French Government Implodes, Stocks Still Rally

The US Dollar is narrowly mixed. It opened Asia broadly higher in sloppy start of the session, which may have been linked to a technical glitch that led to a four-hour delay of the electronic futures trading. Still, the driving force was the divergent trajectory of monetary policy underscored with the Jackson Hole speeches.

The dollar had reached almost JPY104.50, the euro and sterling slumping to almost $1.3185 and $1.6500 respectively. The foreign currencies mostly recovered, with sterling turning positive in early Europe, which sees London markets closed for a banking holiday. The dollar also shed its gains against the yen, returning to the JPY104 area.

The euro is the notable exception. Not only is there heightened speculation that the ECB is moving toward quantitative easing, but also disappointment with the German IFO survey saw the euro make a marginal new low. It was the fourth consecutive month that the IFO survey moved lower and the economists there warn that the German economy may be stagnating this quarter. Not only did the sentiment deteriorate, after all the market was prepared for that, but the results were worse than expected. The headline business climate measure fell to 106.3 from 108 in July. The consensus was for 107. Geopolitical issues were recognized to be playing a role, but it was acknowledged that this is difficult to quantify.

Even the euro has pared its losses. It is trying to establish a foothold above $1.32 prior to the start of the North American session. Resistance is seen in the $1.3210-40 area. A move above $1.66 for sterling would be a constructive development, and could spark further short-covering. However, the $1.6620-50 could pose a formidable obstacle.

The heightened prospect of an ECB QE, which Draghi and others did not explicitly endorse, has sparked a strong rally in European bonds. Core bond yields off 4-5 bp and peripheral bond yields off mostly 9-12 bp, though Portugal's 10-year yield is off more than 20 bp and is now below 3%.

In the biggest development of the day, the French government has collapsed. Over the weekend, the left-wing of the government, led by Economic Minister Montebourg and Education Minister Hamon offered a stinging critique of the government, though blamed its austerity polices on Germany. This led the rest of the ministers, including Prime Minister Valls to submit their resignations.

Montebourg and Hamon misunderstand the political dynamics and it will likely cost them their jobs. Valls is likely to head up the new government under President Hollande to be announced tomorrow. What the leftist ministers failed to appreciate is that Hollande himself has tacked to the center-right. The "Responsibility Pact" that Hollande unveiled in the spring, was not imposed by Germany. It in Hollande embraced austerity and supply-side efforts. Specifically, he endorsed a 40 bln euro corporate tax cut and a 50 bln euro cut in government spending over the next three years.

With Germany's support, the Stability and Growth Pact agreement to limit budget deficits to 3% of GDP has been postponed twice already for France. It is likely to need another grace period and it will likely get it. This is not only the flaw in Montebourg/Hamon's charges, but also the error of those how have argued that the ECB's Draghi broke new ground at Jackson Hole, endorsing greater fiscal flexibility. This has been recognized and operationalized. In response to calls from French and Italian politicians for changes in the Stability and Growth Pact, even Germany's Finance Minister Schaeuble has acknowledged that the pact has some flexibility built in.

French markets have not been punished by the second political upheaval in France in six months. The French 10-Year yield has fallen 7 bp to a new record low below 1.3%. The premium that France pays over Germany is at a two -month low today near 37 bp. French stocks have fully participated in today's equity rally. The CAC's 0.8% gain near midday in Paris is actually a bit better than the Dow Jones Stoxx 600, which is up about 0.5%.

The US economic calendar includes the preliminary Markit service PMI, new home sales and the Dallas Fed manufacturing sector. None of which are likely to shake up the market. Recent housing data has surprised on the upside, and new home sales are expected to rise nearly 6% after a 8.1% decline in June. New home sales have fallen in three of the first six months of the year.