Over the past few weeks the Euro has formed a triple bottom at 1.3450 against the Dollar (the lows were on 19 Feb, 25 Feb and 2 Mar 2010).  Triple bottoms are rare in markets because most times a market prints a bottom, bounces off that bottom the first time it is tested but breaks through the support level if it is tested again (hence the old trading adage “Fade the first test but Go With the second test”).

The Euro now appears to have absorbed the selling pressure which has resulted from the problems Greece has been having in refinancing its borrowings.  Whilst the EU has pledged not to abandon Greece it has still not given any firm details on how it plans to offer support to Greece other than to encourage Greece to reduce its budget deficit towards 3% of GDP (as per the euro-zone’s Growth & Stability Pact).  Greece for its part “would like to borrow on the same terms” as other euro-zone members.  However the bond markets will demand a substantial premium to lend money to Greece until it proves it is actually carrying out the deficit-reduction measures it has promised in recent weeks. Yesterday Greece sold a €5 bln 10-year bond with a coupon of 6.25%, yielding roughly 312 bps over Bunds.

It has also become clearer over recent weeks that any support extended to Greece by the EU will not formally involve the ECB printing any money.  Euro-zone member governments have met public opposition to bailing out Greece with taxpayers’ money and the German press in particular has run stories opposing bailing out Greece if it means Greek public sector workers can still retire earlier than their German equivalents or even suggesting Greece sell off some of its uninhabited islands to raise some money.  Greece has in turn demanded the Germans return Greek gold which the Nazis allegedly stole during World War II…

Back to reality.  The receding prospect of the ECB printing money has helped the Euro to find support over recent weeks.  There is a subtle difference between the ECB printing money in order to buy Greek bonds and other euro-zone banks buying Greek bonds yielding circa 6% (with a strong nudge and guarantees from their respective governments) which they then use as collateral to borrow money from the ECB (at 1%).  The latter is simply good banking even if the net effect either way is the ECB finances loaning Greece money.  In the latter case the ECB can correctly claim that the risk lies not with it but with the banks.

Now that the Euro has found support at 1.3450 (until the market proves us wrong), the forex market can switch its attention to giving the Pound Sterling a good kicking in the run up to the May General Election.

Last Thursday the Fed raised its discount rate by 25 bps to 0.75%, as highlighted 8 days previously in Bernanke’s Exit Strategy speech on 10 Feb 2010.  As a result it now stands 50 bps above the upper limit of the current 0% – 0.25% range for the Fed Funds rate.  The Fed also took the opportunity to announce the return to the usual 1-day time limit for banks borrowing at the discount window (down from 30 days which was first put in place on 17 August 2007 - as the credit crunch first started to bite).  These actions indicate that the Fed is confident that the banks have now got their funding arrangements back into good order.

Despite the FT’s Lex column (20 Feb 2010) claiming that the discount rate is “almost irrelevant these days”, the Fed’s discount rate will become very important when the Fed eventually begins its next rate tightening cycle.  This is because the discount rate effectively represents the upper bound of the overnight interest rate during the period when the Fed is steadily raising rates.  The market doesn’t care about the lower boundary for overnight interest rates when rates are trending higher.

The Fed has also taken the precaution of giving itself the option of paying interest on money that US banks have placed on deposit at the 12 Federal Reserve Banks ($1.1 trillion is currently sitting on deposit).  In this way the Fed can force market interest rates higher should it prove difficult to get the Fed Funds rate moving in the desired direction (because of the $1.725 trillion which the Fed has thus far supplied to the markets via its Quantitative Easing efforts).

However any actual rise in US interest rates is still over the horizon and well out of sight.  The Fed has a so-called dual mandate to both contain inflation and promote employment (unlike the ECB which is only tasked with keeping inflation under control).  US unemployment is still very high at 9.7%  and, counter-intuitively, the unemployment rate may well rise further as a strengthening economy creates jobs.  Bernanke said in testimony this week that low interest rates “are supporting a nascent economic recovery”  and that “although the federal funds rate is likely to remain exceptionally low for an extended period, as the expansion matures, the Federal Reserve will at some point need to begin to tighten monetary conditions to prevent the development of inflationary pressures”.  In plain English, the Fed is going to wait and let the economy grow and create lots of jobs before risking its first rate rise. 

The Fed is simply getting its ducks in a row by preparing the ground for an eventual rate raising cycle.  It has to raise the discount rate first in order to create some additional headroom above the Fed Funds rate which it can then rise into.  By raising the discount rate well in advance of any hike in the Fed Funds rate, the Fed can now sit back and watch the market’s reaction, paying particular attention to 3-month Dollar Libor (the rate at which banks borrow Dollars from each other for a period of 3 months), which has been trading around 26 bps for many weeks now.

The Fed would like banks to borrow from each other and ideally to obtain funds from depositors rather than directly from the Fed itself at the discount window.  Historically the discount rate has been kept 100 bps above the Fed Funds rate and we can expect the Fed to aim for this level in future months.

The Euro continues to trend lower against the Dollar as the recent turmoil in Greece’s government bond markets has started to spread to Portugal and Spain too.  Events are starting to spiral out of control, evidenced by 10-year Greek bond yields rising from below 6% to more than 7% over the past few weeks (inflicting losses on the buyers of Greece’s €8 bln 6.2% 2015 bond which was issued on 25th Jan 2010).

Eight billion euros is only the first instalment on the €53 bln which Greece needs to raise in 2010 and it is this impending refinancing need which will bring matters to a head sooner rather then later.  Greece is now in the market’s spotlight and is really in trouble because this particular bond market storm is not going to simply blow itself out and go away.

The panic in Greece’s bond market is going to have to get a whole lot worse and this will eventually force the rest of the Euro-zone to act.  The markets don’t believe that the Greek government will be able to impose austerity measures on the Greek public (public demonstrations and strikes have already started).  ECB President Trichet has been quoted as saying ”We expect and we are confident that the Greek government will take all the decisions that will permit them to reach their goal”.  What else can he say?  If he told the truth and said they were stuck like pigs in a poke and the squealing would have to get a whole lot louder before they get bailed out, then Greece’s bond market collapse would intensify and yields would rise even more rapidly.

The endgame is fast approaching and it will not include the IMF lending money.  The bigger and more stable members of the Euro cannot allow Greece to be rescued by the IMF and thereby show the whole world that Euro-land can’t manage its own internal affairs.  Whatever tax-raising promises get made by the Greek government are irrelevant (as only time will tell whether they can actually impose the promised tax rises on the Greek public) as Greece does not have the luxury of time on its side.  

The end of this crisis will be signalled by a large amount of money being loaned to Greece by any or all of the following : Germany, France and the ECB.  Watch out for a classic euro-zone “enhanced credit support” fudge whereby the ECB suddenly decides to embark upon Quantitative Easing which involves the purchase of large quantities of euro-zone members’ government bonds.  The EU itself cannot extend a long-term loan because it also represents non-eurozone members.

Markets are going to become even more disorderly before this panic is over but the bigger picture is that this is a panic in the PIIGS’ government bond markets and, whilst it may impact other markets in the short-term, the resolution of the crisis will provide a buying opportunity across multiple asset classes.  The Euro will keep trending lower against the Dollar (and Sterling to a lesser extent) until the crisis is resolved because the resolution may involve the ECB printing a few hundred billion euros.  The ECB will then have joined the other major central banks in the Race to the Bottom and, as usual, the ECB will once again have proved itself to be the slowest to act.

Do the last three weeks of US Dollar strength represent the start of a bigger upswing in the fortunes of the Dollar?

We have just seen the Dollar close higher for three consecutive weeks, as measured by the Dollar Index. This hasn’t happened since the Dollar topped out in March 2009 (as global stockmarkets simultaneously bottomed).  We last saw a strong Dollar rally during July – November 2008 as a mad scramble for dollars took place – see “Get me a Printing Press“.

There is also a confluence of fundamental factors coming together at the moment which together provide a more solid basis for a sustainable rally in the Dollar.  The Fed is scheduled to end its current bout of $1.75 trillion QE bond purchases by the end of Q1 2010.  In addition this week’s FOMC statement highlighted that most of the Fed’s special liquidity facilities will expire on 1 Feb 2010 and that the Fed will also be closing its Dollar swap arrangements with other central banks by 1 Feb 2010 too.  The net effect is that the Fed will be shutting down three different ways in which it has been supplying Dollars to the markets.

For its part, the Euro has been impacted by the recent turmoil seen in Greece’s government bond markets and the currency markets have once again taken note that the Euro is not the same thing as a Deutschmark and it can be undermined to a certain extent by the PIIGS membership.  If Greece really got into trouble, there is no way that the other, more stable, members of the Euro would allow Greece to be rescued by the IMF (and thereby show to the whole world that Euro-land couldn’t manage its own internal affairs).

The Japanese Central Bank is also offering 10 trillion Yen in 90-day money into its money market, although the Japanese have historically been quite timid with their Quantitative Easing and this measure runs true to form in being less aggressive than, say, purchasing long-term government bonds.

Finally the US employment report for November 2009 showed both the unemployment rate falling and weekly hours worked rising.  This implies stronger US GDP (70% of which is consumer spending) which has also served to boost the Dollar.

Neither is the Fed itself going to stand in the way of a Dollar rally.  Now that a tentative recovery has been established in the States and GDP is growing again, the Fed does not need to manage the Dollar lower from here but it would surely be happy to see a combination of the Dollar rallying and lower oil prices (which would serve to keep inflation under control and lower gasoline prices would put more money into consumers pockets).

A Dollar rally at this stage is not negative for US stockmarkets because consumers having more money to spend means that companies can grow their top-line sales and generate higher profits.  These higher profits will help to keep the stockmarket rallying into 2010 (the Dow has been in a 10,200-10,500 range for the last 5 weeks, consolidating now that it has recovered half of its Oct 2007 – March 2009 losses).

There has been some comment about the Fed now having just 100 bps of rate-cutting firepower left and that when rates are this low then cutting them further will be like pushing on a piece of string, i.e. it will have no real effect in stimulating demand.  Doubters of the Fed’s true firepower would be well advised to re-acquaint themselves with a speech given by Ben Bernanke in November 2002 (well before he became Chairman of the Fed). 

This important speech entitled “Deflation: Making Sure ‘It’ Doesn’t Happen Here”, see  http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm , also effectively kickstarted the Dollar to embark upon a six-year slide (finally reaching a low in mid-2008 before the current Dollar rally began in August when the latest planet-wide mad scramble for Dollars started – which has in turn resulted in the Fed creating currency swap lines with other central banks around the globe).

Essentially Ben highlighted that central banks do not run out of stimulatory firepower once the overnight rate reaches zero.  They can move out along the yield curve, buying 3-month paper and then buying paper of progressively longer maturities in order to force market rates lower (accurately foretelling the Fed’s recent buying of commercial paper).  They can also print currency and distribute it to consumers in order to stimulate spending (adding a ‘use-by date’ to the newly printed currency would encourage consumers to spend it rather than hoard it).  This latter suggestion is what prompted the “Helicopter Ben” tag-line although I always preferred Ben “Gutenberg” Bernanke, but then again I do live in Europe.

It took the Japanese over a decade to get around to “quantitative easing” – don’t expect the Fed to drag its feet if it becomes necessary…