Poor Europe No Place to Hide

Poor Europe. (Cue Charlie Brown sad music) China starts the week with an outflanking maneuver, putting the G20 once again off-balance. That leaves little to distract from Europe’s debt crisis. Yes, the G20 will talk about financial reform, but the UK, Germany and France do not yet appear to convince a majority of its bank tax proposals.

While the media has played up the split between the US and the European fiscal approaches, this is arguably just as much about rhetoric as it is substance. To be sure, the peripheral countries are tightening, but together it is a modest part of the euro zone’s GDP. The other austerity measures, including from Germany, are largely about future intentions than immediate cuts in spending. Given the recent Greek experience, it makes sense that European officials emphasize their commitment to put the economies on sounder fiscal footing. After violating their own rules, its makes sense that euro zone members try to rebuild confidence.

At the same time, with unemployment stubbornly high, it makes sense that American officials emphasize its commitment to fostering a sustained recovery. At the same time, US states and local governments are tightening their fiscal policies sufficient to have more than offset the Federal stimulus in Q1 and likely here in Q2 as well. Obama has also asked for 5% spending cuts from numerous cabinet departments for the 2012 budget and this is ahead of the report by the budget commission. Democrat leadership in Congress has promised an up/down vote (as opposed to the laborious process of amendments) on the commission’s recommendation.

There is much talk that Greece is preparing legislation to create the mechanism to tap the 110 bln euro EC/IMF package. This coupled with the portfolio managers adjusting at the end of the month to the ejection of Greek bonds from some industry benchmark indices have seen Greek bonds perform miserably and the cost of insurance to rise to levels beyond what was seen prior to last month’s measures, both for Greece itself and euro zone-wide facility. The mechanisms and ECB bond buying have also not been sufficient to prevent new record wide Portugal premium.

On a separate but related front, there is much concern about the impact of the 1 July expiry of last year’s large 12-month long-term repo operation. While some of the funds will likely be rolled into three month repo, there is concern about European bank funding. Note that yesterday’s BOE Financial Stability Report warned that UK banks faced a GBP850 bln funding gap in the next couple of years.

There have been a few other developments to note today.

First, Japan reported May national CPI and June CPI for Tokyo. The BOJ said that deflation “clearly moderated”. This assessment is only possible if one looks at the headline rates or excluding fresh food prices, but if one strips of food and energy, CPI was -1.6% in May the same as in April. This also holds for the Tokyo figures, excluding food and energy, the 1.4% decline in June was the same as in May. That said, the DPJ government waived high school fees earlier this year and this is also contributing to what the BOJ sees as a moderating deflation.

Second, Australia’s new prime minister and the mining companies appear to have begun negotiations over the resource tax, though the Australian dollar continues to trade heavily (in this risk averse environment).

Third, Canadian dollar is still flirting with key chart levels. The combination of soft to poor Canadian data and US data coupled with more neutral sounding Bank of Canada officials has made the Canadian dollar among the worst performing G10 currencies this week, losing about 2.1% against the US dollar. December BA futures have rallied (implying lower rate) by 25 bp this week as the market scales back the trajectory of BOC policy.