Policy Divergence Theme Driven Home

The combination of the strength of the European data and Federal Reserve Chairman Bernanke's semiannual testimony before the Senate, which is unlikely to signal an early end to QEII, is reinforcing ideas that Europe is likely to raise rates before the US. This continues to weigh on the dollar. Talk of recycling of petrodollars as oil producers seeking to maintain allocation of reserves adds to the dollar pressure.

Nearly every euro zone country that reported a manufacturing PMI came in above market expectations. Both the German and French series beat the flash report out last week. Germany posted a new record high. The overall euro zone reading matched the flash at 59.0 from 57.3 in January, which is the best since June 2000. That that priced moderated to 85.3 from 85.7 in the flash report offers little consolation. It was 79.2 in January and the EMU flash February CPI came in at 2.4%, a tick higher form January. The strength of some of the periphery PMIs, such as Ireland to 56.7 from 55.8, its highest since 2000, must be seen as a favorable development. Even Spain's headline that ticked up ever so slightly to 52.1 from 52.0, is the strongest in 10-months. On top of this Germany reported joblessness fell 52k in February, more than three times more than the market expected.

The EC followed this up with revising higher euro zone growth forecast to 1.6% from 1.5%. German and French growth were revised higher to 2.4% and 1.7% respectively from 2.2% and 1.6% in the November forecasts. Spanish growth was lifted to 0.8% from 0.7%, Italy was unchanged at 1.1%. Taken as a whole, the deepening and broadening of the euro zone recovery may boost ECB confidence to continue to normalize liquidity provisions and lay the groundwork for a rate hike later this year.

Bernanke's testimony is unlikely to be surprising. As chairman, he has increased the transparency and enhanced the effectiveness of the Fed's communication with the market. He is likely to acknowledge the evidence that the economic recovery is strengthening. However, the mandate of price stability and full employment remain elusive. This is after all what the FOMC statements have indicated. More recently, Fed officials have also seemed to emphasize that their commitment to ensure that inflation expectations remain anchored. At the same time, Bernanke may have to explain how a commodity shock pushes weighs on growth while lifting measured inflation. In such an environment, the Fed has, in the recent past, used official speeches to contain inflation expectations, not monetary policy.

There has been a slate of other European data. Sweden reported Q4 GDP of 1.2% quarter/quarter for a 7.3% year/year pace, This simply reinforces expectations of additional Riksbank hikes and a stronger krona. The Swiss economy expanded 0.9% in Q4. The 3.1% growth for the year shows the resilience of the economy in the face of the strength of the Swiss franc, even though Q3 GDP was revised lower to 2.6% from 3.0%. Exports did slip on the quarter, but the 4.0% surge in investment shows how Swiss businesses will cope with the currency strength--boost productivity through capital investment.

Lastly, note that the UK PMI was also better than expected at 61.5, the same as in January. This is important. It should boost the sense that the Q4 contraction is not being repeated in Q1. On the margin, the risk of a surprise rate hike from the BOE next week appears to have risen. While this is not the most likely scenario, the risk is rising, more so for it than the ECB on this Thursday or the SNB later this month.