Muted Turn Around Tuesday

A more stable tone it evident in the global capital markets today.   Risk aversity is being pared, it appears, across the board.   Asian equities followed suit after the US indices fell on Monday, but European equities are firmer, with the French market leading the way.  

Bond markets are mostly lower.  Commodities steadier after both oil and gold made new lows for the year yesterday.  The US dollar itself is mostly softer, but is firmer against sterling, and to a lesser extent against the Japanese yen. 

There may be two factors that have contributed to the calmer markets today.   

First, the euro area GDP was not as poor as had been feared.  It stagnated in Q1, while the consensus had anticipated a 0.2% contraction.  

Most countries GDP figures were in line with expectations, but there were two upside surprises.  Germany expanded by 0.5% instead of 0.1%.  France was flat, while some had expected a small contraction.    That the German ZEW survey was disappointing (10.8 vs consensus of 19) was largely shrugged off, helped by the fact that the current assessment as opposed to expectations rose (to 44.1 from 40.7) and is the highest in a year. 

There was a downside surprise from Italy, which contracted 0.8% instead of 0.6%.    Note that Moody's cut the ratings of 26 Italian banks and maintained negative outlooks.   There was little impact on the sovereign, as CDS prices edge lower, and the 2 bp increase in the benchmark 10-year yield is less than in Spain and Germany today (at pixel time, near midday in London). 

The second factor that may be aiding the market's tone today is a sense that officials will move away from the edge of the abyss once again.   This vague sense was encouraged perhaps by the fact that Greece reportedly will make the 430 mln euro payment on the international bond not covered by the PSI.  More importantly, there is a greater sense today that the political climate in Europe is changing. 

France has a new president.  Among his first acts, even before his government is fully announced he will go to Germany and a tete-a-tete with German Chancellor Merkel.  Merkel's support for Sarkozy was no secret and  Hollande has campaigned against Merkozy.  That is water under the bridge and the most important issue is the state of the fiscal compact and the need to compliment it or complete is with an agreement on bolstering growth.  

Merkel is opposed to the traditional Keynesian fiscal stimulus and is unlikely to be swayed.  However, there is room for compromise.  There are four issues that Hollande is likely to press, even though no firm decision will be forthcoming today.  First, increase the funding for the European Investment Bank.  This is the institution that will likely play a more important role under a growth pact.  Second, reallocate unused EU structural funds, making them easier to access and help spur growth.  Third, Hollande and Merkel will find common ground on financial transaction tax.  Fourth and most controversially, Hollande may press hard for a one year extension to meet EU fiscal targets.  EC Commissioner Rehn appears to be sympathetic to this on a conditional basis.  

Merkel does not appear opposed in principle, but is likely to try to get some additional concessions in exchange.   A new chapter in the European crisis management is at hand, but with the French economy stagnating in Q1 compared with Germany's unexpectedly strong 0.5% expansion, the divergence between the pillars of Europe cannot be denied.

UK reported poor trade figures and sterling has underperformed, partly as a function of the more stable euro tone and partly as a function of  the realization of the consequences of sterling's appreciation.  The visible trade deficit came in at GBP8.56 bln deficit.  The market expected GBP8.4 bln.  Some of the disappointed evaporated when the Feb deficit was revised down to GBP8.59 bln from GBP8.77 bln. 

However the poor March figure was not a function of non-EU trade, which came in 15% smaller than expected at GBP4.1 bln.  That means a significant deterioration with the EU.   Since the middle of January, the Bank of England's trade weighted index of sterling has appreciated 6.25% through the end of April.  This is tantamount to at least 100 bp of tightening of monetary policy. 

Sterling has extended the downdraft that began at the start of the month and has slipped to new lows against the dollar since April 20.   The euro had fallen to its lowest level against sterling since late 2008 yesterday to about GBP0.7965, but is bouncing back today to resurface above GBP0.8000.  Resistance is seen near GBP0.8030. 

The US reports a full slate of economic data today.    CPI tends not to elicit much of a market reaction.  Moreover, the core rate is likely to be stable regardless of the vagaries of food and energy prices. 

Rather at the same time retail sales will be reported.  Our argument has been the modest slowing of the US economy is from the supply not the demand side.   Here the important measure is retail sales, excluding gasoline, autos and building materials.  This is the component used for GDP purposes.  Less than a 0.3% increase would be disappointing.   That said, the headline might be depressed by the decline in gasoline prices.  Look past it. 

At the same time, the Empire manufacturing index will be reported.  It is one of the first indications of manufacturing for May.  It is expected to recover from the out sized decline in April (6.56 vs 20.21 in March).  This will be followed by the TIC data, which is typically too historical to spark a market reaction (It is also subject to significant revisions).  Business inventories for March will help economists solidify expectations for Q1 GDP revisions but may be of little interest to market participants.