Progress for Obama

illustration: DNB markets dealingroom

(20.07.2011) Strong corporate results and new optimism regarding an outcome of the debt ceiling controversy in the US, lifted investors' risk appetite yesterday. Obamas' optimism pulled long US government bond yields downwards, while stock markets rose. The euro has strengthened against the dollar, and the Swiss Franc has weakened from yesterday's record-high.

By Kjersti Haugland, Senior Economist at DNB Markets

Strong corporate results from US technology firms like IBM and Apple overshadowed weak results from Goldman Sachs and Bank of America, and contributed to lift investors' mood. Another boost to optimism was Obama's message about progress in the negotiations regarding the US debt ceiling and budget cuts.

He supports the so-called "Gang of Six" proposal, which has been worked out by a bipartisan group of senators. The proposal involves stabilizing US debt by 2014, by cutting the deficit by USD 3 700 bn in the course of 10 years. This will be obtained by immediate cuts amounting to 500 bn, and a fundamental reform of the tax system. The latter will aim to reduce the marginal income tax, while eliminating holes in the tax system and tax deductions for certain industries and individuals. A reform of Medicare, Social Security and health and pension plans is also included. The response from the Republican Speaker of the House of Representatives, John Boehner, has been lukewarm, but he has asked his members to be available for negotiations throughout the weekend.

A brighter mood served to weaken the demand for safe havens, leading to rising stock markets, a stronger euro and a decline from yesterday's record-high for the Swiss Franc. Long US government bond yields pulled down after Obama's message, and the decline was strongest in the 30-year bonds (10 basis points).
 
The development in the dollar and the euro has lately been strongly marked by the debt unrest, causing intense pressure on both European and American politicians. Many have asked: What is the "least bad" alternative, the euro or the dollar? In our eyes the dollar looks strongest, and we expect EURUSD to pull down towards 1.30 in the course of the next 12 months.

The US debt unrest is caused by a political tug of war, triggered by strategies, rather than real payment problems. USA has the ability to cut expenses and raise tax income significantly, if the country has to. We have seen that long US government bond yields have stayed at very low levels, despite the unrest.

Europe
's situation is quite different. We believe that some sort of default on Greek liabilities is inevitable, given the level of the debt and the gloomy state of the Greek economy. The surge in Spanish and Italian bond yields lately has proven that market distrust may be contagious in the absence of political solutions, and in the worst case scenario (which we do not assign much probabiliy) endanger the capability of the larger countries to service its debt, thereby putting the whole monetary union in danger.
 
Thursday's euro leader meeting is approaching, and Angela Merkel is warning against having too high expectations regarding the outcome. It is unlikely that the meeting will provide a final and "spectacular" solution to the Greek problem.

In the meantime there are new signals about a slowdown in the German economy. The ZEW index, capturing German investors and analysts expectations about the future, fell more than expected in July, from -9.0 to -15.1. The negative sign means that the respondents expect a deterioration in the economic situation going forward. The level is at its lowest since January 2009.
 
UK government debt is also very high, and pound sterling has tended to weaken on increased unrest lately. During the spring and the summer it has also become increasingly clear that the key policy rate will be kept at record-lows for a long time, despite inflation far above target. The British economy is developing weakly, and unemployment is on the rise. Extensive fiscal austerity measures will weigh on the economy for several years.

The MPC expects the ample capacity in the economy to push inflation down and below target again. Given the disappointing macro releases lately, we expect today's minutes from the July MPC meeting to reflect that the committee is becoming more convinced that the rate should be kept low for a considerable time period.