Dollar Firm, Awaiting More Bernanke

The US dollar is firm against the major and most emerging market currencies. Asian equities could not match gains in the US yesterday and the MSCI Asia-Pacific Index fell fractionally. This reflects weakness among emerging market equities, as the Nikkei gained 1.3%. The MSCI Emerging Market Index is off about 0.3%. European shares are firmer with the DAX, the exception, where the losses in technology and consumer services offset the gains in the other sectors. The first decline in SAP software sales was the main impetus.

Debt markets are mostly firmer, following the gains in the US yesterday. Of note, however, even though Spain's bond auction was well received, Italian and Spanish benchmark 10-year bond yields are 1-2 bp higher. Political issues for both countries are becoming salient. There has been talk in the markets about the risk of a Spanish sovereign downgrade. Yet, the 5-year credit default swap is softer on the day and largely flat on the week. Over the past several sessions, Spanish bonos have outperformed Italian BTPs.

The news stream has been fairly light. There are two main developments that stand out. First, a German newspaper (Welt) is reporting that the ECB has reduced haircuts for asset-backed securities as collateral in refi operations. It is difficult at this time to get confirmation, but it is the direction that we (and some others) had thought the ECB was moving. The purpose is to help improve lending to small and medium sized businesses. Such loans can back ABS and now those ABS can be exchanged for more cash at the ECB.

This is important even if of limited consequence. It is another demonstration that the ECB has tools that it can use in addition to interest rates and the size of its balance sheet (SMP/OMT). A more cynical observer might consider this a deterioration in the ECB's balance sheet, by giving more funds for the same collateral than it has previously. 

Yet, the collateral issue would not be as significant if Europe had done what the US had done and forced all major (systemically important) banks to government funds, in a forced recapitalization process. The ECB wrestles with collateral issues because banks remain dependent on ECB borrowings, though at a somewhat smaller degree than a year ago.

The other noteworthy development was the release of UK's June retail sales. They rose 0.2% for a 2.2% year-over-year increase, and the first back-to-back increase since last July. This was largely in line with expectations, though sterling has traded more than half a cent higher after the release, back above $1.52, while the UK gilts are the best performing core bond market. 

The one notable mitigating factor was that the price deflator was the highest over a year (1`.7% vs 1.0% in May), suggesting extensive discounting. The ONS estimates that retail sales will contribute 0.1% to Q2 growth. That report, the first estimate of Q2 GDP is due out next Wed. A rise of about 0.6-0.8% is expected. 

The highlight of the North American session will be the second leg of Bernanke's semi-annual testimony.  This time before the Senate.  The prepared remarks, of course, are identical with yesterday's, but the interest is in the Q&A.  

It seems that Bernanke has been delivering the same message since at least mid-June.  He offers an "if this then that" type of guidance.  Depending on investor positioning, the market has swung between focusing on the antecedent or the consequent.  The antecedent, which investors have focused on more recently, are the conditions that Bernanke has said would be consistent with tapering:  If the economy does not disappoint Fed expectations.  The consequent is the tapering later this year and possibly ending the program around the middle of next year, when, incidentally, Bernanke will most likely not be there.  

We have argued that it seemed more likely that if the consensus is wrong about the tapering, it is that it takes place later rather than earlier.  Some Fed officials seem to want to begin tapering as early as the FOMC meeting later this month, for example.  Our view is based on our sense that the antecedent conditions will not be in place.  Unemployment is likely to be closer to 7.5% when the Fed meets in September than 7.0%, which Bernanke seemed to have suggested in the past as a sign of significant improvement in the labor market.  And looking at the base effect for the PCE deflator, core inflation is likely to still be nearer 1.0% than the 2.0% target.  

In addition, we suggested that the Fed's anti-inflation credentials, which may be more important in the coming years, will be more enhanced by allowing the next chair person to implement the exit strategy, which would be in some sense wasted on Bernanke, who has a different historical legacy.