Europe Still Center Stage

The US dollar continues to show a firm profile as European events continue to dominate investors' concerns. Given the holidays starting tomorrow and running into early next week for some, the first quarter is effectively over. The euro has slipped to new four month lows as the official response to the Cyprus crisis has undermined confidence. What was support for the euro near $1.2880 is now resistance as the euro heads to the next target a little below $1.27.

The flow into the European safe haven, the short-end of the German curve, the US-German 2-year interest rate differential, which continues to closely track the euro-dollar exchange rate, continues to widen out in the dollar's favor. The German 2-year yield negative again and German discount (US premium) has widened out to more than 25 bp, the highest level since the very start of the year. Last year's high was set in August just above 33 bp. With the US 2-year anchored by the US accommodative monetary stance, to see those levels again requires the persistence of high level of anxiety in Europe, which European officials seem willing to provide.

Cypriot banks are to open re-open tomorrow. Details on the capital controls are awaited. It is becoming clearer that over the past week or so there has been capital flight and this would seem to imply a larger impact on the uninsured depositors. Capital is thought to have left via branches/units of Cypriot banks that have been open in the UK and Russia. 

There were limits on how much cash could be taken out of the banks, but that did not seem to block the transfer of equity and other wealth. The Emergency Lending Assistance (ELA), which the national central bank makes available, with the ECB's permission, is expected to initially increase by around 3 bln euros This may be a rough and ready estimate of the leakage.

We note that the freeze did not prevent, with official permission, some business payments and the purchase of some imports such as medicine. It does not appear that there was a discount attached to the Cyprus euro payment, which belies the talk in some quarters that a Cypriot euro now exists.

Italy's unresolved political situation is also coming back to the fore and this is evident with new pressure on Italian bonds, were the 2-10-year yields are up around 15 bp, a bit more than prior to the lukewarm, but acceptable bond auction. .  The center-left Bersani appears poised to tell the president he cannot put together a government.   The lack of cooperation between the three main groupings--the PD's center-left, the PDL's center-right and Grillo's 5-Star Movement--has given rise to speculation of a new technocrat government.  

While this is possible, we suspect there may be another attempt by Bersani's rival for PD leadership, the Florence mayor, Renzi, who has better relations with the center-right.   Bersani ran a weak campaign, snatched defeat from the jaws of victory, and now has failed to find the mechanism to form a government.  Renzi's candidacy may alienate the left wing of the coalition, which itself make a deal with the centrists, like Monti, and the center-right more likely.  

Separately, the economic news is going from bad to worse in Italy.  January industrial orders slumped 1.3% after the December figures was revised to 04% from 0.8%.  Retail sales fell 0.5% in January.  The consensus had expected a flat number and the December gain of 0.2% was revised to -0.1%.  What this means is that retail sales in Italy have fallen for seven consecutive months.  

The same picture of collapsing domestic demand is evident in Spain as well.  Retail sales for February fell 8% year-over-year.  The seemingly slower paces than the 10% contraction reported in January is misleading and is a reflection of prices.  In real terms, retail sales fell 10.6% in Feb after a 9% pace in Jan.  Retail sales have fallen every month for more than two years.    Germany is to report Feb retail sales tomorrow and are expected to have declined for the third time in the past five months.  

France reported that the number of people out of work rose for the 22nd consecutive month.  The 0.6% increase brings the total number of unemployed to 3.188 mln, just below the Jan '97 record near 3.196 mln.  It is no wonder than consumer confidence fell to 84 in March, the lowest since last November.  S&P warned yesterday that the French economy may contract 0.2% this year.  The government's estimate of 0.8% growth seems quite optimistic and will likely be cut.  The Bloomberg consensus is of a goose egg.  

With the economy downturn in Europe looking deeper and more prolonged, while price pressures are moderating, keeps the door open to an ECB rate cut in Q2.  German and French inflation are at multi-year lows.  We acknowledge that the zero deposit rate is the key  to short-term rates, making a 25 bp cut in the repo rate largely symbolic.