Markets Stayed In Consolidation After A Week Of Focus In Spain

Markets were basically staying in consolidation mode last week. S&P 500 extended the pull back from 1474.51 high but received some support from 1430 level. CRB commodity index drew support above 300 psychological level to close at 309.3. Spanish 10-year breached 6% last week but managed to close below this level.

The dollar continued to recover but faced some pressure from 80 psychological level. In the currency markets, European majors and commodity currencies attempted a rebound against dollar but failed to reverse recent decline and has indeed closed quite weakly. One thing to note was what while gold range bounded against the dollar, XAU/EUR, gold on the euro, has indeed spiraled to new record high of 1381.18, after ending a year long consolidation.

Technically, there was no significant development over the week. Though, there were two things to note. Firstly, USD/JPY's recovery was, at this point, more due to strength of dollar then weakness of the yen. And, whether other yen crosses will follow this week would provide much insight into underlying strength of the dollar in the near-term.

Secondly, expect versus sterling, the euro's retreats in EUR/USD, EUR/CAD, EUR/AUD and EUR/JPY are corrective looking. While, XAU/EUR made another record high, the weak rally looks terminal. Thus, we'd still expect the common currency to gather momentum again soon. So overall, we'd slightly prefer to long EUR/JPY in the near- to medium-term.

The ECB, the BoE and the RBA will hold monetary decision meetings next week. While all of them are expected leave their policy stances unchanged in October, further easing would be carried out before the year end.

Spain was a major focus last week. The Spanish government confirmed in the 2013 Budget that the deficit targets are 6.3% of GDP this year and 4.5% next year, down from 8.9% in 2011. In order to achieve this goal in the face of economic contraction and sluggish employment condition, the government announced additional fiscal tightening measures which mainly focused on reduction in spending rather than tax increase.

While the market remains skeptical over whether the target can be achieved, the plan should ease the process for the Spanish government to request financial assistance from the EFSF/ESM. The Budget Ministry said that Spain will borrow EUR 207.2b in 2013. That compares to EUR 192b target for this year. The will push Spain's debt to 90.5% of GDP in 2013.

Results of an independent bank stress test in Spain showed that there is a capital deficit of EUR 59.3b. That's the amount of extra capital needed to ride out a serious economic downturn. And, such amount was slightly lower than June's estimate of EUR 52b. Taking merges and tax effects into considerations, the needed capital would be further reduced to EUR 53.7b.

Under the worst case scenario, Spain's GDP would contract -4.1% in 2012, -2.1% in 2013 and -0.3% in 2014. Unemployment would also jump to 27.2% in two years' time. Among the 14 banks tested, Bankia group has a deficit of as much as EUR 24.7b while 7 out of 14 showed no deficit. Prime Minister hailed that the stress tests were the "biggest transparency exercise ever done" and he emphasized that Spain will pay back the needed money. ECB also hailed the stress tests as "stringent and the asset quality review as thorough."

Unlike Spain, France's 2013 Budget focused on tax hike on business and the rich, rather than spending cut. The government pledged to narrow the deficit to 3% of GDP in 2013 from 4.5% this year and eventually to 0.3% by 2017, compared with 0% in previous estimates. Prime Minister Jean-Marc Ayrault described the budget plan as "a fighting budget to get the country back on the rails." Yet, with record unemployment rate and sluggish macroeconomic data, the government faces challenges even on meeting the newly announced deficit target.

Greece's coalition government also agreed a plan to cut spending over the next two years by EUR 11.5b. Finance Minister Yannis Stournaras said that the agreement gives me a basis for "stronger negotiation" with the international creditor for easing the conditions on fiscal reforms. Pasok leader Evangelos Venizelos said that the European parts are undoubtedly aiding Greece but "not as much as they could" and he urged European leaders to "acknowledge the achievements of the Greek people," as shown in the elections. Greece has yet to secure the next tranche of bailout fund from EU/IMF and Prime minister Antonis Samaras is seeking a two year extension on fiscal reforms. Stournaras will meet with the Troika again on October 1.

In US, Philly Fed Plosser's comment was taken as a reasons for the deeper pull back in risk sentiments. Plosser stated his strong opposition and said that "increasing monetary policy accommodation is neither appropriate nor likely to be effective in the current environment." And he warned that "by greatly expanding the size of the Fed's balance sheet, the new asset-purchase program will exacerbate the challenges that the Fed will face when it comes time to exit."

Plosser said that additional asset purchases are "unlikely to reduce long-term interest rates by a significant amount" and "we are unlikely to see much benefit to growth or to employment from further asset purchases." Plosser also said that "conveying the idea that such action will have a substantive impact on labor markets and the speed of the recovery risks the Fed's credibility." Plosser expects US economy to grow at 2.0% in 2012, and around 3% in both 2013 and 2014.

On the other hand, Dallas Fed Fisher warned that US is "drowning in unemployment," its economy is running at stall speed and inflation is "not a problem. Fisher defended Fed's QE and said no one could fault Bernanke for "using every tool at its disposal to get the economy up and running again." Chicago Fed Evans urged Fed to "do as much as we can" to bolster the resiliency and vibrancy of the economy." And, he continued his push for "explicit state-contingent policy rule" that commits to further easing till unemployment dropped below 7% or inflation shoots above 3.0%. And Evans warned that "modest, cautious, safe policy actions" could risk Japan style lost decade.

In UK, Fitch said over the weekend that while the AAA rating was affirmed, outlook was also kept unchanged at negative. The rating agency said that the negative outlook "the very limited fiscal space, at the 'AAA' level, to absorb further adverse economic shocks in light of the UK's elevated debt levels and uncertain growth outlook." And it warned that "weaker than expected growth and fiscal outturns in 2012 have increased pressure on the UK's AAA rating."