US and EMU Dominate the Agenda in the Week Ahead

The week ahead is eventful. The key issue is whether the events will be sufficient to either significantly change our information set, or inject fresh volatility into the foreign exchange market. While market participants face headline risk around the events, we suspect that, at the end of next week, the investment climate is unlikely to change.

Fed tapering continues at a $10 bln a meeting pace, as the economy is behaving largely in line with the FOMC's expectations, though the weakness in the housing market is genuinely disappointing.  It is generally accepted that the first Fed hike is still more than a year off. The next FOMC meeting (June) will be more important than this week's meeting, which may be as close to a non-event as these things can be. Forecasts will be updated, and Yellen will hold a press conference June.

That the US economy has accelerated after a poor start to the year is generally recognized and will likely be among the few minor changes to the Fed's statement following the FOMC meeting. The first estimate of Q1 GDP will be reported on Tuesday, a day for the FOMC statement. It will be of interest to economists, but probably not investors or policy makers. The fact is that the more recent economic reports have been largely surpassing consensus forecasts.

This in turn suggests economists have not yet appreciated the strength of economic activity, and warns of upside risk to the consensus view for the US jobs data, to be released at the end of the week. At the same time, we also suspect that, given the FOMC's more nuanced view of the labor market, the impact of the monthly jobs report may lessen--barring a significant surprise, perhaps until the tapering is near completion at the end of the summer.

While neither the FOMC meeting nor the US employment data will likely change the general understanding of the trajectory of policy, events in the euro area are more important. There is economic data, like the money supply and credit extension data that may shape the ECB's policy response. Perhaps most importantly the flash CPI report that could force the central bank to act in May instead of June, which we have suggested is the most likely time frame.

To be sure it is financial variables, like the elevated and more volatile EONIA, the contraction in bank lending, and the lowflation that are of most concern to the European central bank. That means the latest unemployment figures and manufacturing PMI survey data due at the end of the week are ironically less important for shaping new policy initiatives.  That said, data that shows the economic recovery continuing, despite the financial issues, may impact the urgency and willingness of some officials to take dramatic action.   

There are four additional events in Europe on Tuesday and Wednesday (April 29-30) that are also important for investors and policy makers going forward. First, on Tuesday, broad details of the upcoming European bank stress tests will be announced by the European Banking Authority. In particular, the stress scenarios under which banks will have to demonstrate that they can withstand without assistance will be revealed.

Second, on Wednesday the ECB will release is quarterly bank lending survey. It may show that demand side considerations are critical and, if true, this may be seen as diminishing the chances of a new LTRO and/or a funding-for-lending scheme. Third, the same day, the semi-annual survey of SME financing will be published. It will likely underscore the ECB's desire to help facilitate lending to SMEs through reviving the asset-backed securities market.

Fourth, and what is likely to have the farthest reaching implication, is the European Court of Justice's ruling on the UK objection to the Financial Transaction Tax (FTT). The fact that it was a shortened proceeding (a decision had not been unexpected until next year) suggests the decision will go against the UK's claim that enhanced cooperation on the FTT violates the EU treaties in that it harms those that do not participate.

Such a ruling would further erode the UK's veto over further EU integration (as does the expansion of qualified majority decision making) and this may fuel the antipathy to the EU and could influence the May parliamentary elections. In addition, it would likely provide judicial support, for greater use of enhanced cooperation to facility greater euro area integration.

The G7 appear set to impose a series of new sanctions against Russia in the coming days. They will likely to be still directed at more individuals, but remain shy of industry wide sanctions. The US wants a more aggressive sanction regime, but Europe is more reluctant. Its trade ties with Russia are ten times greater than the US. That said, anecdotal reports suggest that the sanctions are having a larger effect than the sheer numbers imply, and in particular, a greater cooling effect in financial channels.

The situation has yet to stabilize. The risks are asymmetrical to the downside. Russia is a revisionist power in the sense that it rejects the agreement embodied in the Oder-Neisse treaty making permanent the territorial settlements at the end of WWII. The two major exceptions have been Palestine and Kosovo, but the operative word is exceptions. 

Prior to the recent events, the world was already largely divided between countries that recognized Kosovo and those that recognized Palestine. Russia's Medvedev Doctrine, claiming the territorial settlements are a historical accident and that the Russian state preserves the right to protect Russian ethnic people, especially what is referred to as the near abroad.

Less systemically important, but with potential local impact for investors, there are a few other factors that will be on investors' radar screens. First, two of China’s top four banks, the Agriculture and Construction banks, reported stronger than expected earnings, on wider margins, over the weekend. China will also report its official April PMI readings. We expect the reports to confirm that the Chinese economy is stabilizing at somewhat weaker levels.

Second,the UK becomes the first G7 country to estimate Q1 GDP (Tuesday). Despite the floods, it appears the UK economy accelerated from the Q4 pace of 0.7%. The consensus expects 0.9%-1.0%. The manufacturing and construction PMIs at the end of the week are expected to show an economy stabilizing at robust levels. Yet with the retail sales deflator falling, ideas that the BOE is likely to wait until next year to raise rates is unlikely to be impacted by the reports.

Third, the BOJ meets on Wednesday and, while it stands ready to provide more stimulus; it is not yet convinced this will be necessary. The opinion surveys find more than a 2/3 majority expect more action before the end of July. The March retail sales report and industrial output figures are likely to be inflated by efforts to front-run the sales tax hike. 

Look for the consensus expectation for a 6.0% rise in the monthly sales figure to be borrowing from the April and May sales. Industrial output disappointed in February, declining 2.3%, rather than expand 0.1% as the consensus expected. The market expects a 0.5% rise in March. Disappointment here wild cast a pall on expectations for Q2.