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Prospects Weekly: Ongoing debt-limit debate and disappointing growth reports weighed on the U.S. dollar

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European heads of state agreed on a €109 bn second financial package for Greece today. About one-third of the financing will be covered by debt swaps or rollovers by private bondholders. Aside from improving the terms of existing multilateral loans, the leaders also agreed to expand the European Financial Stability Facility’s mandate, including authority to buy bonds on the secondary market. Ahead of the summit, bond and CDS spreads rose on heightened concerns of a systemic crisis, and Euribor rates continued to rise following recent policy interest rate hikes (to stem inflation). A deal on raising the U.S. debt limit remains elusive. If U.S. sovereign debt were to be downgraded from its top-notch rating, implications for global financial markets and growth could be significant in the face of tighter liquidity conditions. Notably, market confidence in U.S. The ongoing debt-limit debate and disappointing growth reports weighed on the U.S. dollar and equities this week. However, U.S. Treasuries remained resilient as yields held relatively steady. Investors appear more concerned about negative spillover-impacts on growth of a potential default, abrupt spending cuts, and/or credit-rating downgrade than about bond coupon-payments being honored. Worries center on the risks of prolonging the current soft-patch in growth, or on the downside of recession. Global activity slowed markedly in Q2-2011, as reflected in ongoing deterioration in the global PMI manufacturing and services surveys in June—despite the sharp post-Tohoku rebound in Japan and some easing of inflationary pressures. Global PMI new-order surveys also fell on concerns that policy-turmoil and deepening fiscal consolidation in the Euro Area and the United States could undermine growth, and that several developing countries could see a slowdown given tighter monetary policy aimed at curbing inflation. Gross capital inflows to developing countries fell in June, as bond and equity inflows faltered on a flight-to-quality. Still, total inflows nearly doubled in 1H-2011 from a year-prior—buoyed by bank-lending—and likely contributed to strong credit growth in some countries. .

The US-dollar and equities fell this week on mounting concerns of a credit-rating downgrade, abrupt spending cuts or temporary default—and associated negative growth impacts. Investors turned to safe-haven assets, including the Swiss franc and gold, which appreciated to record highs against the dollar during the week. The cost of insuring against a U.S. sovereign default also rose, reaching a …-month high (5-yr. CDS). Reports from the Commerce Department, that U.S. durable goods orders contracted unexpectedly (2.1%, m/m) in June, and from the Federal Reserve, that the slowdown in U.S. growth broadened through mid-July over mid-June, contributed to market jitters. In contrast, Treasuries remained relatively stable, partly reflecting weaker growth prospects as well as apparent confidence that U.S. interest and principal payments will be met. While market confidence has remained relatively strong, it could quickly deteriorate if political gridlock drags on. 

Global PMI surveys for manufacturing and services suggest global growth slowed in Q2-2011. These declines are underscored by the new orders components, which are down a pronounced 8.8 and 6.0 points for manufacturing and services, respectively, since January 2011. Moreover, the ratio of new orders to finished goods components for manufacturing declined over the same period, suggesting continued inventory adjustment to softer demand. PMI manufacturing surveys are down from earlier-peaks in 2011 in 27 of 28 countries (mostly high-income) with current data. All BRICs saw lower June readings on monetary policy tightening, slowing foreign demand and heightened uncertainty, with Brazil’s manufacturing PMI flagging a mild contraction, and Russia and China’s pointing to marginal growth. 

Despite a fall-off in June, gross capital inflows to developing countries rose 41% above year-earlier levels in 1H-2011, with bank lending up 57%. Inflows slowed to $40 bn in June from $51 bn in May, as bonds and equities faltered on a flight-to-quality given heightened uncertainty in Europe. But bank lending held steady, as volatile international market conditions prompted some borrowers to switch to syndicated loans. While bank-lending remains well below pre-crisis peaks, emerging market corporates have started tapping the syndicated loan market again. Bond issuance has been robust as well this year, with Latin America accounting for 40% of total issuance.





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