US Fiscal Cliff Averted, Risk Appetite Increases

There seems to a collective sigh of relief.  The full force of the US fiscal cliff that could have dragged the world's largest economy into a recession has been averted, even though the results do not seem particularly satisfactory as the debt ceiling and spending cut decisions have been postponed for several weeks.  

Global equity markets have begun the year with a bang.  The MSCI Asia-Pacific Index jumped a bit more than 1%, though the Japanese market remains closed for the holiday.   European bourses are around 2%, with the Dow Jones Stoxx 600 up 1.7% near midday in London, led by basic materials, technology and financials.   US S&P 500 are called around 2.5% stronger.  Core bond yields are sharply higher, 7-10 bp, while Italian and Spanish bond yields are 17 and 10 bp lower. 

The US House of Representatives passed the Senate bill by a 257-167 majority and now awaits Obama's signature.  The biggest impact from the measures may be the end of the payroll savings tax holiday.  This will curb disposable income by around $100 bln and may cramp consumption in the first part of the year.  Overall, estimates for GDP will not change much as many economists had built into their forecasts some fiscal drag, but not the complete drag going over the fiscal cliff would have implied.  

Meanwhile, the euro area PMI was a bit disappointing.  The 46.1 reading contrasts with the 46.3 flash reading.  It is a three-month low.  German results were disappointing with the PMI down to 46.0 from 46.3's flash.  France was unchanged from the flash reading at 44.6.  Italy was a pleasant surprise, rising to 46.7 from 45.1 in November.  This is the highest since March.  New orders rose to 46.0 from 43.6.  Spain, on the other hand, was disappointing with a 44.6 reading after 45.3 in November.  

It was the UK, though that was the most surprising.  The CIPS manufacturing PMI rose to 51.4 from 49.2, while the consensus had expected an unchanged reading.  It is the strongest showing since Sept 2011. Of note, the measure of output jumped to 54.0, the highest since April 2011, and new orders rose the fastest since March.  This fans hopes that the UK economy may have avoided a Q4 contraction.  That said, it is a lot of weight to put on the manufacturing survey given its share of the economy.  More important will be the service PMI due out Friday.   

That a majority of the ECB board favored a rate cut in December (though there was no move) and the soft PMI readings would likely support such expectations.  There is even some speculation that the ECB could adopt a negative deposit rate.  However, the spike up in German inflation CPI, which bases on the states' reports suggest the national rate will come in back above 2%, may quell some of the speculation ahead of next week's ECB meeting.  

In addition, a negative deposit rate could perversely trigger a tightening of monetary conditions if the banks respond by repaying their long-term repo borrowings.  Some of the core banks are expected to do so in any event, but a negative deposit rate could spur a larger pay down, in addition to other disruptions in the money markets.  On balance, we expect that the ECB not cut the deposit rate, but allow the rate corridor to narrow. 

The euro reached $1.,33 in Asia and the dollar moved to a high just shy of JPY87.35 before consolidating in the European morning.  This consolidation helped alleviate the short-term over-bought technical condition (on the hourly bar charts) and North American participants seem poised to re-challenge those areas.  For its part, sterling rallied through last year's high to reach $1.6380 and pulled back a full cent before finding a bid.  Technically, it too can re-test the session highs.  Unlike last week, the dollar-bloc currencies are fully participating in risk-on environment.