Irish Budget Likely to Pass, Euro Relief Temporary

Highlights
The US dollar is mostly lower on news that US President Obama reached an agreement to extend the Bush tax cuts for another two years, which has lifted stocks and buoyed risk appetite, despite the speculation that China may raise interest rates this weekend. The euro posted moderate gains, trading out of $1.328 to $1.335 largely in Friday’s ranged on news that the Irish budget will be passed by parliament, following a declaration by Independent Lowry that he will vote in favor of the planned of the budget. The euro gains, along with better-than-expected manufacturing data, boosted sterling which traded out to $1.582, setting a new three day high, but subsequently falling back. USD/JPY is lower after an early rally ran out of steam around ¥82.80 but continues to oscillate around ¥82.50. Elsewhere, the Reserve Bank of Australia decided, as expected, to keep rates unchanged at 4.75%, describing the policy as ‘appropriate for the economic outlook,’ while EM currencies traded higher.

Global equity markets are solidly higher, despite the concerns that China may increase interest rates this weekend, as markets are buoyed by the extension of the Bush tax cuts and the potential budget approval by Ireland. Asian stocks marked the fifth consecutive session of higher levels with the MSCI Asia Pacific up 0.3%. Meanwhile, after a 1.4% m/m drop in Japan’s October leading and coincidence indices the Nikkei is down 0.2% led by losses in consumer, though unities are up 0.8%. European bourses are higher with the Euro Stoxx 600 up 1.1% with sharp gains in materials and industrials. Meanwhile, the FTSE and Dax were both up over 1% led by outperformance in materials and industrials on the back of positive manufacturing and factory order data.

Euro-zone spreads still mostly widened, after the eurogroup meeting of euro-zone finance ministers rejected calls for a widening of the stability fund, despite the high probability that Ireland will pass its budget. It seems the eurogroup followed Germany’s position in the end, but this is unlikely to stop the public bickering which is contributing to the escalation of the crisis. This suggests that the risks for the euro are asymmetric and, although the Irish are slated to pass the budget, any bounces in the euro may be short-lived. Spain’s 10-year yield, for instance, is up 16bp with Portugal’s yield up 11bp. Likewise, Italy’s 10-year yields are up 8b while Ireland’s yields are flat. At the same time, the rise in equities have dampened the demand for safe haven bond with German 10-year yields up 4bp and US 10-year Treasury yields up 7bp. Elsewhere Japan’s 10-year JGB yields rose by 2bp after an auction of 30-year notes saw demand fall off sharply.

Currency Markets

There does not appear to be the basis of agreement among European officials of what to do next to stem the financial crisis. Neither expanding the EFSF nor issuing so-called E-bonds has found strong support. In effect, the eurogroup meeting brought no new decisions on the stability fund or the so-called Eurobonds. Eurogroup head Juncker said a widening of the fund is not immediately necessary, and EFSF chef Regling also said the fund is big enough, while repeating that the fund will issue debt next year, with no problems expected and positive signals from investors world-wide. The fund will be issuing its own debt (a smaller form of the Eurobond) but indebted nations are now calling for euro-zone wide bond issuance mechanism. A German-Netherlands-Austria axis has been sufficient to stymie additional reforms at this juncture and peripheral bonds continue to be under modest pressure.

The Irish budget vote appears a bit anti-climactic after two independent MPs signaled their intention to vote with the government today. The budget debate will begin around 10:45 am EDT and the vote is scheduled for around 2:00 pm EDT. The government’s budget will include about €4.5bln in spending cuts and €1.5bln in tax increases. In order to meet the budget targets while keeping the senior bond holders whole is forcing the government to include more people in the income tax net, cut minimum wage by about11.5% (to €7.65 an hour) and trim welfare benefits. Outside of some headline risk, the market may be looking beyond the Irish budget toward 1) the political fallout, elections early next year and the risk some a new government will want to re-negotiate some aspects of the budget and aid package and 2) an appreciation that with the rate of interest on the aid package set significantly above growth potential suggests no near-term stabilization of debt to GDP ratio. Consequently, as the markets have learned by the Greece experience, the situation is unresolved in any meaningful sense, except that the paper chase and confidence game can continue a bit longer.

RBA left rates unchanged at 4.75%. The Bank said that lending rates are above average and that current policy is appropriate for the economic outlook. The statement is supportive of no change in rates through early next year, although consistent with Governor Stevens’ view in his November 26 testimony that is not unreasonable for the market to price in a hike in the middle of next year. Indeed, the OIS swaps market implies a 25bp increase in the overnight rate over the year. The Bank noted that the household sector continues to show some caution in spending and borrowing while credit growth has been "quite subdued." Employment growth is seen at a possibly more modest pace going forward. As for inflation, the run-up in the exchange rate is seen containing pressure on inflation, with inflation is expected to be little changed over the next few quarters. Yet the statement also noted developments supportive of a return to rate hikes next year such as the positive terms of trade shift stoked by external demand. The Chinese and Indian economies have continued to grow strongly and domestically, terms of trade are at their highest level since the early 1950s, producing strong national income growth. And finally, inflation is seen increasing "somewhat over the medium term." According to the implied probability from the Australian Bill’s future contract the highest probability of a rate hike is from March to June of 2011, with a greater than 60% chance that rates will be higher than the current 5.04%.

Upcoming Economic Releases

At 10:00 EST / 14:00 GMT the US releases it’s Dec IBD/TIPP economic optimism index. The index is expected to increase marginally to 47.2 from 46.7 in November. Later on in the day the US also reports consumer credit and ABC consumer confidence. The consensus is for a -$1bln in consumer credit. In Canada, the BoC announces its policy rate at 9:00 EST / 13:00 GMT which is largely expected to remain unchanged at 1%.