Dollar Gives Back Most of Yellen-Inspired Gains

Comments late yesterday by the Fed's Yellen after headline CPI rose above 2% for the first time in a couple of years, and the largest rise in industrial output since November 2014, spurred a rise in US yields and the dollar. The US 10-year note yield rose 10 bp to 2.43%. It was the biggest rise in a month. The dollar snapped a seven-day drop against the yen with an exclamation point--a 1.8% jump, its best in a two months.  

While the US 10-year yield is unchanged, the dollar is consolidating its gains against the yen in a relatively narrow range of about half a big figure below JPY115.00. It has seen its gains pared more against the euro and sterling, where most of Yellen-inspired gains have been unwound. Sterling found support near $1.2250 and was bid up to $1.2335 by early in the European sessions. The euro recovered have a cent from $1.0620. 

Some observers saw in Yellen's comments stronger confidence in the economy. Bloomberg's calculation of the odds of a March hike increased to a little more than 34% from a little less than 30%. The CME calculation was unchanged at a little below 20%. The March Fed funds futures contract slipped half a basis point yesterday (to 68.5 bp from 68 bp). It is now near 69.5 bp.  

The focus now shifts to the ECB. Of course, after adjusting policy last month, the ECB is highly unlikely to take new initiatives today. The most important new development since the December ECB meeting is the rise in inflation. Headline CPI stood at 1.1% at the end of last year, nearly double the 0.6% pace seen in November. The rise in German CPI to 1.7% can only increase the criticism of the German representatives of the ECB's stance.  

We look for Draghi to push back. Like several other national central bank presidents, Draghi is likely to caution against exaggerating the increase in inflation, and see it as mostly reflecting the recovery in energy prices. The core rate is at 0.9% having bottomed at 0.6%. The ECB will have to wait until new staff forecasts are available in March to understand better if the trajectory of inflation has changed.  

Last month, Draghi acknowledged that deflation forces were almost vanquished. He can extend this analysis a little, but it may not yet be time to change the balance of the outlook quite yet. Still, there may be scope for another type of concession to the more hawkish contingent: the reference that rates will remain low or lower can be modified to suggest less risk of a lower rates.  

Draghi, like Yellen, will also likely recognize the high degree of uncertainty. In addition to the uncertainty around the policies and priorities of the new US Administration, Draghi also has to navigate through several elections, including Germany, France, and Netherlands. There is also some risk of elections in Greece and Italy too.  

US data, including housing starts, permits, initial jobless claims, and January Philly Fed, will be overshadowed by the ECB press conference a quarter hour later. Yellen speaks late in the US, which will be early in the Asia's Friday session but after yesterday's comments, her views are a known quantitity.  

The other talking point today is yesterday's TIC data. The press is highlight the fact that China sold $66.4 bln of US Treasury bills, notes and bonds. It is the sixth consecutive draw down, and the largest since the end of 2011. The US Treasury reckons China still has $1.05 trillion of its paper. Japan reduced its Treasury holdings for the fourth consecutive month. The $22.3 bln liquidation brings the holdings to $1.11 trillion. China and Japan together account for the bulk of the reduced foreign holdings, which now stands at $5.94 trillion, the lowest since 2014.  

We would add two points to the discussion. First, there is often a lot of noise around bills. This may be especially true as the asset managers prepared for a Fed hike. The signal is the long-term flows. These rose $30.8 bln. The private sector is absorbing what official sales that are taking place. The pace is also fairly steady. The monthly average inflow in  2014 was almost $23 bln, and $26.5 bln in 2015. The average for the first eleven months of 2016 was $24.6 bln.  

Second, we note that the Federal Reserve's custody holdings for foreign central banks trended lower through the middle of November reaching about $3.111 trillion. It has risen by more than $70 bln. This data series is not directly comparable to the TIC data. The Fed's custody data show practically no change from the end of October to the end of November.     Our point is that the private sector appears to buying from official sales and that those official sales do not appear to worrisome, and may have actually increased more recently.

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