How Did the Markets React?
As an empty economic calendar laid in wait for the US markets open, the usually inactive overnight sessions were given the opportunity to drive treasury futures and the dollar on comments from the Peoples Bank of China. Governor Zhou Xiaochuan has said at a two day conference in Frankfurt that China will continue with plans to diversify the nations reserves out of US dollars and other assets. Though he said they were not currently selling the greenback, the reassurance of such intentions stoked fear in US security holders. Such concern is expected as the PBoCs more than $1 trillion reserves are the largest in the world. Zhou went on to stress that the diversification would be a gradual process as dumping dollars would stress the economy of one of their largest trade partners and cause large losses on their own books as they would be unloading in a selling market. However, the fact that these remarks are not unique was another reason the US overnight session was readily reacting to the news. Russia has announced it would reduce its holdings of US dollars from 70 percent to an estimated 40 percent, Italy has said it would trim its 85 percent down to 63 percent and many others are following the trend. With all of the plans to unload dollar denominated assets, both treasury futures and the dollar crosses turned lower until more pressing news could take the yoke.
Bonds US 10-Year Treasury Note Futures
After-hours Treasury traders were quick to react to the overnight comments by PBoC Governor Zhou. Dollar-denominated assets account for an estimated 70 percent of Chinas total reserves. Further, most of this is held in different maturity Treasury products, since there they are considered virtually risk-free assets. Now with plans to slowly unwind their current US positions and move into a more diversified basket, one of the biggest holders of US debt will begin to flood a market already saturated by other nations central banks who are unloading their own holdings in an effort to lessen their concentrated dollar risk. After the comments hit the news wires around 8:00 GMT, the T-Note futures contract made a topping tail at 108-08. From there, the sessions light liquidity ground the security 108-05 before calmer head took over.
FX EUR/USD
Like Treasuries, the dollar dropped immediately following the print of Governor Zhous remarks. While most of the US assets in Chinas reserve are in the form of various maturities of Treasury paper, every sale will have a negative impact on the dollar. Like debt instruments, the dollar has loosened its hold on gains that it has won against its major pairings as central banks come out of the woodworks to say that they will trade out of their dollar assets. These plans are sensible given that many economists and analysts expect the US economy to remain soft through the opening half of 2007, while Federal Funds futures are increasingly pricing in an eventual rate hike that would cut returns. Even in the less-than-optimal volatility conditions of the European session, the dollar was slipping in all its major pairings. Specifically in the EURUSD, the anti-dollar move carried the pair off of a touch of 1.2852 and didnt loosen its grip until price action nudged a few points above the closely watched 1.2900 level. This level of resistance was obviously the focus of bulls and bears as those that were long for the ride took profit and new shorts jumped on board to trade off of what is seen as a big level in the benchmark EURUSD.
Equities S&P 500 Index Futures
US equities indices, although making the correct initial move, paid little heed to the diversification comments. In the sparsely traded electronic futures contract for the S&P 500, price action began to take form just before the release came across screens in London and Tokyo. Traders took their time in finding a top a little after 8:00 GMT around 1,384.10. From there a sharp, but short lived, 2.1 point drop pulled the index down to 1,382.00. Governor Zhous warning that he would stick to existing policy and slowly move out of dollar assets didnt look to fundamentally affect equities as much as currencies and debt. Think tanks speculate that US equities make up a very small portion of Chinese reserves. Furthermore, the suggestion that the dollar would weaken in the coming years is actually positive for domestic firms. With a cheaper currency, US products would be more competitive on a global market. A more pronounced move didnt even have time to develop as a report from the EIA stole the headlines.
