Six Observations to Start the Week

The US dollar is little changed against the major foreign currencies and showing a slightly heavier bias against many of the emerging market currencies. The dollar is largely trading within the ranges seen last Friday, with the holiday in the UK (today and tomorrow) sapping some liquidity. Asian equity markets are broadly lower, with the MSCI Asia Pacific Index off 2.25%. Europe bourses are mostly higher, though the DAX is 1% lower. Of note, Spain’s IDEX is up about 2.5% with financials leading the way (+3.7%). Core bond markets are under pressure, while European peripheral bonds are higher. We share six observations to begin the week.

1. The latest string of data confirms a slowdown in many part of the world economy. In emerging markets, China and India growth has weakened. The drop in oil prices is not good for Russia. Among major developed economies the news has not been good. After avoiding a contraction in Q1 due nearly solely to Germany’s 0.5% expansion, the euro area is unlikely to be as lucky in Q2. The weakness in Europe and in its non-European export markets warns that the German engine is tiring. The economic downturn in Q1 in the UK is greater than expected. Forward looking indicators are not very promising even if the Olympics provide some brief fillip. In the US, Q1 GDP was revised down and the most important economic report, non-farm payrolls were dismal and were coupled with downward revisions of almost 50k in the March and April series. The Japanese economy has been bolstered by the recovery from last year’s tragedy and reconstruction efforts. However, weakness in its major export markets may remove a key support for the economy.

2. Central banks were in a wait-and-see mode. They have waited and have seen and a policy response is increasingly necessary. Four central banks meet this week. The real issue about the Reserve Bank of Australia meeting early Tuesday is whether it is going to deliver a 25 or a 50 bp rate cut. They cut 50 bp last time and this was seen as aggressive. Yet a 25 bp cut would simply reinforce expectations for another 25 bp rate cut at the next meeting. This suggests that if the RBA makes the smaller move, that all else being equal, the Australian dollar is unlikely to recover much on the “disappointment.” The Bank of Canada also meets on Tuesday and of all the central banks meeting, the outcome is clearest here. The BOC will do nothing, but its statement may discourage market speculation that it will raise rate before year end.

3. The ECB meets Wednesday instead of its normal Thursday this week. It draws a distinction between monetary policy proper (interest rates) and liquidity provisions (such as SMP and long-term repos). New staff forecasts will also be presented. Both growth and inflation forecasts are likely to be trimmed. The risk of a rate cut seems higher than many observers are suggesting. They have underestimated ECB President Draghi previously. He took bold action at his very first two meetings, unwinding Trichet’s earlier hikes. The LTROs were also seen more aggressive and innovative. He did not wait to establish his anti-inflation credentials as many had expected. It is not decisive, but the IMF has called on the ECB to cut rates.

4. The Bank of England meets Thursday. After the string of poor data warning that the period of stagnation is giving way to contraction, and the full impact of austerity yet to hit (the government sector was a net add to Q1 GDP), the BOE offers the only potential support for the economy. A resumption of its gilt purchases is the most obvious step, but a rate cut, which the IMF has advocated, cannot be ruled out. The latter would catch more off guard and potentially trigger a sharp drop in sterling.

5. The Federal Reserve does not meet until June 19-20. The combination of disappointing data and easier inflation expectations will likely prompt a reaction then. The focus of many observers is on third round of asset purchases. Yet given recent official comments, we suspect there is greater risk of an Operation Twist 2, with perhaps buying MBS with the proceeds of the note sales. There is scope to explore the communication channel, though it may be early to push out the “late 2014” time frame. Bernanke’s testimony on Thursday will be scrutinized for clues.

6. European policy makers are preparing another “comprehensive” response to the crisis. The direction they are clearly but reluctantly moving in is greater integration not less. It is being driven more by necessity than ideology. Spain’s conservative Prime Minister Rajoy is calling for an EMU body that runs national budgets. Owing to the folly of officials suggesting that Greece can leave EMU, which injected redenomination risk, fiscal union is now needed to save monetary union. Officials need to demonstrate in word and in deed that the union is irreversible. The Greek election rightfully commands a great deal of attention, but do not underestimate the role of the French parliamentary elections in influencing Hollande’s negotiating position and scope for compromise.