The US dollar extended yesterday's gains and remain bid ahead of the November jobs report. The deterioration of the economic and political situation in the euro area appears to be the single biggest factor behind the greenback's sharp recovery. The dollar is little changed against the yen as the market grapples with the implication of the earthquake and tsunami.
Asian equity markets were mostly higher with the MSCI Asia-Pacific Index was up about 0.25% and,. of note, the Shanghai Composite extended this week's recovery, gaining 1.6% to bring the weekly advance to 4.1%. European bourses are bit heavier. Spanish and Italian bonds remain under pressures, while Greek bond yields continue to fall as a the bond buy back offer expires today and the market anticipates a successful conclusion.
We share five observations today.
1. The ECB was more dovish than expected. The ECB staff trimmed its growth forecasts yesterday, but are still above consensus expectations. News that its decision to leave rates on hold was a consensus decision,. not unanimous, means that the ECB may be closer to cutting the refi rate than appreciated. At the same time it would seem that it would take a deterioration of the outlook from here to see a rate cut materialize. Any discussion of a refi rate cut would, almost, by definition, raise questions about the deposit rate, the bottom of the rate corridor. While we had thought a refi rate cut in late Q1 13was possible, we do not expect the deposit rate, now at zero, would be cut. Instead the ECB would operate with a narrower corridor. Today the Bundesbank cut its GDP forecasts, with 2013 growth now estimated at 0.4% down from 1.6%. Separately, Germany reported a terribly disappointing October industrial output figures. The 2.6% decline contrasts with the Bloomberg consensus of a flat report, after yesterday's stronger orders data. The next downside target for the euro comes in just below $1.29 and then $1.2840.
2. Italian political anxiety. A second factor that is weighing on the euro is the machinations of Italian politics. The center-right PDL, which had been supporting the Monti government withdrew support yesterday, mostly abstaining from the confidence vote over economic reforms. This has threatened to topple the technocrat government and force early elections. Although Berlusconi's intent is difficult to decipher, this is likely to prove a short across the bow. It is symbolic in nature, meant to signal disapproval of Monti's policies more than an attempt to trigger a political crisis. We note too that on December 17, wealth tax, that Berlusconi opposed, on homes goes into effect. Italian President Napolitano is meeting with the general secretary of the PDL to sort things out. On balance, we expect elections in March, which means parliament would be dissolved in about a month's time top prepare. There is some apprehension that a new PDL-Northern League alliance could bring Berlusconi back to power. That is not our base case.
3. UK industrial output data was horrendous and it re-opens the door to new gilt purchases next year. October industrial output fell 0.8%, whereas the consensus had called for a 0.7% increase and follows the downward revision in the Sept series to -2.1% from -1.7%. Manufacturing itself collapsed, falling 1.3% not the mere 0.2% decline the consensus had forecast. In Q3, it had looked as if the real sector data was holding up better than the survey data. Now, it is the other way around. The PMI led investors to expected better real sector data. Adding insult to injury, separately we note that consumer expectations for inflation in the year ahead ticked up to 3.5% from 3.2%. While sterling is holding above $1.60, it has broken the uptrend from mid-Nov and we look for a move toward $1.5940-80 near-term.
4. The Australian dollar remains resilient. It has withstood the RBA rate cut, softer Q3 GDP details and now a much wider trade deficit. The A$2.088 bln Oct trade shortfall was nearly twice Sept's A$1.4 bln deficit. Exports were flat, while imports rose 3%. It flirted with the $1.05 level yesterday and is consolidating today. Support is seen near $1.0440 and then $1.04. In terms of value, we note that by the OECD's measure of PPP, the Australian dollar is the most over-valued in its universe.
5. The market will look past the US jobs data, which will be skewed by the storm. There may be an initial knee jerk reaction especially given the risks of a weaker than expected report. The BLS will make some adjustment. The employment component of the manufacturing ISM was below 50 for the first time since Dec 09 and while the employment component of the service ISM was still above 50 , it recorded its largest decline since March 2009. The market will look ahead to next week's FOMC meeting, which is expected to increase the long-term assets being purchased (QE3+) as Operation Twist is completed.