Poor Start to Important Week

This is an important week in terms of market levels and central bank meetings.  At least six G10 central banks meet for policy decisions (Australia, Canada, Sweden, euro-zone, UK, and Japan) and several emerging markets (Poland, Malaysia, South Korea, Indonesia and the Philippines).   In addition, US President Obama is expected to propose some fiscal support--like extending the payroll savings tax cut and unemployment benefits and an infrastructure bank/public works project and the German Constitutional Court is expected to make a ruling that will reinforce the German parliament's role in allocation of euro zone aid deals. 

These events take place amid an intensification of the euro zone debt crisis and sufficiently poor U.S. economic data to keep the market expected additional stimulus from the Federal Reserve later this month--with extending maturities of its current balance sheet (so-called Operation Twist).  

The "inside baseball" debate here is over whether the Fed will simply roll the maturing MBS paper into longer-dated Treasuries, which could be a little more than $200 bln next year, or will it also sell some of its shorter dated holdings.   As of late August, the Fed had almost $400 bln worth of US Treasury paper with maturities between 1 and 4 years.   Relative to the amount outstanding, the Fed holds most 2-3 yr paper than the other maturities.  This would seem to make that paper the most vulnerable to a more pro-active stance by the Fed.

If it were just the US economy that was stuck in the mud, it would be sufficiently problematic for the world economy which has still not found a replacement to the US.  However, just as worrisome, if not more so (because of the debt implications) the euro zone economy is coming to a screeching halt.  Leaving aside Ireland, a combination of factors, including austerity measures, appears to be forcing many peripheral countries into recession or worse. 

Spain's non-manufacturing PMI fell to 45.2 in August from 46.5 in July.  Italy's dipped to 48.4 from 4.8.6.  Germany and France did better than the flash readings, but other indicators from the core are just as worrisome and the German reading is still the lowest in nearly two years.   It is true that July retail sales fared better than expected, rising 0.2% instead of falling by the same amount.  

Italy remains particularly vexing.  GDP forecasts are being revised precisely at the moment in time what the government has a large amount of debt financing to be done.  

On Aug 29, the IMF cuts its forecast of Italian growth this year to 0.8% from 1.0% and even more telling it slash next year's growth projection nearly in half to 0.7% from 1.3%.  Italian government officials are acknowledging that it will likely miss this year's and next year's forecasts of 1.1% and 1.3% respectively.  

Meanwhile, Italy has about 14.6 bln euros of debt maturing this week and what appears to be a record 62 bln euros maturing over the course of the month.    

Italy's 10-year benchmark bond yield has risen from 4.86% on August 18 to 5.58% on Sept 5.  It has recouped nearly half of the yield that the ECB managed to engineer.    The CDS market has been even more dramatic.  The CDS price of 447 bp today is a record high.  The peak just prior to the July 21 agreement was 321 bp.  The market is saying that there is a greater chance of an Italian default now than prior to that summit and prior to the ECB's purchases.   An Italian debt downgrade should not be surprising any day now.  

French CDS prices are also at a record 187 bp.  There are two forces at work here.  First, France is less able to cope with the financial crisis than is Germany.   As in a poker game, it is the second best hand that loses the most.  Well, France has that hand.  Its economy is not as competitive as Germany's and its ability to shoulder more of the European burden is much more limited.  Pressure on Italy and Spain "naturally" increase the pressure on France.   Short French bonds (relative to benchmarks, in spreads vs bunds or outright) then maybe lower vol ways to position increased problems in Italy and Spain without being exposed to the vagaries of ECB purchases.   

The second and not totally unrelated force at work appears to be the redirection of US money market funds.  French banks are heavily reliant on US money market funds to secure wholesale funding.   Reports indicate US money market funds are still investing in French bank paper but have only an appetite for shorter dated paper.

Merkel's shellacking in her own east German state is telling.  It is the sixth state election her party has lost. Berlin holds its election later this month.  The FDP lost its representation in yet another state.  The conventional wisdom is that German voters are protesting that she is too soft on the debtors in the euro zone.

While that seems intuitively true the fact of the matter is that the parties that are gaining, especially the Social Democrats and Greens advocate an even more accommodative posture toward Europe, including euro bonds. 

Lastly, turning to Greece, a disorderly default is again at risk.  The 5-year CDS rose to a record 2493 bp. The day after the July 21 (apparent) agreement it was quoted near 1637.  The 2-year yield stands at a record 50.37% and the 10-year yield is 19.34%. Even if Greece was fully and wholeheartedly implementing its austerity packages, the economic downturn would arguably been deeper and the deficit metrics would still be too ambitious.  And as the Socialists fall deeper behind the opposition in the polls, the more reluctant it seems to continue to make concessions.   

Perhaps the way to square the German circle is to assume that German voters realize that the so-called bailing out of Greece is little more than the bailout out of banks, including their own and other European banks.  

Euro positioning is not very strong, according to the latest CFTC figures.  As of a week ago, the next speculative position was short less than 400 contracts.  It is unusual for the speculative market not to have a bet on the euro's direction, it is after all the most actively traded currency pair ($1.5 trillion of the $4 trillion a day average turnover is accounted for by the euro dollar, according to the BIS).  

That trend following market will be looking for a trend to jump aboard and the the tools I use warn of a downside break.   The risk-reversals favor euro puts by a record amount and around 3.7% are well through the previous shelf near 3.5%.  The 2-year interest rate differential is essentially back to where it began the year (23 bp now vs 20 at the end of 2010).  The 5 and 20-day moving averages crossed to the downside (after sterling's led the way).  The euro's 30-day rolling correlation with the S&P 500 and the VIX remains at elevated levels (unlike in the March -Oct 2008 period).

Many will be watching the 200-day moving average that comes in near $1.4010.  The euro has not closed below that average since early Jan and a conclusive break will likely bring on the trend followers and momentum traders.  

Data released on Monday from Australia, including inventories (2.5% vs 0.4% consensus) and corp profits (6.7% vs 3.0% consensus) will keep the RBA from gratifying calls for a rate cut, though the jobs picture did not improve much in terms of ads (employment data coming on Thurs and Q2 GDP the day before).  RBA Governor Stevens is likely to drive home this more cautious message in a speech on Wed.  At the same time the market may have gotten a bit ahead of itself in terms of a New Zealand rate hike and hence my call on being long AUD against NZD last week.   The Bank of Canada may also be more dovish than the market appreciates.  

Finally a word about the Swiss franc.  Wow.  It has already recouped about half of its SNB-inspired losses. Swiss officials cannot sit back and let their hard work come to naught or they risk their credibility.  This CHF1.10 area is important for the euro.  A break would signal a move to CHF1.08, likely in quick order.