Euro Gains Despite Portugal Downgrade; Equity Markets Higher

Highlights

US dollar was weaker vs. the majors, as the euro recovered to end the day higher after it fell to its lowest level vs. the dollar since July 6.  Moody’s downgraded Portugal to A1 from Aa2, but this was offset by strong Greek T-bill auction.  The yen and Swiss franc both softened too as risk appetite came back after strong Alcoa earnings report Monday kicked off US earnings season.  EM FX mostly stronger.  Biggest gainers on the day vs. USD were NOK, HUF, ZAR, MXN, and SEK, while only losers vs. USD were KRW, PHP, and TWD.  US trade gap was bigger than expected in May (-$42.3 bln) and may drag down Q2 growth forecasts slightly, while June budget gap was slightly lower than expected.  Hungary and Poland CPI inflation both higher than expected in June.           

US equity markets were higher, as DJIA, S&P, and NASDAQ ended up 1.4%, 1.5%, and 2.0%, respectively.  European markets were higher too, with Euro Stoxx 50 up 1.9%.  Asian equities are likely to open up today as Asian ADRs were higher during N. American trading Tuesday.  Nikkei futures point to an up Japan open, and the softer yen should help Japan exporters.  US earnings season continues with Intel after markets close Tuesday.

US bond market was lower, as 2- and 10-year yields were up 1 bp and 5 bp, respectively.  European bond markets mostly lower too, as 10-year yields in UK, France, and Germany were up 4 bp, 4 bp, and 5 bp, respectively.  Greek 10-year yields fell 4 bp, Portugal rose 9 bp, Italy rose 3 bp, and Spain fell 2 bp.   

Currency Markets

There is a full slate of US economic reports on Wednesday.  Import prices likely fell for the second consecutive month, something that has not happened since late 2008/early 2009.  The consensus forecast of -0.3% would bring the y/y pace to 5.3% from 8.6% in May.  This would be the lowest y/y reading since last November.  There seems to be little correlation between the euro-dollar, dollar index, or a trade-weighted dollar index and import prices, even when we change lag times.  June retail sales are expected to have contracted by 0.3% m/m after falling 1.2% in May.  This would be the first back-to-back decline since Feb-March 09.  Most of the decline will likely be attributed to weakness in auto sales and a decline in gasoline prices.  Excluding these two items, retail sales may have edged higher.  With high unemployment, heightened job insecurity and serious financial uncertainty on many different levels, it is hardly surprising that the US consumer has withdrawn a bit.  Business inventories will be released at 10:00 EST/14:00 GMT.  Many economists believe that the inventory cycle, in terms of contribution to GDP, may have peaked already.  The May business inventories will likely lend credence to such ideas.  The consensus forecast calls for a 0.3% increase and follows a 0.4% increase in April.  The average monthly increase in Q1 was 0.5%.  Of course, there is a price component here that is next to impossible to forecast, but inventory accumulation appears to be at a more subdued pace.  The last report of the day is not data per se, but the minutes from the recent FOMC meeting.   This also does not tend to be a market mover.  However, this time it is likely to have added significance.  The FOMC minutes will likely contain two things that will interest investors.  First, the Fed’s staff is expected to have updated its forecasts.  Both growth and inflation forecasts have likely been cut.  Second, and which follows from the first, is that there may have been some discussion of what to do if inflation and growth are going to undershoot previous Fed expectations.  One of the talking points that has emerged in recent days by a number of observers is a re-examination of Bernanke’s 2002 speech about how the Fed could prevent Japanese-style deflation in the US.  It is possible that a discussion of the Fed’s options took place.  However, judging from recent comments from a number of voting and non-voting Fed officials (Fisher, Hoenig, Lacker, and Duke), the bar to a resumption of asset purchases seems relatively high.  That said, if in fact there was such a discussion it could move the markets even if the Fed did not decide to act.  On balance, provided that the news from the euro zone remains benign (or at least the bad news, like Portugal’s downgrade, can be offset with more constructive news, like a relatively favorable reception to Greece’s bill auction), soft US economic data or price data, is likely to be dollar negative.  Last Thursday, we warned that a weekly close above 1.2650 would set a new target for the euro into the 1.30-1.31 area.   The euro closed at 1.2640 last week.  The technical conditions, including the head and shoulders bottom formation, suggest that an upside correction to the euro (and the major foreign currencies in general) can continue.  Most immediately, Tuesday’s high corresponds to the trend line drawn off last Nov’s high and mid-April highs.  A move above 1.2740 lends credence to this constructive euro view.

Spain’s Finance Minister Salgado says the downgrade of Portugal by Moody’s does not put pressure on Spain.  It is true as far as it goes, but of course Spain’s problem transcends Portugal.  The ruling Socialists in Spain are seven seats shy of a majority and it has had to depend on smaller political parties for key votes.  The economic austerity measures passed by a single vote in late May.  The Catalan Party (CiU) has warned the Socialists that it will not support the 2011 budget proposals, which will be voted on in September and could threatened the viability of the government. A greater sense of Spain’s political climate may be seen in the coming days as state of the nation debate gets under way, with votes likely next week on various proposals. Our proprietary models suggest the Spain’s macro-economic situation is more consistent with an A rating than the AA from S&P, Aaa from Moody’s, and AA+ from Fitch.  Spain’s 10-year yield is 202 bp on top of Germany, widening 24 bp over the past month.  Moody’s just placed Spain’s bank rescue fund on watch for a possible downgrade.  The fund, known by its Spanish acronym FROB is currently rated Aaa by Moody’s.  By putting it on watch, Moody’s is signaling a likely downgrade in the next three months.  Separately, Fitch has indicated that FROB has sufficient funds (max 99 bln euros), when coupled with existence of loan loss reserves and other reserves  (est. 68 bln euros) to achieve a 6% common equity assets ratio for the overall Spanish banking system.  However, FROB has to raise funds in excess of 9 bln euros in the capital markets, and as a sub-sovereign issuer.  Recall that FROB was initially to help facilitate consolidation among the cajas.  Yet as Fitch notes, their ownership structure is not very clear.  Recent reforms in Spain ban politicians from owning cajas and this was seen as an effort to make it easier for them to raise capital, if/when necessary.  It is widely appreciated that Greece and Portugal are small compared with Spain.  The EFSF mechanism and the stress tests are due out in a little more than a week, and fund managers are looking at peripheral Europe to see if there is value.  Given Spain’s size, some see European officials as having successfully built a fire wall around Spain.  That said, investment in Spain has three risks that we have sketched here. 

Upcoming Economic Releases
Asia: NZ retail sales; Singapore GDP, trade; Korea unemployment; BOJ, BOT meetings Europe/EMEA:  UK jobs; euro zone IP; South Africa retail sales Americas:  US retail sales, import prices, business inventories, FOMC minutes; Argentina CPI; Brazil tax revenues; Colombia trade.  No US speakers of note.