Market's Focus Shifts From US Economy Back to Europe

It as if market participants can focus only on one of the key drivers of financial markets at a time. From last November through May, European financial woes were paramount. As the EU and ECB innovated and, we have argued bluffed (through exaggerating the size of the financial program in mid-May) the liquidity pressure eased and fears of the imminent demise of the euro zone eased, the market turned its attention to the marked slowdown of the US economy. This saw the dollar generally trend lower in the June-July period.

Heightened fears that the world economy would not generate the kind of growth needed to avoid solvency issues in Europe weighed again on the euro in the first part of August. However, the prospects of QEII and the effective easing bias of the Federal Reserve put the dollar on its back foot again late last month. The combination of the stronger than expected manufacturing ISM, the rise in pending home sales and, topped off by last week’s employment data (and back month upward revisions) has shifted the sense of urgency back to Europe.

Here the news stream has been poor. There are media reports suggesting that banks may have understated their exposures in the recent stress tests. Many in the market, including ourselves, have consistently argued that the stress tests lacked the rigor to really satisfy the doubters. There are also reports warning that after a relatively quiet August, European countries are planning on selling some 100 bln euro of paper this month, twice the amount raised in August. There are also new worries over the amount of funds that Basel III would require, with concern expressed by both Belgian and German officials. Costs of the Irish banking system are also weighing on sentiment. In terms of politics, there has been a cabinet reshuffle in Greece, with an eye toward the November municipal elections and Italy’s PM Berlusconi reportedly is trying to push his rival Fini from his parliamentary post which may force elections. Meanwhile there are strikes in the UK and France today.

Lastly, we have argued that the strength of the German economy has masked much weaker performances in the periphery and parts of the core when looking at the aggregate figures. Yet because Germany growth is so dependent on exports, we have been skeptical over the sustainability of its performance. While one number does not a trend make, we think the recent string of news may very well mean that the best is behind it. Today’s poor manufacturing orders data warns of weakness in output in the coming period. The market was expected orders to have risen 0.5% in July, off from the heady 3.2% (revised to 3.6%) rise in June. Instead they fell a large 2.2%. Foreign orders fell 3.7% on the month, which some observers will attribute to the rise in the euro, though this seems to give the currency too much credit and weak global demand not enough. This is assessment is supported by the fact that orders from within the EMU fell 6.1% on the month.

The week’s central bank meetings are getting under way. The Reserve Bank of Australia kept rates steady as widely expected and the statement was more neutral than many expected. There had been some hope that the door to another rate hike toward the end of the year would have been kept more ajar than it was. That said, the risk-averse environment is also weighing on the Australian dollar. The BOJ meeting also ended with consequence. The BOJ’s Shirakawa seemed to push back against political pressure noting that monetary policy should not be influenced by short-term currency fluctuations.

He did express concern that the yen’s strength may discourage capital investment. That said, recall that last week’s capex survey warns that Q2 GDP is likely to be revised up in response. Meanwhile, the DPJ leadership challenge is heating up. Although challenger Ozawa is lagging in to the public opinion polls, he is doing better within the DPJ party that he helped to create. One party poll showed him ahead of Prime Minister Kan 185-164 with 63 undecided. Lastly, we note that with the support of a couple of independents, Julia Gillard is going to remain Australia’s Prime Minister.