Week with Much Potential is Ending with a Whimper

The US dollar remains primarily confined to yesterday's trading ranges and has spent most of the week consolidating within the ranges established after the Fed's decided not to taper its purchases of long-term assets last week.   There had been much potential, with the German election, the flash PMI data, US fiscal morass, and month and quarter-end considerations.  However, rather than induce activity, a choppy, though largely directionless week has been recorded and many key issues remain unresolved.  

The US Congress continues to its brinkmanship tactics and a closure of the government remains possible as the basis of a compromise remains elusive even at this late date.   Negotiations between Merkel's CDU and the SPD to form a grand coalition also appear to be a protracted process and likely to last several weeks. Some reports indicate that even though the CDU barely missed an outright majority, the SPD is demanded half the ministries, including finance.  

There are two elections this weekend to note.  First, Portugal holds its first set of local elections since receiving the 78 bln euro aid package.  The elections are two week before the government submits its 2014 budget, which calls for 3.3 bln in new cuts.  Note that the judicial branch continues to block some of the government's efforts, particular as it related to liberalizing the labor market, by giving employers greater discretion in dismissing workers.    Portugal has benefited from the bond rally sparked by last week's Fed decision, with 10-year yields slipping back below the 7% threshold.  The benchmark yield fell 18 bp this week to 6.86%.  The 2-year yields dipped about 6 bp and is still yielding above 5%.

Second, Austria goes to the polls Sunday as well.  The most likely outcome is a continuation of the grand coalition between Chancellor Faymann's Social Democrats and the conservative People's Party. The election has not seen much foreign interest and we note that Austria's 10-year yields trade inside the French-German spread.  

Meanwhile, Italy has still managed to find good reception to its bond sales, but the political issues are set to come to the fore.  Prime Minister Letta is meeting with President Napolitano to discuss the stability of the government in the wake of fresh threats by the center-right to withdraw support from the government as early as next week if the Senate votes to expel Berlusconi.   At the same time, the issue of the VAT hike is to be decided today.  The center-right argues that abolishing the tax was a pre-condition of forming the coalition, but exactly how to make up for the lost revenues, especially after the earlier decision not to enact the controversial property tax is not clear.  

Although delaying payments to businesses in which the government was already in arrears seems like another exercise in cutting one's nose to spite the face.  Small businesses, who provide many government services, are being squeezed by the banks on one hand, and the government on the other.  Italian 10-year bond yields are back above Spain's.  

Spain is to present its 2014 budget today.  It will seek to achieve a 5.8% deficit next year after around 6.5% this year.  This requires something on the magnitude of 8 bln euro in new savings.  Earlier today Spain reported further deterioration in retail sales (4.2% year-over-year contraction after a 2% decline in July) despite some improving labor market figures.  Yesterday the government announced a new freeze on civil servant wages.  

For its part, the euro is trading within yesterday's ranges, which was within Wednesday's range, and in turn, is at the upper end of the range set in the immediate reaction to the Fed's decision last Wednesday. Technically, the price action appears to be carving out a bullish flag pattern, but sometimes consolidative price action can be misleading.  Only a break of the $1.3460-$1.3550 range will clarify the picture and that is unlikely today.  

Sterling and the yen are the strongest currencies against the dollar this week.  Optimism about the UK economy and diminishing expectations of another round of gilt purchases, driven home by BOE Governor Carney's recent remark appear to have helped underpin sterling, though today's service index for July was disappointing (0.2% vs consensus expectations for a 0.5% increase).  

Of note, in recent weeks, sterling has ostensibly been helped by the rise in yields.  However, this week, gilts have rallied strongly, with the 10-year yield dropped 19 bp this week and this was also seen as favorable for sterling amid talk of good foreign interest buying.   Sterling has gained about 0.45% against the dollar this week and almost 0.60% against the euro.  

The yen has gained about 0.75% against the dollar this week.  Today (thus far) is the sixth consecutive session in which the US premium (on 10-year money) over Japan has narrowed.  The recent peak was set on September 10 near 222 bp.  Today it is below 195 bp.   The dollar has been confined to about a one yen range this week.  Key support is seen from the trend line drawn off the mid-June lows and early August lows.  It is found near JPY98.50.  On the top side, the dollar has not been above JPY100 for more than two weeks.  

Earlier today, Japan reported August headline CPI at 0.9%, up from 0.7% in July.  The inflation is solely due to energy prices, which is also the chief culprit in driving the trade deficit.  If one excludes fresh food prices, the headline CPI stands at 0.8%, but if one excludes food and energy, the deflationary forces are evident:  -0.1% year-over-year.  The same general pattern is evident for the Tokyo CPI, which reports the September inflation figures (0.5% headline and -0.3% excluding food and energy).   The Tankan survey is to be released next week and the supplemental budget to offset the retail sales tax hike is being formed.  

Separately, we note that Japanese investors bought foreign bonds for the second consecutive week, according to the latest MOF report.  However, the latest bond purchases appear to have been financed by the sale of foreign equities.  At the same time, while foreign investors continued to buy Japanese shares (for the third consecutive week), they sold much more Japanese bonds (purchases JPY181 bln of equities and sold JPY726 bln worth of bonds).  

The US reports August personal income and consumption data and this will help economists solidify Q3 GDP forecasts, which are mostly around 2%.  Of interest will be the Fed's preferred, but not only inflation measure, the core PCE deflator.  Little change is expected in the 1.2% rate seen in July. As we have noted previously, this is a lower reading that was seen when Bernanke was a governor at the Fed and was concerned about deflation.  In addition, recall that with the Q2 GDP revisions earlier this week, the core PCE deflator was revised to 0.6% from 0.8%.