Today’s unexpected strengthening of the euro in the wake of yesterday’s Danish “no” vote is providing a welcome respite for Europe’s embattled common currency. The bounce above $.88 primarily reflects short-covering that came when traders found that downside risk to the currency from the polling result already was largely priced in. The oil-price reversal of the past week also is likely providing marginal support. Last week’s surprise euro-support operation by G7 central banks appears at least to have brought an end to the speculative free-lunch enjoyed by euro short sellers. The sterilized intervention, of course, could not have been expected to have a lasting impact turning sentiment in favor of the currency (“Euro Surprise,” September 22, 2000).  But the not-so-veiled threat of additional action has established a floor under the currency that the market seems unwilling to test at this point. Reluctance to challenge the authorities’ tolerance for euro weakness does not equal a vote of confidence in the currency. It could well be, though, that the worst of the storm has passed for the euro. At a yield of 5.23%, 10-year German bunds have rallied by some 10 basis points since the euro hits its lows below $.85 last week, an indication that perceptions of currency risk have diminished. Perhaps the best hope for the European currency finding some measure of stability can be found in the apparent plateauing of a relentlessly strengthening dollar, with gold now rangebound in the mid-$270s.  
 

After first blaming the 0.1% upward revision in the CPI for the bond market’s minor setback earlier this week, the Wall Street cognoscenti seem to have had second thoughts. Or, as today’s Wall Street Journal put it, yesterday’s quarter-point gains reflected “principally relief in the bond market that the revision to consumer price inflation was less potentially inflationary than feared.” Of course, as noted here Wednesday, the one-tenth of one- percent revision could have very little meaning to a market fully aware of the grossly distorted view of the price environment generated monthly by the CPI. To think otherwise, one would also have to accept that long-term bondholders are anxious to lock-in a real return of 2.5% -- the difference between the 10-year nominal yield of 5.8% and the current 3.3% year-on-year consumer inflation rate. That, however, is some 125-150 basis points below historic real-return averages. It’s also true, though, that long-term creditors care less about the current inflation rate than they do about expected inflation and inflation risk. A more accurate, though still imperfect, representation is provided by Treasury’s inflation-indexed (TIPS) debt, which establishes a market-based indicator of real return. Ten-year TIPS currently are yielding about 4%. The spread of around 180 basis points between 10-year nominal and TIPS yields suggests, then, that the market now is discounting for long-term inflation some 150 basis points below the current rate of increase in the CPI.