"Dead cat bounce" in risk assets, in spite of continued disappointments
19/Sep/2011 • Currency Updates•
Equities rallied last week, and safe government bonds sold off. This price action was quite befuddling to us, as it was supported by neither positive macroeconomic news nor decisive action from policymakers. Quite the opposite, if anything. In the US, retail sales confirmed that the economy effectively stalled in August, whereas in Europe funding stress for banks worsened, as debt issuance has ground to a halt and bank reliance on ECB funding increased by EUR27 billion for the week. As for the policy response to the peripheral crisis and continued talk of Greek default, the week brought the many bickering authorities no closer to a consensus. In a particularly ominous development, peripheral spreads failed to close in spite of steady Italian and Spanish bond purchases by the ECB. Only position squaring from investors can serve as an explanation of the modest rally seen in risk assets last week. In FX, we saw a continuation of the trends seen over the past few weeks: surprisingly calm markets and low volatility, at least relative to the wild swings seen in equities and bonds.
The big news for the week was the release of inflation data for August. Although YoY CPI stayed high as expected, at 4.5%, there is a sliver of good news for the Bank of England in that the string of upward surprises in inflation appears to have come to an end. In addition, pay growth has slowed fairly dramatically and market measures of expected inflation have fallen sharply over the past few months. We are becoming more confident that the BoE will announce an extension of Quantitative Easing as soon as the next MPC meeting; the markets seem to agree with our view, and they sent GBP down to the year’s low against the US dollar. We expect such weakness to continue, although we think GBP will hold up much better against the troubled common currency.
Pressure on peripheral bonds and European bank shares peaked on Monday, and eased later in the week. Official denials that Greece was about to fulfill market expectations and default undoubtedly helped. However, little or no progress has been made in getting the many factions to agree on long term solutions. Meanwhile, the folly of the current push for savage austerity is demonstrated by the apparent implosion of the Greek economy, the worsening depression in Portugal, and the inability of the Spanish job market to bottom out, let alone begin the process of absorbing 5 million unemployed workers. Only the ECB’s purchases of Italian and Spanish bonds (over 70 billion EUR worth in just five weeks) allow these countries to place their bonds in public auctions. We maintain a bearish outlook in the Euro, and do not believe that last week’s rally will be sustained.
High volatility data last week continued to paint a weak picture of the US economy. Initial weekly jobless claims, perhaps the highest-frequency meaningful indicator of US economic performance, rose to 428,000, and the 4 week average is now headed upwards, after failing to break through the 400,000 level. These numbers are consistent with a stalled job market. The broad-based slowdown in consumer spending continues, as nominal retail sales (headline and core) were flat in August, considerably weaker than expected. After adjusting for inflation, this means US consumers actually spent less in August than in July, a fairly rare occurrence. These developments did not surprise us in the least, given our bearish outlook for the US economy; however, we were puzzled by the stubbornly high inflation readings for August. We would have expected that the slack in the US labor market and wage weakness would have made more of a dent in core inflation by now, but the latter increased (again) by slightly more than 0.2% last month. It seems like the weaker dollar bears some of the blame, but we will pay very close attention to upcoming inflation numbers out of the US.