Risk assets continue to pull back as euro crisis worsens; US macro data weakens

Tom Tong18/Jul/2011Currency Updates

Recent market patterns continued this week. Equities sold off, mostly weighted by a deepening peripheral crisis in Europe that is now engulfing Italy, as well as weak macroeconomic data out of the United States. They did derive some support, however, from the positive earnings being reported by most US companies. Clearly, the two-speed recovery (booming profits, and stagnating labour market and investment) shows no signs of reversing. Commodities, again, held up much better, finishing flat on the week thanks to strength on precious metals and agriculture. Ultra-safe government bonds rallied as tier 2 (Italy, Spain and Belgium) peripheral bonds sold off. Somewhat surprisingly, FX markets were relatively calm, and the dollar ended the week roughly unchanged as a rally against the troubled euro was more or less offset by sell-offs against other G10 currencies.


The CPI data for June and a spate of second-tier macroeconomic data found a relatively rare agreement between the inflation data and growth prospects for the UK: they both giving clearly dovish signals. Headline inflation finally surprised decisively to the downside, slowing to 4.2% from 4.5% YoY, in spite of accelerating food and energy inflation. This is the first clear cut indication that the large slack in the UK economy is starting to drive prices down, and therefore provides critical support to the Bank of England MPC  majority that wants to delay rate hikes.  The BCC and BRC surveys provided further evidence that US growth is softening, as fiscal austerity bites. Once again, commentators were busy pushing their expectations for BoE hikes further into the future. Sterling, however, was buoyed by the even worse news coming out of Europe and the United States, and rose 0.5% against the greenback and 1.3% against the common currency.


The euro crisis deepened last week as Italian sovereign bonds joined those of Spain and the other peripherals in breaking out to all-time highs in terms of the spread to bunds. A hastily-passed austerity package in Italy, together with the usual chorus of reassuring statements from European officials appeared to stem the panic on Monday, but the subsequent rebound soon petered out and all peripherals sold off in a nearly lineal fashion throughout the rest of the week. Italian and Spanish 10 year bonds crossed the psychologically important 6% threshold. It is increasingly obvious that debt dynamics at these debt costs for all peripheral countries are unsustainable, and that once again bold action is needed from core Europe and the ECB if the euro is to hold together. The upcoming Eurogroup meeting offers some hope in this regard. Official statements appear to hint that Euro officials are moving to include explicit debt relief and debt sustainability in the form of a) lowering borrowing costs in official bailout packages and b) allowing purchases of peripheral debt at market (i.e., far below par) prices for their subsequent retirement. However, these meetings have raised hopes before that were then dashed by ideological and political constraints, so it’s best to be cautious. It is clear that for now the euro continues to trade driven almost exclusively by political headlines and official statements, making it harder than ever to get a handle on its future path.


Another week of weak economic reports had strategists and commentators scrambling to lower their predictions for growth in the current and next quarters. Core retail sales and industrial production surprised mildly to the downside, confirming other June reports that consumption and production both slowed down in tandem during the last month of the second quarter. Particularly worrisome is the near flat (up just 0.1% on the month) reading on nominal core retail sales, i.e., excluding volatile components like autos and gasoline purchases. This is consistent with the very weak news on labour income, and indicative that mass consumption is again sputtering as the engine of the US recovery. Other important news was the mild upward surprise in core CPI, which made (just barely, after rounding) a relatively high print at +0.3% for the month of June. While we are somewhat surprised at the resilience of core inflation given the large and increasing slack that appears to be embedded in the US economy, we still expect core inflation to moderate in the coming months to below 2% on an annualized basis. These weeks’ numbers weighed down the dollar in a week where the euro crisis plus the generalized flight to safety should have provided a nice lift for the dollar; instead, it managed to end the week barely unchanged.


Written by Tom Tong

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