FOREX-Euro advances to 4-mth highs vs dollar on German ruling

* Dollar index falls to new four-month low * German court verdict underpins demand for riskier assets
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More gains expected in anticipation of further Fed easing

The euro climbed to a four-month peak against the dollar on Wednesday after Germany's Constitutional Court approved the euro zone's new rescue fund and budget pact, mitigating concerns about the region's three-year-old debt crisis.

While the court approval was made under certain conditions, it was enough to lift market sentiment, boosting global stocks and reducing borrowing costs for Spain and Italy.

The euro climbed to $1.2936, its highest since mid-May, blowing past reported option barriers at $1.2900. The single euro zone currency has risen more than 7 percent since it hit a two-year low of around $1.2040 in July, boosted after the European Central Bank's pledge to do whatever it takes to preserve the currency.

More gains are expected if the Federal Reserve opts to implement further monetary easing on Thursday, leaving the euro with the potential to test the $1.30 level.

"The euro continues to be in steady favor as a series of events have proven to be supportive, including today's ruling by Germany's top constitutional court," said Samarjit Shankar, managing director of global strategy at BNY Mellon in Boston.

Germany's Constitutional court said on Wednesday the European Stability Mechanism could go ahead but with the condition that any German contribution above 190 billion euros would require prior approval by the lower house of parliament.

Positive momentum continued for the euro as well as higher-yielding currencies following the European Central Bank's unveiling of plans last week to lower the borrowing costs of indebted euro zone countries via bond purchases.

But analysts and traders still worried that the depth of the euro zone's debt problems could temper the euro's rise.

"It is now time to take stock. How much further can the Euro rally?," asked Jens Nordvig, head of G10 FX strategy at Nomura Securities in New York.

He believed that there would be fewer positive European catalysts from here on and said "the short-squeeze on the euro is now in its final phase, and we will be looking for fresh short opportunities."

Traders reported another options barrier at $1.2950 and cited chart resistance at the May 11 high of $1.2958. The euro traded well above a low of $1.2815 hit on caution just ahead of the court decision.

The euro was last up 0.4 percent versus the dollar at $1.2904.

It also rose to its highest in more than two months against the Japanese yen of 100.64 yen. In midday New York trading, it was at 100.44, yen, up 0.5 percent.

Currency markets showed little reaction to the killing of the U.S. ambassador to Libya and three other embassy staff on Wednesday, which pressured crude oil futures.

A potential source of disruption for the euro, however, is a general election in the Netherlands on Wednesday, though polls indicate radical anti-euro parties have lost the momentum they had just a month ago.

DOLLAR FALLS BEFORE FED The dollar fell to a four-month low against a basket of currencies before Thursday's Federal Reserve decision, with the dollar index dropping to 79.522.

BNY Mellon's flows data showed that the dollar was the most sold sold currency across the board on Wednesday, with sterling and the Canadian and New Zealand dollars the most bought.

The Fed looks set to launch a third round of bond purchases this week to try to drive borrowing costs lower and boost a flagging economy, especially after weak jobs data last week.

However, analysts said expectations for more QE were already high which may limit the currency's drop.

The dollar extended losses following a warning from Moody's on Tuesday that the United States could lose its triple-A debt rating if next year's government budget talks do not produce policies that gradually cut the country's debt.

The dollar also fell to a four-month low against the Swiss franc of 0.9337 franc, while the higher-yielding Australian dollar hit a three-week high of US$1.0507.

The Swiss National Bank is expected to keep its target range for the Swiss franc LIBOR unchanged and retain its cap on the euro/Swiss franc currency pair at 1.20 francs when it announces its monetary policy decision on Thursday.

The yen held near a 3-1/2-month high against the broadly weak dollar, trading at 77.88 per dollar. Focus on potential Fed action this week compared to a Bank of Japan viewed to be on the sidelines should keep pressure on the dollar for now.

MONEY MARKETS-European dlr funding costs cheapest in 15 months

A barometer of dollar funding risk reached its best levels in more than a year helped by the prospect of European Central Bank intervention but was seen stabilising from current levels.

The ECB's promise to buy bonds of struggling euro zone states, as well as expectations the Federal Reserve may soon embark in a third round of quantitative easing, has improved sentiment towards riskier assets generally, underpinning European stock markets and Italian and Spanish sovereign debt.

That backdrop has driven the STOXX Europe 600 banking index to its highest in nearly 6 months, reduced the perceived risk attached to owning debt issued by certain European banks and made it less costly for euro zone banks to access dollar funding.

The three-month euro/dollar currency basis swap , which shows the rate charged when swapping euro interest payments on an underlying asset into dollars, was at its tightest since June 2011.

"That is a proxy of European risk appetite and the narrowing in basis is a reflection of decreased tail risks following the ECB's new support measures " Simon Peck, rate strategist at RBS said.

"Today we have seen three-month euro/dollar cross currency basis move a further two basis points tighter as we have successfully navigated the German constitutional court vote on the legality of the ESM and ... another tail risk."

Spanish and Italian bonds rallied and German debt prices fell on Wednesday after Germany's top court gave the green light to the euro zone's new bailout fund, prompting relief the bloc's rescue plans remained on track..
The three-month euro/dollar currency basis swap narrowed to minus 25 basis points from minus 27 bps the day prior, having reached minus 160 bps in November last year when the euro zone debt crisis escalated.
RBS's Peck said there was limited scope for further tightening.

"The narrow levels at the moment are really (based) on happy outcomes for the likes of Spain and Greece but there remain very sizeable risks that we will not see such good outcomes," Ciaran O'Hagan, strategist at Societe Generale said.

Analysts say intervention will not provide a quick fix and some flag the inherent contradictions in the ECB's strategy.

For the central bank to intervene in the market, countries have to ask for a bailout first. But for Spain to seek financial help, it would have to be losing access to financial markets, meaning its borrowing costs would have to be at prohibitive levels, analysts say.

Spain's Prime Minister Mariano Rajoy suggested as much when he earlier said his government continues to study the price of seeking assistance but improved market conditions may make aid unnecessary.

The one-year euro/dollar currency basis swap was also at its narrowest since July 2011 at minus 29 bps, but one money market trader said he expected it to stabilise at around -25 bps given potential risks ahead.

"The whole feel-good factor has come back to markets," the trader said. "How long it will last, I am not 100 percent sure."

Dollar Gains Ground On Stronger US Economic Data

NEW YORK (Dow Jones)--The dollar's rally picked up steam Wednesday morning in New York, hitting a two-week high against the yen, after stronger U.S. economic data fueled bets the Federal Reserve will tighten monetary policy sooner than previously anticipated.
The dollar jumped to the highest level since Feb. 3 against the yen, rising as high as Y91.12. Demand for the greenback pushed the euro well below the $1.37 level, on the back of data that showed that U.S. housing starts in January climbed to the strongest level since July 2009, while industrial production beat analysts' estimates.
"The data show that the economy will rebound in the U.S. before it does in Europe and Japan," said Sebastien Galy, currency strategist at BNP Paribas in New York. Based on that stronger U.S. economic data, "the market is also making a bet that the Fed will tighten [monetary] policy before the [central banks] in Europe and Japan."
Rising U.S. Treasury yields, in the wake of the economic data, is also adding more pressure on the yen and the euro, making dollar-denominated assets more attractive, traders said. Yields on the 10-year U.S. Treasury notes rose 3.8 basis points to yield 3.706%.
Wednesday morning in New York, the euro was at $1.3707 from $1.3772 late Tuesday, according to EBS via CQG. The dollar was at Y90.98 from Y90.11, while the euro was at Y124.70 from Y124.08. The U.K. pound was at $1.5780 from $1.5787. The dollar was at CHF1.0708 from CHF1.0660.
The ICE Dollar Index, which tracks the greenback against a trade-weighted basket of currencies, was at 79.952 from 79.630.
U.S. January industrial production came in slightly better than expected as the factory sector paces the recovery. Production last month increased by 0.9%, with manufacturing up 1.0%. Economists had expected a 0.8% increase. December output was revised to 0.7%; originally, production was reported rising 0.6%.
Earlier, data showed U.S. housing starts climbed 2.8% to a seasonally adjusted 591,000 annual rate compared to the prior month, the Commerce Department said Wednesday. Economists surveyed by Dow Jones Newswires forecast a 5.9% increase in January housing starts, to an annual rate of 590,000. The pace of 591,000 was the strongest since July 2009.
Investors are now eyeing the release of the minutes from the last Federal Open Market Committee meeting, scheduled to be released at 2 p.m. EST.
The dissent vote in the last FOMC's rate-setting meeting "will be the focus" of investors' attention, said Kasper Kirkegaard, a currency analyst at Danske Bank in Copenhagen. However, Kirkegaard said it was unlikely to be "a market mover" event.
"We've already seen [Federal Reserve's chairman] Ben Bernanke outlining some of the Fed's thoughts about exit strategy, hence we do not expect many surprises from the minutes," he said.
Meanwhile, the Bank of England's Monetary Policy Committee was unanimous in its decision to suspend its bond-buying program in February, but for some members it was a close call, meeting minutes released Wednesday showed.
The MPC judged that "a case could be made" for extending its GBP200 billion quantitative easing policy of buying gilts with freshly created central bank money, and said it could extend it in future, if conditions warranted it.

Canada Morning 

The Canadian dollar was slightly lower Wednesday morning after stronger U.S. economic data triggered demand for the greenback.
"We do not think for one moment that the recent uncertainties that have spooked risk assets have disappeared permanently, but, for the moment, the lull in risk aversion should allow the Canadian dollar more room to explore the lower end of the recent trading range against the dollar," TD Securities strategists wrote in a note to clients. "The low 1.04 area has proven to be a source of support for the U.S. dollar in previous phases of softness."

FACTBOX-China, the U.S. Treasury's top foreign creditor

WASHINGTON, Feb 10 (Reuters) - Senior Chinese military officers have recommended Beijing "dump" some U.S. Treasury bonds to punish the Obama administration for Washington's latest round of planned arms sales to Taiwan.

Luo Yuan, a major general in the People's liberation Army, was quoted in an official publication saying bond sales could be part of a package of economic "counter punches" over the arms sales.
Speculation of how China might use its position as America's top foreign creditor to influence Washington has risen steadily as U.S. deficits have swelled and tensions grow over the restricted valuation of the yuan. Following are some key facts about China's Treasury and dollar asset holdings:
* China's holdings of U.S. Treasury debt dipped to $789.6 billion in November from $798.9 billion, a month-on-month decline of $9.3 billion or 1.1 percent. It remains the largest holder of Treasuries, ahead of Japan, which held $757.3 billion in November.
* China's holdings of Treasuries has nearly doubled in the last two years. Beijing held $421.1 billion in Treasuries in March 2007, before the financial crisis emerged, compared to Japan's $611.2 billion, which made it the largest Treasury debt holder at that time. China's Treasury holdings peaked at $801.5 billion in May 2009.
* China's foreign exchange reserves, the world's largest, rose $453 billion in 2009 to $2.4 trillion. While China does not provide a breakdown of its reserves holdings, analysts believe about two thirds is held in dollar assets. A move to punish the United States by selling Treasuries or other holdings would undoubtedly hurt the value of this stockpile.
* China has attributed about $71 billion of the 2009 reserve gains to changes in foreign exchange rates and rises in asset values, citing in particular gains in non-dollar assets. The State Administration of Foreign Exchange has said the appreciation of its non-dollar holdings "has definitely led to growth in outstanding foreign exchange reserves calculated in dollars." Chinese officials also had expressed concerns the dollar's decline last year was hurting its reserves value.
* China held $1.205 trillion worth of U.S. long-term and short term securities, including Treasuries, as of June 2008, according to the Treasury's latest annual data on foreign portfolio holdings. At the end of June 2008, China's forex reserves stood at $1.809 trillion, so the dollar portion stood at almost exactly two thirds at that time.
* China's first purchase of long-term U.S. Treasury bonds and notes from U.S. sources was recorded in March 1985, with gross purchases of $29 million and gross sales to U.S. investors of $11 million that month. China's monthly gross purchases topped $1 billion for the first time in May 1992 and topped $5 billion in September 1996. They exceeded $10 billion in January 2000 and $20 billion in August 2002, peaking at $40.47 billion in June 2009. That same month, China sold $13.85 billion in long-term Treasuries to U.S. investors.
* In November, China's gross long-term Treasury purchases were $28.45 billion with gross sales of $13.51 billion to U.S. investors. Total November purchases of U.S. Treasuries by all foreigners from U.S. sources totaled $1.194 trillion, while sales to U.S. residents were $1.076 trillion.

FACTBOX-China, the U.S. Treasury's top foreign creditor

WASHINGTON, Feb 10 (Reuters) - Senior Chinese military officers have recommended Beijing "dump" some U.S. Treasury bonds to punish the Obama administration for Washington's latest round of planned arms sales to Taiwan.
Luo Yuan, a major general in the People's liberation Army, was quoted in an official publication saying bond sales could be part of a package of economic "counter punches" over the arms sales.
Speculation of how China might use its position as America's top foreign creditor to influence Washington has risen steadily as U.S. deficits have swelled and tensions grow over the restricted valuation of the yuan. Following are some key facts about China's Treasury and dollar asset holdings:
* China's holdings of U.S. Treasury debt dipped to $789.6 billion in November from $798.9 billion, a month-on-month decline of $9.3 billion or 1.1 percent. It remains the largest holder of Treasuries, ahead of Japan, which held $757.3 billion in November.
* China's holdings of Treasuries has nearly doubled in the last two years. Beijing held $421.1 billion in Treasuries in March 2007, before the financial crisis emerged, compared to Japan's $611.2 billion, which made it the largest Treasury debt holder at that time. China's Treasury holdings peaked at $801.5 billion in May 2009.
* China's foreign exchange reserves, the world's largest, rose $453 billion in 2009 to $2.4 trillion. While China does not provide a breakdown of its reserves holdings, analysts believe about two thirds is held in dollar assets. A move to punish the United States by selling Treasuries or other holdings would undoubtedly hurt the value of this stockpile.
* China has attributed about $71 billion of the 2009 reserve gains to changes in foreign exchange rates and rises in asset values, citing in particular gains in non-dollar assets. The State Administration of Foreign Exchange has said the appreciation of its non-dollar holdings "has definitely led to growth in outstanding foreign exchange reserves calculated in dollars." Chinese officials also had expressed concerns the dollar's decline last year was hurting its reserves value.
* China held $1.205 trillion worth of U.S. long-term and short term securities, including Treasuries, as of June 2008, according to the Treasury's latest annual data on foreign portfolio holdings. At the end of June 2008, China's forex reserves stood at $1.809 trillion, so the dollar portion stood at almost exactly two thirds at that time.
* China's first purchase of long-term U.S. Treasury bonds and notes from U.S. sources was recorded in March 1985, with gross purchases of $29 million and gross sales to U.S. investors of $11 million that month. China's monthly gross purchases topped $1 billion for the first time in May 1992 and topped $5 billion in September 1996. They exceeded $10 billion in January 2000 and $20 billion in August 2002, peaking at $40.47 billion in June 2009. That same month, China sold $13.85 billion in long-term Treasuries to U.S. investors.
* In November, China's gross long-term Treasury purchases were $28.45 billion with gross sales of $13.51 billion to U.S. investors. Total November purchases of U.S. Treasuries by all foreigners from U.S. sources totaled $1.194 trillion, while sales to U.S. residents were $1.076 trillion.