Five Key Events Next Week

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The US debt ceiling remains unresolved at this late date.  The market's response over the past week to Europe's new initiatives is poor as peripheral, including Spain and Italian, bond yields and spreads over bunds widened considerably.  Yet as investors, we must look ahead.

There are five key events next week that will be on radar screens, leaving aside the US debt ceiling debate and rating challenge.

1.  Three central banks meet:  The Reserve Bank of Australia, Bank of England and European Central Bank. None are expected to change policies.   Expectations on the RBA are the most vulnerable.  The OIS market still prices in a cut, but this seems increasing less likely.

Unlike most central banks, when the BOE doesn't do anything, it doesn't say anything.  Minutes more revealing, but the economy has stagnated for 9 months, but price pressures too elevated still and trajectory not clear enough to really strengthen calls for another round of asset purchases, at this juncture.

That leaves the ECB.  It has hiked rates twice this year.  The sentiment reading this week was a shock and the flash CPI has eased.  No one is really looking for another hike until Q4 at earliest around Draghi's ascension.  The short-end , like euribor and even the German 2-year seems more a function of safe haven flows that shift in policy expectations.  The ECB got much of what it seemed to have wanted from European officials, though it probably wanted a larger EFSF.  It could not block the likely mini-default of Greece, but it did not the governments to agree to guarantee Greek collateral--though probably not in sufficient size to satisfy Trichet.

2.  The EU/IMF/ECB, the self-styled Troika (was it really that long ago that the US Treasury and the IMF were seemingly joined at the hip?), perform their first check up since it received the aid package.  Ironically the prior and minority government collapsed trying to ram through an austerity package.  The terms of the aid package actually were less onerous and odorous, but as growth weakens, the new government appears to have largely committed itself to the very austerity it shunned in opposition.  There is little if any chance that the Troika will not make the next tranche payment to Portugal.

However, it is important for investors to begin appreciating that the Troika will make roughly quarterly visits ahead of the tranche payments and that at different times for different aid recipients this could be a market factor.  It could also aggravate political vulnerabilities.  As growth undershoots and/or interest rates overshoot, the savings have to be made up elsewhere and this keeps the tourniquet tight.

3.  Despite the looming risks of default and downgrade, the US Treasury intends to hold a quarterly refunding and it is to make its announcement next week.   It had signaled intentions to raise around $72 bln.   The month of August is likely to be challenging for the Treasury Dept.  There are hundreds of billions of dollar of maturities and coupon payments.  On one hand, what buying is not discouraged by the low yields might be be the falling dollar.  On the other hand, the risk of default and downgrade may discourage new buying until the situation stabilizes or at least becomes more transparent.

The US debt ceiling debate, following on the heels as it does of the Iraqi invasion and especially the lack of weapons of mass destruction, the sub-prime triggered crisis, the large deficits for as far as the eye can see, Madoff, has eroded some of the United States' status and prestige, and to the extent these are elements of power, US power has diminished.  The possibility that the largest economy in the world by far and the numeraire provided would get even this close to default (and not the first time) due not to the lack of borrowing ability, but simply because of what appears to be a dysfunctional body politic is truly stunning.

I have often argued that the weakness of political leadership throughout major industrialized countries limits the degrees of freedom in developing strong and innovative policies to address crises.  What is taking place now only underscores this observation.  In my book, Making Sense of the Dollar:  Exposing Dangerous Myths about Trade and Foreign Exchange, I identified two possible scenarios under which the US would no longer be the global leader.  

One of course is if there was a realistic alternative.  Much commentary is in this space.  I have tended to argue against those who claim there is a major diversification of reserves, or that the dollar's role as a invoicing or vehicle currency is challenged.  I have reviewed various metrics or international power and do not see an immediate challenger.  

The second scenario, and one that I have played down, is abdication.  I recognize some former advocates of free-trade have changed sides.  I recognize that some now question the value of providing the primary reserve assets.  Yet, I believe and continue to believe that on balance, among America's political elite is a bipartisan consensus to remain a global leader.  It does not seem to be out of intent as much as incompetence that makes it appear that the elite are bent on abdication.  Indeed, the political elite of a number of countries appear to be losing credibility and the political vacuums are scary and dangerous.

4.  US jobs data will be reported on Friday August 5.  The employment report is the single most important monthly economic report, but is also among the most difficult to forecast.  The early call is for about a 100k increase in non-farm payrolls and this reflects expectations for a loss of about 25k government workers.  I suspect the string of poor economic reports may end with the employment report.   May and June were simply horrible for job creation (private sector added net 73k jobs in May and 57k in June).  

Employment growth is not the same thing as growth measured by GDP calculations.  Note that non-farm private sector payrolls grew an average123k in Q2.  The economy (advance estimate) grew at a 1.3% annualized pace.  In Q1 that we now learned generated 0.4% annualized growth created a net 191k jobs per month on average.  

However, the downside risks are great in terms of policy response.  A disappointing report is likely to renew talk of a policy response and it is difficult to see this coming from fiscal policy is any meaningful way.  Signals and symbols may be exhausted quickly by the Fed, leaving investors to contemplate more precisely where is the bar for QEIII.  

5.  New leverage rules come into effect in Japan on August 1.  Rules, outlined by the Financial Services Agency (FSA, which is like the US SEC) in 2009,  and are applicable to Tokyo Financial Exchange will cap leverage at 25 times, down from 50 times currently.  A poll conducted by an online broker found a little more than a quarter said they would reduce their volume.  The lower leverage may, on the margins, serve to reduce some volatility.  It may impact the volume of the TFE, where there was nearly 400k contracts short dollars recently.  However, on balance, the market impact is likely to be minimal at best.  

It is nonetheless noteworthy that one of the real though not very much discussed anymore contributing factors to the dimensions of the financial crisis is leverage by investors.  Yes in the US and several other countries the household sector became increasing leveraged, but that is not where the cause of the crisis truly resides.  It is the leverage of the financial institutions that is the real culprit.  Financial institutions of several European countries, not just Iceland and Ireland, but the UK, Germany and France, and Switzerland, bank liabilities are some multiple of GDP.  The reduced leverage to 25 times in Japan is still probably higher than needed, but much less than available by other exchanges, allowing/spurring regulatory arbitrage.