Bernanke and Europe Boost Dollar

The US dollar has been boosted by expectations that Spain and Cyprus are close to requesting aid and Fed Chairman Bernanke’s reluctance to tip his hand to the US Congress yesterday. This coupled with reports that the euro area finance ministers will hold a conference call over the weekend, following on the heels of French-owned Fitch’s 3-step downgrade of Spain, has forced the euro to give back half of the gains seen since the low prior to the disappointing US jobs data a week ago.

The market fears that yesterday’s rate cut by China, the first in several years, is not as much a reflection of the past string of soft data, but a forewarning of poor data to be reporting in the coming days. The MSCI Asia-Pacific Index fell by 1.3%, but still managed to finish the week fractionally higher to break the five week losing streak, though foreign investors appear to continue to pare holdings. European bourses are lower, with the Dow Jones Stoxx 600 off about 0.6% near midday in London, led by basic materials, resources and financials. Notable Spain is an exception, with the IBEX up about 0.3% headed into the weekend. Financials are only slightly lower.

European officials seem to be moving toward a Spain-lite aid package. Spain will only seek to borrow funds needed to recapitalize the banks and not to secure fiscal funding through 2014. Such a program would come with lighter conditionality, perhaps largely limited to existing reforms and greater control over regional finances. Spain will likely be given another year to reach the 3% deficit target. The question is how much does it need for the banks.

The IMF’s report due out Monday following its late April stress test will help as will the private auditors’ report due out before the end of the month. Next week Spanish banks are expected to present to the central bank plans on meeting the new (May 11) requirements for new provisions. With yesterday’s downgrade, Fitch estimated 60-100 bln euros. S&P estimate is 80-112 bln for this year and next. Recall earlier estimates by the Center for European Policy Studies estimated Spain needs 270 bln, projecting bank losses will mount to 380 bln euros. Moody’s had previously estimated bank losses around 306 bln euros

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As Federal Reserve Chairman, Bernanke has rarely given policy signals during testimony before the Joint Economic Committee of Congress. He did not deviate yesterday. The fact that some many observers have been disappointed that he did not signal QE3 says more about psychology that what the FOMC will do on June 20. It is a bit like a Rorschach test. While the loss of momentum in the labor market is important, we are sensitive to seasonal and the echo from the impact Lehman’s demise. 

The American consumer continues to be resilient. Real consumer spending rose 2.75% in Q1 and early Q2 figures the pace has been largely sustained. The fall in gasoline prices should also be helpful. ISM manufacturing orders rose in May to its highest in a year, while the decline in export orders speak to domestic-led strength in this forward indicator. The recent survey of senior loan officers showed the strongest demand for credit from businesses and households in nearly 10 years. Bernanke cited two main risks: One emanating from Europe, the other from the fiscal cliff. Continuation of some form of operation twist, with perhaps extending the duration of the short-end being sold and buying MBS, seems a more measured response. 

Many are comparing Bernanke with the BOE’s King and ECB’s Draghi who passé don opportunities this week to demonstrate a greater sense of urgency in the face of the sharp economic deterioration. There are two big differences: the US economy is expanding, albeit modestly, while the UK and the euro zone are contracting, and they held policy making meetings; all Bernanke did was testify.