Big Picture to Begin Week

Given the developments, the price action in the capital markets has been limited. The dollar is little changed, with a softer bias. Global equity markets are generally flat, with the MSCI Asia Pacific Index up about 0.25%, and the MSCI Emerging Market Index is down about 0.6% and the Dow Jones Stoxx 600 in Europe is down about 0.1% near midday in London. Most of the major bond markets are flat to slightly lower. 

The market still lacks closure on both the German election outcome and US fiscal policy, the two key points of interest for investors.  Merkel's CDU did much better in the weekend election, but fell shy of an absolute majority.  Its current coalition partner, the FDP, failed to meet the 5% threshold and thus will not be presented in parliament and forces the CDU to look elsewhere for a coalition partner.  The SPD, Greens and Left could, in theory form a majority, but for largely parochial reasons, the SPD and Greens refuse to enter into talks with the Left.  

A Grand Coalition between the CDU and SPD still appears to be the most likely outcome, but a CDU-Green coalition is possible, though a little less likely.  It may take a few weeks to sort this out, but Germany's European stance is unlikely to change.  However, Merkel's strong showing may solidify her influence in European politics.  That fact that the FDP did not meet the 5% threshold was not completely a surprise, but the strong showing by the anti-Europe AfP (4.7%) may have longer-term implications.  

The Fed's decision not to taper last week does not exactly put monetary policy on the back burner.  Bullard's comments before the weekend that it was a close decision and tapering was possible in October if the economic data was better, keeps the market on edge.  Several Fed officials speak this week and the market is looking for insight into the Fed's thinking.  Today, two non-voting members, Lockhart and Fisher and one voting member, Dudley speak today.  One of our interpretative points continues to be that the key to the Fed is its own Troika:  BYD (Bernanke, Yellen and Dudley).  

We do not think an October tapering is very likely.  It would give too much credence to high frequency, noisy data that is subject to statistically significant revisions.  Moreover, even though the Fed reduced its GDP forecasts, we suspect it was not enough and that the economy therefore under-perform Fed expectations.  Specifically, the economy expanded 1.8% in H1.   The market expects Q3 growth to be around 2%.  To reach the Fed's central tendency, the economy has to grow nearly 3% in Q4,

We also remain concerned that the Fed's forward guidance is compromised by the transition taking place at the Fed (not just Bernanke, but several other governors as well).   The Fed that gives the forward guidance will not be the Fed to implement it.  

Meanwhile, the Fed's Fixed Rate Full Allotment Reverse Repo program trial beings today (and will run through late January).  The fixed rate begins at 1 bp (though can move as high as 5 bp).  It allows the Fed to drain $24.5 to as much as $49 bln on an overnight basis.  The important point is that it will put a floor under general collateral rates, which had been trending toward zero over the summer, and threatening to distort US money market.  This facility will help the Fed when it begins to taper and normalize monetary policy.  

However, it is US fiscal policy that is rivaling monetary policy.   The spending authorization and debt ceiling issues leave the government poised to shut down at the start of next month unless a last minute compromise is achieved.  The House bill that funds the government on the condition of defunding Obamacare is going to be rejected in the Senate and sent back to the House without that condition.  Part of the problem is that the House leadership is struggling to control its party and the same can be said of the Democrats, where between Syria and Summers, Obama was outflanked.  

News that HSBC flash manufacturing PMI for China rose to a six month high of 51.2 (from 50.1), with healthy rises in new orders and export orders solidifies the sense that the world's second largest economy has not only stabilized, but is turning higher.   The news initially helped the Australian dollar, which many uses as easily accessible proxy for China.  Initially the Australian dollar fell through Friday's lows to about $0.9345 before rebounding above $0.9400.   However, the Chinese data failed to spur gains in the Asian currencies, though the yuan itself was fixed at new lows.  

The main economic data for the euro area was also reported today.  The flash PMI was mixed.  Weakness was seen in manufacturing, but continued recovery was evident in the services.  This helped lift the composite to new 2 year highs of 52.1.  

This generalization is illustrated in both German and French readings.  Germany manufacturing slowed to 51.3 from 51.8 in August.  The market had expected a small gain.  The service reading rose to 54.4, a new 7-month high, from 52.8.   France saw its manufacturing slip to 49.5 from 49.7.  Economists had expected a push through the 50 boom/bust level.  This is a four month low.  On the other hand, the service sector reading rose to 50.7 from 48.9 and is a 20-month high.  The Markit group which compiles the data suggests that is its consistent with 0.4% Q4 GDP in Germany, 0.3% for France and 0.2% for the euro zone as a whole. 

Japan's inflation data is released at the end of the week, but the focus is shifting from monetary policy toward fiscal policy.  The Abe government is preparing a fiscal package to blunt the impact of the retail sales tax hike that will most likely be implemented on April 1.  Reports suggest the package can be a as much as JPY5-10 trillion and include the end of the corporate surcharge for the Tohoku rebuilding and new auto incentives.  A formal decision is now seen likely in early October.