FX markets continue to accumulate risk correlated trades with the USD being the funding currency of choice. The higher German PMI data (although only slightly) started the EUR run in yesterday's European session and picked up support as anticipation for a hawkish Trichet in tomorrow's ECB meeting gained traction. EURUSD & Euro zone yields rallied as elevated inflation levels, improving economic environment and corresponding comments from ECB members suggest that Europe will tighten ahead of the US.
This sentiment is supported by outgoing voting member and well-known QE dissenter Kansas City Fed President Hoenig, who said that 'QE3' might get discussed should the US economic fundamentals not improve. That said the market truly seemed to embrace this idea that the ECB and Fed are on completely different paths and interest rate differentials will continue to improve in the favor of EUR. And at this point the EUR trade has gotten slightly overbought. The CFTC shows that speculative EUR longs are now at an 11 week high while rates markets are currently pricing 75bp of hike for 2011.
Given the bandwagon mentality of the trade we suspect that heading into the tomorrow's ECB meeting there is considerable opportunity for Trichet to disappoint, and are watching vigilantly for a corrective pullback. Outside the FX markets, there clearly seems to be an improvement in risk sentiment, equity prices continue to rally with DJIA up 1.21% and S&P up 1.65%. Commodities were mixed as crude prices dropped due to the risk premium built up around events in the Middle East declining, while industrial metals such as copper rallied to all time highs - boosted by a string of positive PMIs that provided global growth bulls a sense of optimism.
UK Manufacturing PMI came in significantly stronger than expected at 62.0 vs. 57.9 forecast, providing sterling with the demand to climb to 1.6200. In addition, historical hawk Sentence reiterated his stance that gradual stable hikes now will prevent the BoE from having to tighten too quickly in the future - a course of action that would be potentially even more destabilizing/shocking to the economy. He also warned that markets should not read too deeply into the weak Q4 GDP estimate, stating the impact of bad weather is notoriously difficult to model. We agree with both statements and suspect that the BoE MPC members are leaning towards addressing the growing threat of inflation while we suspect that Q1 GDP will illustrate a healthy UK recovery. As we had suggested yesterday, events in Egypt have faded into the background.
President Mubarak announced that he would not run in September's election but would not step down till then. He insisted that he would finish his term in order to assist an orderly transition to a new government. We doubt this will have a calming effect and suspect protestors will only accept President Mubarak's immediate resignation. It seems like contagion or disruption in oil routes are a limited probability trade for now and believe risk appetite will improve.
In Asia, as China, Taiwan and Korea were preparing for the New Year holiday, news hit the wire that Australia's Cyclone Yasi has been upgraded to max category 5. The news pushed the AUD off its highs and the market predicts further natural disaster induced erosion in economic activity. The spill over effect into regional Asia is likely to be more imported inflation, tighter monetary policy and renewed currency wars(this will be one to watch). As for today, the US ADP will be the economic highlight as a precursor to Fridays critical payroll data.