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.

The first hint of higher interest rates in the States arrived after this week’s FOMC meeting.  Thomas Hoenig (President of the Kansas City Fed) emerged as the first interest rate hawk on the FOMC and voted against an unchanged monetary policy.  Hoenig “believed that economic and financial conditions had changed sufficiently that the expectation of exceptionally low levels of the Fed funds rate for an extended period was no longer warranted”.  In plain English Hoenig wants the Fed to signal to the markets that it is going to begin hiking interest rates at some stage in the not too distant future.

At the moment Hoenig is the only dissenter on the FOMC.  It will pay to keep a close eye on whether his view gathers support at future FOMC meetings.

The market’s reaction thus far to Wednesday’s announcement has been most evident in the US Dollar.  Its rally, which began after the 4 Dec 2009 Employment Report, has continued and the Dollar Index (DX) has now broken above its 200-dma.  The 50- and 200-week moving averages are the next resistance levels to be surmounted and they lie just above the current 79.59 level of the DX.  Hoenig hankering after US rate hikes will only serve to help the Dollar to extend its recent rally.  Commodities (as measured by the CRB index) have reacted badly, the US stockmarkets have remained under pressure (but they started falling two weeks ago) but the all-important US Treasury bond market has traded sideways despite Hoenig hinting at higher rates sooner rather than later.

However it is difficult to believe that the Fed is going to implement the first rate hike until the US economic recovery has gained significant traction which results in a very visible fall in the unemployment rate from its current 10%.  There is so much spare capacity in the States that the Fed can afford to let growth continue to build momentum without worrying about higher inflation resulting anytime soon.  Any premature rate hikes would be a serious policy error which would impact the economy & stockmarkets severely.

A more likely explanation for Hoenig’s action in voting against the others is that it allows the Fed to test the market’s reaction to a proposed change in the current policy stance of “low rates for yonks”.  If markets react badly over the next few weeks (particularly if the US bond market tanks) then we can expect all the other FOMC members to very publicly bang the drum that interest rates are not going up anytime soon.  The FOMC knows full well that it will eventually have to tell the markets that rates are not going to stay at “exceptionally low levels for an extended period” and this is a low risk way for it to prepare the markets for an eventual change in monetary policy.

I still think that the first US rate rise is out of view and over the horizon (and more likely to take place in 2011 than 2010) but will be paying close attention to future FOMC statements for clues as to when policy is likely to change.

The Fed and the BoE are going to allow themselves to fall behind the curve as they seek to hold rates low whilst an economic recovery gains traction and begins to absorb some of the spare capacity which has been created by the recent recession (i.e. unemployment falls and manufacturers’ capacity utilisation rises).

We saw the first inklings of how this will play out in practise after last Friday’s US employment report.  A stronger than expected 4th December 2009 report (which showed the unemployment rate falling by 2/10ths and non-farm payrolls essentially unchanged at -11,000, together with the prior two months revised to show 159,000 fewer jobs lost) caused the market to price in a rate hike by the Fed in Q2 2010 and the Dollar rallied on expectations of US rates rising.  However the Fed will probably keep rates on hold for far longer than the market currently thinks and we are going to see repeated attempts by the market to price in a series of rates hikes which will fail to materialise on time as the Fed stays firmly & willingly behind the curve.

So the US and UK yield curves are likely to steepen further as the Fed and BoE deliberately keep rates on hold whilst an economic recovery builds strength and they will want to see their respective unemployment rates much, much lower before they dare to begin hiking rates.  The press may ascribe 10-year Gilts selling off (higher yields) to worries about Labour’s complete unwillingness to sketch out a plan to bring the budget deficit back under control but actually the gilts market doesn’t care about Labour’s economic plans because the view at the moment is that the Conservatives are going to win next May’s general election and it will be their budget plans for 2010-15 which will matter. 

The more likely explanation for higher 10-year yields is that government bonds always sell off when the market scents economic recovery and last Friday’s US employment report hinted towards a sustainable trend of lower unemployment and consequently stronger GDP ahead. This is also why the strong correlation between a weaker Dollar & stronger stockmarkets (which has been maintained since stockmarkets bottomed in March 2009 all the way up until last Friday) now appears to have broken down. Markets are now sensing growing GDP which implies corporates will grow their top line sales (hence higher profits, so the stockmarket rally continues) and growing GDP also implies US Dollar strength after the weakness we have seen in the last 9 months.