Dollar Soft, FOMC Announcement Awaited

Some indication of progress on US fiscal talks, anticipation that the Fed extends QE3+ tomorrow, speculation of a cut in China’s required reserve, healthy Spanish T-bill auctions and a much stronger than expected German ZEW survey is encouraging risk-on plays, with the dollar and yen laggards, peripheral bonds firmer, and emerging equity markets extending recent gains. European shares are advancing for the seventh consecutive session.

Outside of the euro, the major currencies are struggling to extend gains against the greenback. Sterling may be struggling on the back of reports that suggest two large UK banks will be paying $2.5 bln in fines to the US though it is a bit simplistic in this day of high finance to expect the banks simply to go to market and purchase the dollars. Separately the UK’s RICS house price balance fell to -9% from -7%, while the market had looked for improvement.

The Swiss franc is back on the defensive as well. It knew that UBS was going to charge fees on franc deposits which encourages speculation that the SNB may do the same, or lower its franc ceiling, at Thursday’s quarterly review. UBS had an existing program, before Credit Suisse’s announcement last week, but today’s move seems to be broadening it to include all 3rd party bank customers. The euro pushed through CHF1.21, but has thus far remained well below the ~CHF1.2165 high from last week.

The dollar extended yesterday’s recovery against the yen. Recent data leaves little doubt that the Japanese economy is contracting for the second consecutive quarter. Deflationary forces continue to be evident. Next week's BOJ meeting comes on the heels of this weekend’s national elections. Political and economic considerations have favored the weak yen story. The five-fold increase in gross short yen futures contracts at the IMM since early Oct illustrates the extent to which sentiment has shifted. Meanwhile, option-related offers near JPY83 are thought to be helping provide a cap to the dollar.

The German ZEW survey showed investor confidence unexpectedly rose to a seventh month high. And why not? Tail risks in the euro area have been reduced (more owing to the ECB, over the BBK’s objections). The German stock market has rallied strongly, with a 5.6% gain in the past month alone (28.3% year-to-date). The ZEW seems more optimistic on the German economic outlook that than the BBK itself which last week warned of a contraction here in Q4 and growth not returning to Q2 13.

Italian bonds and stocks are firmer today. Some observers have downplayed recent political events, suggesting that all that has happened is that the election will be held a few weeks earlier than previously anticipated (February instead of March). Yet something more profound has happened. It revealed the weakness of Monti’s technocratic government reforms. They lack a certain democratic legitimacy. This means that they do not have broad based support. It is seen in the platforms of the major and minor political parties, all of which seem to take exception with this or that reform.

Many ask if Italy can live without Monti, but he has been prime minister for a single year. Perhaps the question is, can Italy live without Berlusconi, who has served three times as premier. Although his party is lagging in the polls, an alliance with the North League and coupled with the growing disenchantment with austerity and recession (which is associated with Monti and the center-left PD seems more committed to) coupled with arcane electoral rules may be sufficient to give Berlusconi a fourth term.