The U.S. fiscal cliff is a major media talking point, but the eurozone political cliff is the much more pressing threat as elected governments risk a rapid loss of control. With intense pressure to help fill the political vacuum, the ECB is likely to cut interest rates this week and trigger a renewed flood of defensive funds into the Swiss franc and yen. Any euro rally on a Spanish bailout request would reverse very quickly as October political and economic storms intensify.
The eurozone remains in a binary outlook as it will either survive intact in a weakened form or exist as a smaller currency union based around Germany. The denouement is coming ever closer, illustrated by the fantasy budgets presented by Spain and France last week. The Madrid government in particular is increasingly isolated and distanced from domestic realities, a sure sign that a political end-game is approaching fast with levers of power increasingly ineffective. Developments in Catalonia and within Greece will need to be watched very closely as the scent of rebellion becomes ever stronger.
There must be a growing sense of panic within the ECB with increasing fears that it has been left hanging out to dry. Backsliding by Germany on conditions for the ESM and banking union, allied with severe political stresses within Spain, are threatening to derail the ECB strategy. For now, the bank has no choice but to continue to whatever it can to salvage the euro and keep policy extremely loose.
A key fact for the bank to consider is that the economic environment is continuing to deteriorate. Confidence levels may have been improved initially by the ECB plans, but the PMI indices remain at three-year lows with the latest money-supply and lending data also disappointing. The latest austerity budgets in Spain and France can hardly have improved the overall mood, and the economy is set to contract sharply for the third quarter. In this environment, the ECB is set to cut benchmark interest rates again. The negative euro impact is likely to be intensified by the risk of growing splits within the Governing Council, especially after the higher than expected inflation reading last week.
The latest Swiss reserves data will be extremely important on Friday. The most recent release showed a notable slowdown in the rate of reserves accumulation which suggested that pressure on the euro had eased. Care is of course needed in looking at monthly data as the bank can manipulate the data to some extent, but there will still be very important evidence on underlying pressures both on the Swiss franc and the euro. A big increase in reserves would be very negative for the euro.
The latest U.S. employment data on Friday will inevitably trigger fresh volatility, especially if there is a figure substantially away from consensus. There is unlikely to be a major impact on interest rate expectations as the Fed has signaled that it will maintain an aggressive monetary stance and push ahead with mortgage security buying even when the unemployment rate starts to decline.
A weak figure would strengthen the hand of doves within the Fed while a robust reading would be important in increasing inflation expectations and strengthen the hand of dissenters. In this context, the Thursday FOMC minutes will certainly be important to assess the divisions within the Fed and the medium-term policy implications. The greater impact is liable to be political, especially as a very weak figure could reopen the U.S. Presidential election campaign.
Monday's U.S. PMI manufacturing data will be important, especially after a weaker than expected reading for the Chicago PMI last week. After three successive readings below 50, another below par reading would certainly increase unease surrounding the U.S. and global economy. The non-manufacturing index will be released on Wednesday.
The Bank of Japan will announce its latest policy decision on Friday as frustration within the central bank increases. After weakening in immediate response to easing last month, the yen is now stronger than before the decision, increasing pressure for even more radical action.
The Bank of England will hold its latest interest rate meeting on Thursday and the most likely outcome is that there will be no change in rates or quantitative easing. The existing bond-purchasing programme is not due to be completed until November and there appears little need to jump in at this stage.
The U.K. PMI data over the first three days of the week will certainly be very important for sterling. September's data showed an important divergence from eurozone trends as the U.K. manufacturing data recorded edged back to the 50 area and there was an important lift in the services index. If further headway can be maintained this month, there will certainly be a more optimistic U.K. tone. Any retreat, however, will increase speculation over a credit-rating cut.
The Reserve Bank of Australia can afford to wait at this Tuesday's meeting. They will certainly be very wary of the dark clouds spreading from China, but there is time to assess the situation. There is the potential to signal a November rate cut if growth concerns intensify.