China Hikes, focus again on US Yields

China again has taken the easier option this morning ahead of its inflation numbers tomorrow. They raised Bank’s required reserve ration by 50bp (18.5%) instead of hiking interest rates. This will certainly take some of the week’s apprehension out of the market, and perhaps true to the PBOC word, we are looking at a tighter monetary policy next year. Hiking the reserve ratio is designed to curb lending rather than crimping growth. Capital markets will be focusing on this mornings University of Michigan consumer confidence survey and probably more specifically the inflation expectations component, a rise will derail the fall in US yields and support the USD. The combination of a two-week interruption in Treasury supply and the Fed continuing to extract duration through QE operations is likely to support Treasury prices and may put pressure on the dollar as we head for this years ‘turn’.

The US$ is weaker in the O/N trading session. Currently, it is lower against 13 of the 16 most actively traded currencies in a ‘whippy’ trading range.

Weekly US unemployment claims last week fell more than expected, renewing hope for the labor market recovery. Also providing support for optimism was the bullish headline for US wholesale inventory and sales. Unemployment claims fell by a seasonally adjusted-17k to +421k. Analysts caution that with the strong seasonal distortion, the market probably will not get a clean reading on the underlying trend until the middle of February. The market welcomed the claims decline, especially after last week’s employment report showing that the unemployment rate rose to +9.8%. The four week moving average fell by -4k to +427.5k and is currently at its lowest level in two years. It’s the fifth consecutive week that the average has declined, stronger proof that the market is slowly improving. Digging deeper, the data also revealed that the one-week lagging continuing claims fell by -191k to +4.086m and that the unemployment rate for workers with insurance also fell by -0.2% to +3.2%. This data will provide fodder for us to expect better NFP numbers soon.

Wholesale Inventories rose by +1.9% in October, the tenth consecutive monthly gain. The headline print was supported by both durable (+0.9%) and nondurable (+3.2%) gains. The September print was also revised higher (+2.1% from +1.5%), which would suggest that inventories will contribute positively to the 3rd Q GDP revisions. Even wholesale sales managed to post its fourth monthly gain, supported by nondurable (+3.7%) and durables (0.5%), allowing the inventory to sales ration to remain at 1.18, somewhat on level terms with the pre-recession print.

The USD$ is lower against the EUR +0.07%, GBP +0.38%, JPY +0.22% and CHF +0.23%. The commodity currencies are mixed this morning, CAD -0.01% and AUD +0.31%. Despite Canadian Housing starts surprising the market, the loonie managed to give up some of its recent gains as commodities underperformed and the dollar index surged. Housing starts rose this month for the first time in four months (+11.6%) in Canada, to a seasonally adjusted annual pace of +187.2k from a revised +167.8k rate in October. The loonie is again within striking distance of parity as the currency slowly gains traction on the crosses on global optimism in response to Obama’s tax-cut continuation. The market also expects further support from the Russian Cbank converting approximately 1-2% of total reserves into loonies. The currency outright has wilted from Governor Carney’s comments after the BOC sat on the fence and kept rates on hold earlier this week. They have been careful not to say too much until it has updated its economic outlook. Carney acknowledged economic growth in the second half of this year has been weaker than previously anticipated and expressed concern about the expected recovery in net exports (that’s a strong loonie problem). The market has taken this as a dovish sign. Futures traders are pricing out the possibility of any monetary stimulus in the first two quarters of 2011. The market will also be focusing on what China may do after the release of its inflation numbers this Saturday.

Much stronger than expected Aussie employment data blew all analysts expectations out of the water and pushed the currency higher yesterday. However, not enough of a rally as the Aussie is set for a weekly drop on concern that Chinese inflation data tomorrow will back the case for Asian nations to tighten monetary policy, damping demand for higher-yielding currencies. Not aiding the currency is the concerns for long dated interest rates in the US. The currency did manage to pare some of it’s O/N decline after Chinese reports showed that exports and imports surged last month, topping analysts’ expectations. Year-to-date, the Australian economy has added just over +425k new jobs, dragging down the unemployment rate to +5.2% from +5.4% month-over-month. Analysts are beginning to agree that with the tight labor market will bring the RBA back into the picture, but agree that Governor Stevens is not behind the curve just yet and will not be required to hike rates in February. With consumers boosting their savings significantly in an environment of rising job and wage growth, suggests that the RBA is still ahead of the curve. Governor Stevens has also mentioned that rates are ‘appropriate’ for the economic outlook. Investors remain better buyers on dips, planning an assault on parity again (0.9877).

Crude is higher in the O/N session ($88.70 +30c). Crude prices found some support yesterday, as the market, at least short term, focused on the week’s large fundamental drawdown of inventories and not on the strength of the dollar. The EIA inventory crude headline fell -3.82m barrels to +355.9m. Supplies were forecasted to drop by -1.4m barrels. However, there was an unexpected increase in gas and distillate fuels stocks. Gas inventories rose +3.81m barrels to +214m last week vs. a forecasted fall of-300k barrels. Supplies of distillates (heating oil and diesel) climbed +2.15m barrels vs. an expected decline of-900k barrels. Technically, the rise in these categories confirms there is nothing wrong with supply, but the demand picture is not that strong. The market seems to be also pricing in the possibility of a tighter Chinese monetary policy. If the PBOC raise rates too much, it could have a big affect on oil demand and a strong reason for OPEC to put off making any changes at its upcoming meeting. Again, the market will meet resistance at the $90 print.

The strong dollar and the outlook for a more robust economy as well as better yielding treasuries have hurt gold this week, however, bottom feeders managed to have stemmed the slide, believing that the $60 fall from its highs was a good opportunity to own a store of value as an alternative investment. It was only natural to see some profit taking after gold surged to a new record on Monday ($1,432.50). Even with the dollar strengthening, the commodity remains supported by the persistent concern over Euro debt levels. To date, debt contagion has driven investors into the third ‘reservable’ currency as they seek a store of value. Despite the fear that China will tighten their monetary policy, a move to curb speculation and dampen inflation, global demand remains robust. Even though the one direction lemming trade seems to be overdone, investors continue to hold gold as a hedge against currency debasement and long-term inflation. The Euro-zone backdrop will try to put a floor on gold prices on demand for a haven. Year-to-date, the metal is up + 28% and is poised to record its 10th consecutive annual gain ($1,391 -$1.90c).

The Nikkei closed at 10,212 down-73. The DAX index in Europe was at 7,002 up+38; the FTSE (UK) currently is 5,814 +6. The early call for the open of key US indices is higher. The US 10-year eased 4bp yesterday (3.21%) and is little changed in the O/N session. The US yield curve has shifted aggressively higher this week, recording the highest yields in eight months after the Obama administration decide to extend the Bush-era tax cuts for another two years and as dealers took down the last of this weeks $66b of new product. The US government is to help boost economic growth but expand the deficit, both of which are negative for rates. These higher yield point to higher cost and certainly defeats Bernanke’s objective at the moment. The tax-cuts suggest that helicopter Ben’s stimulus package will probably ‘not’ require any increases in nominal note and bond sizes in the near term. Yesterday’s $13B 30-year auction was strongly received, coming down at +4.41% vs. the +4.455% WI’s. The bid-to-cover ratio was 2.74% vs. the average of 2.58 from the past four auctions. These higher yields have been supporting the dollar all week.

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