Dollar Mixed, Markets Nervous, Politics Cut Appetite for Risk

The US dollar is narrowly mixed amid heightened political concerns.  A shutdown of the US federal government looks increasingly likely and the withdrawal of the center-right ministers has prompted a crisis in Italy.  Global equities have been undermined, with the MSCI Asia-Pacific Index off almost 1.5%, and the MSCI Emerging Market Index off 1%.   

European shares are faring a bit better, with the Dow Jones Stoxx 600 off around 0.8% near midday in London.    Italian shares are off 1.6%, led by the financials.  Separate from the national politics, the CEO of the largest retail bank (Intesa) was forced out over the weekend.  Core bond markets are firm, but the periphery, led by Italy are weaker, with the Italian benchmark 10-year yield up 7 bp, with the credit default swap up 18 bp.  

Italy's Prime Minister has called for a vote of confidence, which now looks likely Wednesday.  It is possible that Berlusconi over-played his hand, but his strength has often come from his adversaries under-estimating him.  As we had suggested, the proximate cause was not the Senate vote to enforce the ban against the former prime minister for being convicted of tax evasion, but rather the increase in the VAT.  While center-right ministers withdrew support from the government as Berlusconi instructed on his birthday, it is not clear that many in the party are prepared for early elections and may end up supporting the government in the confidence vote.   

A shutdown of the US government now looks inevitable, barring a last minute deal.  It will be the first government shutdown in seventeen years.  The hit on the economy depends on two variables:  the duration of the shutdown and the percentage of federal workers than are furloughed.    In addition to the economic fallout, there is political fallout to consider as well.    Polls suggest that the House Republicans will be blamed more than President Obama and this may be a factor in next year's primaries and Congressional elections.   The immediate market impact is to support a risk averse posture. 

Meanwhile, China, which will be on holiday for the rest of the week, launched the free-trade zone for Shanghai yesterday and it is far too early to conclude as the Financial Times does in the front page story that it is off to a slow start.   We note that despite the HSBC final PMI was revised to 50.2 from 51.2, Chinese stocks bucked the global down draft, with the Shanghai Composite up almost 0.7%, led by technology, consumer services and goods.  

The disappointing Chinese PMI initially weighed on the Australian dollar, but it has since recovered and is trading at session highs as North American dealing rooms open.  The central bank meets tomorrow as is not expected to change rates, though with the Australian dollar around 5% above last month's lows, it may recognize scope for lower rates. 

Japan's data dump was mixed.  The September manufacturing PMI rose to 52.5 from 52.2.  However, August industrial output fell more than twice the consensus expectations (-0.7% rather than -0.3%), and the year-over-year rate was squeezed back into negative territory (-0.2% from 1.8% in July). Vehicle production slumped 7.6% in August after a1.5% decline in July.   Retail sales rose 0.9%, offsetting half of the revised 1.7% decline in July..  Housing starts slowed to an 8.8% year-over-year pace from 12.4% in July, while August construction orders surged 21.4% (year-over-year) from 13.7%.   

The August employment report and, more importantly, the Tankan survey will be released the first thing Tuesday in Tokyo.  The market expects the survey to show small improvement and a rise in capex plans to 6% from 5.5%.  At the same time, the focus is quickly shifting to the supplemental budget that will help blunt the impact of the retail sales tax that appears increasingly likely to be implemented at the start of the news fiscal year (1 April 2014).  Local press is reporting that at JPY6 trillion, it may be larger than previously expectation. 

The dollar gapped lower against the yen and a small gap remains open between last Friday's low (~JPY98.10) and today's high (~JPY98.06).  The JPY97.53 low seen in Asia is the weakest the US dollar has been since August 29.  The uptrend line, we identified, off the June and August lows, has been frayed (~JPY97.65), but after the initial move, the greenback has held above it. 

European political developments are overshadowing economic developments, but we note that German retail sales snapped a 2-month decline to rise 0.5% in August.  That said, the market consensus had looked for a 0.8% gain.  However, the disappointment was mitigated by the sharp upward revision to the July figures, from a drop of 1.4% to only a 0.2% fall.  

Merkel's CDU has rejected the SPD call for a tax hike and the negotiations to form a new government are most likely to be protracted.  Meanwhile, Portugal's ruling party (Social Democrats) suffered in the weekend municipal elections, though the junior coalition partner fared better.  The austerity in next year's budget, to be officially unveiled in a couple of weeks, which will include new spending cuts was reportedly a key factor in the election. 

Austria held national elections.  The grand coalition suffered, but may still be strong enough to maintain power.  The Chancellor's Social Democrats won 27.1% of the vote, its smallest take since WWII.  Its coalition partner, the People's Party, garnered 23.8% of the vote, its worst showing also since WWII. 

The euro briefly slipped through the pre-weekend low, but held above last week's low (~$1.3462) and has been consolidating in the European morning.  The general consolidative range seen since the Fed's decision remains intact. 

Sterling continues to push ahead and reached its highest level today since early January, edging close to $1.6200.  Better mortgage data, with approvals rising to their highest level in 5 1/2 years was the latest catalyst, but there continue to be talk of the Vodafone purchase helping lift sterling.   The euro has also fallen to new lows since the start of the year against sterling.  Although the next psychological support is seen near GBP0.8300, the technical target is near GBP0.8260, the 61.8% retracement of the euro's rally off the GBP0.7755 low seen in July 2012.  

The US reports the Milwaukee and Chicago purchasing managers survey and the Dall Fed manufacturing activity.     These will be overshadowed by the political developments.  Canada report July GDP figures, which are expected to offset the 0.5% contraction seen in June.