is to outline an alternative path towards fiscal sustainability. Momentum towards a cut in fiscal spending is building. All this adds to pressure on the Fed to maintain easy monetary policy; Bullard suggests a likely pause after the end of QE2, with tightening only to begin in the winter. We expect today’s March retail sales data to rise to 0.6% after surging 1% in February, but the rise will likely be a result of rising prices rather than real spending, further highlighting overall weakness in growth.

The softer outlook for US growth and increasing signs of a Fed on hold post-June reduce the incentives to switch to alternative funding currencies such as the CHF and JPY. Thus while risk appetite is likely to rebound, and though the rationale for a weaker JPY remains, that weakness may not be expressed against the equally anaemic USD.

But if US growth is entering a soft patch and rates are going to stay low, where are investors to put their excess cash to work? With few alternatives, they will continue to go to where the growth and tightening is: Asia, Latam & Australia. Inevitably this also leads EUR higher through recycling of intervention USDs.

In this context, two key events in Asia will shape risk appetite over the coming days. First up is tomorrow’s policy decision from Singapore’s MAS; on balance, markets are anticipating further tightening, which, if delivered, is likely to set off another shift to Asia and a rebound in risk appetite. A surprise on-hold decision from the MAS will have markets questioning whether this marks the beginning of the end of Asian tightening, potentially triggering another risk-off move as appreciation expectations are scaled back. The second event is Friday’s Chinese data, which will shed further light on the prospects for continued growth in the second-largest economy.

Data show extreme speculative USD selling:

IMM data shows non-commercial accounts selling USD in a big way and now nearing extreme levels Past spot- position analysis would suggest USD selling could continue a little further should the market continue with the current focus on central bank responses to higher oil prices....

We have highlighted how rising inflation expectations have been eating into real yields in recent research pieces. While advising caution, we have been advocating selling the USD versus the EUR, though mindful that at some point higher rates will see EMU peripheral economies entering a fisher style debt trap at which point CDS will rise and undermine the EUR. However, we are not there yet and the market at this juncture remains fixated on how central banks are responding to second round inflation effects coming from soaring crude oil prices.

An examination of publicly available positioning data shows that the heavy selling of the USD may have been led by speculative accounts. The CFTC/NYCE figures on dollar index futures shows that non-commercial accounts are selling just over 36K contracts on dollar index futures. The non-commercial short position was more or less flat at about 2K in mid-2010 but rose to 20K from between August and October 2010, just after the eventful Jackson Hole speech from Fed Chairman Bernanke.

While the selling was pared back heading into the G20 meetings in November, the short position has consistently increased since the turn of the year, rising from 15K up to 35K presently. This is effectively the largest short position since around August 2007 before the financial crisis broke out and even before the bouts of food price inflation were seen in mid-2008. While it signifies vulnerability to a short squeeze, since 2007 the futures positioning data for non-commercial accounts has tended to lead actual dollar index price action since 2007. However, the lead-lag varies between 8 to 12 weeks. Admittedly this overly simplistic position-spot correlation study would suggest that the broader dollar- defined here by the dollar index- could continue to remain under pressure.

Other sentiment indicators like option risk reversals would also suggest ample scope for the USD to weaken further. Chart 2 compares three month 25-delta risk reversals as scaled by implied volatility for the EUR/USD and the AUD/USD. As can be seen, relative to recent history risk reversals seem biased in favour of USD calls still, perhaps as many are still defensively positioned fearing that the USD funded carry trade may be about to unwind.

These indicators would suggest that should the markets initial reaction to higher oil prices continue to remain on the credibility of central banks in dealing with potential second round effects, then the dollar may have much more scope to weaken multi-week. However, once the market senses that central banks are getting behind the curve; negative real rates should see an exodus of capital not only from equities but also money market funds which will see the US dollar rallying.

Indeed, there were already signs of this yesterday with USD/Asia trading higher even as G10 was broadly stronger against the USD in European trading. Our other preferred indicator of US banks’ USD liabilities shows that the US dollar has been the preferred funding currency of choice suggesting that a heavy sell off in emerging markets will turn the USD at some point.

The USD will remain on the back foot even with the release of strong US data. Yesterday, the Beige Book and the ADP reports confirmed that the expansion of the US economy has accelerated in February. However, Fed President Bernanke suggested that rates will only start to rise once there has been a well established trend towards higher employment. That’s not yet the case. FED’s Lockhart views commodity price rises as a temporary event adding that the FED would be wise to complete its current USD 600bln quantitative easing program. Hence, US short term rates have remained anchored at low levels keeping the US yield curve steep for now.

The FED's accommodating stance contrasts with the ECB where today’s press conference will see Trichet preparing markets for a rate hike. CPI running at 2.4% and PPI at 6.1% will provide the arguments for the ECB’s hawkish stance. Hence, EUR/USD will remain supported from a rate differential point of view. Meanwhile, the release of the EU bank stress criteria has been delayed until 18th of March.

The good news is that the ESA will release - with the stress test conditions - how to backstop failing banks. Remember, the reason why the US bank test was successful was not only down to the criteria used, it succeeded due to the decisive injection of equity. It looks like the ESA is now considering a similar procedure. The EUR will react positively. Bundesbank’s Weber’s urging to strengthen the growth and stability pact and to be careful in widening the EFSF and the ESM warns that current EMU reforms may go in the wrong direction, creating future inner EMU tensions. However, the market will not trade on long-term prospects and will continue moving on sovereign funds buying the EUR.

While Middle Eastern event risks loom large we see continued sovereign USD selling. On Wednesday the PBoC announced that it will allow all of its companies to use the RMB for imports and exports. In the past year authorities allowed 67k corporates operating in 20 provinces to use the RMB as a factoring currency.

Although it will take several years until the RMB reaches full convertibility yesterday’s announcement by the PBOC will increase the discussion concerning the USD’s role as a reserve currency. Yesterday, we reported that the hot money inflow has increased from RMB 403bln in December to RMB 501bln. These inflows will boost China’s currency reserves and increase speculation ofChina continuing USD selling via its sovereign accounts.

This morning China reported its February service sector PMI declining to 44.1 reaching a two year low. Chinese New Year distortions have played in and there will certainly be a rebound in the March release. However, we stay convinced that Chinese growth is set to disappoint this year as authorities will have to fight inflation and the speculative hype in the real estate market.

The AUD will suffer once slower Asian/Chinese growth put commodity prices under pressure. This morning Australia reported January building permits falling by 15.9% and while Australia’s January trade balance was coming in stronger than expected at AUD1.8bln there was a notable decline of exports and imports.

Expect the China February PMI to be largely unchanged from January’s level. Regional factory surveys point to a strong ISM index for February.

Non-farm payrolls in February probably grew at their fastest rate since last April.  Our outlook is more optimistic than the typical forecaster and we are looking for non-farm payroll of 200k, against a general consensus of 190k. We do believe the unemployment rate will increase to 9.1% from 9.0%, which is in line with consensus.

The dramatic events in the Middle East over the last few weeks will likely continue to impact global financial markets. We will be watching events in Libya and elsewhere closely.

Monday 28th

India GDP (Q4) We expect 3QFY11 GDP growth to moderate to 8.4% yoy, after growing 8.9% in 2QFY11, mainly due to the weak performance of the manufacturing sector. The consensus expectation is at 8.6% yoy growth. Euro zone CPI (Jan) The preliminary reading of the January CPI came in at 2.4% yoy, above consensus of 2.3% yoy, and contributed to expectations of ECB hikes sooner rather than later. Consensus expects a final reading of 2.4% yoy; we expect a slightly lower reading of 2.3% yoy. Canada GDP (Q4) Consensus expects activity to have grown 3.0% qoq seasonally adjusted and at an annualized rate in Q4, up from 1.0% qoq in Q3. United States Personal income and spending (Jan) We forecast personal income to have grown 1.0% mom in January, above consensus of 0.4% mom, while we think personal spending grew 0.4% mom, in line with consensus. We think the core PCE price index grew 0.12% mom, a touch above consensus of 0.1% mom. United States Chicago PMI (Feb) We forecast a fall to 68.0 in January, a touch above consensus of 67.5 and down from 68.8 in January.

Tuesday 1st

Australia central bank meeting There is a strong consensus that the RBA will leave rates unchanged at its March Board meeting, and rightly so given the dovish commentary out of the central bank over recent weeks. Market pricing suggests just one rate hike is likely over 2011, consistent with our forecast increase in November. However, our rates call is out-of-consensus, with most economists expecting an earlier hike. Indonesia CPI (Feb) We forecast inflation to peak at around 8% in 2Q2011, with quarterly averages of 7.5% and 7.7% for 1Q2011 and 2Q2011 respectively. So far, the rise in headline inflation was largely due to a pickup in food inflation, while core inflation remains stable.

Global PMIs We expect the China February PMI to be largely unchanged from January’s level. There is no consistent bias in historical PMI readings in February. Canada central bank meeting Consensus expects the Bank of Canada to keep the policy rate unchanged at 1%. United States ISM (Feb) Regional factory surveys point to a strong ISM index for February. We forecast a rise in the ISM to 61.0, up from a reading of 60.5 in January. Consensus expects a smaller rise to 60.8. United States Bernanke testimony We expect no significant change in tone in Chairman Bernanke’s monetary policy testimony.

Switzerland GDP (Q4) Consensus expects GDP to grow 0.5% qoq in Q4, after growing 0.7% qoq in Q3. Sweden GDP (Q4) Consensus expects GDP to grow 1.0% qoq in Q4, following growth of 2.1% qoq in the previous quarter. We expect Q4 GDP growth to come in at an above-consensus 1.3% qoq. It is important to note that GDP data in Sweden are prone to revisions and preliminary national accounts data can deviate significantly from the later-revised GDP figures.

Wednesday 2nd

South Korea CPI (Feb) Consensus expects CPI inflation to rise to 4.3% yoy from 4.1% yoy in Jan. We believe February inflation will remain high on elevated food and energy prices and base effects. Australia GDP (Q4) Partial data released thus far (trade, retail sales, capex, construction and motor vehicle sales) suggests economic momentum was pretty modest in the December quarter. Though we will refine our estimate in light of further economic reports this week, we currently estimate the economy expanded by 0.4%qoq. This is below consensus of 0.6% qoq.

Poland GDP (Q4) Consensus expects GDP growth to measure 4.4% yoy in Q4, up slightly from 4.2% yoy in Q3. Poland central bank meeting Consensus expects the policy rate to remain unchanged at 3.75%. Brazil central bank meeting Consensus expects the target rate to be lifted by 50 bps to 11.75%.

Thursday 3rd

Brazil GDP (Q4) We forecast GDP to grow 1.0% qoq, above consensus which is looking for a rise of 0.8% qoq, following a rise of 0.5% qoq in Q3.

Turkey CPI (Feb) Consensus expects inflation to fall to 4.17% yoy in February, down from 4.9% yoy in January. Philippines CPI (Feb) Consensus expects inflation to rise to 3.7% yoy in February, up from 3.5% yoy in January and following a jump from 3.0% in December. Sequential inflation momentum has risen sharply, with inflation running close to 10% mom seasonally adjusted annualized in recent months.

Euro zone central bank meeting

United States initial claims Consensus expects the reading for initial claims to be 395k, against 391k in the previous week. United States non-manufacturing ISM (Feb) We are looking for a reading of 58.5 in January, below consensus of 59.4, which is unchanged from January.

Friday 4th Indonesia central bank meeting We expect Bank Indonesia to raise rates by 25 bp to 7.00% at its monetary policy meeting in March to curb rising inflationary pressures. Consensus is split between on hold and a 25 bps hike. Brazil IPCA (Feb) Consensus expects IPCA inflation to measure 0.83% mom, unchanged from the reading in January. We expect a slightly higher reading of 0.87% mom.

United States Payrolls (Feb) Non-farm payrolls in February probably grew at their fastest rate since last April. We are more optimistic than the typical forecaster and are looking for non-farm payroll of 200k, against consensus of 190k. We think the unemployment rate will rise to 9.1% from 9.0%, which is in line with consensus.

Mexico central bank meeting Banxico is likely to keep the TdF unchanged at 4.50%. Statement neutral (unchanged).

The US Federal Reserve is set to nudge its economic forecasts higher when it releases an update on Wednesday – although recent speeches suggest its officials are less impressed than the markets by stronger data.

The crucial number for judging the Fed’s next move ought to be its forecast for future price rises. If the Fed’s rate-setting open market committee thinks inflation in 2012 or 2013 will be above its goal of "2 per cent or a bit below", then logically it should raise interest rates.

But a quirk in the way the FOMC makes its growth and inflation forecasts means that they are not a clear signal of its plans for monetary policy. To improve communication, some FOMC members think the Fed should consider publishing a forecast of future interest rates as well.

"I think it would be interesting to reveal what is the central tendency or the range of the Fed Funds rate that the committee expects at the end of the year that is consistent with their forecast," said Charles Plosser, president of the Philadelphia Fed.

"I’d certainly like to explore going in that direction," said St Louis Fed president James Bullard.

When FOMC members forecast growth and inflation they must assume "appropriate monetary policy". That may seem innocuous, but it means that each member’s forecast is based on their ideal path for interest rates, and not what they actually expect the Fed to do.

For example, a hawk such as Thomas Hoenig of the Kansas City Fed – who has argued that interest rates should be raised to 1 per cent – should assume those higher rates when forecasting. But the result may be that his predictions do not show the inflation he is concerned about.

"It could easily be the case that two members had a very similar-looking forecast but the path of policy to get there may be very different," said Mr Plosser.

The Fed refused a Freedom of Information Act request for its detailed guidelines on making economic projections. It said that releasing them "would hinder, rather than encourage, honest and frank communication among committee members".

Opinions differ on how important the issue is in practice and all Fed officials argue that their forecasts convey useful information – it is just not the same information as in a private sector forecast of the economy.

"It’s not a pure forecast but the reality is that it’s not very far away," said Frederic Mishkin, a Columbia University professor who pushed for the Fed to publish more detailed forecasts as a governor from 2006 to 2008.

"The differences in forecasts based on what individual FOMC participants believe would be appropriate monetary policy and what they expect the committee to do would not be that great," Mr Mishkin said.

However, when there is a wide range of views on the FOMC the effect on the forecasts becomes larger. Monetary policy takes time to work so the effect is also greater on the forecasts two and three years out.

The result is that the longer-range forecasts are as much a guide to what the Fed is trying to achieve as to what it actually expects to happen. "It tells you what each individual member thinks is possible: it’s a metric on how powerful they think policy is," said Mr Bullard.

That is valuable information but it leaves a gap: the forecasts do not give a clear signal of how the FOMC expects to change policy in the future. Giving an explicit forecast of future interest rates might help the Fed to communicate with the markets.

Mr Mishkin said publishing rate forecasts would be valuable – although less important than the FOMC agreeing on a single clear inflation objective – but he noted a difficulty.

"The problem with interest rate projections is political: the Fed could be accused of flip-flopping," he said. Often, the Fed would not move interest rates as it had forecast when the data changed.

The Fed declined to say whether its working group on communications, led by vice-chair Janet Yellen, was looking at forecasting. Ben Bernanke, chairman, has often spoken in favour of transparency but the forecasts may not be an immediate priority.

Today we are focusing on the JPY and GBP. We expect both currencies to weaken. The JPY has not yet adequately responded to rise of the 2-year US bond yield to 0.85%. US retail sales, the Empire State Index and the NAHB housing market index are due today. Strong readings should put USDJPY above the 83.95 chart level opening upside potential into the 85 handle.

Yesterday’s release of China’s trade numbers showing strong import and export growth in combination with today’s CPI release showing an increase of 4.9%, and thus remaining below the 5.2% consensus estimates, have pushed commodity prices higher as investors gained conviction that China’s boom can continue for somewhat longer without developing overheating tendencies.

In the currency world the JPY and the CHF stand for long cash positions. Hence, we watch international yield levels and with the US bond market being the biggest in the world it is the US bond yield moving the JPY lower.

EUR/USD:

A concern that moved FX markets yesterday was the future of the current President of the Bundesbank Axel Weber. Speculation that the known hawk Weber might not succeed ECB President Jean-Claude Trichet caused the FX markets to fear that the ECB’s monetary policy could remain expansionary in the longer run, putting the euro shortly under pressure.

After that, the attention quickly returned to Fed Chairman Ben Bernanke’s testimony in front of the budget committee of the House of Representatives. But even here markets were disappointed – had they been hoping for some news. Bernanke only acknowledged that there was “some ground for optimism on the employment front” and “increased evidence” for a self sustaining recovery. However, the unemployment rate would remain high for a long time, according to Bernanke. Otherwise, inflation was remaining low and the Fed would remain committed to its target of price stability. At the same time, the Fed had the necessary tools to facilitate a smooth exit from QE2, Bernanke said. to sum it up, nothing new on the Western front: the Fed will continue its QE2 program as planned and the threshold for a change to the program obviously remains very high.

It appears there are no signs that the Fed might raise rates earlier than expected even if the new member of the FOMC, the head of the Dallas Fed Richard Fisher, in particular, continues to sound skeptical about the Fed’s current stance suggesting that at the next FOMC meeting, where he might give a dissenting vote. So, In our opinion, no reason to go long the dollar for longer moves, following the news from the other side of the pond. Today’s US initial jobless claims would have to surprise notably on the upside to provide the dollar with more support again. On the other hand, the euro might only be granted limited upside potential since it should run into good resistance in the 1.3750 area. Therefore, with no major news on the agenda today EUR/USD is likely to trade in a channel.

GBP:

It is our consensus that the Bank of England will not raise rates today. There is nonetheless speculation on the markets that the BoE might become active today. Following the disappointing Q4 GDP data we consider this to be extremely unlikely though. The impression of a continued recovery will have to be confirmed by the economic data published over the coming months.

With regards to the economic uncertainty due to the budget consolidation the BoE will want to ensure that it doesn’t act too quickly. Even though the high inflation rate gives cause for concern, while there are no signs of inflation expectations also rising, the BoE is unlikely to tighten its monetary policy. It will be interesting to see whether MPC member Martin Weale, who voted in favor of a rate hike for the first time at the January meeting will once again vote this way. The disappointing GDP publication might have caused him to change his mind.

However, Weale’s comments suggest that he will again vote for a rate hike. The details will only emerge with the publication of the meeting minutes on February 23rd. We therefore do not expect a surprise today. If rates remain unchanged the GBP might come under slight pressure, as some market participants are likely to feel disappointment. The publication of December’s industrial production data is likely to take a back seat in the run up to the BoE meeting.

AUD:

The Australian labor markets report for January is proof that the RBA is well advised to remain vigilant. Employment recorded a strong +24k increase and the unemployment rate remained stable at 5.0% despite a rising participation rate and despite the floods in Queensland. Even if the flood and cyclone catastrophes are likely to affect economic growth in Q1 this year – Treasurer Wayne Swan even considers a contraction to be possible... the underlying tone remains very positive. The RBA expects growth to accelerate even more in the second half of the year causing it to raise significantly the GDP outlook for 2011 in its Quarterly Monetary Policy Statement last week. There is already a shortage of qualified workers, in particular in the booming commodities sector, and labor market conditions are likely to tighten further over the coming months.

This in turn means there is a considerable risk of an increase in wages. So the RBA is well advised to look through the natural calamities and to continue to base its monetary policy on the medium term outlook. Despite the strong em- ployment report, the AUD has lost ground. Weaker retail sales, the surprisingly early rate hike of the PBoC and failure to break the 1.0180-1.0200 area in AUD/USD this week eventually triggered profit taking.

US:

The Fed should seriously consider pulling back on its $600 billion stimulus program given stronger growth and a brighter jobs picture, Richmond Fed President Jeffrey Lacker told a business gathering overnight. “The distinct improvement in the economic outlook since the program was initiated suggests taking that re-evaluation quite seriously,” Lacker said. “That re-evaluation will be challenging, because inflation is capable of accelerating, even if the level of economic activity has not yet returned to pre-recession trend.”

Dallas Fed President Richard Fisher also said that he would oppose further Fed easing and would move aggressively to trim the central bank's bond holdings should inflation emerge. “Barring some unexpected shock to the economy or financial system, I think we are pushing the envelope with the current round of Treasury purchases,” Fisher, an FOMC voter, said. “It is hard for me to envision a scenario where I would not use my voting position this year to formally dissent should the FOMC recommend another tranche of monetary accommodation.”

Atlanta Fed President Dennis Lockhart said inflation is still below the central bank's comfort levels and price rises for individual goods or services does not signal broader price pressures are around the corner. Lockhart said the central bank cannot address rises in the cost of living, but needs to ensure prices overall remain stable. "For the moment, inflation, properly defined, is tame, in my view. And the rise of individual prices does not signal incipient inflation,'' Lockhart said.

WSJ says the White House will propose a path to wind down and eventually eliminate Fannie Mae and Freddie Mac and specify a range of options to replace the mortgage companies that have played a key role in the housing market for decades, according to people familiar with the matter. (IGM)

EUROPE:

ECB Mersch said policy makers are “obliged to rigorously intervene” if inflation “translates into an impact on price stability through second-round effects.” But he added that rising commodity prices are beyond the central bank’s control, noting that inflationary pressures from food prices should be regarded as “temporary.” EU’s Junker said open to 30 year extension to Greek bailout repayment if Germany agrees to consider. Greek debt buyback an idea worth following, must discuss within eurogroup. Further, Euro bond idea will eventually be agreed but not in near future.

Euro zone finance ministers will discuss how to give their rescue fund more firepower and how to tackle new crises at a meeting on Monday, but final decisions are unlikely before March, euro zone sources said. Finance ministers from the 17 countries that use the euro and the President of the European Central Bank Jean- Claude Trichet meet on 14 February in Brussels to try to make progress on a new, comprehensive response to the sovereign debt crisis. (Reuters) The British government raised its levy on bank balance sheets by GBP 800 million this year, and said it still hoped to reach a deal on bank bonuses and lending levels. The change will bring the total amount raised under the levy to GBP 2.5 billion, up from GBP 1.7 billion. Chancellor of the Exchequer George Osborne told BBC Radio 4 that the decision was a good-faith move designed to ensure banks are fully aware of their operating environment as they prepare to announce bonus payments in coming weeks.

UK CBI expects the economy to grow 0.6% in Q1 compared to the shock 0.5% contraction in Q4. This marks an upgrade from its previous f/c of 0.2% growth although it downgraded its f/c for 2011 GDP growth to 1.8% from 2.0%. The CBI said it expects inflation to peak at 4.5% in Jan and average 4.2% in Q1, which is more than double BoE's 2.0% target. CBI expects BoE to start hiking rates gradually from Q2 of 2011 to reach 1.25% by the end of the year due to persistent high levels of inflation arising from higher energy and commodity prices and the VAT increase. (IGM)

UK shop price inflation to 2.5% y/y in January vs 2.1% in December although discounts and promotions kept it from pushing even higher. The BRC said that January food price inflation rose to 4.6% y/y, its highest level in 18 months as corn prices rose 92% and wheat 80% last year. (IGM)

The Greek paper Kathimerini cites Belgian think tank Bruegel which "has recommended that Greece should restructure its public debt as soon as possible, and that this should be one of the main elements of a comprehensive response to the eurozone crisis to be agreed by European Union leaders when they meet next month.

In a policy brief published on Monday, the Bruegel think tank argues that Greece is “clearly on the verge of insolvency” and that the swift restructuring of its debt, with creditors accepting a 30 percent “haircut,” should form part of a three-pronged strategy that includes the strengthening of the euro-zone banking system and policies to foster greater growth in member states with weak economies. “Our conclusion therefore, is that Greece has become insolvent and that further lending without a significant enough debt reduction is not a viable strategy,” the think tank argues."

CHINA:

The PBoC hiked lending and deposit rates, seen as a more aggressive measure compared with recent RRR hikes In order to control asset inflation, the proportion of deposits relative to overall money supply may have to rise substantially....which in turn opens the scope for substantial tightening which should see “quasi-China” trades like the AUD suffer.

The PBoC hiked key rates by 25 bps on Tuesday, taking the 1Y lending and the deposit rates to 6.06% and 3.00% respectively, effective Wednesday. The move was always expected, though the timing was once again odd- just a day before end of the lunar holidays. The move suggests that authorities remain concerned by inflationary pressures. In the recent policy cycle, authorities have preferred to use quantitative controls (RRR, etc) rather than moving the policy rate. Since the easing seen in 2008/09, the RRR has overtaken the peak seen back in 2008. However, unlike 2008, both the lending and deposit rates have been kept considerably lower- some 100bps below 2008 levels.

However, goods price inflation has been picking up in China more sharply than envisaged previously. While the December CPI moderated to 4.6% from 5.1%, our economists expect CPI to potentially accelerate above 6% in the second quarter. However, the existing inflationary pressures are not only restricted to the goods markets, but also the asset markets, including the property sector.

China has been taking a number of measures to rein in house price inflation since last year, including increasing the down payment for home purchases on second and third home purchases, in addition to increasing the holding period so as to bear down on any speculative investments. The measures appear to have had some effect; for instance, the NDRC house price index has moderated from 11% in Q1 2010 to below 7% in November. However, whether this will be successful enough will likely boil down to whether the authorities are successful in attracting savers to place their income in deposits rather than into the equity and property markets.

Chart 1 plots savings deposits as a proportion of M1 money supply to house price appreciation. As can be seen, the two share a decent negative correlation, implying that authorities would need to orchestrate a higher deposit ratio in order to reign in property price inflation. However, in order to do this, savers and investors would require a much higher real rate of return which is currently being undermined by inflation.

For this to happen, authorities would need to raise rates by a significant margin if chart 2 is to be believed. It plots the real deposit rate against the same savings/money supply ratio. Our economists are looking for RRR hikes up to 22% (from 19% at present) and 150-200bps in lending/deposit rates over the next year. The bottom line is that one should be prepared for the prospect of significant monetary tightening from China in the year ahead. Given the Australian dollar has been driven to overvaluation extremes by global liquidity, if Chinese authorities act to move ahead of the curve and raise rates, the AUD will have a substantial scope to weaken.

EUR/USD is currently rebounding following the stronger than expected Eurozone CPI data which came in at 2.4% y/y in January against the market expectations for a reading of 2.3% y/y. However, we are of the view that the renewed hawkishness of the ECB is just a warning at this stage and that the central bank is not in a position to hike rates given the fragile position at the periphery of Europe. This suggests that EUR/USD rebounds on the current inflation spike will remain limited. Indeed, previous attempts by the ECB to normalize policy over the past year have ended in deeper problems, hence without an agreement regarding a longer term EU rescue framework in place we believe that the ECB will find it difficult to tighten policy without negative implications for the countries struggling at the periphery of Europe. Indeed, the German retail sales fell sharply, declining by 0.3% m/m in December against market expectations for a 2.0% m/m increase. It is also interesting that the German Retailers Association is looking for only flat growth in retail sales in real terms in 2011. The hopes of a recovery in the Eurozone are still very much pinned on German and if German fails to develop any momentum, then the outlook for the periphery remains bleak. We look to sell EURUSD rebounds.

USD/JPY is under pressure with markets jittery over the situation in Egypt and the prospect that the upheaval won’t be limited to just Tunisia and Egypt. US data were upbeat on Friday; Q4 GDP came in a little softer on the headline than expectations at 3.2% but the details of the report lent a strong tone to the report. Consumer spending surged 4.4%, the strongest showing by far in the recovery. Meanwhile trade contributed 3.4pp as imports fell substantially after surging in Q2 and Q3. Inventories subtracted 3.7pp as the inventory cycle came to a close leaving final demand at an impressive 7.1%--the strongest reading since 1984. Meanwhile the UoM rebounded to 75.7 in the second half of January after it dropped to 72.7 in the first half of the month. However, perhaps more important will be the ADP and non farm payrolls report this week, with the FOMC meeting last Wednesday reiterating that the pace of job creation was insufficient grounds for a change in policy. Stronger labor market data could have an impact on perceived interest rate differentials as well as the hedging behavior of Japanese investors. The potential for an unwinding of short USD/JPY hedges will drive the rebound. Support at 81.82 (Jan 19 low), resistance at 82.93 (Friday high).

Hello Traders, This is what JP and the big money traders think! Following the big money is not a bad idea if you know how. Here is what the scuttlebutt is for this week.

With the market anticipating the busy US event schedule along with any further developments from Europe, the Asian session on Monday seemed to be at a loss of direction especially despite the various EU political events and reports by ECB officials over the weekend. Australian 4Q PPI came in on the softer side with import prices being the main drag. AUD fell roughly 25pips following the release but has regained some of its losses. As such, G10 currencies have traded in a narrow range today – NZD is the top performer among G10s closely followed by USD.

The two main points for the week include whether the 2-week-long out-performance of EUR continues, and whether the USD-selling trend continues. Note that last week, the EUR rally combined with USD weakness led EURUSD to trade up to the 1.36’s for the first time since last November given the comments from Trichet along with the easing concerns over European peripherals.

This week is full of US events that could impact the UST yields and hence the dollar – FOMC, 2-year, 5-year, and 7-year UST auctions, along with a number of US economic data releases. We believe risk is to the downside for the greenback, given its weakness despite elevated 10-year UST yields. Thus, any weak economic numbers, strong auction results, or dovish language from the FOMC could lead to a decline in UST yields and to an easy fall for the dollar. US earnings also continue. Also keep in mind this week sees many EM rate announcements, including Bank of Israel and Hungary’s central bank today, which may have the market directing more focus on EM inflation risk.

FX: NZD (0.0%) is the only pair that gained against USD, with AUD (-0.1%) following behind. SEK (-0.3%) and JPY (-0.2%) are the under-performers. FX vol: As per usual on Mondays, vols broadly opened lower than forward vols and have drifted lower. AUDUSD gamma is being offered aggressively despite the upcoming events.

Commodities: Oil up 0.3% at $89.50/barrel. Gold up 0.7% at $1,351.40/oz. Bonds: JGB curve flattened in the morning, but faced steepening pressure in the afternoon. Equities: Equities trade mixed across the region – Nikkei +0.7%, Hang Seng Index -0.3%, Shanghai -0.4%, KOSPI +0.5%.

Until Next Time Happy Trading Kevin.