Summit gotta give

• Spanish bond yields fall on EU summit hopes, but risk of disappointment looms 
• Bank of England reports on financial sector (and policy implications) overshadow GDP revisions 
• US releases help gauge scale of slowdown in light of Philly Fed's sharp dip 

Despite the swift downswing in risk sentiment in recent days, following further declines in key global surveys, Euro area peripheral yields fell. Most importantly Spanish 10-yr yields dropped below the 7% mark (currently 6.49%) and Italian yields below 6%. Specific factors had some influence, including hopes that Spain’s bank bailout would be an EFSF, not ESM operation (easing subordination concerns) and possible ECB technical changes. Yet most of the outperformance appeared to be short-covering with hopes that next week’s EU Summit produces a game-changing outcome.

Optimism about the coming Summit (Thursday/ Friday) were fuelled after post G20 comments from US President Obama and Treasury Secretary Geithner, and more recently by pressure from the IMF. Yet yesterday’s Euro area finance ministers meeting showed Germany is far from isolated in its views, with Dutch and Austrian ministers showing little appetite for change. The history of disappointing Summits counsels caution. That said, the overall situation seems more precarious and a failure to act risks a marked worsening in the Spanish situation and threatens a full blown bailout. Hopes for progress on mutualised borrowing still appear far-fetched and even a tentative banking union agreement may be a stretch. Hence markets are focusing on the prospect of EFSF/ESM secondary market bond purchases. However, we doubt that this will have a lasting impact and risks perpetuating the crisis over the summer.

In the absence of any marked progress at the Summit, markets will look to the ECB meeting the following week for hopes of support. The worsening in key surveys this week suggests a growing case for stimulus. Thursday’s ‘flash’ inflation estimate looks set to drop and sharp declines in oil and global commodity prices raise the prospect of inlation falling below target earlier than the ECB expected, removing further constraints to stimulus. Our global team forecasts a 0.25% refi rate reduction in July.

Domestically, central bank reports on aspects of the financial system should be of more interest than economic releases. For example, the third estimate of Q1 GDP is unlikely to change the reported -0.3%. However, the economic outlook has deteriorated. With the Bank of England likely to broaden its policy response to this deterioration, as well as, we think, a £75bn extension of QE in July, Q2’s Credit Conditions Survey will be closely watched. Governor King’s appearance before Parliament on Tuesday should provide further insight. We will also watch for details of today’s interim Financial Policy Committee meeting, likely alongside the biannual release of the Financial Stability Report and its press conference on Friday. With policy stimulus taking a more technical steer and specifically aimed at reducing the feed through of Euro area problems via banking channels, today’s meeting likely saw vigorous debate about policy options.

Otherwise, we will watch US releases in the light of the sharp drop in June’s Philly Fed survey. Friday’s Chicago PMI will give a steer to the likely impact on the following week’s ISM, with forecasts for a more muted response. Consumer confidence measures should hold up reasonably well, with concerns about the softer outlook, somewhat assuaged by the sharp decline in retail gasoline prices. These forward-looking indicators are likely to prove more important to the Fed than final revisions to Q1 GDP (Thursday). While the Fed ’s extension of Operation Twist this week fell short of hopes for further QE, Chairman Bernanke hinted that this remains an option if the US sees a sharper deceleration, something that a worsening in the Euro area could precipitate.

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