European euphoria

Good day, and welcome to another Monday morning. It was quite a wild ride last week that took us from one extreme to the other in the span of a few short days. I was sitting here trying to think of something that I could draw for comparison, and for some reason the old TV show The Incredible Hulk popped into my head. I was picturing the mild-mannered man going about his everyday life and then something triggers the transformation into this green monster that nobody understands or likes. Fear then jumps into the picture along with overreaction, and then as quickly as the Hulk wreaked havoc, he disappears and we see that same mild-mannered man walking down the street with his backpack until the next eruption.

I know that’s it’s too easy to let yourself get sucked into the latest episode, but in these times, looking at the big picture will probably be associated with prudence. We went from the European problems almost boiling over, at least from a headline perspective, to an improvement in the outlook that things might end up being all right by the time we packed it up for the weekend. I’ll be sitting at master controls until tomorrow, and then Chris takes us through the weekend as Chuck stays off the grid while he takes his summer vacation. If we take a look at the currency returns from last week, it actually turned out to be a decent week, as most currencies appreciated by about 1%. I’ll hit on the currencies later, but first, let’s take a look to see what happened on Friday.

As Chris reported, things got started as European policymakers said they would do everything necessary to protect and preserve the euro (EUR).  Those words alone were enough to move the markets and provided the security blanket they were so desperately seeking. Who knows how long this will last, but it’s a what have you done for me lately kind of world that we live in, so we could be singing a different tune by the end of the day. A big part of the issues we saw early last week stemmed from the perception that the ECB wasn’t taking enough steps, but this broad statement did the trick. The question now becomes what does everything exactly mean.

It’s looking more likely that another round of bond buying or quantitative easing will soon be on the horizon. ECB president Mario Draghi is supposed to meet with the Bundesbank in an effort to come up with a plan. It’s reported that Europe’s rescue fund will buy government bonds on the primary market while the ECB purchases on the secondary market in order to reduce borrowing costs for Spain and Italy. Additional rate cuts and loans to banks are also on the table, but the fact that Germany appears to be on board is not only a must, but also adds instant credibility. Officials said that giving a banking license to the European rescue fund isn’t a part of the immediate plan, but would provide assistance down the road.

At the end of the day, European officials threw the markets a bone in hopes they stay preoccupied for a while, or at least until they’re done scrambling around. I’m sure we’ll get some pushing back and forth before the ECB Governing Council meets on Thursday, so it could be another bumpy ride. This week also looks to be a busy one for U.S. economic data, so maybe things won’t be as bad, since all eyes won’t squarely be focused on Europe. First, let’s take a look at the economic prints from Friday.

We finally saw confirmation that the second quarter did, in fact, slow down, which came as no surprise. The first print of second-quarter GDP came in marginally better than expected at 1.5%, but was considerably lower than the revised first-quarter printing of 2%. Bernanke recently said that economic activity appears to have decelerated somewhat during the first half of the year, but I would say it’s a complete understatement. I don’t know about you, but I would say a 51% fall in economic growth in the first quarter compared with the fourth quarter and then followed by a 25% fall in the second quarter would be considered more than somewhat of a deceleration.

There were a ton of revisions made to growth figures over the past few years, some positive and some negative, but that’s all out of sight and out of mind. I did come across an interesting tidbit called Okun’s law, which is name after the late Yale professor Arthur Okun. This observation tries to correlate the statistical relationship between GDP and unemployment changes. The gist of it basically says that for every 1% year-over-year growth that exceeds the trend rate, which the Fed defines as between 2.3-2.6%, unemployment should drop 0.5%.

The rubber that meets the road here is that the unemployment rate dropped 1%, going from 9.5% in June 2009 to 8.5% in December 2011, but GDP grew at an average 2.3%. If my math is correct, then we would have needed a 4.3% GDP growth rate to support the fall in unemployment, assuming the lower end of that range. Those of you who are frequent readers know one of the explanations of how this can happen, namely the government simply not taking an accurate count by excluding certain segments. But that discussion is for another day.

Moving on to more disappointment, personal consumption fell to 1.5% in the second quarter, from a revised 2.4% showing on the previous report. The 37% reduction in household spending was the ninth time over the past 10 reports and remains consistent with the gloomier outlook in corporate spending. Consumer spending is the lifeblood of the U.S. economy so these types of reports don’t paint a rosy picture. There isn’t much on the horizon that would look to provide a jump-start, so as long as employment gains remain grounded, these types of results would look to be the norm.

We also saw the final revision to July consumer confidence, and it didn’t end pretty. The index came in at 72.3 and represents the lowest level of the year so far as the usual suspects remain at play. The employment picture is, obviously, the big one, but the troubles in Europe and the rough patches in the financial markets for the better part of the month also had a heavy hand. It would be one thing if there were light at the end of the tunnel, but unfortunately, it’s still very dark, so it’s no wonder the consumer outlook over the next six months has waned.

As I mentioned, it’s going to be a jampacked week, so there’s going to be plenty of stuff on the minds of investors. We ease into it today, as we’ll see only the Dallas Fed manufacturing report, which is expected to show more weakness. But we take off from there. Some of the big reports that we have in store include personal income and spending, manufacturing, the FOMC meeting and the all-important July jobs report. The two reports that should pack the biggest punch are be the Fed meeting on Wednesday and the July jobs jamboree on Friday. The Fed rate decision is a given, but the markets can’t wait to see if there will be any stimulus talk, so look for some volatility leading into the meeting.

With economic growth slowing as much as it has and consumer spending remaining in the same boat, you would have thought the stock market was headed for some trouble, but it did the exact opposite. The euphoria, as temporary as it may be, from Europe spilled over and just goes to show you that the markets were looking for an excuse to rally. At the same time, aggregate earnings from S&P 500 companies are expected to drop 0.8% in the second quarter for the first time since 2009, so it was just a matter of time before slow consumer growth went full circle. I’m not even your last choice on looking at the stock market, but thought I would report what I saw.

Well, I told you as I opened the show that it actually turned out to be a decent week for the currencies, but that’s not to say it wasn’t a bit hair-raising for a few days. The South African rand (ZAR),  which was getting clobbered, turned in the best score card by rising 1.5% to end the week. Surprisingly enough, the euro finished runner up with a gain against the dollar of 1.35%. How about that for a turn of events? The yen even turned a fractional gain, so everything finished up, including both gold and silver. As we’ve warned many times in the past, this market volatility has no sense of direction and can snap either way at a moment’s notice.

The change in scenery that really caught my eye as I was heading out the door to start my weekend was the fact the euro was trading with a 1.23 handle and the price of gold was firmly above $1,600. In fact, the euro touched a three-week high of 1.2377 on Friday morning amid the proclamation from policymakers, even though Spanish unemployment rose to 24.6%, the highest on record, and Italian business confidence fell more than expected. Aside from the euro, the announcements also had a profound impact on bond yields as Italy’s 10-year yield fell below 6% and the Spanish counterpart fell to 6.74%, which is a far cry from a couple days prior.

The Canadian dollar (CAD)  got close to breaking on through to the other side of parity, which it hasn’t seen since mid May, as it traded all the way to $0.9965. The rise in oil prices and stocks represented the helping hand. We didn’t see any economic data that would have gotten the ball rolling, so it was merely a risk on type of move. The increased risk appetite also cast both the Australian dollar (AUD) and New Zealand dollar (NZD)  into the top of the charts on Friday, so the word of the day was definitely risk on.

In the spirit of the Olympics, I’ll move over to the pound sterling, (GBP)  which did manage to squeeze out a slight gain on Friday by trading into the 1.57 handle. The Bank of England, and the ECB, for that matter, meets later this week and is expected to maintain its bond-buying program. It’s not likely they will increase the scope, as they’ll most likely want to see the progression thus far. Since the U.K. has found itself in the middle of its first double-dip recession since the 1970s, it’s no wonder why they have only allocated $14.6 billion of public money to host the summer games, compared with the $70 billion that China forked over on the Beijing Olympics. That’s about as black and white as you can get.

Jumping around a bit, the rand got a boost as central bank officials explained that further monetary easing isn’t automatic. After they took the markets by surprise in cutting rates at the previous meeting, the markets translated that action into the start of another rate cut cycle. While the Swiss franc (CHF) is connected at the hip with the euro, we did see a leading indicators type of report rise for a sixth straight month, and to the highest level in nearly a year. The domestic economy has been hanging on with unemployment remaining at three-year lows, but the continuing slowness out of the eurozone is expected to take its toll as the year progresses.

In another surprising turn of events, the Norwegian krone (NOK)  finished in last place on Friday by falling 0.5%. There weren’t any data reports to initiate its depreciation, so it looks as though the increased sentiment from the eurozone prompted some movement out of the so-called safety of Norway. The fundamentals remain in place, and its high sovereign credit rating remains a beacon for the safe-haven flow of money, but as we saw, the opposite effect is also possible.

As I came in this morning, the dollar has regained some lost ground against the euro as Spain’s second-quarter GDP contracted 0.4%. We also had a European consumer confidence indicator fall to the lowest level since September 2009. On the opposite end of the spectrum, the Swedish krona (SEK)  has put together a decent day so far, as their second-quarter economic growth increased more than expected, to 1.4%. Other than that, gold and silver are sitting on slight losses, but it’s shaping up to be another day for the dollar.

Then There Was This: Evidence signals wider Libor manipulation; FSA to fast-track review. In addition to Barclays, Royal Bank of Scotland and UBS might have been deeply involved in manipulating the London Interbank Offered Rate, according to court documents and sources. “RBS is one of the banks tied up in Libor,” CEO Stephen Hester said. “We’ll have our day in that particular spotlight as well.” Other information suggests manipulation began in earnest in 2005. U.K. Chancellor George Osborne instructed the Financial Services Authority to fast-track a review of the matter and report its findings by the end of September.

To recap: Which market personality will show up today? It was all about European optimism as policymakers pledge to do everything possible, so now we just need to wait and see what actually happens. Aside from a rise in the euro, the other immediate impact was the fall in Italian and Spanish bond yields. Second-quarter GDP and consumer spending both slowed and just confirmed that things aren’t heading toward the right path. It’s going to be a busy week in the data department, with the Fed meeting and July employment numbers holding the most weight. The currencies ended the day as well as the week on a positive note. And Olympic spending tells a tale.

Mike Meyer
for The Daily Reckoning

The Daily Reckoning