Two Major Developments at Start of the Week

There have been two major developments.  The first is what appears to be the basis of a US debt deal that will avoid a technical default and may in fact avoid an imminent downgrade of its credit rating.  The second development is batch of purchasing managers surveys that warn of powerful economic headwinds.

The brinkmanship tactics that brought the US to the edge of default appears to have produced a agreement that is clearly better than no agreement but hardly resolves the underlying fundamental problem.  The hard decisions have yet to be made and another commission, reinforced by automatic cuts if the commission fails, will conclude like previous commissions and most reasonable assessments that some combination of increased revenue, slimmed down military and addressing the so-called entitlement spending to put the US on a sustainable fiscal path (I do not like the word "entitlements" because large fights were fought over things like unemployment compensation, social security, medicare, etc  as the rights of citizenship--the basket of goods one gets because one is living in a modern and wealthy country.  That basket of goods is not historically fixed but changes over time.  Nor is it simply a partisan debate as the latest component of that basket of goods--prescription benefits--was advocated by the last GOP president).

The US has technically defaulted in the past.  It seems more embarrassing than destabilizing, but it is good that this can be avoided.  The rating is a different story, but more recently the head of S&P has tried to clarify recent statements that made is seem that $4 trillion in savings is necessary to avoid a downgrade.  At this point, assuming the debt deal passes both houses (easier in the Senate, harder in the House perhaps), I suspect the debt rating agencies will not be in a hurry to cut the US rating.  Perhaps a decision is made by the end of the year, but it is not a done deal.  

Yet as important as this is, the second development seems to be the key today.  Purchasing managers surveys, and especially the forward looking component of new orders were particular poor and worrisome.   Eurozone PMI was unchanged from the flash reading at 2-year lows.  New orders are deeper below 50 boom/busty at 47.6 from just below 50 in June.  German new orders were revised lower to 47.4 form 47.9 and over 50 in June.  French new orders below 50 as well.  European slowdown appears to be gaining momentum.  

That said, Italy was a surprise to the upside and its headline reading is just above 50.  New orders are below 50 at 48.5.  Output is up for the second consecutive month.  Spain, on the other hand, disappointed with a sub-50 reading of 47.3.  This is a difficult environment for its bond auction on Thursday.   Ireland too has a headline reading below 50 at 48.2 from 49.8 in July.  

The UK manufacturing reading is also below 50 at 49.1.  New orders fell to 47.6, which is the lowest since May '09.  Output is also the lowest since then, while employment fell to its lowest reading since March 2010.

Australia and Taiwan's PMI readings fell below 50 and among other things, this probably says something about China.  Australia's new orders fell 14.4 points to 40.  New order weakness also weighed on Taiwan's headline of 46.1.  

US manufacturing ISM was also poor.  The 50.9 reading is the lowest in nearly 2 years.  New orders fell below 50 (49.2), as did order backlog.  Employment slipped to 53.5 from 59.9 and prices paid fell to 59 form 68. Not a very promising start to Q3.  

The euro tested the 50% retracement of its run-up since July 12, which comes in near $1.4187.  The 61.8% retracement is found just above $1.41.  It is posting an outside down day.  A close below Friday's low near $1.4230 would seem to confirm, but follow through is critical.  The weakness of euro zone data may encourage the market to re-think the Q4 rate hike.  Trichet's comments at this week's press conference can help shape opinion.  

The US-German 2-year spread is near 75 bp now.  That is roughly a 17 bp decline over the past week and is the lowest since the third week in Feb.  It is off nearly 55 bp from its peak in early June.   This coupled with the technical price action of the euro warns of further downside potential and the market seems ill-positioned for.  I would show resistance now near $1.4230-50.  

Sterling is also posting an outside down day.  Friday's low was about $1.6260 and a close below it would confirm the pattern, pending follow through.  The weakness of the UK data, including a decline in input prices may alter the expectation of the vote at the BOE's MPC meeting this week as the hawks may lose some support.  The odds of another round of asset purchases would seem to be increasing.  Perhaps it is a Q4 story.  

The yen and Swiss franc are still the preferred safe havens.  The impact on the domestic asset markets is quite different.  The Nikkei is the best performing G7 equity market since early June.  Swiss stocks have responded poorly to the strength of the franc, while Swiss bonds have been among the best performers.  

Lastly, the odds are increasing of yet another aid package in Europe.  It is too early to talk about Spain and Italy, but Cyprus is moving quickly toward the edge.   A major blunder has destroyed a power station that provides have of the island's electricity.  It is like Ireland and Iceland in the sense that it recent economic success was a function of a vast banking system that overwhelms everything else.  Its banking assets were more than 7 times larger than the country's GDP, though its public debt was "only" 65% of GDP.   Its corporate tax schedule rate is lower than Ireland's.  

An increase in its tax rate and curbs on its bank secrecy are likely to be among the demands if it needs assistance.  It is a very small economy, the sums involved will not overwhelm the EFSF, but it is another hand in the till.  Cyprus bank exposures to Greece are also an important source of strain, recognized albeit belatedly by the rating agencies.  Press reports indicates that, for example, Cyprus' second largest banks has 12.5 euros exposure to Greece, which is tantamount to 40% of the bank's loan book.