Merkel /Sarkozy, King's Letter and Asia Update

Global equities are unable to match yesterday’s US 2% rise which put the S&P 500 close back up 1200 for the first time since August 3. Asian shares did manage to rise for the second consecutive session, but the gains were trimmed following news of Germany’s disappointing Q2 GDP of 0.1% (quarter-over-quarter) and the MSCI Asia-Pacific Index finished up 0.2%.

The standout was South Korea’s Kospi that tacked on 4.8%, which was on holiday on Monday. Foreign investors were net buyers of Korean shares for the first time in two weeks. Commodities, financials and technology were the strongest sectors. European bourses are sharply lower, with most major courses off 1.5-2.0%. Commodities and industrials are among the weakest sectors, following regional growth data, and financials in the Dow Jones Stoxx 600 essentially market performers. Major sovereign bond markets are subdued, but Italian and Spanish 10-year bonds are finding the 5% yield level sticky and prices are rising in the CDS market.

Merkel and Sarkozy’s meeting is capturing the imagination of the market even though both sides seem to throw cold water on the idea of a European bond. Nevertheless, the issue remains very much in the fore. There has been much interest in the idea floated in numerous variations of a blue bond/red bond.

Essentially, the blue bonds would be the European bond and would cover up to 60% of a member’s debt. It would be “jointly and severally” (to use the legal jargon) guaranteed. The red bonds would be issued by the national sovereign and take on their risk; obviously a penalty rate for those with debts over the Stability and Growth 60% mandate.

The market suspects Sarkozy is more interested in a European bond than is Merkel. Germany’s opposition may not be what the media have played up and that is Merkel and Finance Minister Schaeuble’s objections. Consider that the two main opposition parties in Germany, the SPD and Greens have both called for a European bond. The head of the BGA (German exporters association) has also endorsed the idea. Today, a government economic advisor also seemed to suggest some flexibility on the issue.

This is not to dismiss public apprehension, but to underscore that at the heart of European crisis lies politics and this year’s string of elections indicate that the ruling CDU/CSU/FDP coalition is losing support. A European bond may not be popular in Germany, but one is reminded that Germany never had and could not have a referendum on the euro. If such were possible, it would have lost.

Merkel and Sarkozy are expected to hold a press conference around 16:30 GMT (12:30 EST). There is potential for surprise after the attempt to lower expectations. At the very least, some discussion of tightening up enforcement of EU budget rules and some increased coordination efforts. Confirmation that the region practically stagnated in Q2 (0.1% quarter-over-quarter in Germany and the Netherlands, 0.2% Spain, follows a unchanged reading from France last week, producing a 0.2% pace for the region after 0.8% in Q1) may inject a note of urgency into the discussions.

UK inflation was reported above expectations and BOE governor King wrote his seventh letter to the Chancellor to explain the missing of the target. Headline CPI rose to 4.4% year-over-year pace from 4.2% in June. The BOE expects inflation to head toward 5% before peaking. In King’s letter he recognizes that there are still a range of views on the MPC, which warns that there may still be a dissent when the minutes from the MPC meeting are released.

Given that it is the seventh letter to explain the inflation overshoot, with the MPC taking action, one must question the current meaning of the BOE’s inflation target. Both the short-end and long-end of the UK debt market shrugged off the higher than expected inflation report and sterling is recouping some of the ground lost yesterday to the euro.

News from China is worth highlighting today. First, the head of the HKMA and the Financial Secretary have rejected suggestions that to peg to Hong Kong dollar to a basket of currencies, as Singapore does, or to the yuan instead of the dollar. The pressure is arising from the acceleration of inflation that some see as a result of the dollar peg. HK CPI rose 5.6% in June, the fastest in 3 years. Food prices, as in the case in the mainland, seem to be a primary culprit, through rents in HK are also rising.

Second, the yuan has been the strongest Asian currencies since July 21, rising a little more than 1% against the greenback, which is essentially twice as much as the second strongest currency in the region (Philippine peso). China Securities Journal, reports that China may widen the yuan/dollar trading band, which now is 0.5%. The journal suggests that the narrow band is a source of speculation and is slowing the diversification from the dollar by making exporters reluctant to take other currencies, which have wider bands and hence more volatile, for trade settlement. The yuan has been fixed at record highs each of the past five trading sessions.