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March 27th 2011: Weekly market Preview - Have Euro leaders miscalculated?

The ECB and Euro-zone governments have both laid out their policy intentions and the next week will be extremely important in determining whether these decisions were correct and are sustainable. The ECB wants to concentrate on inflation and is still looking to push ahead with an interest rate increase at the April meeting. As far as the Euro –zone governments are concerned, a decision on strengthening the interim stability mechanism will be delayed until June following failure to reach agreement at last week’s Summit meeting.

With the Prime Minister forced to resign after losing a parliamentary austerity-package vote, Portugal remains a dead man walking and will soon fall into the arms of the stability fund. Although certainly a setback, in the bigger picture the harsh truth is that Portugal did not matter that much. The key for the EU now is to draw a line in the sand and stop any further contagion spreading to Spain, Italy, Belgium and even France. If they are unable to do so, then the Euro’s short-term outlook will be bleak indeed. In this context, the decision to delay a decision on strengthening the EFSF until June is extremely risky as the markets may well demand a response well before then, especially if confidence in Spain’s banking sector deteriorates further. Political tensions would be close to breaking point if the EU is forced into hasty action to protect Spain.

If European fears intensify over the forthcoming week, then there will be intense pressure on the ECB to defer any interest rate increase. Their decision to effectively pre-announcement the April increase would then look like a serious miscalculation and the central bank cannot afford to make such mistakes, especially as it faces a leadership transition later this year.

As far as economic data is concerned, the focus will certainly be on the US employment releases with the ADP report on Wednesday and pivotal monthly BLS payroll report on Friday.

The recent US data has certainly been a very mixed bag with sharp declines in new home sales and a weak durable goods report. Jobless claims, however, have remained below the 400,000 level throughout the month which suggests that the underlying labour market is still firm. Erratic data remains a risk, but there should be a solid payroll report.

The consumer confidence data will also be watched closely as there was surprising weakness in the recent University of Michigan consumer confidence reading. After a run of favourable readings, the March figure dipped sharply to a 12-month low. No doubt, rising energy prices played a significant role, but an important question is whether consumers are picking up an underlying deterioration in conditions or simply reacting to headlines. Usually, consumer sentiment is a lagging indicator, but a sharp confidence decline could certainly be significant.

At this stage, it looks unlikely that the data will jolt the Fed from its baseline expectation that QE2 will be maintained until completion in June while there will be no QE3.

There are no major UK pieces of data until the PMI data on Friday, but Sterling risks demonstrating the very fine line between optimism and pessimism. Less than a week ago, Sterling pushed to a 15-month high close to 1.64 against the dollar before dipping back to near 1.60 on Friday as ratings agencies expressed reservations. If markets sense blood over the UK growth and ratings outlook, the Sterling decline will be swift indeed.

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