- Dollar Suffers its Biggest Drop in Nearly Three Months as Risk Appetite Surges, but Will it Last?
- Euro Benefits from the Dollar’s Tumble but Greek Bailout Troubles Endure
- British Pound Finds Little Encouragement from Inflation at Levels that Historically Point to Rate Hikes
- Australian Dollar Rallies after RBA Minutes Reveal Last Meeting’s Hold was a Close Call

Dollar Suffers its Biggest Drop in Nearly Three Months as Risk Appetite Surges, but Will it Last?
Drawing a perfect contrast to yesterday’s low-liquidity and low-volatility session, the dollar marked its biggest daily drop since November 25th today as risk appetite burst back to life. The combination of last week’s slow retracement of the January bear wave, an extended absence for American liquidity and the prolonged anticipation of Greek bailout details all worked towards encouraging the sharp advance in investor sentiment through the session. Ultimately, this was a substantial step towards a meaningful reversal for underlying optimism and the US dollar; but this is far from confirmation that a new trend is underway. Risk appetite is a guiding force in its own right; and its consequential peaks and troughs can overwhelm tangible fundamentals trends or even highlight particular elements of the market itself. These are the circumstances that surround the European Union’s efforts to deal with its financially-burdened members. Should risk appetite catch, the market can very well over-look the troubles that this major economic region is facing and instead highlight standout signs of recovery. Are speculators and investors ready to once again spurn risk and leverage themselves for return? Unlikely. The influx of speculative capital through 2009 inflated asset prices to levels that are arguably well above values that are warranted under the restrained outlook for economic recovery. As a loose gauge for how much excess risk premium was worked off in the past month’s retracement, the Dow Jones Industrial Average slipped just a little more than 8 percent from its high this year and carry interests retreated less than 7 percent. Then again, the market can remain rational longer than any one of us can remain solvent.

Euro Benefits from the Dollar’s Tumble but Greek Bailout Troubles Endure
Given the remarkable rally in risk appetite and EURUSD Tuesday, it would seem that the threat of a Greek default has completely diminished. However, this is not the case. In fact, it was the exaggerated sense of fear in capital markets this past month that intensified scrutiny of the European Union’s struggle to bring its member back to code. According to official’s schedule yesterday; the full 27 member nations were expected to convene today on the topic of possibly helping Greece and dealing with other problems that may very well arise going forward. Yet, the commentary that would reach the market would offer little additional information on reaching hard-fast steps towards rescuing the struggling economy should conditions worsen. In fact, Greek Finance Minister Papaconstantinou would remark today that the country is ahead of schedule in reducing its deficit and was not preparing additional measures for the March 16th meeting. Confidence is important to convey; but this lack of a backup plan could prove burdensome. All in all, it seems policy officials may look to skirt this issue in hopes that market sentiment has improved without their having to take steps. That would be quite the gamble. As for scheduled data, the Euro Zone ZEW investor sentiment survey fell for a fifth month; while the German Current Situation component rose to a 15-month high.

British Pound Finds Little Encouragement from Inflation at Levels that Historically Point to Rate Hikes
While a bounce in overall sentiment would help the British pound gain traction against many of its major counterparts; the single currency found little support from a very influential and seemingly hawkish economic release. The year-over-year reading of the consumer price index for January advanced as expected to a 3.5 percent clip while the core reading hit 3.1 percent. This pushed the reading well above the 3.0 percent limit, the level at which the central bank has to pen a letter to the Exchequer. In the note, BoE Governor King said this surge was likely “temporary” and allowed a significant timeframe to ignore heated inflation readings by saying it should cool by the second half of 2010.

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Come April, the entire credit market could see a marked change. For starters, farm loans will be extended at a bank’’s base rate. In addition, the market for short-term loans will shrink. Unlike now, when banks are offering less-than-a-year loans at 6-7 per cent, the lenders will not have the freedom to lend below the base rate from April.

From all available indications, the base rate for most public sector banks will be around 9 per cent and they will be unable to offer below that rate.

“The base rate will put an end to cross-subsidisation. All the rates above the base prime lending rate (BPLR) will now come closer to the base rate and sub-BPLR loans will move above the base rate. Banks will have better bargaining power and bargaining will be more scientific,” said Punjab National Bank Chairman and Managing Director KR Kamath.
Punjab & Sind Bank Chairman and Managing Director GS Vedi said base rates would bring in more transparency and would be beneficial to the borrower.

In a note, ICICI Securities said if the Reserve Bank of India’’s draft guidelines were implemented from April, as proposed, the new norms might affect short-term borrowings by non-banking finance companies and some companies, as their current short-term borrowing rates were lower than the base rate for most banks.

“Bankers were mispricing loans under the present system. Sub-BPLR lending for loans up to Rs 2 lakh, which is proposed to be permitted, will help improve availability of credit and pricing for small borrowers,” added Union Bank of India Chairman and Managing Director MV Nair.

“SME (small and medium enterprises) borrowers, who got loans at higher rates, will be able to reduce their cost of borrowing,” Indian Overseas Bank Chairman and Managing Director SA Bhat told a news agency. At present, SMEs are availing credit at around 14-16 per cent.

In addition, a private sector bank executive said banks would exercise the interest rate reset option at faster frequency, as the base rate would be more dynamic. Given that it will be linked to the cash reserve ratio, which RBI uses as a tool to periodically adjust liquidity and the cost of deposits, the rates are going to be more dynamic. Besides, it will also be a function of loan demand and the amount of liquidity available in the market.

For instance, given that banks are parking around Rs 75,000 crore to Rs 80,000 crore through RBI’’s reverse repo window used to suck out excess liquidity, they are expected to continue maintaining higher than the prescribed 25 per cent statutory liquidity ratio. “The market for short-term loans will shrink, but banks will look to invest more in corporate bonds and commercial papers given the restriction on lending below the base rate,” said Corporation Bank Chairman and Managing Director JM Garg.

But there are some issues on which bankers are seeking greater clarity.

“It is unclear whether the tenor premium can be considered as tenor discount. For instance, if I want to lend for short term, it doesn”t make sense to add a tenor premium to my base rate. Any lending for a tenor below my base rate tenor should have a tenor discount,” the chief financial officer of a private sector bank said.

Besides, some of the lenders will approach RBI to put curbs on sub-base rate lending in phases. “It will affect our overall structure given that majority of the loans are below the existing benchmark rate,” said an executive at one of the largest banks in the country.

Corporation Bank’’s Garg said the bank would see yield on advances rise marginally from the present level of 10 per cent, as 80 per cent of the loans were extended below the prevailing BPLR. “On short-term loans, I was earning 6 per cent, which will be 9 per cent or higher from April,” he said.

But, as far as margins are concerned, PNB’’s Kamath said it would be zero sum game.
Meanwhile, at a meeting with bank chiefs on Thursday, RBI said that lenders should be ready to roll out the base rate mechanism from April and added that it would address any concerns that banks had.

Introduction of base rate will result in sharp reduction.
Bankers are still busy with their calculators trying to work out the proposed base rate that the Reserve Bank of India (RBI) plans to introduce from April but they estimate the benchmark rate will decline to around 9 per cent from 11-15.75 per cent at present.

State Bank of India, the country’s largest lender, has estimated its base rate at around 9 per cent against the prevailing benchmark prime lending rate (BPLR) of 11.75 per cent. Ditto for Union Bank of India.

Similarly, a Bank of India executive said the base rate will be around 300 basis points lower than the prevailing BPLR of 12 per cent.

Corporation Bank sees it a tad higher, while Allahabad Bank and Punjab & Sind Bank expect the rate to be between 9 and 10 per cent.

Last evening, RBI issued draft guidelines that proposed to shift from a system of benchmark prime lending rate to a system of base rate from April.

RBI has proposed that banks calculate the base rate on the basis of the cost of funds, overhead costs, adjust for the “negative carry” for funds impounded for the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR) and add a profit margin.

The main ingredient will be the cost of deposits, with banks that have lower costs, such as SBI, having an edge over the others. “Given that the base rate will be a function of the cost of deposits and operating efficiencies, banks with higher Casa (current and savings account balances) and lower cost-assets (ratio) will benefit as their base rate would be lower than industry average, thereby allowing them to earn higher spreads on their products,” ICICI Securities said in a note.

At the same time bankers warned that the rates they have calculated are based on the present cost of deposits. “It base rate may vary every quarter because of cost of funds, CRR and SLR. It will become very dynamic and can change on quarterly or even on a monthly basis,” said Corporation Bank Chairman and Managing Director JM Garg.

The adjustment for negative carry on CRR and SLR will result in a gain of around one percentage point for banks.

While Union Bank of India Chairman and Managing Director M V Nair, who is also the chairman of the Indian Banks” Association said that the move will bring about more transparency in pricing, bankers said, it will put an end to the bargaining power of large companies. That is because RBI wants to put an end to sub-base rate lending for all segments other than export finance and directed rate of interest (DRI) scheme for low income groups.

Bankers said only large public sector companies and AAA-rated private players would be able to avail of loans at base rate. Similarly, only short-term loans such as working capital will be available at the base rate.

Short-term rates for large players may go up, but the good news is that bankers expect the lending rates for small and medium enterprises to fall.

“Even that will be a function of demand and supply, if the credit demand is high and liquidity is tight, then the best borrower will also have to pay a premium,” said Corporation Bank’s Garg.

Early yesterday afternoon, the US and Canada simultaneously released their Trade Balance. The U.S December Trade Balance came out wider than expected ” the deficit rose to -40.2B as imports surged more than exports.

Forex Analysts had predicted that the deficit would contract to 35.8B from its previous reported level of 36.4B, instead the US trade gap unexpectedly widened to its biggest level this year.

Even though exports climbed to their highest level since October “08, this eighth consecutive rise in exports was trumped by an 8.4% increase in Imports (particularly petroleum).

The result of faster economic growth in emerging countries combined with a drop in the dollar’s value is allowing American goods are becoming more competitive and may in fact propel gains in sales overseas that will spur further gains in U.S. manufacturing.

On the other side of the 49th parallel, Canada also saw their Trade Deficit widen more than expected. As imports slightly outpaced exports, Canada’s trade deficit remained at 0.2B, versus the expected forecast that the trade deficit would shrink to 0.1B. The 1.7% increase in exports was slightly outpaced by a 1.8% rise in imports resulting in Canada’s trade deficit with the world widening to $246 million in December from $201 million in November.

According to the Bank of Canada, the combination of low U.S demand and strong Canadian dollar are a “significant drag” on the economy. Governor Mark Carney has pledged to keep his benchmark lending rate at a record 0.25 percent through June to stimulate demand unless the inflation outlook shifts.

Following the release of both countries trade balances, the Canadian currency tumbled against the USD- the pair increased from the day’s open of 1.06651 USD/CAD to 1.0686; however, by yesterday’s close, the Loonie managed to regain some of its lost ground against its US counterpart- closing at 1.06265.

Across the Atlantic, the Euro continues to move away from its 8 month low against the USD, as speculations increase that today’s EU summit will shed light on a possible rescue package for Greece. With the EU holding their 1 day summit today, the EUR increased from yesterday’s close of 1.37336USD to a high of 1.37995 in Asian markets early this morning.

While the Euro continues to rise versus its American counterpart, the British Pound continues to plummet against the USD. Yesterday, the Sterling was hit hard as the BoE Inflation report forecasted low inflation for a long period, suggesting more quantitative easing ahead; the Pound plunged 0.88% from its opening price of 1.57088 to 1.55701, finishing off the day at 1.55974.

Yesterday, the Bank of England lowered U.K.’s economic outlook and forecast inflation to undershoot its 2% target. The central bank Governor Mervyn King also kept the door open for further quantitative easing.

Britain’s February Inflation Report depicts economic growth to reach around 3.2% in the second quarter of next year- smaller than the previous estimate of 4%. According the BoE, the strength of the recovery is highly uncertain and output is unlikely to return to a level consistent with its pre-crisis trend for a considerable period.

King forecasted inflation to exceed 3% in January, but estimates the figure to fall below the target quickly. Annual inflation had exceeded the central bank’s 2% target in December for the first time since May 2009 and stood at a nine-month high of 2.9%. “It is more likely than not that inflation will be below the target for much of the forecast period, but the risks are broadly balanced by the end,” the bank said.

Shortly midnight, Australia released its employment change for January as well as its current unemployment rate. With both numbers coming out better than expected ” employment change increased to 52.7K versus expected 15.1K causing the unemployment rate to tumble to 5.3% versus expected 5.6% and prior 5.5% ” the Aussie rose more than 1% against the dollar and the Yen.

The AUD/USD opened in Asian Markets this morning at 0.87506- after the release of the better than expected employment data, the pair increased 1.75% to a week high of 0.89040.

Canada’s dollar dropped by the most in almost three months as oil fell and a report showed consumer prices rose less last month than forecast, reducing the chance the central bank will raise rates before the second half.

The currency declined for a second day, touching the lowest level in more than two weeks, as stocks fell and the U.S. dollar rose against all of its major counterparts. Canadian government bonds climbed.

“The numbers are suggesting people are getting nervous,” said David Watt, senior currency strategist in Toronto at Royal Bank of Canada, the nation’s biggest lender. “The Bank of Canada is heading to a tightening campaign in the third quarter now the debate is will they go in July or September.”

The Canadian currency, nicknamed the loonie, depreciated 1.6 percent to C$1.0479 per U.S. dollar at 12:10 p.m. in Toronto, from C$1.0314 yesterday. It dropped as much as 1.7 percent, the most on an intraday basis since Oct. 30, to touch C$1.0489, the weakest level since Jan. 4. One Canadian dollar buys 95.43 U.S. cents.

The consumer price index rose 1.3 percent in December from a year earlier after gaining 1 percent in the previous month, Statistics Canada said today in Ottawa. The median forecast of 26 economists in a Bloomberg News survey was for a 1.6 percent gain. Core inflation, which excludes energy and food, was unchanged at an annualized 1.5 percent, less than forecast. The Bank of Canada’s inflation target is 2 percent.

U.S. Dollar Strength
The greenback gained against all 16 of its most-traded counterparts tracked by Bloomberg. The Canadian currency fell against 12.

“The soft CPI numbers were somewhat of a catalyst for the price action, but the U.S. dollar has been strong across the board, which means weakness for Canada, the other commodity currencies and the euro,” said Jack Spitz, managing director of foreign exchange at National Bank of Canada in Toronto.

Crude oil for February delivery dropped 2.4 percent to $77.12 a barrel on the New York Mercantile Exchange. Raw materials generate half of Canada’s export revenue, and crude is the nation’s biggest export. Stocks fell, with the Standard & Poor’s 500 Index plunging 1.6 percent.

The yield on Canada’s two-year note tumbled as much as eight basis points, or 0.08 percentage point, to touch 1.19 percent, the lowest level since Dec. 8, before trading at 1.2 percent. The price of the 1.25 percent security maturing in December 2011 rose 11 cents to C$100.10. The benchmark 10-year note’s yield fell as much as seven basis points to 3.41 percent, the lowest since Dec. 18.

Validates Rate Decision
The lack of change in the core consumer-price data today “validates the central bank’s decision to keep interest rates at rock-bottom levels,” Erin Weir, an economist for the United Steelworkers union in Toronto, wrote in a note. “The prospect of having to raise rates to quell inflation is far away.”

Canada’s central bank held the benchmark overnight lending rate at a record low 0.25 percent yesterday. Policy makers reiterated they will keep the rate there through June, barring a change in the inflation outlook, and repeated that the Canadian currency’s “persistent strength” hampers economic recovery.

The benchmark lending rate was 4.5 percent when the bank began cutting it in December 2007.

Currency traders are betting which countries will raise interest rates as the global economy shows signs of emerging from the worst recession in more than half a century. Investors tend to favor the currencies of nations whose borrowing costs are rising because yields are higher.

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Chinese authorities signaled Wednesday that bank lending would slow significantly this year, the latest in a series of moves intended to forestall inflation and stave off bubbles in the stock and property markets.

Liu Mingkang, chairman of the China Banking Regulatory Commission, said he expected Chinese banks to extend loans totaling about 7.5 trillion renminbi ($1.1 trillion), a decline of nearly 22 percent from the record 9.6 trillion renminbi lent last year.

“This year we will continue to control the pace and demand of the credit supply,” Mr. Liu said at a conference in Hong Kong, The Associated Press reported. He added that regulators were paying special attention to loans for local government projects and real estate. All banks, he added, had been ordered to “heighten their vigilance against an impossible, embedded credit risk.”

Stock markets in China and Hong Kong fell on the news. The Shanghai composite index, the main gauge of the mainland Chinese market, ended 2.9 percent lower, while the Hang Seng index in Hong Kong dropped 1.8 percent.

Shares in Bank of China and China Construction Bank sagged 3.4 percent and 3.1 percent, respectively, in Hong Kong, while Industrial and Commercial Bank of China fell 2.6 percent.

Still, economists said the signal from Chinese policy makers was neither surprising nor drastic and showed that Beijing was “tapping on the brakes” rather than engineering a major policy reversal.

“The 7.5 trillion renminbi target for this year is hardly an insignificant amount by anyone’s definition,” said Patrick Bennett, a strategist at Socit-Gnrale in Hong Kong, adding that he believed the market reaction had been excessive.

“Bank lending has apparently been strong in the first weeks of the year,” Mr. Bennett said, “and the recent policy moves and announcements are clearly designed to deal with that at an early opportunity.”

A government stimulus package worth 4 trillion renminbi ($645 billion), coupled with the spree of easy credit as the country’s state-owned banks were told to lend freely, helped China stave off a sharp economic slowdown last year.

The easy cash has helped drive a rapid rise in China’s stock and property markets, while feeding concerns that some of the loans extended by eager banks may turn sour.

Inflation has been on the rise as the Chinese economy has picked up speed, adding to the pressure on the authorities to temper economic activity and limit price increases.

Zhu Baoliang, chief economist for the State Information Center and a senior government official, said Wednesday that consumer price inflation had accelerated “significantly” in December and was likely to average 3 percent this year, Reuters reported.

At the same time, exports, a main driver of China’s economic growth, rebounded more quickly than expected at the end of last year, giving the authorities more leeway to unwind some extraordinary stimulus measures.

In another recent action to scale back lending, the Chinese central bank ordered state-owned banks last week to set aside a bigger share of their deposits as a reserve against failed loans – 16 percent for larger banks, an increase of half a percentage point. Smaller banks reserve requirements were raised to 14 percent, from 13.5 percent.

The central bank raised the rate on a closely watched interbank loan this month, and it raised the rate on its one-year bills. Analysts also expect China to start gradual increases in the benchmark lending rate – a more sweeping policy tool – though that is not expected until the second half of the year.

So far, only a handful of countries, including Australia and Norway, have begun to nudge up interest rates as their recoveries have taken hold.

Summary (Euro Outlook: Neutral)
- Events: Tues-German, Euro-zone, ZEW Sentiment, Wed-German PPI m/m, y/y, Thurs-ECB Monthly Bulletin, Flash Manufacturing and Services PMIs for the Euro-zone, France, Germany
- The ECB’s tough choice: remain on target for stimulus exit and rate increases later this year and boost the euro, but a strong euro would do to the weaker economies exports
- EZ ongoing Greek tragedy could spread well beyond its national borders, Spain & others could be worse still, plenty of other fiscal problem children, so ECB must make an example of Greece
- German Economic Minister Bruederle talks down euro sentiment, saying that Germany was not experiencing a self-sustaining economic recovery
- Economic data further undermined euro this past week
- EURUSD maintains its ascending channel for now despite the above travails

Analysis
While the EURUSD can be a misleading gauge of strength for the euro (as it has recently been more responsive to the US dollar), the benchmark pair currently presents an accurate portrayal of the single currency, its main uptrend long broken by dollar strength, now struggling to hold onto another such rising channel.

Key Euro Drivers
Taking a quick glance across the majors, it becomes apparent that nearly every one of the euro crosses is sitting at the bottom of a broad range. It is make or break time for the unloved currency; and the catalyst for its ultimate bearing will likely fall to one of four pressing issues:
1. The financial stability of the European Community (particularly of the PIGS: Portugal, Greece, Ireland/Italy, Spain), referred to often in these pages as sovereign debt threat
2. US dollar performance either improved fundamentals or
3. US dollar performance as a safe haven should risk appetite retreat
4. A meaningful change in interest rate forecasts

The US Dollar
The primary driver of the euro is the interplay of risk appetite and the dollar, points 2 and 3. Because the EUR/USD pair by itself is about 30% of all forex trade, these two currencies tend to push each other in opposite directions. Should risk appetite rally or plummet, expect EURUSD to follow suit. See our US Dollar Weekly Outlook for the key events and forces to watch for measuring the dollar’s outlook, and thus so too the euro’s.

Sovereign Debt Threat
The next major concern is the threat of further sovereign debt downgrade or outright default. This has loomed large over the euro since Dubai World’s problems drew attention to sovereign credit risk and got the various rating agencies attention and alerted them not to be caught unawares again.?? The failing financial health of Greece, which clearly has lacked the political will for real financial reform, has undermined confidence in the euro and in prospects for the growth, stimulus reduction, and rate increases needed to support the euro.

The downside of developing a single market among different nations has been laid bare through the recent economic difficulties. In sum, fundamentally different economies have different needs and priorities While German and France have been quick to recover and can benefit from a stronger euro as the group’s most prosperous members, others have struggled to recover, particularly as a strengthening euro hits their more easily replaceable, less competitive exports, harder.

Most crucially, each member government gives up lot of flexibility to combat financial downturns, like its right to individually adjust monetary policy, manipulate its currency, increase its debt load and more, that have given the US, UK, and others crucial tools to adapt to unfavorable conditions. It is unclear how many of the weaker members will meet the goals policy makers have set out and EU officials have warned no exceptions will be made. Currently the balance of power in setting policy is clearly with the wealthier Northern countries.

The current picture offers no clear solution. The Greek PM reiterated that Greece was not seeking any IMF bailout or planning to exit the Euro Zone, but then again he provided practically no details on how the country would finance its budget or drastically cut its debt-to-GDP ratio in order to meet the EU’s Maastrict criteria. The ECB published its opinion on Greek debt restructuring law, stating that the move could hinder the flow of credit and hurt markets. On Friday, the ECB’s Trichet talked tough, declaring that the country has a “major debt problem” and that no government should expect special treatment,” specifically mentioning both the Greek and Irish situations. His words pushed the 10-year Greek/Bund spread beyond the 280bps level. Spreads among other peripheral European debt have widened noticeably as well: the Ireland/Bund 10-year spread was at +162bps, while the Portugal spread was at over +95 bps, at its widest level since last April. In short, it’s getting more expensive for these countries to borrow, creating a vicious downward spiral.

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