Muted Turnaround Tuesday On Tap

The US-German 2-year spread, which continues to do a good job tracking the euro, also held below last week's high and now is trading at its lowest level (smallest US premium since the middle of last week). Yet, given the news stream and market positioning, the turnaround appears to lack conviction. The euro ran into offers near $1.3080 and sterling bears took a stand near $1.5200.

A stronger turnaround than the dollar can be found in China and Italy. China's stock market was hit hard yesterday after the weekend measures to slow the housing market. Led by the financials, the Shanghai Composite recouped nearly half of yesterday's losses. The National People's Congress began earlier today and the government announced a GDP target of 7.5%, unchanged from last year, along with a a 10% increase in spending that would be focused on health care, education and agriculture, according to reports.

Italian bonds and stocks which fell yesterday are recovering today. The impetus is two-fold. On the one hand, following yesterday's EU meetings, the Economic and Monetary Commissioner Rehn reaffirmed a more lax stance, indicating that the protracted downturns could justify reviewing deficit targets for a "certain number" of countries. This leads to the second spur of today's correction. While this was clearly the direction of movement before the Italian election, it creates space for a possible political compromise in Italy to allow some weakening of Monti-induced austerity without triggering a backlash. As messy as it may appear, the Italian political forces do seem to be moving toward some kind of solution to the hung parliament. Remember, even under the best of circumstances, when the center-right won with a landslide, it took four weeks to put together a government.

The euro area service PMI showed a bit of improvement from the 47.3 flash reading, rising to 47.9. However, the real take away, and one not lost on the foreign exchange market which sold into the euro's bounce, was that the February reading was weaker than the 48.6 seen in January. The Markit group that compiles the data says it is consistent with 0.2% contraction in Q1 GDP. Of note, the recovery in Germany seems more solid, though there is some anxiety ahead of the industrial orders and production reports later this week. France also showed improvement over the flash (43.7 vs 43.6), but is so far below 50 to make it irrelevant. Italy's and Spain's reading were horrible at 43.6 and 44.7 respectively falling from 43.9 and 47.0.

Separately, the euro area reported a stronger than expected 1.2% rise in January retail sales, slowing the year-over-year decline to -1.3% from 2.9% at the end of last year. On its face, this does not seem sustainable and the real signal from the euro area is one of weakness in aggregate demand and high levels of unemployment.

After reporting weak manufacturing and construction PMIS, the UK reported a better than expected CIPS service PMI. It rose to 51.8 in February from 51.5 in January. The consensus had expected a decline to 51.0. It is the highest reading since last September. Sterling reacted positively and although it does support economic forecasts calling for a small expansion in Q1, there was warning embedded in the day. Input costs rose to a 14-month high and this warns of a potential squeeze on margins. This may help explain why the gilts are the worst performing core bonds market today and why the FTSE is lagging behind the major European bourses.

The Reserve Bank of Australia was the first of the major central banks to meet this week. It stood pat and issued a statement that was quite similar to the previous one. The economic data reported before the meeting supported the decision. January retail sales rose 0.9%, which was twice the gain the market expected and the first increase in four months. Separately, the current account deficit unexpectedly narrowed in Q4 12 as the narrowing of the income deficit offset the deterioration of the trade balance.

There are three developments in Japan to note. First, one of the less appreciated aspects of Abenomics is to boost labor income. The government must be pleased then with the news earlier today that labor cash earnings rose 0.7% year-over-year in January. The consensus had anticipated a 0.3% decline. It remained a better than expected report even though the December data was revised to show a 1.7% decline rather than 1.4%. It was the first positive figure since last April. Second, in testimony BOJ-deputy nominee Iwata who previously seemed to advocate foreign bond buying seemed to pullback, suggesting that other measures needed to be tried first. Third, the DPJ, which has a majority in the upper house is threatening to block the same Iwata's nomination on grounds that he supports a change in the BOJ's charter (erosion of its nominal independence).