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Weekly Wrap-Up
– The salutary effects of the giant €750M “EuroTarp” bailout package announced on May 9th have proven to be short lived, as contagion from the European debt crisis has paralyzed markets with fear this week. Investors spent the week dumping all asset classes and cramming funds into the safety of the US Dollar, Japanese Yen, German Bunds and US Treasuries. Equity markets have been hit especially hard, with the DJIA plunging more than 5% on the week and opening under 10,000 on Friday. The Dow and the S&P500 officially entered correction, with both indices down well over 10% from recent highs from late April, retesting the levels hit during the artificial low created by the May 5th “flash crash.” Volatility has spiked higher, as the VIX tested above 45 late in the week, its highest since the market lows last March. The euro has been a major factor again, with the single currency whipping between lows near 1.2150 to a high of nearly 1.2700. On Tuesday, Germany announced it would ban naked short selling of certain bank stocks and CDS on Euro Zone debt, pushing the euro down to its weekly lows and causing consternation among the nation’s European partners, none of whom were ready for the unilateral move. US data has not been supportive: the May Empire Manufacturing Survey was way below expectations, with the new orders component dropping sharply, the US initial weekly jobless claims came in higher than expected (and well above the weekly reports seen over the last four weeks), while the April leading indicators printed its first negative reading since March 2009. For the week the DJIA fell 3.8%, the Nasdaq declined 5% and the S&P500 dropped 4.25%.

– After the European debt crisis, perhaps the biggest story of the week was the Senate debate and ultimate passage of the financial regulatory overhaul bill. Voting on various amendments to the package continued early in the week, as the Democrats easily swatted back Republican attempts to water down certain provisions of the bill, and also managed to push discussion of the ultimate shape of Senator Lincoln’s proposal to force banks to spin off their derivative operations back to conference committee (where many hope it will die a peaceful death). An initial cloture vote failed, but with some fine tuning to please individual legislators a second procedural vote was successful on Thursday. House and Senate negotiators will begin reconciliation talks on the legislation next week and leaders were optimistic that a final bill will go to President Obama to sign before the July 4th Congressional recess.

– The FDIC released its quarterly troubled bank list on Thursday, showing a 10% increase in the number of institutions on the list since Q4 2009, although FDIC Chairwoman Bair took pains to accentuate the positive. “Industry earnings are up. More banks reported higher earnings, and fewer lost money,” she said, noting that the improvement in earnings was largely due to a reduction in the amount banks set aside for loan losses.

– High-profile retailers reported March quarter earnings this week, providing some insight into the state of the emerging recovery in US consumer spending. Leading home improvement retailers Home Depot and Lowe’s met or slightly exceeded expectations and raised their full year guidance. However, Lowes offered soft guidance for next quarter, warning that “problems remain” with US consumer confidence. Wal-Mart was also a bit ahead of expectations in its Q1 but below par in Q2 guidance, stating that its customers are still concerned about their personal finances and unemployment, as well as higher fuel prices. Target missed revenue expectations and stated that May sales are running somewhat behind expectations. In tech, Hewlett-Packard offered better than expected Q2 results and an improved outlook for the full year. Executives stated that the demand environment continues to improve. Brocade Communications and Dell both reported lackluster, in line reports after the close on Friday, and both stocks were slammed by risk aversion on Friday.

– Credit markets were subject to the same retreat from risk that dictated sentiment for other asset classes this week. Credit default spreads between investment grade and high yield debt widened significantly amidst sharp declines in equities on Thursday. Alarmingly, money market spreads continued to drift wider over the course of the week in the face of increased central bank liquidity. Three-month USD Libor closed out the week a smidgeon away from the 0.50% mark, the Libor-OIS spread reached 27bp and the TED spread hit 33bp – levels not seen since the summer of 2009. Germany’s unprecedented move to ban naked short CDS positions on Euro Zone government bonds only served to further unsettle markets; many market participants called the move ill conceived given the fact that the overwhelming majority of CDS volumes traded out of London. The futility of the ban was best exemplified in CDS spreads for the PIIGS, which initially moved back to pre-bailout levels before recovering.

– US Treasuries and German Bunds were predictably well bid in the overall flight to safety this week, while yields fell off a steep cliff. The yield on the benchmark 10-year Bund set new all-time lows at 2.63% on Friday while the US long bond tested 4%. Yields across the US curve moved out to levels not seen since mid 2009 with the benchmark 10-year yield declining some 25 basis points on the week. The 2-10 year spread narrowed to six-month lows below 250 basis points. Fed fund futures have all but priced out a rate hike by the end of the year.

– In currency trading the flight-to-safety trade drove strength in USD- and JPY-related pairs as contagion fears gripped markets and the single currency took investors for a crazy ride. The EUR/USD rollercoaster roared into the week around 1.2360, tested as low as 1.2150 on Wednesday and spiked to within striking distance of 1.2700 on Friday morning, driven by frenzied rhetoric and a fair number of rumors all out of Europe. The euro’s worst levels were seen on Wednesday morning after chatter circulated that the Greek finance minister was heard stating that Greece could consider leaving the Euro Zone (the rumor was firmly denied by the Greeks). Current events aside, there has been no end to the bearish euro sentiment among currency analysts, some of whom are predicting euro-dollar parity in the foreseeable future. Positive news had a hard time making a dent in the risk aversion, including word that Dubai World had reached a restructuring deal with its creditors and Greece completing a €8.5B bond repayment on May 19th. However news late in the week that French President Sarkozy and German Chancellor Merkel would present a united front at upcoming EU and G20 meetings plus the German parliament’s approval of the €750B Euro rescue package penetrated the murk, sending EUR/USD out to weekly highs.

– Many commentators blamed at least some the euro’s volatility this week on copious and often contradictory rhetoric from European officialdom. Comments from ECB Governor Nowotny were a fine example: Nowotny first reiterated the standard G7 view that currency volatility was not desired, but then followed that up by saying the euro would remain within its historical range. Dealers keenly noted that at the launch of the single currency in 1999, EUR/USD was around 1.1800. The all-time low was 0.8225 in October 2000 and the all-time high was 1.6038 in Jul 2008. Needless to say, that is a rather broad historical range. Euro Group President Juncker called the pace of the euro’s decline unwarranted, but also said that joint FX intervention was not needed.

– EUR/CHF briefly traded under 1.4000, which coincided with the release of Swiss FX reserve data from April. Market sources asserted that the Swiss National Bank was bidding with several yards of euros a day around 1.4000, which is now the new “line in the sand” after the bank pulled its bid at 1.4300-25 earlier in May. The SNB released data on its April FX holdings on Friday showing that the defense of the franc had cost it a billion francs a day in April.

– The yen maintained a firm tone on risk aversion concerns couple and early redemption of some uridashi issues. EUR/JPY tested below the 110 handle for the first time since Nov 2001 while USD/JPY remained within earshot of the pivotal 88 level.

– Despite the 6.5% plunge in Nikkei225 index this week, the Bank of Japan surprisingly raised its assessment of the Japanese economy this week for the first time in seven months. In a unanimous decision, the BOJ said the economy is recovering moderately and is expected to maintain that trend, as the pace of capital expenditures was deemed to have improved. Policymakers also extended liquidity to private banks via a one-year 0.1% fixed loan term which may subsequently be rolled over.

– New Zealand’s annual budget boosted the Kiwi Dollar on Thursday, helping remedy the pronounced weakness on Wednesday that was sparked by the New Zealand Central Bank’s Stability Report calling for fiscal consolidation. The budget forecasted FY10/11 net debt at 19.5% rising to 23% by FY11/12, announced an increase in sales tax to 15% from 12.5% and cut the corporate tax rate to 28% from 30% starting in FY11/12. Policymakers raised the government’s 2010 growth forecast to 3.2% from 2.4%, noting that expectations for faster growth would reduce the need for additional borrowing.

– The minutes for the most recent RBA tightening decision were decidedly bearish, not only confirming rates on hold for some time but also suggesting that policymakers may be less comfortable with such a policy stance. Back on May 4th, the RBA board judged that the limited potential for contagion in Asia from the European fiscal crisis merits moves to address mounting inflationary pressures. However the minutes suggested that policymakers now expect some time to pass before EU concerns are resolved, with the impact on Australia potentially somewhat more pronounced.

– Comments from a Chinese cabinet advisory body as well as sovereign wealth fund helped reverse some of the panic selling evident at the start of trading in the week’s final session. CASS researcher Zhang Min said policymakers are likely to push back any feared monetary action because of the problems in the EU. On a related note, China’s 50-year debt auction – the first in seven months – sold at 4.03%, below 4.30% prior. China sovereign wealth fund CIC expressed confidence in the EU plan, also stating that the impact of the fiscal crisis may be less than feared.