Initial Anxiety Stemmed, More Later and 6 Observations

The mostly as expected election results sparked a quick but dramatic bout risk-off activity. Equities have been sold (with Greek equities crushed, off more than 6% late in the local session, with a 13% loss in financials) and core bonds are firm, including French bonds.   In fact, the French premium over Germany in both the short (2-year) and long (10-year) end has actually narrowed today and this may embolden Hollande. 

Several of the major currencies gapped lower and have mostly recovered, with sterling and Australian dollar even turning higher on the day in Europe. The opening gaps in the euro and Swiss franc have not been filled, but look for selling pressure to re-emerging as the gaps are narrowed. The top of the euro gap, which should now offer resistance, is near $1.3080. A similar level against the Swiss franc, which should off the dollar support, is near CHF0.9185.

We identify six considerations for participants in the global capital markets for the week ahead.

1. The political uncertainty regarding the electoral outcome in France and Greece is resolved, but now the key unknown is the policies of the new governments. Even before elections, it became clear that the agenda in Europe was shifting. ECB President Draghi’s recent support for a growth pact has signaled the change. The EU’s top economic official, Olli Rehn, recognizing that austerity needed to be complimented pro-growth policies, has called for a European Investment Pact. This issue, broadly conceived, will increase in salience in the coming weeks.

2. To consolidate Hollande’s victory in France, the Socialist and their allies need to secure a majority of parliament in next month’s election. The petite oui for Hollande warns his coat tails may not be very long and that cohabitation may result. Merkel’s Free Democrat ally continues to sit its political fortunes diminish. This makes a Grand Coalition with the Social Democrats, the most likely result of next year’s national election, though a SPD-Green coalition cannot be ruled out, especially if the German economy gets sucked back down with most of Europe. Next week’s election in Germany’s largest state, North Rhine-Westphalia is unlikely to see the CDU or FDP move out of opposition. Whatever emerges as the next government in Greece, questions of its stability and sustainability will be just as important as its program.

3. Despite the unexpected 0.1% decline in the US unemployment rate and back month upward revisions, the April jobs report was disappointing. Many are concerned that investors should be prepared for payback after the unseasonably warm weather boost reported job growth. There is also the concern that since Lehman’s demise, the seasonal adjustments to the data have exaggerated the economy’s weakness in the first half and especially the second quarter. In addition, it appeared output ran ahead of demand and is being brought back into line, which the message we took from the outright decline in manufacturing output in March. The key issue is the magnitude of the US economic moderation. Provided demand holds up, as it presently appears to be the case, the economy can re-accelerate in H2. We look to the decline in gasoline prices too help boost discretionary spending. In addition, the Senior Loan Officer Survey reported the strongest demand in a decade for businesses and household credit.

4. A prerequisite for a change in monetary policy is a change in the underlying economic assessment. The Federal Reserve just provided new forecasts and growth near the pace that the economy has averaged for the past ten quarters of 2.5% will not prompt a policy response. The ECB’s Draghi reminded investors that it will publish new growth and inflation forecasts next month. In March it revised its forecast for GDP to -0.1%. The risk is that it is downgraded further, but before that, on May 11 the European Commission will provide its new economic forecasts. This will underpin the momentum toward a growth or investment pact.

The Bank of England’s MPC meets on May 10. Its gilt purchase program will be completed shortly and we, like most, do not expect QE to be extended. We expected the BOE, like the Fed and ECB to move to the sidelines. It does not appear that its economic forecasts have changed very much, despite the weakness in the first estimate of Q1 12 GDP. Rather prices are proving sticky and there does not appear to be a majority on the MPC that is prepared to endorse new purchases at this juncture.

5. Norway’s central bank meets to decide on rates May 10th as well. It delivered a larger than expected 50 bp cut in December and followed it up with a 25 bp cut in March to bring the key deposit rate to 1.5%. With price pressures subdued (underlying CPI, which is the preferred measure may have fallen to 1.0% year-over-year in April due for release on May 10th too), there is scope to push the deposit rate to 1.25%, the low point in 2009. However, we expect the Norges Bank to stand pat, to await clear economic signals. Retail sales have been strong and with the currency flat on a trade-weighted basis, the currency has not blunted the easing of monetary policy.

6. The Australian dollar has been a darling for months and even though it has fallen almost 7% from its late February high.  Speculators had the largest gross long position among the currency futures as of May 1. Central bankers who diversified into the Australian dollar recently also will not be happy. The Australian dollar has filled its opening gap, and now is meeting resistance in the $1.0200-20 area. 

The combination of stale longs exiting, momentum shorts coming on and the bid from the central banks sidelined, the downside pressure on the Aussie may grow. This employment report at  on May 9th is seen as key to interest rate expectations.  Today's stronger than expected March retail sales report (0.9% instead of the Bloomberg consensus 0.2%) failed to dissuade expectations for a June cut, which are near 80% currently.  .