FX: Nervous Consolidation: Correction Pending

The foreign exchange market remains in a heightened state of anxiety, but the majors are mostly trading within yesterday's ranges.  The short sales bans in Italy and Spain have not eased the pressure on the local bourses or bond markets.  In fact, for the first time in eleven years, the Spanish 5-year yield moved above the 10-year yield.   It is tempting to attribute the backing up of the German and Dutch yields to Moody's decision to assign them, along side Luxembourg, negative outlooks, but Finland, who was spared, is also seeing its yields rise in tandem with Germany and the Netherlands.  

Still corrective pressures are building.  The scenario we outlined called for foreign currencies losses in the first part of the week and some stabilization and recovery mid-week ahead of the first look at Q2 US GDP on Friday.  That scenario is still unfolding.

The bounces in the foreign currencies should be limited and may fall shy of technical objectives.  Initially, it looks like the euro can test the $1.2140-50 area, with sterling moving toward $1.5580-$1.5600.  The Australian dollar is testing $1.0320 and a break of it can see $1.0370-80.  The dollar appears content to trade within the JPY78.00-60 range.  The greenback finds initial support against the Canadian dollar near CAD1.0150.   

Three reports tomorrow stand out.  First is Australia's Q2 CPI report.  Inflation pressures likely eased on year-over-year basis and whatever quarter-over-quarter bounce that may have taken place from the 0.1% reading in Q1 is likely to have been modest and won't stand in the way of further easing, though the RBA's Stevens seemed in to hurry to confirm what had been rising expectations for a cut early next month.  

Second, the ECB reports money supply figures.  Money supply growth and lending is expected to be anemic.  Given the likely debate about what to do with the corridor that the refi remains within now that the deposit rate is zero suggests that the ECB is unlikely to cut rates in August, but another 25 bp cut in the refi rate still looks likely in Sept.  

Third, the UK becomes the first G7 country to provide a preliminary estimate for Q2 GDP.  A contraction of 0.2-0.3% is likely.  It will be the third consecutive quarterly contraction and the fourth in five quarters.  The IMF is urging the UK government to soften its austerity, though it shows little interest in complying.  Still, the moribund economy is going to add to the stresses on the  governing coalition.  The Lib-Dems are paying a heavy price in the opinion polls for joining forces with the Tories.  

The rise in HSBC's flash China manufacturing PMI to 49.5 from 48.2 has done little to lift sentiment.  It is still below 50, meaning that the decline may be slowing, but the economy has yet to bottom.  Nevertheless, this is what a bumpy landing may look like.  At 51.2, output is at its highest level since Oct last year and new orders are at a three month high.  

Watch the Chinese stock market.  The Shanghai Composite gapped lower on Monday and although prices entered the gap today, a small gap remains open. Last Friday's low was near 2162 on the index and today's high was near 2156.  The most bullish development would be a gap higher opening tomorrow, leaving a two-day island bottom in its wake.  Second best would be a gains above the 2187 area, which is where the 20-day moving average can be found.  The Shanghai Composite has not traded above this moving average since early June and has not closed above it since May 10.  

In contrast, the euro zone flash PMI warns that the economic contraction in Europe is set to deepen in Q3.  Indeed, the Markit people who conduct the surveys warn that the flash reading (44.1 for manufacturing and 47.6 for services) is consistent with a 0.63% decline in GDP.  Of note the forward looking new orders component of the manufacturing survey fell to 42.9 from 43.5.  

Germany's flash readings are particularly disturbing as the engine for the euro zone appeared to fade in Q2 and today's data warns that further weakness should be expected in Q3.  The manufacturing PMI fell more than expected to 43.3 from 44.7.  The consensus was for a 45.3 reading.  The service PMI fell to 49.7 from 50.3.  The consensus expected a 50 reading.  

France's service sector fared better, but its manufacturing is getting hammered.  The manufacturing PMI slumped to 43.6 from 45.3.  The consensus had hoped for a small improvement.  The service PMI rebounded back above 50 (50.2), from 47.3.  The consensus looked for 47.8.  

It is simply unclear where aggregate demand is going to come from in Europe.  Pundits can argue until they are blue in the face that austerity in the face of economic contraction can only exacerbate the downturn.   Regardless of the veracity of such arguments, a key point has been lost, which leads to talking past each other.  

Simply put, as Monti tried explaining to Obama nearly a month ago, economics in Germany is located within moral philosophy.  Growth is not viewed as a function of "demand management" but  is a product of virtuous behavior.  The German ordo-liberal model is based on cooperation and punishment.   Defectors must be punished otherwise the order breaks down.  Therein lies its interpretation of the euro zone debt crisis.