EUR Reserve Currency?

Forex markets are in the midst of what could be a sea-change in general market sentiment. The focus since 2008 had been on the U.S. housing bust, with its undermining of confidence in the U.S. financial system

Forex markets are in the midst of what could be a sea-change in general market sentiment. The focus since 2008 had been on the U.S. housing bust, with its undermining of confidence in the U.S. financial system which necessitated substantial government support and a recapitalization of many major players in the industry. As difficult as the process has been, at least there has been a significant blood-letting in the industry and presumably there are not now a lot of major problems hiding under the rug.

The U.S. problems have by no means been resolved yet with a spend thrift government committing taxpayers to heavy future deficits as far as the eye can see and eventually a heavier tax burden. Sharply higher taxes would seem to point to future deflation, just what the spending is intended to prevent. On balance this scenario has been a significant weight on the USD and has raised questions about its role as the world reserve currency.

The EUR has usually been seen as the logical replacement for the USD as the global reserve currency. The Eurozone is larger than the U.S. in terms of population and GDP, and sports a central bank patterned after the conservative German Bundesbank, which has been respected by all. The EUR seemed to be in its ascendency. Then came Greece . Greece qualified for the Euro-zone in 2000 and was admitted on 1 January 2001. The problem with Greece is that its finances have never been what they should have been and to put it nicely, they have been cooking their books.

The Greek debt crisis has been coming to a head over the last few weeks. If the problem was just Greece then it could have been easily contained. Markets are concerned that the fiscal crisis in Greece to other more vulnerable governments in the Eurozone. There is a concern that the contagion that has suddenly made the EUR weaken could spread. Furthermore, the currency is suddenly not seen as the solid currency that many had thought. The USD by comparison is being seen as a viable alternative to the EUR. For the record, Japan ?s fiscal problems are much worse that the U.S. and Europe

In current markets the focus has been on the debt crisis in Greece . As of Friday, there appears to be some sort of an agreement by the EU to support Greece . Traders are unhappy about the lack of specificity in the announced agreement. We feel that the EU agreed to help Greece but that those providing help still will need approval from their respective governments before a deal can be signed. Furthermore, Greece has to agree to make further unpopular budget cuts at home.

Any bailout deal will not be popular in Germany and Chancellor Merkel is facing a number of local elections in coming months. Voters in Germany are unhappy with the concept of Germany as the guarantor of all of the countries in the Eurozone. This is what puts the EUR in a no-win situation. Traders had been worried about the risk of defaults in the Eurozone. Now they worry about which other countries will be tapping them next. Either scenario is EUR negative.

Risk Reduction Back

With a night to reflect, forex markets continue to be dissatisfied with the outcome of talks about the Greek debt discussions. The lack of details yesterday increasingly are being seen as an indication that there had been no specific agreement to come to the assistance of Greece. It might be that the EU is looking for the government to reign in its own expenses first. Now we hear today that next weeks ECOFIN is unlikely to make concrete decisions on financial aid. The USD is trading higher vs. the EUR on the news.

Word that China has just raised its reserve requirements by 50bps surprised the markets. The timing of the move, just before the week-long Lunar New Year holidays has impacted the markets with gold tumbling. and commodities and the commodity currencies weakening. This is shaping up to be an active pre-holiday session as dealers engage in risk reduction trading strategies.

Trading in the U.S. is likely to be choppy today as dealers remain hostage to the Greek crisis. Just about any eventual outcome can be cast as negative for the EUR. The Lunar New Year holiday this weekend will limit Far East participation next week. This will be a three day weekend for North American markets. Today sees many key U.S. economic data releases delayed due to the weather problems in Washington. D.C.

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FOREX

EUR/USD is much lower. The equity correlation trade has been working off and on recently. The ECB has been backing away gradually from extraordinary policy ease and worries about the weaker Eurozone economies have been a weight off and on.

EUR/CHF is unchanged. It has been established well below its perceived 1.50 SNB floor. USD/CHF is higher. The SNB periodically has reconfirmed EUR/CHF support. The SNB made comments that it would continue to prevent excessive franc gains against the euro. The SNB periodically has been intervening in the EURCHF cross.

USD/JPY is steady, and the EUR/JPY is down. Japanese forex policy is now aiming at weakening the JPY. The government and BOJ have reconciled their differences.

GBP/USD is weaker. EUR/GBP is lower. Mixed data have been triggering GBP instability. BOE King recently indicated that a weaker GBP could contribute positively to U.K. economy.

COMMODITIES and Commodity Currencies

The CAD is weaker. The Bank of Canada has been turning turned less dovish as the economy stabilizes. Canada could be one of the early major economies to raise interest rates, but not immediately.

The AUD and NZD are much lower. Risk trades keep cycling in and out. The RBA surprised by holding rates steady. Some still expect an April RBNZ rate hike.

Gold and Oil are weaker. Gold, oil, equities and the commodity currencies are all carry trades. Gold is another anti-dollar.

EQUITIES & INTEREST RATES

Far East equity markets closed mixed before the Chinese policy tightening. European bourses are up. U.S. equities are lower.

The U.S. 10-yr note is 3.69%, -4 bp. Fixed income markets are vulnerable as they consider the prospect of an end to excessive Fed ease and large borrowing needs by the the U.S. government. Nevertheless. Fed Funds should remain low for an extended time period.