EU Summit Kicks Off, Euro Up

Highlights
The US dollar is mixed, stuck in narrow trading ranges amid the light volume of the holiday season. After falling below yesterday’s figure, the euro strengthened to $1.3266 but gains may be limited with the start of the EU summit today. In addition, the euro recovered some ground after falling to multi-year lows against both the SEK and CHF. Cable recovered from earlier session lows to trade in the $1.5600 region, receiving a bounce from retail sales while the BoE Inflation Attitudes Survey showed expectations 12 months ahead at the highest level in two years. The dollar remained stable just around ¥84.00 as US yields back away after yesterday’s highs. Elsewhere, New Zealand’s dollar sagged as measures of business and consumer confidence slipped back, leading to the biggest loss in the G10, while Australian consumer inflation expectations hit a five month low but unlikely to dampen the mood for rate hikes in 2011. EM currencies were split, with gains for HUF, PLN, and INR while PHP, IDR and MY declined.

Global equity markets are weaker, dominated again by declines in Europe, ahead of the EU summit. The MSCI Asia Pacific index is down for the second day in a row, today by nearly 0.2%. The Nikkei, however, was flat led by outperformance in financials as the stock index was boosted by a stronger dollar versus the yen. Meanwhile, Chinese stocks continued to decline with the Shanghai index down 0.4%. On the whole, European bourses are down again but arguably less troublesome day than yesterday with the Euro Stoxx 600 up 0.4%. On the other hand, the FTSE and Dax are both down with the FTSE led by losses in energy while the Dax was bogged down by materials.

The fixed income spotlight shines again on the euro-zone periphery after Spain sells €1.7bln 2020 bonds along with €618mln 2025 bonds. The auction, technically, was not considered a failure since Spain managed to roll-over the debt. But nonetheless Spain’s refinancing costs indeed rose with the average yield up nearly 100bp from November’s auction. The auction was an important gauge of sentiment in the Spanish debt market following Moody’s signal yesterday to review its debt rating along with the general impact of the debt crisis. Overall, the average yield of the 10-year periphery debt rose to 8.02% from 7.98% yesterday, with Greece’s yield up 16bp. The Swiss National Bank (SNB), as expected, left rates unchanged at 0.25%, indicating currency appreciation as a concern for the growth outlook. Elsewhere, the Reserve Bank of India left rates unchanged at 5.25% while Turkey had a failed bond auction ahead of its central bank meeting where the consensus is for a 25bp drop. And finally China’s long-term debt rating was raised by S&P to AA- from A+.

Currency Markets

The EU Summit begins shortly. Out of the cacophony of voices will come some agreements, principally the modifications of the Lisbon Treaty, the closest thing to a constitution that Europe may have for quite some time that will enshrine the European Stabilization Mechanism–the successor of the EFSF. This may include an agreement on collective action clauses. German Chancellor Merkel was sharply criticized by political opposition in Parliament on grounds of not being supportive enough of Europe. SPD leadership is clearly more supportive of initiatives like a collective bond than is the CDU. This and the need for an agreement could see politicians do what politicians do and kick the can of controversial issues down the road. There is unlikely to be agreements on collective bonds, or increasing the guarantees of the EFSF, or having the EFSF purchase bonds. There may be agreement on new funding for the ECB. This year will finish without a clear and convincing strategy to address the debt crisis which will be a major force into next year.

European economic this session has been pretty mixed, with euro-zone composite PMIs coming in below expectations, UK retail sales beat expectations (inflation survey increased) and the Swedish unemployment rate came in below expectations. The euro-zone November final manufacturing PMI was revised down to 55.3 from 55.5 reported initially. This is, however, still up from the 54.6 in October and the improvement over the month still means the euro-zone recovery remains on track. The country breakdown confirmed that Germany, and especially the German manufacturing, remains the main driver of growth and that the recovery remains uneven across countries. Indeed, The uneven recovery across countries coupled with the renewed flaring up of market tensions means downside risks to the growth outlook remains, even though overall euro-zone data speaks against a double dip recession. UK retail sales rose, beating expectations. Although the retail sales were better-than-expected, the annual figure still indicates soft consumer spending. Besides, the sales should see a late-year boost ahead of the planned VAT increase and the 330,000 expected public sector jobs as part of the UK’s austerity package. Yet the rise in UK inflation expectations should keep sterling well bid but spare capacity should limit wage growth which is likely to drive the MPC rhetoric.

The SNB, as expected, left the Libor target range unchanged at 0-0.75% and continues to target a 3-months Libor rate at 0.25%.The inflation forecast for this year was left unchanged, while the forecast for next year was revised marginally higher to 0.4% from 0.3%. At the same time, the forecasts for 2012 and 2013 were revised marginally higher. Meanwhile, Growth in Switzerland was robust in the third quarter of 2010, but the weakening of exports, overall, points to a significant reduction in growth in the quarters ahead. The SNB acknowledged this and thus expects GDP to grow by some 1.5% in 2011, following growth of about 2.5% in the current year. Arguably, though, concerns about stability in the euro-zone have led to renewed financial market tensions and a general flight to safety. As such, the Swiss franc continues to appreciate with the trade-weighted exchange up nearly 15% since May. Should these tensions in the euro-zone escalate, in our view, this may have a detrimental effect on the Swiss economy as the currency strength weighs on GDP growth and pushes down inflation. If a deflation threat emerges, the SNB asserted it would take the measures necessary to ensure price stability. This in fact leaves the door open to future intervention if indeed euro-zone debt crisis does not have a smooth resolution over the medium-term.

Upcoming Economic Releases

At 8:30 EST / 13:30 GMT the US releases a host of data starting with housing starts, current account and continuing claims. Housing starts are expected to improve while the current account is expected to marginally widen. Jobless claims are to increase to 425k from 421, though the 4-week moving average is at 2-year low. Afterwards, the Philly Fed is expected to decline to 15 from 22.5. Events: Geithner at Congressional Oversight Panel and House vote to enact stimulus package.