Calm before the Storm?

The US dollar is little changed against most of the major foreign currencies today as a consolidative tone emerges pending fresh developments. The euro made a marginal 2-year low in early Asia, but narrow ranges have prevailed and the euro has traded in a little more than a quarter cent range in Europe, mostly below $1.23. The dollar has been in an even tighter range against the yen, where a 14.8% decline in machinery orders (consensus was for around a 3% decline and a current account surplus half of what was expected) played on growth fears. Soft Chinese CPI (2.2% June from 3.0% in May) and weak jobs ads undermined the Australian dollar ahead of the employment figures later in the week. 

Growth concerns are undermining equity prices ahead of the beginning of the US earnings season. The MSCI Asia Pacific Index was off 1.5%, with the Shanghai Composite approaching the lows for the year and the Nikkei posting its biggest decline in a month (-1.4%). European bourses are faring slightly better, with the Dow Jones Stoxx 600 off about 0.35% near midday in London, with financials among the weakest sector off more than twice the index headline. Stress in peripheral debt markets continues with Spanish 10-year yields continuing to flirt with the 7% threshold, while Italy moves through the 6% level. That the 2-year yields are up even more than the longer end of the curve indicates the intensification of anxiety. Note too that Spain’s entire curve and CDS pricing has now risen through Ireland’s.

Two fears continue to dominate investor concerns: global growth slowdown and the European debt crisis. Neither can be expected to ease in the week ahead. The economic data from Europe and the US will not have the gravitas and the China’s data is expected to show, as Premier Wen suggested in a weekend interview, that downward pressures on the economy are still relatively large, even though the slowdown is stabilizing. Nor will the European finance ministers do more than talk and negotiate, with an agreement on aid for Spanish banks and Cyprus still a couple of weeks away. 

The June US jobs data were disappointing, especially after the ADP report had prompted some to revise their expectations higher. That said, some details of the report were somewhat more encouraging. These include the increase in the work week and rise in average hourly earnings. Nevertheless, average monthly US jobs growth slowed to about 75k in Q2, which is the lowest since Q1 ’10. The key question many investors are asking is whether the Fed’s decision to extend Operation Twist was a forward looking decision, which is to say they anticipated further soft employment data, of whether the Fed was responding to the weakness already seen. 

The minutes from the June FOMC meeting may shed light on the internal discussion, but we see the Fed’s decision to be forward looking and that the employment data was sufficiently mixed to keep the FOMC on the sidelines at the July 31-August 1 meeting. However, a Reuters’ survey suggests primary dealers continue to look for QE3. The median estimate now suggests a 65% chance rather than a 50% chance found in the June 20 survey. Eight expect QE to be announced in Aug-September and 12 by the end of the year, though the odds of a recession are seen as 1 in 4 over the next 12 months. Of those that expect QE, 9 expect the Fed to buy Treasuries as well as mortgage-backed securities. The anticipated size of the operation ranges from $300 bln to $750 bln.

At the EU Summit at the end of last month, the finance ministers were charged with implementing the agreements by July 9. There are two chances of this: slim and none. The one likely achievement of today’s meeting will be agreeing on filling vacancy on the ECB board. Otherwise, there are four key issues presently and none are likely to be resolved (and the lack of resolution keeps pressure on the debtors): aid to Spanish banks and Cyprus, bank supervision, access to the EFSF/ESM, and what to do about Greece. 

 It is clearer now that that recapitalization of Spain’s banks is politically impossible before the Troika makes their report. The condition for the EFSF/ESM to lend directly to banks is that a single bank supervisor (ECB) is established. This is going to take several months. That means that Spain is going to have to borrow from the EFSF and that this will count as part of Spain’s debt, even if the conditions are less onerous than imposed on the other aid recipients. In addition, both an EU official at the end of last week and German Finance Minister Schaeuble in a weekend interview a Spanish paper seemed to suggest that countries requesting aid for their banks will still need to provide guarantees. 

That underscores the fact that the creditors will continue to resist debtor efforts to mutualize sovereign and/or bank debt. Moreover, banks are only one dimension of Spain’s challenges. Regional debt is another and today the concern is that the Valencia region may face default without more government aid.