The Rally in Risk Hits Profit Taking in Europe

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Market Drivers For Jan. 2, 2012
US lawmakers avoid Fiscal Cliff, sending risk higher
EZ PMI Manufacturing misses UK surprises to upside
Nikkei closed but Europe up 2%
Oil $92/bbl
Gold $1682/oz.

Europe and Asia:
EUR German CPI
EUR EZ PMI Manufacturing 46.1 vs 46.3
GBP UK PMI Manufacturing 51.4 vs 49.2

North America:
USD Construction Spending 10:00
USD ISM Manufacturing 10:00
USD ISM Prices Paid 10:00

Risk assets staged a strong rally in the wake of last minute deal to avert the Fiscal Cliff with equities rising by 2% while high beta currencies spiked to test recent highs in Asian session trade, but the rally ran out of steam in Europe as profit taking and weak economic data took FX off its best levels of the day.

The House of Representatives passed the deal to avert the Fiscal Cliff voting 257-157 to pass the bill that increased taxes for income earners above the $400K level and increased taxes on dividends from 15% to 23.8%. However, perhaps the biggest aspect of the bill was the fact that it allowed the 2% payroll tax cut to expire, effectively raising taxes on 77% of the all Americans in move that would raise an additional $100 Billion in revenue. It is unclear just how much an impact that payroll tax hike would have on consumer spending this year, but clearly it will have a some depressive effect on aggregate demand.

As trading proceeded in Europe the initial enthusiasm over the deal began to melt away and profit taking kicked in especially after EZ economic data showed further contraction in the region’s manufacturing sector.

EZ PMI Manufacturing printed at 46.1 versus 46.3 eyed with German data dropping to 46.0 from 46.3 while French PMI remained steady at 44.3. Only the Italian PMI readings showed some significant improvement rising to 46.7 from 45.4 originally reported. Overall the manufacturing sector for the EZ region remains in contraction territory but has started a slow climb back towards the 50 boom/bust level after bottoming out in August at 44.6.

The data was better in UK where the PMI Manufacturing rose to 51.4 from 49.2 expected hitting its best level since September of 2011. The uptick was driven primarily by domestic demand and is a good sign that UK economy may be showing small signs of growth, although the Construction and Services PMI due later this week will be much better evidence of economic conditions in the country. Cable ignored the data and sold off below the 1.6300 level as profit taking flows overwhelmed the fundamentals.

Whether or not the risk rally can sustain itself will depend to a large extent on reaction in US equity markets as well the latest ISM Manufacturing data due at 13:00 GMT. Markets are looking for rise back above the key 50 boom/bust level to 50.2 from 49.5. ISM Manufacturing has been in contraction territory for 4 out of the past 6 months. Therefore today’s data could prove critical to markets assessment of US growth in the last quarter of 2012. Despite the uncertainty that surrounded the Fiscal Cliff negotiations, regional surveys have shown improvement in US manufacturing activity signaling that today’s report could meet or beat expectations. A positive data point could help extend the risk rally, but if the ISM report misses printing below the key 50 mark, it could trigger a bigger wave of profit taking and unwind the whole overnight rally as fears begin to mount that the slowdown in US activity has already started while lawmakers dilly dallied over the Fiscal Cliff negotiations.

Boris Schlossberg
Managing Director

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