Sterling is Pounded and Eurozone PMI Disappoints

Global equities are beginning the last week of February on a firm note.  The MSCI Asia Pacific Index rose 0.75%, with China's markets gaining more than 2%, leading the way. European shares have followed suit.  The Dow Jones Stoxx 600 is up 1.7% near midday in London, led by materials and telecom.  Like the MSCI Asia-Pacific Index, the Dow Jones Stoxx 600 is flirting with last week's highs.   

Oil is trading nearly $1 a barrel higher, even though many are skeptical that the Russia and Saudi Arabia-led output freeze is a game-changer.  Both countries increased output in January as if preparing for a freeze.   It is unreasonable to expect the Iranian to agree to any freeze in output before they have ramped up their production.  Otherwise, they would have agreed to suspend their nuclear drive for naught.  

In the foreign exchange market, sterling's slide is the main feature.  It is off 1.6% or nearly 2.5 cents to approach the January 21 multi-year low a little below $1.4100.  The concern is that Prime Minister Cameron's deal with the EU failed to change the debate in the UK.   Despite Cameron's personal appeal, London Mayor Johnson came out in favor of Brexit.  This was seen as a major blow in some quarters though we suspect narrow political considerations may have played a role.  Johnson is seen as a likely rival of Osborne to succeed Cameron.   

There seems to be nearly universal agreement that Brexit would be negative at least initially for sterling and the UK economy.   Cameron's negotiations with the EU in effect froze the supporters of continued membership, but in the coming days, they will be entering the fray.  

Outside of sterling, the FTSE is higher, but lagging other major European bourses.  The 10-year gilt yield is a couple of basis points higher, more in line with US Treasuries than German or French bonds. 

The flash eurozone PMI disappointed expectations and the euro has been sold back toward $1.1060, where it broke out of the sideways pattern in early February.    The PMI showed four things that are worrisome for ECB officials.  Activity slowed.  Business cut prices.  Forward-looking new orders are their weakest in a year.  Hiring was the slowest in five months.     

The PMI will only further encourage expectations for additional ECB action when it meets again on March 10.  The introduction of a tiered reserve system, which other central banks with negative policy rates have adopted, seems likely.  The market leans toward a 20 bp rate cut  Some expect the asset purchases to be accelerated and extended.   

The German slowdown is particularly worrisome.  Its manufacturing fell to 50.2 from 51.9 in January.  It is the weakest in 15 months.  The French reading at 50.3 (up from 49.9) is above the German reading.  The German composite, however, is at 53.8 (down from 54.1), while French composite slipped below 50 boom/bust (to 49.8), the lowest since January 2015.  

The eurozone economy grew faster than the US in Q4 15, but this was a bit of a fluke.  The divergence is likely to be evident again in Q1 16.  The eurozone economy is slowing while the US economy is re-accelerating, with the Atlanta Fed's GDPNow tracking 2.6%.   

The premium the US offers over Germany's 2-year yield peaked at the end of last year near 142 bp.  As the market unwound bets on Fed hiking this year and the safe haven bid in light of the precipitous drop in equity markets, the US premium fell to 117 bp on February 8.  The euro topped three days later near $1.1375.  The premium today is near 130 bp.  We suspect a break below $1.10 would being washing out some of the new speculative long euro positions that had been established in recent weeks.  

We note that the dollar-bloc currencies and emerging market currencies are trading firmer today.  The risk appetite that was missing since the start of the year seems to be testing the waters. 

The US economic calendar begins slowly with the Markit flash manufacturing PMI being the main report.  The manufacturing sector appears to be stabilizing after contracting last year as drop in oil prices ran through various sectors.  

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