QE3 next week is officially off the table after this morning’s U.S. GDP report showed the economy expanding by 1.5% in the second quarter. Economists had only been looking for a 1.4% rise and not only did the data beat expectations but growth in Q1 was also revised higher. Given the significant weakness in retail sales and the decline in trade, we had anticipated a sharper contraction in growth but the slowdown in Q2 was nominal. Private investment, exports and imports grew at a stronger pace in Q2 while personal consumption slowed less than expected. The better than expected GDP number comes at a very good time for the U.S. dollar because it reinforces the strong possibility that the Fed will forgo QE3 next week. If Q2 GDP was less than 1%, the Fed might have felt compelled to discuss the idea of more QE but now they have reasons to continue questioning the extent of U.S. weakness and the need for more stimulus. This could be very bullish for the U.S. dollar if the ECB sweeps in with more support next week.

Meanwhile across the Atlantic, the U.S. GDP number forced the EUR/USD to give up earlier gains. Nonetheless, a further decline in Spanish and Italian bond yields and rise in European stocks alleviates pressure in Europe. Spanish 10 year yields are now much closer to 6.5% than 7% and Italian yields are back below 6%. An article by Reuters talking about how Spain’s Economy Minister floated the idea of a EUR300 sovereign bailout with his German counterpart last Tuesday is making the rounds this morning, but we believe the recent decline in yields reduces the pressure and urgency to act. In other words, the decline in yields have bought policymakers time to find a way to help Spain OR Italy if borrowing costs skyrocket again. We don’t expect Spain to make a formal request for a full scale bailout unless yields rise back above 7%. Spain’s Deputy Prime Minister Saenz confirmed that the government won’t seek a rescue because it “isn’t an option.” While encouraging we have heard such claims before by countries that later had to knock on the window of the EU and ask for help.

The German Finance Minister welcomed the comments made by Mario Draghi yesterday to secure the euro. He supports the idea of using the EFSF to buy government bonds but does not believe that giving the rescue fund a banking license is within the ECB mandate. Instead the French newspaper Le Monde claims that coordinated action is being planned by the ECB and European bailout fund to lower borrowing costs by buying Spanish and Italian debt. The EU denied everything in the report but reactivating the Securities Markets Programme is a measure put forth by many bank economists as a possible policy action in the coming weeks and an idea that is also lending support to the euro.

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