Dollar Least Ugly

The US dollar is broadly higher against the major and emerging market currencies to start the week. Of note, the euro broke $1.30 last week and is breaking $1.29 today.  Sterling is near its lowest level in a month and barely held above the $1.6050 area.  The Australian dollar has busted through parity for the first time since late December '11.  Global equities are broadly lower, core bonds higher, and peripheral European bonds under pressure. Oil and gold prices are at the lows for year.

There are three main impulses shaping the investment climate, each emanating from one of the three largest economic areas. The economic data from the US due out this week should show that the economic moderation is modest. China responded to the recent signs that its economy continues to slow and has yet to “land” by cutting required reserves, maintaining the pace of a 50 bp cut every other month.  Events in Europe, however, continue to dominate the macro-environment.  What makes the week ahead important is that there are a multiple of potential flash points. They are not limited to the periphery, but events in Greece continue be unsettling.

Ironically, many observers critical of the aid to Greece have found themselves rather sympathetic to Syriza’s Tsipras. Barrina last minute miracle, new elections will be had and one poll shows Syriza on top, which If borne out next month, would give it a bonus of 50 parliamentary seats in the 300 seat chamber. Greece faces an international bond maturity of 436 euros that was not covered by the PSI. It is likely to use its grace period before deciding whether to default. At the end of the week it has a 3.334 bln coming due to the ECB and EIB, and hence the recently paid tranche of assistance.

Prime Minister Rajoy’s second attempt to address Spain’s banking system before the weekend fell flat. It is on its face hardly sufficient. Without getting hip deep in the nuances, consider just one set of numbers: The Bank of Spain’s estimates that Spanish banks have 180 bln euros of trouble assets and the government will now require them to increase their provisions to 84 bln euros!

Leave aside that the Band of Spain’s estimate is woefully optimistic (Spanish banks, for example, hold 655 bln euros in residential mortgages that are not covered by the reforms announced before the weekend). The risk is that disappointing response will force the Rajoy government to be even more aggressive in dealing with the regional governments, which appears to be the sine qua non of getting a one-year delay in its EU fiscal targets. The confrontation could come as early as Thursday May 17 when Madrid is to approve the regional government’s spending plans.

Spain is the most decentralized country in the euro area and the EC has called for determined action to curb “excessive” spending at the regional level. Three regions seem particularly vulnerable to aggressive action: Asturias, where an interim government cannot agree on a spending program; Valencia, which paid 7% on rolling over 6-month bills recently; and Andalucia, the most populated region and one in which Rajoy’s Popular Party failed to capture in the recent election and whose budget has already been rejected once by Madrid.

In Germany, Merkel’s CDU was sharply rebuked in the weekend election in the country’s most populated state of North Rhine-Westphalia. The results can only heighten the possibility that Merkel joins the 11 European heads of state that have been voted out of office since the crisis began. Germany will sell bonds this week. Record low yields may be deterring some investors and there have been a couple of auctions recently that were not completely covered recently.

At the same time, based on a couple of press reports many observers detect a change in German rhetoric. The head of the BBK economics department seemed to suggest that Germany may have higher than average inflation within the euro area, a shift from very low to moderate levels. Around the same time German Finance Minister Schaeuble backed higher wage settlements in Germany to help reduce imbalances. At the same time, less noted that last week the Bundestag reject the Merkel’s 6 bln euro income tax cut for the 2013-2014 period.

On one hand, the higher than average German inflation is partly a function of the deflation Germany is insisting on in the periphery. On the other, Germany may find that inflation is just as hard to create some times as it is to destroy.

Hollande is sworn as France’s new president in on May 15 and the new government will be closely scrutinized for clues into its orientation. Two issues will confront him immediately. First several companies reportedly held back “redundancies” in the election period, seemingly seeking to help Sarkozy. These may be announced as early as this week. Second, and more significantly, the EU warned on May 11 that next year’s French deficit will be 4.2% of GDP rather than the 3% target. This will require savings of something on the magnitude of 25-30 bln euros. Hollande will not be afforded a honeymoon. Midweek, France will also sell bonds in this environment.