Positive US data and European deal buy asset markets, Euro

Tom Tong31/Oct/2011Currency Updates

The one thing European officials can do well is lower market expectations. In fact, they did such a thorough job of it that even the minimal agreement reached, lacking critical details and insufficient in scope, was enough to surprise investors positively. The continuation of positive economic surprises out of the US and China indicated that these two economies may not be dragged down into recession by Europe – though the economic prospects there are still deteriorating. However, investors were apparently caught short both the common currency and risk markets by the Thursday morning EU summit communiqué. The Eurostoxx 50 index ended the week 5% higher, and the trade weighted dollar gave up nearly 2%.

We think the markets clearly overreacted to the rather lacklustre news from the EU summit (see our special note from last week). One ominous sign is the behaviour of the critical Italian sovereign bond yields. In spite of the market euphoria, the 10-year benchmark closed the week above 6.00%, nearly 13 bp higher than the previous weekly close.

GBP

Last week was very quiet in the UK. No major releases or policy actions were announced, save for the CBI industry survey in manufacturing. This showed a sharp drop, presaging a contraction in UK industrial output in 4Q. Given the weakening macroeconomic backdrop, we think that the UK is set to lead Euroland into recession as early as next quarter. On the positive side, it is unlikely that this recession will be a deep one. The upswing, such as it was, was so mild that there are few financial or investment excesses to purge this time around. Cold comfort, but we’ll take what we can get.

In the absence of market-moving news, Sterling went back to behaving like a low-beta version of the Euro, rising 1% against the greenback but dropping 0.7% against the common currency.

EUR

Please see our special note above for our comments on the outcome of the EU summit. To reiterate, we think the markets clearly overreacted to the rather lacklustre news from the EU summit. One ominous sign is the behaviour of the critical Italian sovereign bond yields. In spite of the market euphoria, the 10-year benchmark closed the week above 6.00%, nearly 13 bp higher than the previous weekly close.

The macroeconomic backdrop in Euroland has deteriorated quite significantly while Euro officials and the ECB dithered. Italian consumer confidence is now lower than at height of the 2008 crisis. The Spanish employment picture is an unmitigated disaster. Overall unemployment is getting close to 22%, and the Spanish labour market continues to shed net jobs month after month. It is now clear that the confidence crisis has spread to the core countries, and overall Euro PMI sentiment indices are at levels indicative of outright economic contraction. We think that last week’s agreement is a day late and a dollar (or rather, a trillion) short. The European crisis cannot be solved without direct ECB involvement. We await Mario Draghi’s first conference as ECB head next week to see if he departs from Trichet’s sadomonetarist line. Absent a clear change in tone, we have trouble seeing how the Euro can sustain these lofty levels.

USD

Macroeconomic data over the past few weeks must have brought some relief to the worried Fed. 3Q GDP confirmed that the US is not nearing a recession. The trend-like growth of 2.5% was driven by a very encouraging 16.3% saar increase in business fixed investment. Further, the number would have been 1.1% higher had it not been for an unexpected drawdown in inventories. This bodes well for next quarter. In addition, the expiration of tax incentives at the end of 2012 provide an incentive for firms to move investment expenditures from 2012 into the last quarter of 2011, and we think it likely that the data will continue to surprise on the upside over the next few weeks. All of this should be mildly supportive of the US dollar, and we look more kindly on the greenback than we have for quite some time.

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Written by Tom Tong

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