"Light at the End of the Tunnel" Boosts Markets

Market Highlights:

• Pursuit of Yield Lifts Currencies 
• Euro Strengthens on Interest Rate Outlook 
• Signs of Life in US Mortgage Market

Best Rates Guaranteed with XE Trade. Get a Free Account

Pursuit of Yield Lifts Currencies

Traders moved out of their caves over the trading cycle, bidding up equities, commodities and high-yield currencies while sending the US dollar downward. The Big Dollar fell to a 15-month trade-weighted low against its major rivals as investors sold Treasury bills and moved funds into overseas alternatives.
Global market optimism rose after Japanese Prime Minister Naoto Kan said that he could see “light at the end of the tunnel” as conditions improved at the Fukushima Dai-Ichi nuclear plant north of Tokyo and in a clear vote of confidence, Warren Buffett said that Japanese investments now represented a "buying opportunity". Mr. Buffett's words are widely heeded in the financial markets - and by retail investors who are quite likely to begin pouring funds back into Japanese markets in the coming days.
The Dow Jones Industrial Average shot past the 12,000 barrier once more, capping its strongest three-day performance since September. Equities have not yet recovered from the losses sustained over the past ten days, but panicked selling is being gradually replaced by hesitant buying.
Crude oil fell slightly to trade just above the $102 handle this morning. Markets appear to be fully discounting the loss of Libyan production for the foreseeable future, while also betting that unrest in Bahrain and Saudi Arabia will be contained in the coming days.
The Canadian dollar remained rangebound in advance of the federal government budget to be tabled later today at 4 pm Eastern Time. Finance Minister Jim Flaherty is expected to announce further spending increases, while upgrading the government’s revenue forecast to a greater degree in order to move the budget into surplus territory by 2015. This would make Canada the first country among the G7 group of nations to achieve a balanced budget, and has been a fundamental driver of the currency’s strength over the past year as international investors move assets into the country. Flaherty is also expected to stick to an earlier commitment to drop the corporate tax rate further, to 15% by 2012.
Euro Strengthens on Interest Rate Outlook
The euro broke the 1.42 mark against the US dollar after European Central Bank President Jean-Claude Trichet told the European Parliament that he had "nothing to add” to the comments he made earlier this month. He called for "strong vigilance" on inflation in early March - words which were widely interpreted as indicating an imminent interest rate hike. Trichet's Italian colleague Mario Draghi echoed the hawkish stance, saying that the bank is "prepared to act in a firm and timely way" against inflation risks.
Given the uncertainty prevalent in the remainder of the world economy, this concern about inflation risk may seem misplaced. However, the European economy differs from others in a very significant way. Many workers have inflation-linked salaries, meaning that their wages automatically increase as prices rise. The indexes that form the basis of these inflation calculations include such volatile commodities as food and oil - which have skyrocketed over the past two years. Therefore, while other central banks have the luxury of stripping out this 'non-core inflation', the Europeans are forced to consider its 'second round' impact, as rising wages push prices up further. This means that Trichet & Co. must react to rising inflation much more quickly. 
The currency is also being propelled by rising optimism around the European Union summit planned for Thursday and Friday. Leaders have said that they will deliver a ‘comprehensive’ package of reforms aimed at resolving the region’s sovereign debt crisis, and early indications would suggest that negotiations are proceeding successfully.
European finance ministers agreed on a new 500 billion euro rescue facility yesterday, which will be called the European Stability Mechanism. The new fund will replace the temporary entity that was set up during the height of the crisis last year. Germany will contribute 27.1% of the available money that can be employed in bailing out struggling sovereign issuers, France 20.4%, Italy 17.9% and Spain 11.9%.
Last week, the finance ministers agreed on a set of sanctions to be used in punishing countries with rising budget deficits – many of which have been increasing since the euro’s creation in 1999. The new rules are scheduled to go before the European Parliament for approval in the coming weeks, and significant opposition is likely. Political parties in several countries are under fire for their support of the euro project, which may make the ratification process more difficult.
These steps have been roundly criticized in the press, with billionaire investor George Soros the latest to disapprove. In an op-ed piece in the Financial Times yesterday, he said that the reforms would “set in stone a two-speed Europe”, with northern European exporters such as Germany retaining their competitiveness while southern Europe struggles. Soros expects this to “generate resentments that will endanger the European Union’s political cohesion”. Given Soros’s reputation as the man who brought down the pound, his comments should be taken as an indication that the road ahead for the euro is unlikely to be smooth.
Signs of Life in US Mortgage Market
In a little-noticed development, the US Treasury Department announced its intention to begin selling parts of its $142 billion dollar portfolio of mortgage-backed securities.
The vast majority of these instruments were purchased during the financial crisis in an attempt to rescue the US residential mortgage market from imminent collapse. Real estate prices are still declining, but the pace has slowed in recent months while lending conditions have seen improvement. That the Treasury now considers the market healthy enough to reabsorb these securities will be widely perceived as a sign that the US recovery is now on a solid footing, with little chance of a real estate-led relapse on the horizon. Very positive news for the US economy, the US consumer, and ultimately for Canadian exporters...have an excellent day!
By Karl Schamotta, Senior Market Strategist