Eurodollar futures – Bond price have remained under pressure Thursday although benchmark U.S. treasury note futures have reversed sharply off intraday lows at 115-18 and are trading at 115-29 with a yield of 3.84% and two ticks higher on the session. The shorter end of the curve is facing deeper losses following the release of weekly initial jobless claims, which came in at 434,000. The data may have raised the appeal of longer dated bonds on the view that although the economy is improving, it’s not likely to spur a massive recovery in the labor market just yet. There is a mixture of bargain hunting and short-covering that’s preventing bonds from deeper losses ahead of Friday’s key employment report.

The fixed income market continues to digest the minutes from the December meeting at the Federal Reserve in which members debated the potential need to add further stimulus when the existing measures ran their course in the first quarter. The FOMC clearly attaches enormous weight to the housing market, where it is close to finalizing the purchase of $1.4 trillion in mortgage securities. Having achieved stability in declining real estate values the Fed has scored a major victory albeit at a great cost to the tax payer. But one gets a sense from yesterday’s minutes that such stability is far from assured beyond the conclusion of the current pace of buying, which is why the Fed discussed the possible need to bolster its commitment.

The words of incumbent Japanese Finance Minister, Naoto Kan might be enough to put his predecessor in to an early grave after his first press conference with reporters following Wednesday’s appointment. Retiring Minister Hirohisa Fujii went to great lengths to advocate not only a flexible yen stance, but one that would permit the unit to strengthen upon signs of economic virility. Mr. Kan took full advantage Newton’s laws of physics with his first words to ensure that an object in motion, namely a falling yen, stays in motion until another force acts upon it. The Japanese yen faced fresh weakness today as it fell to ¥93.17 per dollar.

Although the validity of the Big Mac index in determining the value of currencies in the real world is suspect, it is still an intriguing idea nonetheless. The Economist's Big Mac Index is based on the theory of purchasing-power parity (PPP). Exchange rates should equalize the price of a basket of goods in different countries.

The index shows which countries' currencies are under and overvalued. The most overvalued currency according to the index is the Norwegian Kroner, which is almost 100% above its PPP rate. The most undervalued currency according to the index is the Chinese Yuan, unvervalued by almost 50%.

For choice global bond prices are marginally lower in mid-morning U.S. trading hours by it has to be said that ahead of Friday’s employment report, yields have come to a virtual standstill. A mid-morning service sector reading from the ISM showed that the service sector finally returned to expansionary territory last month, dragged higher by ongoing manufacturing activity.

I noted in the Daily IB FX View earlier that both driving forces affecting currencies might be unlikely to retain their influence and that’s evident in bond prices today. There is no slide in Japanese government bonds over fears that new Finance Minister Naoto Kan will wreck plans to rectify an ugly budget deficit. Nor is there any flight to safety in German bunds following the Stark warning that Greece should not expect fellow members of the Eurozone to reach into their own pockets to rectify its own wayward fiscal position.

Early forex trading was shaped by a pair of events, neither of which is ultimately likely to remain forceful later in the day. The stepping down of Japanese Finance Minister, Hirohisa Fujii is one of those events feared more during its formation than in its aftermath. Mounting speculation had surrounded the tenure of the 78-year old minister after he asked permission to resign due to ailing health. The dollar surged on the news rising to ¥92.50 owing to speculation that the drive towards fiscal austerity ushered in by Mr. Fujii may be sunk with the wrong successor. However, the swift appointment of Deputy Prime Minister Naoto Kan should help reinforce the prospect of no change to fiscal policy. The second event is a rehash of the saga surrounding the public deficit of Greece but this is largely in the market’s paranoid mind if you follow the paper trail of facts.

The dollar index closed slightly higher in trading Tuesday, helped by mixed equity market momentum. Overnight, the majors had some weak attempts to move, but lacked a trigger that looked like holding. As the U.S. session approached, the major currencies started to slide lower against the U.S. dollar, as it seems the dollar bulls are lurking with intent. The main engine behind the strength of the dollar is the fact that the market is currently re-pricing the U.S. yield curve, which triggers long U.S. dollar orders.

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Global bonds have a far better tone to them today after another Fed speaker, this time Elizabeth Duke, stirred up the notion that an economy operating in many sectors at a below capacity reading will result in stable price expectations. After driving the yield curve up to close to a height braced for near-imminent tightening from the Fed, investors today are having an easier time seeing the woods through the trees. Yields at the U.S. 10-year are lower at 3.78% - a one week low - ahead of data showing a possible third consecutive monthly increase in factory orders. That would be another confirming signal of economic recovery.

European bonds were sluggish although ultimately towed the line and reversed earlier in the day losses. French and German government bond prices faced earlier selling pressures after the EU statistic’s office reported strengthening consumer price increases. The December CPI estimate of 0.9% was up from the December reading of 0.5%. Meanwhile, both nations remain issuers of public debt, which earlier helped depress bond prices before the U.S. fixed income market towed the line.

The story remains the same everywhere you look around the world. The manufacturing baseline expansion continues to underpin expectations for a decent first half of the year. Money managers see little reason not to add equities, commodities and higher yielding currencies to their portfolios as investing resources are shifted to where opportunities continue to arise. Dollar bulls are also dealing with a self-induced rise in treasury yields that inevitably sets the scene for a showdown with the Fed. Yields around the world have been marched up to the top of the cliff and those who used the excuse of rising yields during December to buy the dollar are going through a severe bout of self-doubt as the dollar weakens. In the presence of comments from two Fed officials in two days aimed at reinforcing the low interest rate environment, traders need added rationale to remain positioned dollar long. It’s time to either back down the hill or face the leap of faith into the abyss.

Paul McCulley, portfolio manager at Pimco, made a rather astute comment that stuck with me, “You can only eat what’s in the cafeteria, and right now the cafeteria doesn’t have anything particularly appetizing in it.” That metaphor certainly rings true in today’s market. Many economists are predicting a very strong US GDP result for 4th quarter 2009, a statistic that is mostly attributable to massive government intervention and the restocking of inventories. The longer term question remains: will top-line sales provide earnings growth going forward rather than corporate cost cutting. In addition, we have highly respected economists such as Paul Krugman stating that a recession in the second half of 2010 after fiscal and monetary stimulus fade has a “30 to 40 percent chance”. These uncertainties, mixed with the fact that the government will be stopping its buying programs and will also be forced to term out its massive debt, will put upward pressure on interest rates. With this sort of backdrop, what do you invest in?

Bottom Choices:

An early push higher in the value of the dollar quickly subsided on Monday as traders kicked the tires of U.S. monetary policy beginning to realize that while an early change in short term settings is unlikely, any changes later in the year might be minor.

Chasing the dollar higher in December in search of rising yields might therefore have been a premature shot at what may turn out to be a relatively small prize. The additional and yet traditional headwind this time of the year stems from a raging demand for risk appetite. Two Chinese manufacturing surveys either side of the New Year break today reinforce the notion that its economy probably grew at a double-digit pace in the fourth quarter. Commodity prices are higher in sympathy with prospects for improving demand the world over. Early 2010 will prove the relative degree of sensitivity for commodity rich nations to equity and interest rate movements. Until now the theory of rising yields has seen them give up gains to the dollar, while the test will really be what happens if equity prices accelerate in quarter one.

One of the most consistent messages from U.S. Treasury Secretaries in the last decade was that America has a strong dollar policy. During that period the trade-weighted dollar (the U.S. dollar measured against a basket of six currencies proportional to U.S. trading activity with the respective countries) fell approximately 21%. The value of the dollar went down against the Euro, the Yen, the Swiss Franc, the Canadian dollar and the Australian dollar. It traded flat against the British Pound. One wonders what would have happened if America had a weak dollar policy.

The U.S. trade-weighted dollar opened in 2000 around 99. It then rallied in the beginning of the decade (this was a continuation of a rise that began in 1995) and peaked with a double top just above 120 in 2001 and 2002. It was mostly downhill from there until it hit bottom in the 71.50 area in 2008. A flight to safety during the Credit Crisis rallied the dollar back to 90. It closed out the decade at 78.22. The decline of the dollar in the first ten years of the 2000s was merely a continuation of a much longer drop that began in 1985, the year that the trade-weighted dollar peaked at over 160. In the twenty-five years since then, it has lost more than half of its value.

A positive end to the calendar year in the form of lower claims for unemployment insurance has left the U.S. government bond market nursing losses as evidence mounts that it won’t just be champagne flowing into the New Year. The improving economic tone looks certain to improve in the first quarter of 2010 sending expectations higher for a change in the policy settings from the Fed. At this stage of the game there is little point in trying to assuage investors that the Fed won’t shift policy anytime soon – which it won’t. The bleeding wounds of capital losses on bonds are evidenced by a one month surge in yields in the last five weeks from 3.15% to 3.89%. Yields are ending the year within a single bad session of reaching the 4% peak witnessed mid-year when investors first panicked about a change of heart from the Fed.

With European markets already closed for New Year celebration there is a lack of newsworthy material and price action to report other than in the dollar complex.

A sixth consecutive weekly reading below the critical half million mark saw the dollar rally from earlier losses following signs Asian central banks might be switching dollar holdings to euros on the final trading session of 2009. The stronger than anticipated reading for initial claims showed a smaller measure of 432,000 people signed up for unemployment insurance during the week ending last Saturday. Investors were braced for a slight rise after last week’s revised 454,000 reading but were treated to a year-end bonus indicating the lowest reading for initial claims in 17 months. The dollar snapped back sharp losses against the British pound having declined to $1.6237 while it has also curbed losses against the euro from $1.4440 earlier to $1.4383.

There is very little to trade off today. The U.S. serves up another belly full of seven year notes after Tuesday’s auction went well. Don’t forget that no one said investors have lost their appetite for debt at this point – the reality of a recovering economy and the removal of emergency liquidity measures simply means that at some point official rates will rise. Precisely when remains the number one guessing game in year-end financial media circles. The bottom line remains that recovery, stimulus removal and an ongoing gush of supply means the government faces a rising interest bill on newly minted notes and bills.

An overnight warning from ratings agency Standard & Poor’s over Japan’s dicey debt burden hurt the Japanese yen and along with the continued rise in U.S. note yields, the spread between comparable Japanese and U.S. 10-year maturities stood at its widest in two years at around 250 basis points. The recent dollar outperformance against the yen is largely attributed to the raft of support it’s getting from the rising yield curve.

As the old saying has it, “As Goes January, So Goes the Rest of the Year.” It would be nice to think that the New Year would be greeted by at least a tad of optimism. Investors typically buy the equity market at the start of January as no one wants to miss out on the act. And after an uncomfortable first quarter, investors spent the second half of the year getting back on their feet despite incessant warnings that the road to recovery would remain a rocky one. You’d think it might be an appropriate time to perhaps crank up the confidence level buy even just a notch. But in his New Year’s message to Great Britain Prime Minister Gordon Brown issued the same message to the nation when he referred to “a still fragile” recovery that “needs to be nurtured.” He told Britons he had a blunt message: “Don’t wreck the recovery.” The pound is fast losing friends into the end of the year.

A paper inviting comments from academic and institutional onlookers released by the Federal Reserve on Monday is the latest catalyst for a continued collapse in bond prices sending yields higher around the world. U.S. 10-year note prices fell lifting yields to the highest since August while the slide in British government bonds continued after a prolonged holiday weekend lifting yields to the highest in 12 months. Once again the trading mindset is being increasingly shaped by an ebullient feeling underpinning rising global equity prices, driving optimism in the ongoing recovery process. Meanwhile rising consumer confidence data released today by the Conference Board confirms a rosier outlook ahead.

Eurodollar futures – The yield on the June 2010 Eurodollar futures contract has risen from 0.5% at the start of the month to 0.69% today after having breached the earlier December lows yesterday. Chicago-traded fed funds futures now imply a 60% chance of a quarter-point raise in rates from the Fed by the summer months. Much of the damage has come in the last three trading sessions, with yesterday’s session causing havoc on account of many investors taking a long weekend. Still, Monday’s volume was high and indicates more bearishness ahead for Eurodollars.

The dollar index is down by 0.3% at the start of North American trading still typified by thin trading conditions. The underlying theme remains intact. Investors expect to build on the closing arguments from 2009 and see better things happening next year. There is building anxiety in the bond markets tipping off investors that the period of ultra-low monetary policy is likely to disappear from the agenda in 2010 and like it or not, a higher and steeper yield curve is but one of the ingredients of recovery. The dollar’s recent rally in line with that view has come to a sharp halt as investors realize that there will be no jump in short rates, just a gradual rise. Meanwhile the Japanese yen continues to play second fiddle to the dollar as investors figure it will be left in the dust as and when global interest rates finally budge.

Momentum Remains Light

The currency market came to a standstill during European trading hours, after a smoothly trending Asian session that had the dollar sold. The range-bound trading pattern is in-line with the light trading volumes observed overnight, which did not allow the market to move anywhere decisively, or at least to test any important price points. Ahead, the market is expected to pick up some additional momentum during the U.S. open, but nothing out of the ordinary that could test easily the 4 Hour chart ranges that will need to break if a trend reversal can follow through.