Disappointment in Core, but Some Positve News in Periphery

The shockingly weak euro zone flash PMI, especially the sub-50 reading for German manufacturing, is the main focus today. New orders have been weak and the Bloomberg consensus does expect the euro zone economy to contract not only in Q1 but in Q2 and Q3 as well. Many participants seem to have confused the dramatic equity market rally in Q1 and reduced tail risks with economic strength.

There is also a bit of a double-whammy for Germany. It had diversified its exports away from the periphery in Europe toward Asia, especially China just as fears of a harder landing--more pronounced slowdown, have been "confirmed" by the drop in the HSBC flash manufacturing PMI.  

As the core of Europe is the flash point today, there have been some encouraging developments on the periphery that should not be overlooked.

First, Greece's Jan-Feb budget deficit (excluding social security and local government figures) fell 53% year-over year to 495 mln euros. This compares with a target of 879 mln and 1.05 bln in the Jan-Feb 2011 period. Greece also reported that the January current account deficit of 1.5 bln euros is more than a 40% reduction from January '11 2.75 bln deficit. Somewhat better tax collection and higher taxes, coupled with the dramatic compression of local demand is having the impact that Greece's creditors desire.

Second, Portugal also reported a sharp reduction in its current account deficit. The January shortfall of 808 mln euros represents roughly a 35% reduction from a year ago. Exports are improving and there was a drop in the volume of fuel imports. It also appears there were few Portuguese tourists going abroad--perhaps reflecting domestic recession.

Third, Ireland has a 3.1 bln euro promissory note coming due at the end of the month. It appears an agreement is in the works to allow it to be replaced by a 25 year government bond.

The second tier of the periphery, namely Spain and Italy are not faring as well. There is talk that Spain may be downgraded, but we suspect this reflects the flurry of high profile reports lately warning about the outlook for Spain rather than something from the rating agencies per se. In Italy Monti is pushing ahead with labor market reforms, though the largest Italian trade union is resisting.

The yield on Italy's 10-year bond (generic) has risen every day this week and is now trading about 40 bp higher than on March 9th when the yield bottomed. The yield now is above 5% for the first time since March 3. Recall that because of the sovereign bond holdings by Italian banks, the decline in sovereign yields not only lower the debt servicing costs for the government but also strengthened the banks' balance sheets. The process could go into reverse.

The same dynamic is evident in Spain. Spain's 10-year yield has risen by about 65 bp this month. Today is the ninth consecutive session that has seen the Spanish 10-year yield rise. It is flirting with the 5.5% level for the first time since mid-February.