Federal Reserve dominates the agenda in the Week Ahead
Friday’s payrolls may have been a disappointment but the market is still uncertain as to whether the data represents an ‘appreciable’ weakening in the US economy. While the market did move towards pricing in a Federal Reserve (Fed) ease in the aftermath of the jobs data there is a strong force of opinion that the Fed is unlikely at this stage to announce significant new policy measures.

This opinion appears to be based both on the notion that the Fed has no incentive to shock the market and on the view that despite the weak labour data, most other economic indicators continue to suggest expansion, albeit at a moderating pace. A consensus appears to be emerging that if the Fed does announce new measures at its policy meeting on 10 August that these are most likely to take the form of a reinvestment into the bond market of proceeds from maturing mortgage backed securities.  Insofar as this was first flagged in an article in the Wall Street Journal last week it would not shock the market.  It would have the additional advantage of not expanding the Fed’s balance sheet any further at this stage so strictly speaking it would not be a new round of quantitative easing.

The dollar has traded in a choppy fashion this morning as the market grapples with the possibilities that face the Federal Reserve.  Having flirted on Friday with the risk that the Fed could be on the cusp of easing again, the US dollar is a touch stronger this morning as the market recognises that the Fed may not at this point expand its balance sheet any further. While steady policy from the Fed this week could boost the US dollar a little further, in the near-term the dollar could find the going touch with German economic data suggested that the European Central Bank (ECB) is far better positioned to carry on reigning in exceptional  policy measures.

ECB policy supports EUR near-term, but medium term outlook less certain
With the exception of a disappointing German Jun production report, German economic data are suggesting that the recovery is faring far better than that in the US. For the past two weeks, the ECB has bought very small amounts of bonds suggesting that this liquidity providing program (which started in May) may be about to draw to a close.

The tone of president Trichet tone at the ECB press conference last week does suggest that the recovery in the German economy will allow the ECB to continue to withdraw exceptional policy measures. In contrast to Germany other parts of the Eurozone (in particular Spain, Greece, Ireland and Portugal) will struggle to record any growth this year.

Too much tightening of ECB liquidity provisions could bring the debt crisis back to the boil. When the euro was initially launched it was envisaged that individual governments would use fiscal policy to fine tune uneven economic conditions which would inevitably result from a ‘one size fits all’ monetary policy. Governments in Ireland, Greece and Spain failed to do this in the ‘fat’ years and their failures led to asset price bubbles in Ireland and Spain and to a badly managed budget in Greece. Now in the midst of their fiscal retrenchment they haven’t got the spending power to offset any tightening in monetary conditions. The sovereign debt crisis in Europe has not evaporated and the ECB will have to tread carefully to keep the lid from blowing off.  Near-term the contrast between the policies of the Fed and the ECB may drive €/$D higher.  However, the medium-term outlook for the EUR is still mired in fiscal concerns. 

Sterling faces headwinds but could still win back ground
In all likelihood the coming quarter will be a tough one for the UK economy since it will bring with it the initial impact of the Government’s austerity measures. While weaker data are likely to keep the sterling crosses volatile it remains possible that sterling can appreciate further.

The next key focus is this week’s quarterly Bank of England Inflation Report. Typically, governor Mervyn King has shrugged off the strength of the consumer price index (CPI) suggesting that inflation will be pressured lower by excess capacity in the economy. While it is unlikely that he will steer away from this line too much, stronger second quarter data suggested that excess capacity levels are a little lower than previously thought suggesting that the Bank may have to revise higher its inflation projections.

Such an outcome is likely to be supportive for the pound. Next week the markets face the release of the monthly UK Public Sector Net Cash Requirement data. The previous set of budget data were far worse than expected. That said, insofar as the subsequent release of second quarter GDP was almost twice the market consensus there may be some room for an improvement in the borrowing data in July. Whether or not sterling performs better against the dollar or the euro depends very much on the trajectory of €/$ and thus the outcome of the 10 August Federal Open Market Committee meeting.