Currencies Consolidate Awaiting Key Events

The US dollar is consolidating the losses suffered at the end of last week. It remains largely confined to the ranges seen before the weekend. The Swedish krona is the best performer following the better than expected Q2 GDP (1.4% vs 0.3% consensus).  The Australian dollar is the other exception.  Speculation of a rate cut next week have been scaled back.  The Australian dollar's 4-day advance has brought it from under $1.02 to almost $1.05. 

Asian shares responded favorably to the pre-weekend US equity rally, with the MSCI Asia-Pacific Index gaining more than 1%, gapping higher for the second session. However, China’s Shanghai Composite bucked the trend, losing 0.9% to fall to its lowest level since Q1 09. European bourses are higher, with the Dow Jones Stoxx 600 gaining around 0.6% near midday in London, led by the financials (+1.5%). Bond markets are mixed, though Spain yields have continued to fall with the 2- and 10-year yields off about 16 bp. Italy’s bond auctions produced mostly lower yields.

 

If art is about tension and release, European officials are great artists. Episodically over the last couple of years, tensions in the euro are would mount, as investors doubted the capability and willingness to resolve the debt crisis and European officials would provide for some release in the form of fresh policy initiatives. Yet these initiatives were seen as little more than plasters, and relief was always and only temporary.

The stakes have become increasingly higher, and in a vacuum apparently created by the pending German Constitutional Court decision on the ESM and fiscal pact and the summer holidays, the ECB stepped forward. ECB President Draghi appeared to reach the end of his rope and there was a sense of urgency. He recognized that that the policy “transmission mechanism was broken” and promised action that “believe me, it will be enough”.

In honor of the Olympics, let us say Draghi seeks a game changer. Reports indicate that he specifically has indicated willingness to resume the Securities Market Program (SMP), under which the ECB buys sovereign bonds in the secondary market that are not satisfactorily reflect the its policy stance. In addition, he wants the EFSF to purchase said sovereign bonds in the primary market. Although Germany does not approve of the former, it seems somewhat sympathetic to the latter. 

EFSF purchases are legally possibly now, but require a formal request. Germany’s Schaeuble has been very forthright. He sees no great urgency to act. So what, he asks, if Spain has to pay a few percentage points more for a few auctions. Financial markets may not be rewarding Spain’s reforms, but they will Schaeuble assures. Spain’s Treasury is adamant. It neither needs nor seeks a full-scale aid program and it will not request European funds to bring down its borrowing costs. 

Part of the reason the SMP program did not work in the 2010 and 2011 efforts in terms of pushing yields down is that the market understood that they were both half-hearted and limited in scale. The EFSF has limited funds available given its commitments. What would be a game changer is if the ESM was granted a banking license so it could borrow theoretically unlimited amounts from the ECB. 

Yet the creditor nations, especially Germany cannot sanction this because this represents nothing less than an open-ended financial liability. Not only is a decision on a banking license premature in the sense that the ESM does not exist today, other decisions, like a cut in the deposit rate or official sector involvement in the adjustment of Greece’s program, do not have to be addressed this week and therefore won’t be. There is substantial risk that Draghi will be unable to fully deliver on his promise for shock and awe. 

The FOMC meeting is the other main event risk of the week. The key members of the FOMC (Bernanke, Yellen and Dudley) cannot be pleased with the recent data that suggests growth is not strong enough to bring down the unemployment rate. However, at this juncture, we suspect the Fed will be content with altering its guidance and preparing for a stronger policy response at the next meeting in September. This will give it two more employment reports to consider as well as a better sense of the sustainability of the soft patch within the sub-par performing economy. 

Consumer spending and business investment in equipment and software has been resilient. It will not go unnoticed by officials that disposable income remains strong; rising at a revised 3.4% pace in Q1 (from 0.4% initially) and 3.3% in Q2. The drag from net exports was due more to imports than exports, which grew at a 5.3% annualized pace in Q2. The stronger imports appear to have bolstered inventories, so a run down in inventories in Q3 may be offset by slower import growth. An easing of the European crisis could also ease a headwind that the Federal Reserve has identified. 

On balance, the market is unlikely to be disappointed with a change in guidance as this will keep the door open to stronger action in September. Bernanke’s Jackson Hole at the end of August will be scrutinized for clues, as in a repeat of his 2010 signal of QE.