German Court Decision and Data Extend Risk-On Rally

The German Constitutional Court cleared the remaining hurdle to the ESM and this has encouraged a further extension of the risk-on rally.  The US dollar is bearing the brunt of the move ahead of the other key event of the week, the conclusion tomorrow of the FOMC meeting, where the perceptions of the risk of QE are running high.  

The market appears to have its sights set on the $1.30 level for the euro and $1.6180-$1.6200 for sterling.  The Australian dollar is actually leading the move today, gaining marginally more than the euro, and resurfacing above the $1.05 level for the first time in three weeks.  While the $1.0550 area may off some resistance, there does not seem to be much stopping a run back to the early August highs, a bit above $1.06. Meanwhile, cross rate losses for the yen are helping the dollar hold yesterday's lows near JPY77.70. As is often the case when the greenback comes under pressure, the Canadian dollar is losing ground on the crosses.  Yesterday's poor Canadian trade figures may also be taking a toll.   It is largely flat against the dollar in the European morning, making it the second worst major currency so far today behind the yen.

The economic data has generally surprised to the upside.  In particular, industrial output in the euro area rose 0.6% in July, while the consensus foresaw only a flat report.  The July increase offsets in full the decline seen in June.  This was helped by the news that Italy's industrial output fell "only" 0.2%, half of what the market expected.  

For its part, the UK reported a 15k decline in the claimant count, the biggest drop in two years.  This was also better than the consensus’ flat expectation.  This follows on the heels of other favorable UK data recently that includes the service sector PMI, industrial output, suggested some economic stability here in Q3.  

This in turn, follows better than expected Chinese lending data and some greater confidence creeping in that the Chinese economy is close to a bottom.  And Japan reported its core machinery orders, a lead indicator for capital spending, rose 4.6% in July, roughly three times more than the consensus expected and follows a 5.6% rise in June.   This helps recoup a chunk of the nearly 15% decline seen in May. 

At the same time, German, French and Spanish August inflation figures all came in on the high side (2.1% for the Germany and France and 2.7% for Spain).  This will likely to dampen any lingering hopes that ECB can cut the 75 bp refi rate next month.  This, coupled with the fact that the despite the new program, the ECB has not bought a single bond, while the Federal Reserve is seen poised to announce some expansion of its balance sheet on Thursday, offers stark contrast.  Although we have not found a good relationship between balance sheet expansion and bilateral currency moves, this contrast, given market positioning, seems to be a key consideration at the moment.  

The Italian bill auction went off smoothly, helped by the favorable German Court ruling, which were the best European officials could have hoped for.  The Court essentially capped German exposure to the ESM to 190 bln euros, without additional parliamentary approval.  It also required that both houses of parliament are kept informed on all ESM decisions.  With the risk-on environment, core bonds are under pressure and this explains the generally poorer German 5-year auction.  At 61 bp, the yield is still extremely low by any measure but the 31 bp that the 5-year auction produced last month.  Germany also raised about 1 bln euros less than the 5 bln intended. 

The fact that Spanish yields continue to trend lower means Rajoy continues to see no urgency to request assistance.  He continues to rule out a full aid package.  With the Spanish 2-year yield (generic) near 2.84% and the Germany 2-year at about 7 bp, the spread is approaching a levels that appear to be in line with what officials think is nearly right (~250 bp spread).  

The Dutch election looks like a cliff hanger between the Liberals and Labor. The OMT, FOMC meeting and the German Constitutional Court ruling, the Dutch election has been largely overshadowed. To be sure, Dutch bonds have under-performed other euro area bonds, including the other three countries in which the rating agencies all still give the highest status to, over the past month, as core bonds generally suffered at the hands of the recovery in the periphery.

As the OMT eases the perceived the tail-end risks of a euro zone bust-up, Dutch two-year yields have returned to positive territory (~10 bp) after dipping shallowly into negative territory last month. The fractious nature of Dutch politics means that it will likely take some time to put a new government together. The markets (and Merkel) would prefer a government led by former Prime Minister Rutte and the Liberal party. However, recent polls show a dead heat with Labor.

The key, as is often the case in multiparty system, the performance of smaller parties may be more indicative. A coalition with Labor and the other smaller liberal party D66 would also be seen as market friendly. A government, however, that includes the Socialists or the anti-immigration, anti-EMU Freedom Party may see investors prefer Austria over the Netherlands and earn an extra 20 bp annualized. That said, the Dutch macro-economic fundamentals are among the best in the euro zone.

The public sector debt to GDP ratio is among the lowest in the area, though the household debt stands near 120% of GDP. It has a well-diversified economy. Near 190% of GDP, Holland can boast among the largest pension resources in the euro zone. Retirees there reportedly have among the highest purchasing power of pensions at around three-quarters of national wages. Long-term care costs are estimated at twice the EU average due to the comprehensiveness of its coverage and low co-payments.

The Dutch, like others, seem increasingly reluctant to sacrifice the basket of goods they get from the state (entitlements or the rights of citizenship?) for an arbitrary target an arbitrary time frame. When euro tensions rise again, the Netherlands will benefit from perceptions that in a break-up situation, a new Dutch guilder would likely appreciate. When such expectations arise again, investors may again pay to give their money for a short period of time to the Dutch government.