Euro Still Under Pressure

The euro remains vulnerable. The Q4 10 GDP figures were slightly disappointing (0.3% rather than 0.4% consensus), but the adverse impact of the weather and the stronger PMI readings this year encourage the market to look past these figures. The same is true with the ZEW survey. The current assessment remains strong, but the future expectations are at 15.7 (consensus was 20).

The Sword of Damocles that hangs over the euro remains the unresolved and arguably worsening debt crisis. It is true that Spain and Greece has successful bill auctions today, but more importantly, Portuguese 10-year yields remain well above 7%.

Officials that will likely form the new Irish government after next week's election have indicated:

• A desire to renegotiate the interest rate of its aid package; the EU has signalled that it is open to this next year but not this year.
• It wants greater burden sharing with unsecured senior bond holders.
• It does not want the government pension fund to finance the bailout.
• It has no intention of raising its corporate tax rate.

At the same time, it is becoming clearer that Irish banks will require more capital. There is some suggestion that the more than €50 bln that Irish banks have borrowed from the Irish central bank rather than the ECB is a rough approximation of the kind of sums needed.

The problems are not confined to the periphery. The German political situation looks increasingly like a constraint on policy options. A study commissioned by the junior coalition partner the FDP and conducted by constitutional experts warned that because of the nature of the permanent debt facility (ESM), it will require a 2/3 majority to approve. Merkel has a simply majority in the Bundestag (lower house) and does not even have that in the Bundesrat (upper house). In the spate of state elections that begin this weekend, the government's position will likely weaken further.

U.K. January CPI was in line with expectations, rising 0.1% on the month but lifting the year-over-year rate to 4% from 3.7%. The core rate ticked up to 3.0% from 2.9%. The BOE is now obligated to write its fifth explanatory letter to the Chancellor. King attributes the price pressures to the VAT hike, past sterling weakness and the more recent increase in commodities. He warns of the risk of further increases in the coming months. However, King continues to suggest that excluding these "special" or "transitory" factors, CPI would probably be below 2%. While acknowledging a range of opinions on the MPC, he cautions against trying to drive CPI down too fast on grounds that it generate "undesirable GDP volatility."

This may give a hint of tomorrow's BOE quarterly inflation report. For his part, Osborne seems to accept King''s statement at face value and seems to recognize that the government's fiscal policy (tight) can buy the BOE time. Even though there has not been much of an interest rate reaction to the CPI or BOE, sterling itself has traded firmer after an initial wobble. The immediate hurdle is near $1.6135. The New York market may be reluctant to push it above there, as short-term momentum indicators are getting stretched and the inflation report is out early tomorrow in the U.K., just after the employment report.

Sweden's Riksbank delivered the 25 bp rate hike that had been loudly telegraphed and widely anticipated. Of note: The Riksbank seemed to upgrade both its growth and inflation trajectory and tweaked up its anticipated path of tightening to 2.5% in Q1 2012 from 2.3% previously. The central bank meets against April 20 and another 25 bp rate hike is likely. Note that Sweden reports January CPI figures on Thursday this week, and the headline rate is expected to fall 0.4%, but due to base effects, the year-over-year rate will still tick up to 2.6% from 2.3%. The core rate will likely be better behaved, slipping to 2.0% from 2.3%. "Buy the rumor, sell the fact" on the rate hike has been dampened by the modest upgrades and the general bullishness toward the krona.

Lastly, we note that while Swedish officials do not seem disturbed by the krona's strength (strongest major this year +4% vs. USD), a number of Swedish businesses have begun raising concerns and the equity market continues to under-perform.