Today's Developments and 4 Important Observations

The US dollar is broadly firmer against the major currencies to start the week, but remains well confined to ranges seen at the end of last week. The market lacks conviction after shrugging off the disappointing European flash PMIs last week. Even though Italian and Spanish bonds are firmer today, outperforming Germany, we detect a deterioration of conditions in Europe and are concerned about a flare up in tensions after the market gets through the quarter-end portfolio adjustments.

Today’s developments include a better than expected German IFO reading (business climate 109.8 vs consensus 109.6) and an increase in Italian consumer confidence (96.8 in March, the highest since last July, from 94.4 in February). There are also signs that Germany will relent at finance ministers meeting at the end of the week and allow the EFSF and ESM to run simultaneously until the middle of next year.

Asian shares were mostly lower, with the MSCI Asia-Pacific Index off about 0.5%, led by losses in Taiwan and India. While the decline in the former appears to be profit taking, the losses in the latter seem more significant as investors continue to be concerned about the direction of policy. The Indian rupee itself is trading near 10-week lows against the US dollar.

European shares are more mixed, but of note Spanish shares are off sharply, extended the losses seen in the second half of last week, bringing the four-day loss to almost 6%. At the end of the week, the government will unveil the 2012 budget, with new austerity measures (the talk today focuses on electric utility hike and a cut in subsidies).

We share four important observations to begin this week, the last of the first quarter.

First, we expect politics to be a more important driver in Q2. This past weekend’s developments are but a small taste of things to come. There were three electoral developments. In Hong Kong, the election committee picked Leung Chun Ying as the next leader replacing Donald Tsang. China has promised Hong Kong direct leadership elections in 2017, so at least on paper this could be the last elite-picked leader.

One of Germany’s smallest states, Saarland went to the polls. The SPD and Left Party recorded more votes than the CDU and its ally the Free Democrats, but the SPD ruled out a coalition with the Left Party and will most likely form a grand coalition with the CDU. There are additional state elections in May, with NRW, the most populous state, on the 13th. In Frankfurt, the SDP looks to have ousted the CDU for the first time in 17 years. The real loser in the week end contests were the FDP and this increases the likelihood that next year’s national elections will also result in a return to a grand coalition.

In Spain, Prime Minister Rajoy’s PP failed to secure a majority of seat, which most likely leave the Socialists and its United Left ally in control with 59 of the 109 seats in the Andalusia regional election. This may complicate Rajoy’s efforts to rein in the regional spending. Note that Thursday Spain will see its first general strike since November 2010.

Second, the CFTC Commitment of Traders data shows a sharp reduction of the net short euro, yen and sterling futures positions. However, in both the euro and yen’s case this was a function of new speculative longs being established rather than shorts being covered. In the week through March 20, the net short euro position fell by about 16k contracts, with new longs rising 10k and shorts falling by about 6k. The net short yen position was cut from 42.4k to about 25.8k contracts. New longs rose 12.5k while shorts were reduced by a little less than 4k contracts. Sterling was on only one of the majors that experienced genuine short covering. The net short position was slashed to 15.8k from 41.8k, which is the smallest since last September. Shorts were reduced by 22k and the longs added around 4k contracts.

Third, this week’s US economic data is expected to be fairly strong; featuring a recovery in durable goods orders (~3% after a 4% decline in January), an upward revision to Q4 11 GDP to something closer to 3.3%-3.5%, helped by stronger consumption, especially of services, and strong income and consumption data for February. At the same time, Bernanke’s speech today to business economists will be his first opportunity to address the expectations that have lifted US yields in recent weeks.

Fourth, a number of emerging market central banks meet with week, including Turkey, Israel, Hungary, South Africa and Czech. On balance, we do not expect a change in policy. If there is a surprise, it could be that Turkey narrows their operating rate band.