FX is in Slo Mo

The foreign exchange market is a bit like a soap opera these days.  There is a major/macro story arc. Currently that is one of slowing or subdued growth among the major industrialized countries.  It is characterized by ongoing but slow recovery from the 2007-2009 financial and economic crisis.  And this despite historic amounts of fiscal and monetary stimulus.   It is also characterized by weak political institutions and/or leadership.  Unelected central bankers have moved into the gap, but they do not have the tools or legitimacy to completed fill the vacuum.    

The arc does not change often and rarely rapidly.  What does change are the little stories that over time accumulate to shape the larger arc.    Here is where I think we are:

US:  While admittedly not a good predictor or the official jobs report, the ADP estimate (and Challenger report) is not picking up a collapse in the US labor market.  Such a collapse could be sufficient to trigger QE3 even if core inflation was still elevated.  The FOMC minutes reflect a wide array of views.  The dissenting hawks had previously been the focus, but comments from Evans and the minutes suggest that there may be a number of doves who seek more stimulus.

Before the FOMC meeting, President Obama is expected to make an important domestic policy speech that is expected to include a call to extend the payroll savings tax, an infrastructure bank (public works) and some mortgage relief through Fannie and Freddie.  

Meanwhile, there continues to be a stark contrast with sentiment/surveys and real sector data.  The stronger than expected personal consumption report released at the start of the week offered stark contrast to the sharp drop in the Conference Board's measure of consumer confidence.  Those warning of a renewed recession in the US have shifted their focus out of Q3 and into Q4 and Q1 12.  

Lastly, note that with some 490 of the S&P 500 reporting, Q2 appears to be the seventh consecutive quarter of 10%+ earnings growth.  

Europe:  The ECB's bond purchases in recent weeks have bought officials some time to approve the July 21 agreement on expanding the function of the EFSF.  However, the Greek-Finland collateral agreement has not been resolved and undermines the veneer of cohesiveness and coordination and threatens the approval of Greece 2.0.  Moreover, the Troika (EU/ECB/IMF)  reviewing Greece cannot like what they see.  The weaker growth performance means that fiscal targets are likely to be missed.  Reports that the Greek government has requested more time to reach deficit targets are unlikely to find favor in Brussels (or Frankfurt).  

Euro zone growth came to a near dead stop in Q2.  Germany expanded by a heady 1.5% in Q1 (quarter-over-quarter) and then only 0.1% in Q2.  The recent German data, including today's retail sales and employment report, as well as the flash PMI, ZEW, IFO surveys warn of little improvement here in Q3.   The risk of a Q4 rate hike has greatly diminished and one must begin considering under what circumstances the ECB could reverse course and cut rates.  

Given the emphasis that the ECB puts on headline inflation and how headline inflation in the euro zone has been driven by commodity and especially energy prices, it is hardly surprising that officials are reviewing their inflation estimates.  The initial 2.5% CPI estimate for Aug, matching the July pace, lends support to ideas that that price pressures peaked in Q2 just as the ECB delivered its first or two hikes.    The next ECB meeting will be accompanied by new staff projections.  Inflation should be marked down.  Growth forecasts are likely to be reduced this year and next.   This is going to immediately translate into higher baseline deficits.  

ECB bond purchases hare slowing and this will reinforce perceptions that at 5% 10-year yields in Spain and Italy, officials are content.  However, the lukewarm response to the Italian bond auction warns that Italian and Spanish bond yields are likely to continue to creep up.  

The debate in the German parliament about the EFSF is worth paying attention to.  The key is how much control the German parliament will insist on.  This is important as the German Constitutional Court prepares to render its ruling on September 7th.   Anything that appears to be a blank check or surrendering authority/sovereignty may be at risk.    

France seems ill-prepared to deal with any more burden sharing on the EFSF (excluding the possibility that Cyprus will have to receive aid at some point).  Finland's collateral dispute could see it not participate in Greek 2.0.  It would be a dangerous precedent but if it does materialize, it is a negative for France.  In addition, if Italy and/or Spain fall into a new recession (quite possible), would they still be as willing to participate in new assistance programs?    France seems particularly vulnerable to new euro zone tensions.  

Japan:  The sixth new Prime Minister in 5 years.  That says it all (but it won't stop me from elaborating).  The lack of strong leadership, which is a theme that is woven into much of my commentary in recent years, is patently obvious in Japan.  The government may be reshuffled but no fresh policy is forthcoming.  No bold vision of a 21st century Japan.  No articulation Japan's relationship with the rest of the world.  

Yet the economy is recovering from the spring disaster.  Yet as the July industrial production figures showed (earlier today), the recovery is slowing.  The consensus expected a 1.4% increase in output, but the actual preliminary estimate was less than half as much at 0.6%.  The year-over-year rate fell to -2.8% from -1.7% in June.  It is possible that the energy output will be slow coming back on line, but there is also the suspicion that the strength of the yen is encouraging Japanese companies to expand capacity offshore.  

Japan's exports, we learned previously were weaker in July and given the importance of regional trade may be a warning of slower growth in Asia.  South Korea, earlier on Wednesday reported an unexpected contraction in July industrial outputs.  That said, the driver of regional growth, China, appears still on track for a soft landing, which should limit the region's downside.  

Currencies:  The euro has spent most of the first two months of Q3 in a $1.40-$1.46 trading range.  There is no sign of an imminent break out.  Sterling has likewise been largely confined to a $1.60-$1.66 trading range.  A break out does not seem likely any time soon.  The yen, as usual, is a different kettle of fish.  Most recently, dollar-yen has been mostly confined to a JPY76-JPY78 range.   Although the Ministry of Finance confirmed intervention of JPY4.5 trillion (~$50 bln), the dollar remains in its trough.   Japan does not seem as resolute as Swiss officials in fighting currency appreciation.  They have not been nearly as successful.