After Summers, Risk-On Rally Begins

News that Lawrence Summers withdrew from what turned into a bit of a contest to replace Bernanke as Chairman of the Federal Reserve has sparked a risk-on rally. Without a cash market, due to the Tokyo holiday, US Treasury futures rallied strongly and US stocks traded higher electronically, helping lift emerging market assets as well.

Although opposition to Summers was well known, it appeared to have risen to a critical mass over the weekend, but his withdrawal was still a surprise. Yellen would appear to become the favorite candidate again, but other potential candidates seems to be in play as well, including former vice chairman Donald Kohn and Christina Romer.

Assuming that Summers was indeed going to be Obama's nominee, it represents the second time in short order that the President has been frustrated by the Democrats in Congress which will give rise to talk of a lame duck president ahead of key legislative battles over the debt ceiling and rearguard action over Affordable Care.

The CSU's outright victory in the Bavarian election would seem to bolster Merkel ahead of the weekend national election. However, the cloud in the silver lining is the FDP. They failed to achieve the 5% threshold for the Bavarian parliament and are now straddling that area in national polls. With the AfD squeezing Merkel for a few percentage points (but less than the 5% threshold), a poor showing by the FDP may reinforce speculation of a Grand Coalition.

Ironically, the Australian dollar is the strongest of the majors today, gaining about 1.3% against the greenback and completely recovering from the drop spurred by last week's disappointing employment report. It had approached $0.94 for the first time in nearly 3 months. Although the upside momentum eased after the initial thrust, the overall upside does not seem over and we suspect there is potential toward $0.9500.

The euro was initially marked up to almost $1.3380 on the Summers news, but has been confined to about a 20-25 tick range since. We see risk for a marginal new high into the $1.3420-50 area, which has capped the euro in June and August.

It appears to be primarily a US dollar issue as the two key crosses, euro-yen and euro-sterling are little changed on the day. Sterling too was marked up in early Asia, but managed to reach a new marginal high just before European activity got under way, just below $1.5960. This is the highest it has reached since mid-January.

While global debt markets have rallied in sympathy with the US Treasuries, we note that Portugal is an exception. The 10-year bond yield is up 4 bp (7.29%) and brings the gain over the past month to 103 bp. The 2-year yield is up 4 bp at 5.7%, which represents a 235 bp increase over the past month. The Troika is in Lisbon to review progress on the aid package. There is increasing concern that it is still dependent on assistance. The rise in yields signals Portugal's access to the capital markets has not really returned.

Tokyo markets were closed for the equinox, but the drop in US yields and broad dollar weakness saw the greenback fall to JPY98.50, which is below the 20-day moving average for the first time since late August. A near-term base is trying to be carved out near JPY98.70, from which the dollar could firm toward JPY99.40 before facing more serious resistance once again.