China Assures on FX FOMC Preview amp Yield Differentials

The latest comments from China’s central bank hinting at further currency strength and resorting to FX as part of monetary policy maneuverings are mainly aimed at assuring Washington and foreign holders of RMB bonds of value preservation despite the first sub 8% GDP outlook in five years and the lowest CPI reading in 18 months.

The comments regarding further RMB strength were also aimed at managing market expectations considering the onset of further declines in the reserve requirement ratio. China has been consistent in interchanging interest rates and currency management in steering its monetary and diplomatic policies for economic and political means.

Recognising that China’s currency policy will revert to the economic conversation at this year’s US presidential race, Beijing would want to maintain a base for arguing back against its critics.

Note that EU critics of China’s handling of its currency and intellectual property have long been silenced after Beijing repeatedly vowed its support for euro zone-based investments and sovereign bonds.

The US and Canada have yet to be won-over when Beijing cements its support for bolstering IMF reserves. The chart below indicates the 25% increase in RMB vs. USD since 2005, extended throughout the boom/bust cycle in commodities, equities and trade.

Looking ahead, markets would be correct to expect another 5-7% decline by end of the first-quarter in 2013.

FOMC & “Operation Twist II”

This week’s FOMC statement will likely recognise the ongoing improvement in US labour markets, while likely stating that more will be needed. Any explicit realisation of optimism will be gauged by the markets as a step closer towards ‘sterilized asset purchases’, which could be interpreted as ‘Operation Twist II’.

Markets and the Fed are fully aware that outright QE3 would trigger renewed USD weakness, further escalate energy prices in an election year and even fresh ‘currency war’ criticism from emerging markets, specifically China and Brazil.

Tuesday’s FOMC statement is anticipated to trigger USD-positive bias.

EUR/USD & Yield Differentials

As the Fed inevitably continues to recognise the uptrend in employment and the pick-up in retail sales (Tuesday’s anticipated figures), while the ECB renders euro zone bank dependent on three-year money, markets may further drive interest rate differentials towards US and away from the euro zone. This is already weighing on the 10-year yield spread between Germany and the US (at 8-month lows of -0.23%).

Consequently, EUR/USD could well start to follow interest rate differentials, and gradually reach the $1.25 territory by mid Q2.