It was a case of "bad news is good news" last week. If markets become convinced that the news is so bad that central banks might have to act in a major way, seemingly bad news can be magically transformed into good news for equities, which, as of early Friday afternoon, were set for a modest gain for the week in the US. The Bank of England announced a new package of measures to try to kick-start bank lending, while European Central Bank (ECB) and US Fed officials assured markets that they'll pump in liquidity as needed if markets begin to freeze up after the Greek elections on Sunday.
There was bad news from Europe as the boost from the weekend announcement of a bail-out for Spain's banks evaporated rapidly. The funds will be channeled through the Spanish government and, therefore, will add to its debt. Unfortunately, this bailout approach doesn?t break the death-spiral embrace between Spain's banks and its government. Spanish bond yields rose, and contagion spread to Italy, pulling its yields up too.
There was bad news too, on the domestic front as incoming data was downbeat. May retail sales and industrial production both declined, while unemployment insurance claims ticked higher. The silver lining came from falling producer and consumer prices as lower gasoline and food costs came through, bolstering consumer purchasing power and holding down business costs.
Meanwhile, the future of the Eurozone hangs in the balance as Sunday's Greek election approaches ? a poll being presented as an unofficial referendum on Greek euro membership. We doubt that Greece has a long-term future in the Eurozone, but if pro-bailout parties were to form a government, concerns about an early exit would ease considerably.
If there's no clear majority, uncertainty will drag on. If an anti-bailout coalition is elected, a Greek exit would likely follow in short order, unless the rest of the Eurozone caves in with improbable concessions. Markets would quickly ask "who's next," and the pressures on the Eurozone periphery would intensify. Emergency central bank support would likely kick in, but that's hardly a scenario that one should classify as "good news".
Even if no emergency action is needed, the Fed has a regularly scheduled meeting and press conference set for Wednesday, during which, Fed participants will have to scale back their expectations for US growth. In response, we expect the Fed to extend the expiring "Operation Twist" into the second half of the year. More substantial action ? such as expanding its balance sheet (QE3) or extending its "low rate" guidance into 2015, seems unlikely this time, but should the Greek elections turn out unfavorably for markets, the Fed might opt for a stronger policy response.
Domestic data this coming week (June 18-22) is limited, and will take a back seat to the Greek elections and the subsequent market and central bank reaction. We expect both housing starts and existing home sales to ease back in May, although we expect housing permits to improve, signaling that there's still an underlying pick-up in housing activity under way.
Tuesday, June 19 ? Housing Starts (May)
Housing starts likely declined 1% in May, to a 710,000-annual rate. Lower employment in residential construction suggests an easing in housing starts. But we expect housing permits to improve further, signaling that there's still an underlying pick-up in housing activity.
Wednesday, June 20 ? FOMC press release 12:30 pm / press conference 2:15 pm
The Fed will show its concern that the economy continues to underperform its expectations in terms of growth and employment. But it probably isn't ready yet to implement another major easing beyond extending its maturity-extension program, Operation Twist, which is aimed at pressing down on long-term yields. That could change if the financial markets are in shock after the Greek elections.
Thursday, June 21 ? Existing Home Sales (May)
Despite an increase in mortgage applications in March and April, existing home sales likely fell a token amount in May, since the Pending Home Sales Index (a leading indicator for closings) moved down in April.
