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USD Begins Week With Broad Decline

Fear that last week's economic data would prompt the Chinese to take decisive action to slow the rate of inflation was unfounded.   The numbers were worse than anticipated, CPI y/y was up 5.1%, higher than the expected 4.7% increase, and 4.4% in the previous period.  The PPI came in up 6.1%, higher than the 5.2% forecast, and 5.0% in the previous period.  The market has been encouraged because the Chinese response has been only a modest increase in bank reserve requirements.  While this may defer the deflation of the real estate market in China, propping up the investments of the wealthy Chinese, the less affluent will suffer as inflation continues.  I wonder how Paul Volcker would respond if he were the Central Banker. Look for the increased living costs in China to cause unrest and demands for higher wages.

With the threat of harsh curtailment of the Chinese boom removed, this set the stage for equity and commodity rallies,  and aided the risk-on currencies to rally against the USD.  Some of the strength may have been short covering in the euro and the pound.  Last week the COT report showed speculators aggressive sellers of those two currencies.  And as major trading partners with the Chinese, the currencies of Japan and Australia also gained.

Part of the USD weakness might be the agreement on the extension of the Bush Tax rates are a mixed blessing.  Yes, the lower rates may stimulate economic growth, but the reduction of the Social Security Rates will reduce revenue and and the extension of unemployment benefits will increase the outflow.   Further, the  $1.4T estimated US 2011 deficit will keep the Treasury busy peddling their bills, notes and bonds.  Servicing the $13.8T debt cost around $414B last year and borrowing costs are now higher, with the 10 year benchmark note now yielding 3.28%.   These rates may eventually prove attractive to some investors, but not today as higher risk investments are favored.

This morning the pound came under early pressure when a Rightmove HPI m/m came in at -3.0%.  The average asking price in England and Wales fell 3% to 222,410 pounds continuing lower after a 3% drop in the previous month.  This was the biggest consecutive two month drop since the Index was founded in 2002.  The early break down to 1.5720 proved to be a great buying opportunity as the pound rallied to almost 1.59.  Later the PPI Input came in at +0.9 higher than the estimated + 0.7, but lower than  the 2.2% in the previous period.   Tomorrow we the CPI, estimated at 3.1% one tick lower than the 3.2% in the previous period.  The 3.0% is on the high side of the Bank of England's inflation target, but considering the tenuous status of the economic recovery, it is doubtful this will lead to a higher rate.

The strength of today's rally has exceeded out expectations.  In the pound, the futures open interest is not large, and there was heavy long liquidation in the previous period.  This left the large specs with a big net short position, better than 12,000 contracts in the most recent period.  Often when shorts are squeezed, their market exit lacks grace, as they just pay the price to get out.  Should the rally in the pound versus the USD continue tomorrow, we will be tempted to sell the pound in the 1.60 area, should we trade there early.  A market that spends time lower and then comes roaring back late in the day, is not the kind of action we will sell.  We will be watching the market action for trading clues.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.