Dollar Softens at Start of Eventful Week

The US dollar is trading heavily against the major and most emerging market currencies.  Even though Tokyo markets were closed, the dollar extended its pre-weekend losses against yen in Asian activity before steadying in the European morning.  The euro and peripheral debt markets have reacted positively to the new Italian government and the apparent acceptance of Spain's announcement that two more years to achieve the 3% budget deficit target.  

Italy's bond and stock markets have been outperforming over the last couple of weeks and continue to do so today.  The 10-year bond auction was easily absorbed at yields not seen in nearly 3-years.  The equity market is leading European bourses higher with a 1.5% gain to bring the month to date advance closer to 10%.    This has helped lift the euro, which tested the $1.3100 area in early European turnover, before consolidating.  

For its part, sterling has extended its recent gains and is trading at the best level against the dollar in eleven weeks.  The technical objective near $1.5600 and the 100-day moving average near $1.5630 area are seen as the next main hurdles.  

This week is eventful but shortened by the mid-week May Day holiday and the Japanese Golden Week.  It  features the ECB and Federal Reserve meetings, new EU macro forecasts, a new batch of PMI surveys, and the US auto sales and jobs report.  The backdrop for this week's activity is important.  There are three main characteristics of this macro economic backdrop.  

First, the US economy has softened in recent weeks and measured price pressures have eased.

Second, Europe is backing off from the austerity push that has characterized fiscal policy in recent years.  This is taking place as European interest rates have fallen significantly and premiums over Germany have narrowed.  

Third, the Bank of Japan will be doubling its purchases of Japanese government bonds and doubling the average maturity of its purchases.  This has yet to trigger capital outflows from Japan.  Institutional investors may begin deploying this year's strategic allocation after this week's Golden Week Holiday.  This may coincide with foreign investors slowing their purchase of Japanese shares after buying more than $60 bln worth this year already and seeing a more than 50% rally since the election was called in mid-Nov last year.

The ECB meeting may be the most interesting event this week.  The ECB indicated earlier this month that if economic data worsened, it was prepared to cut the refi rate.  Several ECB officials seemed to echo these sentiments.  However, it took evidence that European locomotive, Germany, was stumbling in the form of a three surveys (ZEW, PMI and IFO), to swing the consensus in favor of a 25 bp rate cut this week. Today's CPI reports from both German and Spain underscore that price pressures are easing.  

While we have anticipated a rate cut by the ECB here in Q2, we are wary of how far and fast the pendulum has swung in favor of a move this week.  We see two important reasons why the ECB may choose to wait a month.  First, next month the ECB updates its economic forecasts.  For some, perhaps even including the BBK, it may be preferable to wait for these new updates. The EC will also update its forecasts on May 3, to be followed by new policy recommendations at the end the month.

This may not be a deciding factor, if it weren't for the second reason.  The ECB, even when led by some one whose national origins lie with a southern European country, wants countries to pursue disciplined fiscal policy.  Spreadsheet errors notwithstanding, the ECB institutionally wants European countries to get their fiscal house in order, if for no other reason, it is needed for the proper transmission of monetary policy.  The time that the ECB bought in the form of the LTROs and OMT are not being used by national leaders to restructure and win the confidence of investors.

With the EC President recently suggesting that the austerity agenda has gone as far as it can, and the IMF softening its push for austerity, the ECB is the last of the Troika committed to austerity.   A rate cut now would be seen as sign of approval.

This ECB meeting will be held in Bratislava, the capital of Slovakia.  Although we do not put much significance in that, for an institution that puts much emphasis in appearances, this would seem to be another objection.

Some also may suggest that the ECB could cut rates to give a little help to the new Italian government.   The new government may be the most pro-Europe one that was possible, but among first things the new prime minister signaled was that there has been too much austerity, and among the first measures it enacts may be a repeal of the unpopular property tax.  The next payment is due in June.

In absolute and comparative terms, the Federal Reserve's meeting will be a non-event.  We expect some recognition of the weaker economic data,  but do not expect a substantive change.  The Fed's leadership and an overwhelming majority of the FOMC favor the continued purchase of $85 bln of long-term assets a month.  Those favoring a tapering off of purchases are likely to be quieted by the recent softness of the economic data.  This may give those favoring a stronger Fed response more of the media spotlight.

The ECB and FOMC meetings, however, may steal the thunder from the economic data.  The market has already taken on board that the weakness in the euro area economy continued not just in Q1 (where some national GDP figures will be published this week), but also into Q2.  Meanwhile, economist forecasts for US data have erred recently to the upside and the risk is that improvement in the labor market slowed.   Auto production has been an important part of the US manufacturing recovery, and while auto sales are faring much better than in Europe, they appear to be steadying.