The US dollar is broadly stronger as euro zone developments continue to take a toll on market sentiment. Greece is headed for fresh elections next month, and concerns remain whether it will be able to form a workable government willing to enact the necessary reforms. Euro zone periphery yields are mostly higher, with the Portuguese 10-year yield up nearly 30 bp. This backdrop should continue to keep the euro under pressure and broadly boost the US dollar. Support for the euro is seen at the January low near $1.2625, but further losses appear likely and we stick with our $1.24 target for Q3. Resistance lies near $1.2800. A dovish inflation report, skewed market positioning, and the stronger dollar has hurt sterling, despite the better than expected employment report. The Scandis are little changed against the dollar, but the dollar bloc and EM currencies remain under pressure. Global shares are broadly lower. MSCI Asia index finished 2.5% lower. European shares are down as well, with EuroStoxx 600 at its lowest level this year. Bank shares are down 0.6%. S&P 500 futures point to a flat open.
 

The first meeting between Merkel and Hollande appears to have gone well. Also, Hollande’s choice of German-speaking Ayrault as Prime minister is widely viewed as good for Franco-German relations. The two leaders said growth-oriented policies would be considered for Greece, as long as Greece was committed to further austerity. While this is an oxymoron, a read between the lines suggests that the euro zone is signaling that it may give Greece some wriggle room. How much remains to be seen, but the two leaders also said Greece should stay in the euro zone. Our base case remains that a watered-down way for Greece to stay in the euro zone is still preferable to a disorderly exit. Any Greek exit is unlikely to provide closure to the crisis, with Spain, Italy, and Portugal likely to come under even greater pressure. InTrade currently has the odds of a country leaving the euro zone at 42% in 2012, 60.8% in 2013, and 65% in 2014, all up from earlier this month. Longer-term players should note that the $1.26 area is the final 76.8% retracement level of the 2010-2011 rise in the euro, break of which would suggest a test of the June 2010 low near $1.1875.
 

Dollar/yen is at its highest level since May 3. The 2-year US-Japan has been moving more in favor of the dollar in recent days, rising to 18 bp today (highest since mid-April) from the trough of 14 bp last week. The yen is outperforming within G10, however, and EUR/JPY has fallen to levels not seen since mid-February. There have been reports that Japan exporters are getting more concerned with EUR/JPY and not just focusing on USD/JPY. Q1 GDP will be released May 17 and is expected to post 3.5% annualized growth. Public investment will expand due to quake reconstruction, while the GDP deflator will remain negative but the rate of decline should be lower. With the yen broadly firmer, pressure will remain on BOJ to ease. For USD/JPY, resistance seen near 80.50.
 

The strong dollar tone, a squeeze in market positioning, and the inflation report are all nudging sterling broadly lower. Sterling is finally succumbing more to the broad dollar rally. CTFC data show speculative players have built up sizable long sterling positions, leaving the currency vulnerable to outsized losses as the dollar rally continues. BOE also revised its CPI forecast to a much slower rate of decline relative to the last report in February. Growth was also revised lower over the 2-year forecast horizon. The takeaway is that even though it was a fortnight ago that the BOE ended its QE program, external risks and a dovish inflation report suggest greater risks of QE returning. Gilt yields are lower on the day, consistent with broad sterling weakness. Data-wise, the UK labor market showed further signs of firming, with employment rising and the unemployment rate falling. However, with unemployment still elevated, consumer confidence weak and real wages stagnant, consumer spending should remain soft.
 

We may be reaching a tipping point for BRL, as currency weakness is taking on a life of its own and hurts the Brazilian equity market. Officials continue to send signals that they welcome a weaker currency, with Mantega speaking yesterday and Rousseff today. A weaker currency needn’t hurt investor sentiment, but what DOES hurt sentiment is what appears to be nonstop official encouragement of this weakness. Coupled with an aggressive central bank easing cycle, we think foreign investors are rightfully spooked now. 2.0, 2.075 key levels for BRL. Bovespa has dropped 7% over the past week (9% in USD terms) and is a notable underperformer in EM. Elsewhere, local press reported China’s four biggest banks have made almost zero net new loans in the first half of May. According to the report, two of the lenders increased outstanding loans by less than CNY20 bln, while the other two posted drops as repayments exceeded new credit. PBOC cut the reserve ratio by 50 bp on May 12, but it seems monetary easing has not been enough so far. Officials should start easing more aggressively to stimulate lending and growth in China.

The US dollar is generally weaker, as euro zone Q1 GDP unexpectedly stabilized (0.0% q/q vs. -0.2% q/q expected).  The euro rose from its lowest level in almost four months against the dollar, shrugging off news that Moody’s downgraded 26 Italian banks.  There is likely further scope for turnaround Tuesday, with Hollande expected to discuss his growth compact proposal with Merkel and Greece expected to make its debt payment today.  Finance ministers at the Eurogroup meeting yesterday hinted that they may offer Greece extra time to meet budget targets.  However, with the Greek president unlikely to form a unity government, new elections are likely to take place on June 17. This backdrop should increase market uncertainty and with policymakers for the first time publicly mulling the potential of a Greek EMU exit, market sentiment should remain negative.  Any euro bounces are unlikely to last long and we think medium-term investors are best positioned to sell euros into rallies.  We remain on track for our 1.27 end-Q2 and 1.24 end-Q3 targets.  Cable is marginally lower after the poor UK March trade data.  RBA minutes offered little news, with the improvement in market sentiment boosting the Australian dollar.  Global shares are mixed. The MSCI Asia Pacific index sank 0.6% but European stocks are rebounding from their lowest level in 4 months.  The EuroStoxx 600 is up 0.1% but bank shares are flat.   

France has a new president.  Among his first acts, even before his government is fully announced he will go to Germany for a tete-a-tete with Chancellor Merkel.  Merkel's support for Sarkozy was no secret and Hollande has campaigned against Merkozy.  That is water under the bridge and the most important issue is the state of the fiscal compact and the need to compliment it or complete is with an agreement on bolstering growth.  Merkel is opposed to the traditional Keynesian fiscal stimulus and is unlikely to be swayed.  However, there is room for compromise.  There are four issues that Hollande is likely to press, even though no firm decision will be forthcoming today.  First, increase funding for the European Investment Bank.  This is the institution that will likely play a more important role under a growth pact.  Second, reallocate unused EU structural funds, making them easier to access and help spur growth.  Third, Hollande and Merkel will find common ground on a financial transaction tax.  Fourth and most controversially, Hollande may press hard for a one year extension to meet EU fiscal targets.  EC Commissioner Rehn appears to be sympathetic to this on a conditional basis.  Merkel does not appear opposed in principle, but is likely to try to get some additional concessions in exchange.   A new chapter in the European crisis management is at hand, but with France’s economy stagnating in Q1 and Germany's expanding an unexpectedly strong 0.5%, the divergence between the pillars of Europe cannot be denied. 

We do not think strong German data is euro-positive.  It should be seen as negative since this divergence with the rest of the euro zone is unlikely to move Germany to make concessions to those pushing for more growth-oriented policies.  Indeed, the euro zone’s economic performance has basically become divided along the lines of Germany and then everyone else.  Overall euro zone GDP stagnated in Q1 vs. expectations of 0.2% q/q contraction and so avoided a technical recession.  Germany’s stellar performance was offset by weakness in virtually every other country, but it’s certainly not time to break out the champagne.  Besides France stagnating in Q1, we saw Greece, Portugal, the Netherlands, Italy, and Cyprus continuing to contract.  Interestingly, Germany may start to feel the pinch as German ZEW sentiment weakened to 10.8 in May from 23.4 in April, the first drop since November. 

The UK visible trade deficit was widener than expected in March (-GBP8.56 bln vs. -GBP8.40 bln consensus).  Exports to Germany held up, but economic weakness in the rest of the euro zone hurt the overall trade deficit, and will be a net drag on Q1 GDP.  The intensification of the euro zone debt crisis should continue to see the euro decline against sterling.  Against the dollar, sterling peaked on 4/30 around 1.6300 and recently finished below the 20-day MA for the first time since 4/16.  With the 5-day MA crossing below the 20-day MA, technical pressures may continue to push cable lower.  Tomorrow’s inflation report is awaited for clues on BOE policy and the chances of any further easing.     

Spillover of euro zone weakness to EM is hitting Eastern Europe particularly hard.  Czech Republic entered a recession after a second straight q/q contraction in Q1, while Hungary is right at the edge as Q1 contraction followed stagnation in Q4.  Romania too is in recession.  With all three small open economies that depend on exports to Western Europe, the prognosis remains grim.  However, they all benefit from having their own currencies, which will continue weakening and helps the adjustment process.  Brazil seems content to let the real weaken.  Finance Minister Mantega expressed no concern with Monday’s flirtation with the 2 level.  As long as the pace remains controlled, Brazil is unlikely to act to support BRL.      

The US dollar is broadly higher against the major and emerging market currencies to start the week. Global equities are broadly lower, core bonds higher, and peripheral European bonds under pressure. Oil and gold prices are at the lows for year. There are three main impulses shaping the investment climate, each emanating from one of the three largest economic areas. The economic data from the US due out this week should show that the economic moderation is modest. China responded to the recent signs that its economy continues to slow and has yet to “land” by cutting required reserves, maintaining the pace of a 50 bp cut every other month.
 

Events in Europe, however, continue to dominate the macro-environment. What makes the week ahead important is that there are multiple potential flash points. They are not limited to the periphery, but events in Greece continue be unsettling. Ironically, many observers critical of the aid to Greece have found themselves rather sympathetic to Syriza’s Tsipras. Barring a last minute miracle, new elections will be forthcoming and one poll shows Syriza on top, which if borne out next month, would give it a bonus of 50 parliamentary seats in the 300 seat chamber. Greece faces an international bond maturity of 436 euros that was not covered by the PSI. It is likely to use its grace period before deciding whether to default. At the end of the week it has a 3.334 bln coming due to the ECB and EIB, and hence the recently paid tranche of assistance.
 

Prime Minister Rajoy’s second attempt to address Spain’s banking system before the weekend fell flat. It is hardly sufficient. Without getting hip deep in the nuances, consider just one set of numbers. The Bank of Spain’s estimates that Spanish banks have 180 bln euros of troubled assets and the government will now require them to increase their provisions to 84 bln euros. Leave aside that the Band of Spain’s estimate is woefully optimistic (Spanish banks, for example, hold 655 bln euros in residential mortgages that are not covered by the reforms announced before the weekend). The risk is that a disappointing response will force the Rajoy government to be even more aggressive in dealing with the regional governments, which appears to be the sine qua non of getting a one-year delay in its EU fiscal targets. The confrontation could come as early as Thursday May 17 when Madrid is set to approve the regional government’s spending plans. Spain is the most decentralized country in the euro area and the EC has called for determined action to curb “excessive” spending at the regional level. Three regions seem particularly vulnerable to aggressive action: Asturias, where an interim government cannot agree on a spending program; Valencia, which paid 7% on rolling over 6-month bills recently; and Andalucia, the most populated region and one in which Rajoy’s Popular Party failed to capture in the recent election and whose budget has already been rejected once by Madrid.
 

In Germany, Merkel’s CDU was sharply rebuked in the weekend election in the country’s most populated state of North Rhine-Westphalia. The results can only heighten the possibility that Merkel joins the 11 European heads of state that have been voted out of office since the crisis began. Germany will sell bonds this week. Record low yields may be deterring some investors and there have been a couple of auctions recently that were not completely covered recently. At the same time, based on a couple of press reports many observers detect a change in German rhetoric. The head of the BBK economics department seems to suggest that Germany may have higher than average inflation within the euro area, a shift from very low to moderate levels. Around the same time German Finance Minister Schaeuble backed higher wage settlements in Germany to help reduce imbalances. Further, it is less noted that last week the Bundestag rejected Merkel’s 6 bln euro income tax cut for the 2013-2014 period. On one hand, the higher than average German inflation is partly a function of the deflation Germany is insisting on in the periphery. On the other, Germany may find that inflation is just as hard to create some times as it is to destroy.
 

Hollande is sworn in as France’s new president on May 15 and the new government will be closely scrutinized for clues into its orientation. Two issues will confront him immediately. First several companies reportedly held back “redundancies” in the election period, seemingly seeking to help Sarkozy. These may be announced as early as this week. Second, and more significantly, the EU warned on May 11 that next year’s French deficit will be 4.2% of GDP rather than the 3% target. This will require savings of something on the magnitude of 25-30 bln euros. Hollande will not be afforded a honeymoon. Midweek, France will also sell bonds in this environment.