Euro correction might extend towards 1.0780

Outlook:

We get the usual Thursday jobless claims today but the heavy lifter among the data sets is retail sales. A consultancy named Retail Metrics forecasts 1.9% y/y after -0.8% in Jan. Yesterday the WSJ ran an article on a little watched indicator, the Commerce Dept’s quarterly services survey. Led by a Q4 rise of 4.2% q/q in health care services (from 0.3% in Q3), this indicator implies rising GDP. It is incorporated in the official GDP revision, which we get March 27. The first revision for Q4 was 2.2% and now it will likely be higher. Big houses are already revising their forecasts upward. JP MorganChase has 2.5% from 2.1%, Barclays has 2.3% from 2.1% and Macroeconomic Ad-visors has 2.4% from 2.3%.

So what will the Fed make of it? Numerous analysts try to make hay out of the too-strong dollar that is harming exports as well as unhedged foreign earnings. Maybe the Fed postpones the first rate hike be-cause the dollar is already too strong. But as the FT notes, “Some 87 per cent of the US economy is do-mestically driven, meaning factors such as resurgent jobs growth will be far more important in determin-ing the interest-rate outlook.” The Fed tends not to give a fig for the dollar, which is under the purview of the Treasury, anyway. Besides, normalizing rates in the US is not the only thing at fault—Europe is having a growth and deflation crisis of its own making, and European QE would drive the euro down even if the US were following a steady-hand policy.

On another front, we continue to get evidence of a vast rally in European equities on QE. One US invest-ment manager (Federated Investors) told the press "The floodgates of new demand into European equi-ties are just starting to open." Federated has 76% already allocated to Euroepan stocks. Lipper reports inflows of $4.3 billion into European equity assets through March 4, against a $4.9 billion outflow from US equity funds. “Last year, European stock mutual funds and ETFs posted inflows of just $1.3 billion, compared with $116 billion into U.S.-focused stock funds.” Also, TrimTabs has a record US outflow of $9.7 billion into European stock ETFs between Jan. 16 and March 6. And the FT notes “Europe's FTSEurofirst 300 index of top regional shares has rallied 15 percent this year, beating the benchmark U.S. S&P 500's 0.9 percent loss year-to-date.”

This can get a little confusing—overall capital outflow from Europe by Europeans and former foreign investors diversifying into euros, including official reserve managers--but in equities, massive capital inflow. The euro’s drive to become a reserve currency competitive with the dollar’s status is now on hold until after QE ends, and QE is going to last until end-2016. The Big Shift is just begin-ning—it’s only the first week of QE and look what happened already. And we still don’t have an actual hike from the Fed. We are not even really sure we get the green light next week upon removal of the word “patient.”

Bottom line—if we already have 190 points yield spread favoring the dollar and the dollar has rallied over 20%, how much farther does it rally when the yield spread widens to 250 bp? That is our home-made estimate of the premium that investors demand over Bunds in order to backstop a lasting dollar rally. (If inflation expectations rise farther and faster in the US than in Europe, the spread has to widen by more, say 300 bp.) This is just a guess, of course, but if most traders see the spread as determinative, any correction now—in the first week of QE—will be limited.

One bright spot—we have no contagion from Greece. The standard measure is the yield spread of the peripherals against the Bund, and those continue to contract. Today the FT reports the yield spread of Italy and Spain over Bunds is the same—86 bp, with the outright at 1.06%. Imagine! Spanish and Italian 10-years are yielding only a little over 1.06% while the US has 2.10%--and nobody has any inflation. This is a historic anomaly. Meanwhile, the Greek 10-year yields continues to stay high—over 10%--and the spread against Bunds widening. This puts Greece out alone on the edge. From a political point of view, the absence of contagion means Greece has one less card to play. At this point, Grexit would not cause a pan-European crisis. It might even be good for yields.

Net-net—if the euro correction continues today, as seem likely at 8:15 am ET—we can expect a rise to perhaps 1.0780 (the linear regression) or one of the Fib numbers named above. But longer-run, by which we mean Friday, look for continuation.