Hopes surrounding a shift in tone at Fed Chairman Bernanke's congressional testimony are likely to underpin risk appetite at the start of the week and keep the dollar generally on the defensive. Bernanke is likely to keep all options open at this stage which may disappoint the most ardent optimists and trigger a more sober market tone, but should for now at least prevent a meltdown in risk conditions. Bernanke is likely to adopt a slightly more dovish tone and may shy away from quantitative easing by looking to explore other policy avenues, especially with Treasury yields already at historic record lows.
Any improvement in risk conditions should not be confused with the likelihood of an extended Euro rally as the currency is still likely to be crushed on political and economic grounds as divisions intensify. A key feature during the coming week is likely to be a further breakdown of the relationship between global risk appetite and the Euro. The political and economic risks are continuing to build within the Euro area as the cohesion is unravelling rapidly. The political and economic dynamics are pushing Europe in a dangerous direction towards factionalism which is extremely dangerous from a longer-term perspective. Trends in benchmark bond yields will again be the yardstick for underlying tensions within the Euro area.
From a short-term perspective, if risk conditions improve, there will be the risk of the Euro being used as a funding currency, especially with the ECB taking a more aggressive stance.
Fed Chairman Bernanke's congressional testimony is always an extremely important market-moving event and this semi-annual appearance on the economic outlook will certainly be watched particularly closely. The Fed chief will face the Senate Banking Committee on Tuesday with the House of Representatives 24 hours later.
The sense of gloom surrounding the US outlook was lifted slightly by a decline in jobless claims to the lowest level since March 2008, but the economic storm clouds have been gathering after a series of disappointing payroll reports and overseas vulnerability.
The latest Fed minutes confirmed that the FOMC had edged moved slightly closer to additional quantitative easing and there were potentially important comments from Regional Fed President Lockhart on Friday. He stated that the current policy would be untenable if conditions deteriorated and the net tone of his comments clearly indicated greater concern over the outlook. Lockhart is not one of the ultra doves on the FOMC and the fact that his views have shifted slightly is certainly important.
Bernanke's narrative will therefore be extremely important for market sentiment. In particular, markets will be looking to assess what could conditions could trigger additional Fed action. It will also be important to assess whether political considerations will have an important impact on the Fed's thinking ahead of November's Presidential election.
There is a high risk of a much more dangerous phase later this quarter as markets are forced to contemplate the impotency of central banks and governments as they will have increasingly limited effectiveness in supporting demand conditions.
There are important US economic data releases with retail sales due on Monday followed by the consumer inflation release on Tuesday and housing data on Wednesday. The most important release of the week could well be the Philadelphia Fed survey on Thursday. The last two releases have been sharply weaker than expected, increasing unease over the manufacturing sector as a whole as the national PMI index dipped to below the 50 level for the first time since the third quarter of 2009. The index is always prone to high volatility and it also dipped into negative territory in 2011, but another very weak reading would increase unease surrounding the outlook.
The most important Euro-zone release will be the German ZEW index on Tuesday. The recent evidence has suggested that the German economy is now being undermined by the wider Euro-zone stresses and the slowdown in key export markets such as China. The ZEW index fell very sharply for June and another rapid decline for July would undermine confidence in the German outlook. There would also be an important political impact as pressure for a shift in German stance would also increase.
As far as the UK economic releases are concerned, the latest unemployment data will be released on Wednesday with the government borrowing data on Friday with the retail sales data sandwiched between the two. The data will be very important in showing the economic trajectory at the start of the third quarter, especially as the latest NIESR data suggested that the economy contracted again for the second quarter. The Bank of England minutes will also be watched closely on Wednesday to see whether the MPC was close to expanding policy even further at the July meeting. Sterling looks to be on borrowed time given the fundamental backdrop.
The Bank of Canada will hold its latest monetary policy meeting on Tuesday and looks to be the best-placed G7 bank not to submit to the general mood of gloom and there is no possibility of a cut in interest rates.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
