Eventful Week Begins Slowly

In fact, consolidation is the general theme in the broader capital markets as well. Equity markets are narrowly mixed, with the MSCI Asia Pacific eking out a marginal gain and the Dow Jones Stoxx trading with a slight downside bias in the European morning, Spanish and Italian bond yields are firmer across the curve as ECB buying does not appear imminent.

The economic news stream has been light. Two developments stand out. First, French industrial production data (July), like German data reported last week, was stronger than the PMIs had suggested. French output rose 0.2%, led by a 0.9% rise in manufacturing output. The consensus had expected a 0.5% decline on both the headline in manufacturing output. Second, China's data generally disappointed. Over the weekend, it was reported that industrial output fell to its slowest pace in three years in August, while CPI ticks up for the first time in five months. Today's news of a wider trade surplus ($26.6 bln from $25.1 bln) was a function of a small increase in exports (0.6% on the month), but a unexpected fall in imports (-0.3%).

The combination of the heavy event risk coupled with the mutli-year low in the three month volatility in both the euro and yen underscores the market's vulnerability. A theme many investors appear to have latched on to is the policy response whose anticipation has been building in recent weeks. Such a response reduces what in the market's vernacular is a reduction of tail risk.

Yet it is not quite what was anticipated. Many had expected some kind of monetary response, either with a reduction in required reserves or a cut in key rates in response to the continued signs of a slowdown in the world's second largest economy. Instead, China has responded with infrastructure spending. Reports indicate that some 60 projects, valued at almost $160 bln, have been approved, which is about 2% of GDP. This may overstate the case as Xinhua news agency reported that many of the project had previously reported.

The ECB announced the Outright Monetary Transaction (OMT) program. However, the success of the anticipation in driving down Spanish and Italian interest rates and CDS prices makes it unlikely that the ECB will be buying a single Spanish or Italian bond in at least the near- term. Spain's Prime Minister Rajoy continues to show no sense of urgency and continues to resist the pressure from Europe officials.

We are still a month away from a near-term resolution. The "key date" now appears to be the mid-October EU Summit. Spain has a large bond redemption in late October, which may provide additional pressures. Italy is even further away from requesting assistance. Italy's BTP auction on Sept 13, with yields near six month lows, will be the first such auction since the ECB meeting.

That leaves the Federal Reserve as the one place where the action is most immediate and likely. The US's economic performance is not spectacular, but it is among the best for the large high income countries. Most OECD countries wish they had the US economic performance. Growth appears around 2% and looking slightly firmer in Q3 over Q2. Even in the best of times, most EU countries do not expand by 2%. Consumer prices are also rising at a rate of about 2%, around what some central banks actually formally target. Yet this is simply not good enough for the Federal Reserve. Following the disappointing August employment report, the risks of a new balance sheet expansion exercise have increased. Estimates appear to largely range between $300-$600 bln.

There are four other important events that can be anticipated this week. First is the Germany Constitutional Court ruling on September 12, though some reports suggest it may be delivered on the 11th instead. Given that the German parliament has already approved the ESM, it is difficult to envision the court overturning it. New conditions or limits may be imposed, but if the Court were to declare that any deeper integration would require a referendum or constitutional change this would have greater potential to have market impact.

Second, the Dutch election is the same day. The polls suggest a close race between the Liberals and Labour. Investors should be prepared for it to take some time to cobble together a new government.

Third, the Swiss National Bank meets amid some speculation they might lift euro/franc floor from CHF1.20 to CHF1.22. We think this is unlikely as the additional potential cost does not appear to be worth the potential gains of less than a 2% depreciation of the franc.

Fourth, the EC President, Barroso, is expected to outline proposals for EU banking supervision. Ironically, within days of the ECB's critics arguing the central bank has overstepped its authority, the EU will propose giving great supervisory responsibility. The key here: the debate that will ensue means that it is unlikely to be launched at the start of next year as had been hoped. This is turn limits the ability of the EFSF/ESM to lend directly to banks.