supply pressure and quality doubts weigh on dollar
foreign demand for T-notes at auction
Â·ECB set to keep
refi rate on hold
Â·ECB staff to revise down growth and inflation projections
Focus shifts to US government bonds
In the last fortnight, the forex marketsâ€™ focus has shifted
somewhat. Up until about 10 days ago, the dollarâ€™s weakness was primarily a
sign that international investorsâ€™ risk appetite was gradually growing in view
of the first green shoots of economic improvement and favourable equity markets.
The EUR-USD rally from 1.36 to 1.40 in the middle of last week, however, was
triggered mainly by sharp falls in Treasury prices. Within a few days, yields
on 10-year T-notes climbed from around 3.20% to 3.60%, even peaking at over
3.70%. The yields on equivalent Bunds also rose from around 3.35% to 3.60%.
The interest rate increase corresponds to a certain extent
with hopes that an economic recovery is
on the way â€“ safety is no longer the number 1 priority.
In this case, however, supply side factors played a decisive role. Apparently
the yield jump was triggered by the US Treasuryâ€™s announcement that the
following week it was planning to issue over 100bn of 2-, 5- and 7-year T-notes
(plus 61bn of 3- and 6-month T-bills). This drew investorsâ€™ attention to the
extraordinarily high level of public borrowing. Then it was announced that
S&P had changed Britainâ€™s credit rating outlook (up to now AAA) from stable
to negative. This intensified investorsâ€™ worries. A considerable number of
market participants also see the â€śyellow cardâ€ť given to the UK as a warning to the US to keep an eye on its own credit quality.
The dollar is under pressure because the US government is borrowing abroad on a large scale. At
the end of 2008, $3215bn US government bonds, more
than half of all privately held US Treasury securities, were in foreign hands. Chinaâ€™s holdings alone amounted to well over $700bn. The depreciation
of the dollar shows that international investors are becoming less willing to
hold existing dollar-denominated debt, let alone increase it.
At the beginning of the week, the leading article in
the Financial Times provided some degree of reassurance. It said that, despite
critical comments by government spokemen in the last few months, Chinaâ€™s official foreign exchange authorities were still
buying US government bonds. The last few daysâ€™ auction results show that about
45 per cent of the $101bn T-notes were bought by indirect bidders (foreigners).
Compared with previous years, this is quite a reasonable proportion; it should
be borne in mind, however, that the proportion of foreigners interested in the
longer maturities was smaller, and that prices, particularly at the long end,
had fallen significantly beforehand.
ECB set to keep refi rate unchanged
The ECB governing councilâ€™s monthly meeting is being
held next Thursday. We are expecting the refinancing rate to be kept on hold at
1%. At the beginning of May, the council had kept its options open for further interest
rate cuts, but had given no clear indication that rate cuts were planned.
According to the ECB, the dramatic GDP collapse in the first quarter had been
taken into account when rates were lowered to 1%. The economic outlook has not
deteriorated significantly since then. The leading indicators are currently signalling
that the downswing is slowing, but an economic recovery in the eurozone is
still a long way off. However, this is more or less in line with expectations.
We predict that the new ECB staff projections will be adjusted in accordance with the revised view of
the ECB council. The staff should reduce its GDP forecast for 2009 significantly
to about â€“4%, but the forecast for 2010 is not likely to be revised at all, or
only slightly to just below zero. The inflation forecasts could also be revised
down somewhat. The growing output gap is creating a deflationary impetus,
which, however, is being partially offset by the expected increases in energy
prices (the staff projections derive the expectations from the forward
prices). But on the whole we are not expecting the revised ECB staff projections to give any fresh indication as to future policy.
The ECB has announced that on 23 June it will conduct
the first long-term refinancing operation with a maturity of one year. Full
allotment is planned at the current refi rate. Apparently, the council is
considering extending this offer by setting a sort of â€śinterest rate floorâ€ť.
The idea seems to be that the tender could become less attractive if markets
are expecting further interest rate cuts. In our view, if such a commitment is made,
it will at best be worded in very general terms, given the considerable
Rieke +49 69 718-4114
Grabbe / Klaus NĂ¤fken
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