July 30th 2012: Weekly preview - This week decides the Euro-zone's fate
The importance of this week should not be underestimated and there is very little chance of the Euro surviving in its current form if Germany fails to blink. ECB President Draghi has laid down the gauntlet, putting intense pressure on the German government and Bundesbank to allow much more decisive support measures to keep the Euro together. If Germany fails to bend, the Euro area will fracture terminally on a torrent of capital outflows. If the ECB does take further action and Germany shows some flexibility, which is the more likely outcome, there will be relief surrounding risk appetite, but there is still very little chance for a sustained Euro rally as the price for a salvaged Euro-zone area would be a sharply weaker currency to help underpin the economy. Any initial Euro gains would be eroded rapidly.
ECB President Draghi has prepared the ground for Thursday’s ECB meeting with his comments last week. These were certainly not off-the-cuff remarks and they represent a key strategy to help rescue the Euro-zone in a recognisable form. The problem for Draghi is that he has raised the stakes and expectations dramatically. In this context, if he cannot get support for his proposals, then market sentiment will turn extremely ugly and put the Euro under intense selling pressure.
The evidence suggests that Draghi will push for fresh bond buying by the central bank, together with an interest rate cut and a fresh LTRO. Clearly, there will be no opposition to such aggression from the peripheral central bank representatives who are desperate for any measures to support demand conditions. The debate with representatives from the core Euro countries will be much more difficult. There will be concerns that demand within the Euro-zone is deteriorating fast which will maintain the pressure for further action. Germany, however, will be extremely uneasy over the medium-term outlook for inflation and there will certainly be very tough opposition to further non-conventional measures such as a resumption of bond buying through the SMP.
There is certainly the potential for a bitter dispute within the ECB and open disputes between key players would risk a major deterioration in confidence surrounding the ECB and wider Euro-zone. It is possible that Draghi is proposing to throw every conceivable measure it can to throw at the crisis and hope to get as many past the German defence. Nevertheless, if the ECB fails to get German backing, then there will be a surge in selling pressure on Spanish and Italian bonds.
The Greek outlook will remain an important focus during the week and, despite some proposals for central banks to take a haircut on Greek holdings, there is increasing evidence that it will be cast adrift with little prospect of further loan support.
The US Federal Reserve will also face an extremely important decision on Wednesday. There will certainly be a complication in that the ECB meets after the Federal Reserve and the Fed is theoretically acting blind. There is, however, a strong probability that it will be given clear insight into the ECB’s actions. There is certainly a growing chance of Fed involvement as part of a co-ordinated effort to underpin demand. If the Euro is to be salvaged, the currency will need to depreciate sharply and Fed inaction will be critical in helping to resist renewed aggressive dollar deterioration. In this context, the ECB measures will be diluted if the Fed boosts quantitative easing. Ironically, therefore, although Fed action could boost market confidence in global demand, it may well be best served by holding policy steady for now.
The data for the week ahead will inevitably be dominated by the US payroll data on Friday. The impact may be lessened to some extent by the fact that it follows the crucial central bank meetings. If the Fed has already taken action to boost quantitative easing, then the payroll impact will certainly be lessened. The data will be much more important if the Fed signals that future action will be dependent on future activity. In this context, another weaker than expected figure would certainly increase the potential for further action at September’s FOMC meeting.
Ahead of the payroll data, the latest ADP release is due on Wednesday followed by the jobless claims data on Thursday. The US manufacturing PMI data will also be extremely important on Wednesday, especially following the dip to below the 50 level last month. Another sub-50 reading would certainly fuel expectations of a further slide in the economy as a whole. A weak release would also increase pressure on the services-sector data due on Friday.
The Bank of England policy meeting will also be held on Thursday. This gathering should be broadly uneventful following the quantitative easing seen last month. It is unlikely that the bank would want to take further action at this time unless there is some form of global co-ordination.
The UK economic data will certainly be watched very closely during the week. The latest manufacturing release is due on Wednesday followed by the construction data on Wednesday and services release on Thursday. The most important release will be the services data and a slide to below the 50 level would pose severe risks for the UK outlook.
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