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Yesterday's narrative, posited by many, was that Chinese large banks were drawing down loan loss reserves and recognizing bad loans, as a prelude to defaults, and that the rise in money market yields was precursor to a rate hike. This was supposed have been negative to risk assets.

Today, HSBC reported its flash manufacturing PMI for China rose to 50.9 from 50.4 and the new orders component rose to new 7-month highs. The PBOC failed to provide liquidity to the banking system that rates rose further, with the 7-day repo rate rising 73 bp to 4.79%.

Today risk asset are doing better and the U.S. dollar is softer. Asian shares were mostly higher, though not in China or India. European bourses are higher, with the Dow Jones Stoxx 600 up about 0.25% at pixel time.

In addition to the HSBC flash PMI for China, there have been other developments. Of particular interest was news that the euro area flash PMI disappointed. The key take away is that the composite PMI snapped a 7-month improving streak, falling to 51.1 from 52.2. The consensus had called for an increase to 52.5. Markit estimates that this kind of reading is consistent with 0.1%-0.2% GDP.

The details showed the French manufacturing remains below 50 at 49.4, down from 49.5 in September. The service PMI held above the 50 boom/bust levels but only barely at 50.2, down from 50.7. Germany reported a modest increase in the manufacturing PMI (51.5 from 51.1), but the service sector eased to 52.3 from 53.7.

Just as importantly, if not more so, the excess liquidity in the eurosystem has fallen below 200 bln euros, which previously was seen to be the key to keeping EONIA near the 0 deposit rate. Recently, Draghi has sought to play down the linkage between the excess liquidity and EONIA. Draghi's position appears to be that the ECB has the tools to respond if needed. But of course, he has to say that and it is not so obvious that he is right.

Earlier today the ECB's Mersch opined that another LTRO does not appear necessary. If the bank stress tests are to be sufficient robust, banks that rely on official money, such as the LTRO, should be penalized. Banks may seek to avoid LTRO funds even if they were made available. Theoretically, the ECB could stop sterilizing the sovereign bond purchases made under Trichet. However, this would likely run into strong objections on the grounds that it is in violation of ECB's charter and treaties.

The ECB could cut the refi rate, but it is not the floor of short-term interest rates in the current environment. The repo rate is somewhat less significant now with the deposit rate at zero. Lowering the refi is a blunt instrument and is unlikely to push rates down.

The ECB can liberalize its collateral rules to further, while this might loosen liquidity for a little while, continued pay downs of the LTROs and technical developments would likely reduce the excess liquidity again. In addition, lowering the quality of collateral or reducing the haircut on some forms of collateral currently being accepted may also run into objections by those who are concerned about the deterioration of the central bank's balance sheet.

The point of this is to illustrate why the ECB may actually struggle to find an effective tool if there EONIA faces upward pressure. This does not appear to have happened yet. EONIA was at 4.04 bp yesterday, about 5 bp lower than where it finished last week and was at the lowest level since Oct 11.

In contrast the effective Fed funds were 8 bp yesterday. The idea is that if EONIA grinds higher and move above the effective Fed funds rate it could trigger sharp euro advance and shift the incentives to favor use of the dollar as cheaper funding currency.

While the euro has made new two year highs today, sterling is confined to yesterday's ranges. The first estimate of Q3 GDP is due tomorrow, but today's CBI industrial trade survey for October warns that the economy may have lost some momentum at the start of Q4. The balance came out at -4 from +9 and the Reuters' consensus called for a small increase. It is the lowest reading since July.

Canada's central bank met yesterday. It downgraded growth and removed what was effectively a tightening bias. This saw the U.S. dollar rally from near CAD1.03 to CAD1.04. Today there has been some follow through buying and the dollar is testing the month's high near CAD1.0420, which corresponds to a 61.8% retracement of the greenback's decline since early July. A convincing break will target CAD1.0500-50.

Norway and Sweden's central banks met today. Neither changed rates. The Riksbank eased its rate path ever so slightly (1 bp), but the central bank governor was quick to counter any idea that this was dovish. He argued the central bank's communication has been effective and that the market correctly interprets its stance to be consistent with a rate hike in 12-18 months.

The Norges Bank noted that the krone and CPI are lower than expected, but it continued to signal a rate hike as early as next summer. If the recent soft real sector data does not prove t be transitory as the central bank seems to believe, then it may, like the Bank of Canada, drop its tightening bias.

Since the Aussie's peak in April, it has held below its 200-day moving average. It was first tested in early May and for the first time sense, it was tested yesterday. At was off that average, which came in near $0.9750, that the Australian dollar made a key reversal (new highs for the move and then a close below the previous day's low). There has been some follow through selling today, lending credence to the key reversal pattern. We'd peg support near $0.9550.

There is not much that can be said of the U.S. data. Weekly initial jobless claims and the flash PMI appear to be skewed by the fiscal melodrama. Many short-term market participants were frustrated being devoid of data while the government was closed. Now data is available, but it is not very useful. Separately, the U.S. August trade surplus in real and nominal terms was little changed. There was not much of a market reaction. North American participants do not appear to be anxious to buy the U.S. dollar. To the contrary, seem more comfortable still trying to sell it against most of the majors, except the dollar-bloc.

Source: Dollar Mixed, Excess Liquidity In Euro Area Falling