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Friday was a remarkably dim day for the dollar, and yet apart from ‘flows’ it was no easy task to pinpoint an exact trigger for it. During the early afternoon there were some large sell orders for the greenback, especially against the euro – the single currency almost touched 1.32 at one point, after declining to 1.3050 earlier.

Sterling did even better, with cable climbing from under 1.57 to above 1.5850. The dollar index, which had seemed rather comfortable above 80 over recent days, suddenly and rather inexplicably found itself below that level. Video:

Interestingly, bond yields were under continued assault, with 10yr bund yields up above 2.0% for the first time in a few weeks and the 10yr gilt yield climbing to 2.43% – just two weeks ago, it was trading below 2.0%. US treasury yields also rose, not helped by news that one-year inflation expectations in the latest University of Michigan survey had jumped to 4% from 3.3% in the latest month. Stocks remained well-bid while Brent crude rose above USD 124.

Guest post by FxPro

Commentary

Keep a close eye on Spain. Although the political and financial temperature in Europe has definitely eased over recent months, a myriad of potential issues and concerns remain. Right near the top of the pile is Spain, where the economy is once again back in recession, the unemployment rate is a staggering 23%, house prices are collapsing and the government is set to implement even further austerity this year. The new Prime Minister Rajoy is doing a commendable job in an extremely difficult situation. Having inherited a much higher budget deficit of 8.5% of GDP, the EU is prodding Rajoy to rein in the fiscal shortfall to 5.3% this year; earlier this month Rajoy defied Brussels by announcing that the 4.4% target for 2012 was far too punitive, and that he was setting sail to achieve 5.8%. With private consumption declining in response to huge unemployment and high household debt, achieving the latter would be a remarkable achievement for Rajoy’s government, despite its apparent determination. Also, Spanish banks are increasingly reliant on ECB funding for survival, a further indication of the economic malaise afflicting the country. Bank borrowing from the ECB by Spanish banks jumped to a record high of EUR 152.4bln last month, up almost EUR 20bln from January. Spanish bank borrowing from the ECB is second only to Italy, which tops Europe with EUR 196.4bln (this is a January figure). Unsurprisingly, Spain still concerns both investors and traders. For example, the 10yr government bond yield is essentially unchanged for the year to date, whereas the Italian 10yr yield has fallen by a staggering 230bp. Clearly, very little of that abundance of ECB liquidity has found its’ way over to the Iberian Peninsula. Spanish stocks are also under-performing – the IBEX 35 index is down 2% so far in 2012, compared with a 22% rise in the DAX and a 13% gain for the Euro Stoxx 50. Spain remains the elephant in the room for Europe.

Fiscal compact resistance. Increasingly apparent over recent weeks is that some national parliaments at balking at ratifying Europe’s fiscal compact. In France, Socialist opposition leader Hollande has already promised that he will seek to renegotiate the pact should he be elected in the upcoming Presidential election; he currently leads Nicolas Sarkozy in the polls by a comfortable margin although the gap is narrowing. Ireland has decided to hold a referendum on the treaty closer to mid-year and in the Netherlands there is opposition to the treaty from both of the contenders for the leadership of the Labour Party. Spain’s Prime Minister Rajoy tested the EU’s mettle almost immediately by announcing a revised fiscal deficit target for 2012 of 5.8% of GDP, well above the 4.4% target mandated by Brussels. This resulted in a flurry of activity, with the EC ultimately relenting; Spain’s revised deficit target for this year is 5.3%. Even German politicians are having their doubts. Some senior members of the SPD are wanting extra concessions as the price for their acceptance, in particular the implementation of a financial transactions tax, a policy beloved by French President Sarkozy. Chancellor Merkel needs the support of the Social Democrats, because the fiscal-compact legislation needs to pass the Bundestag with a two-thirds majority. Despite these inevitable bumps in the road, it is still highly likely that the pact will ultimately be enshrined into European law. In the end, only 12 of the 17 members of the eurozone need to vote in favour of the legislation. Right now, some of what is transpiring is mere political posturing.

Brazilian fragility. One of the real stand-outs so far this month has been Brazil, for a number of reasons that we’ve talked about before.   The real is down nearly 5% (vs. the USD) in March, but there were signs of stabilisation in the latter half of last week. Comments on Thursday (Bloomberg) citing unnamed government officials suggested that rates could remain low for the coming 18 months and that inflation is not going to be a constraining factor on further rate cuts.   But even this scenario will keep rates significantly higher than most other major currencies (the key rate is currently 9.75%), which is why Brazil has taken to other means to curb currency strength, such as imposing a levy on foreign loans and has hinted at still more measures to tackle the issue. The reason for such rhetoric stems from the fact that, on the majors, there is no other currency offering such a high real rate of return.   So despite the correction we’ve seen this month, the real is still 4th in the ranking of major currencies in terms of total return; the kiwi, South African rand and Mexican peso standing above it.   For Brazil however, the focus is really on the economy and within this, how it copes with slower growth in China.   Brazil’s industrial base has already been struggling in recent months, recording five consecutive months of negative YoY growth.   On a rolling (12-mth average) basis, exports to China have nearly doubled over the past three years, making Brazil more vulnerable to a slowdown in China, which certainly appears to be in train.   What may help Brazil is the shift we’ve seen in global risk appetite, which has been less inclined to jump into currencies which are perceived to be overvalued, despite the rally in stocks we’ve seen so far this year. This should go some way towards helping Brazil fight against further unwanted appreciation of the real.