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China's Q1 GDP disappointed expectations and market rumors and is the chief driver of the capital markets today. The official measure of growth was 8.1%. The consensus was 8.4% before yesterday's rumors of a 9% rise made the rounds and helped lift sentiment--seeing equities rally, gains in the dollar bloc currencies and a weaker dollar. All that is in reverse now.

Nevertheless the major foreign currencies look fairly resilient and the risk is that they continue to recover into the North American morning and topping out before the close of the European session. This could see the euro move toward $1.3200 and the Australian dollar toward $1.0430, which may offer more attractive selling areas.

The combination of renewed hopes of China easing (though I personally suspect China is not in a big hurry to do so) and the failed North Korean missile test helped lift Asian equities, with the MSCI Asia-Pacific Index up almost 1%, the real political tension now has gone largely unnoticed. The standoff between China and the Philippines is becoming increasing tense, with both sides sending military reinforcements, according to press reports.

A sharper than expected slow down in China means something else in Europe. Given the focus on austerity in Europe, the key question, I keep returning to, is where will aggregate demand come from? Stronger world growth would help. Softer Chinese growth is seen as a proxy for emerging markets in general and other fast growing markets.

The risk is that economies may contract faster than austerity can be implemented, leading to higher deficit to GDP ratios, which then require more savings and hence another vicious cycle. Is it little wonder why the Spanish stock market is falling to new 3-year lows today? The 5-year credit default swaps on Spain's sovereign is making new highs for the year today and approaching the record high just above 491 last November. LTRO? What LTRO?

Separately, Italy reported a 0.7% decline in February industrial production. A 0.2% decline had been expected. And even this understates the seriousness. Manufacturing plunged 1.1% after a 0.9% drop in January, when headline industrial output fell 2.6%. Italy's equities are off about 4.7% over the past five sessions, joining Spain, Portugal, the Netherlands (AEX) lower on the year now.

Little noticed, the Federal Reserve reported late yesterday that its holdings of Treasuries for foreign central banks rose to a record level in the week through Wednesday. The $2.759 trillion just surpasses the previous record high set last August. As this week's quarterly refunding settles, it would not be surprising to see a further rise in next week's report.

It is interesting to note that of the $5.048 trillion of US Treasury held by foreign investors, the Federal Reserve is holds about 55% in its custody account. Since mid-January, custody holdings have risen by about $100 bln. The healthy reception to this week's Treasury refunding, the custody holdings, and yesterday's news that China's reserves jumped about $124 bln in Q1 (on a cumulative $2.15 bln trade surplus) should help ease some anxiety that the low US yields were deterring buyers.

Lastly, in the emerging market space, South Korea's central bank stood pat, but Governor Kim's comments were somewhat hawkish. There was the obvious relief that the North's missile test was a flop. Arguably even more surprising was Singapore's decision to tighten policy. With Chinese landing still to be determined, many thought Singapore would be more content to wait and see, though Singapore data has surprised on the upside with Q1 GDP rising 9.9% quarter-over-quarter and retail sales spiked to 19% year-over-year. The Sing dollar rallied, with the greenback pushing toward the SGD1.24 base.

Source: China Disappointment Buoys Dollar