Last week, we recognized that the US dollar was overstretched and anticipated some consolidation/correction. Yet the pace and magnitude of the move was surprising, especially in light of the series of disappointing developments in Europe, which include the initial failure to resolve Greece’s funding problems and the EU’s next 7-year budget.  Nor was the economic data inspiring, as the main report of the week, the Nov flash PMI reading, suggests the euro area economy continues to contract here in Q4.

In contrast, the US reported stronger than expect existing home sales and housing starts, as the painfully slow recovery in the housing market continues.  Weekly initial jobless claims slipped back as the impact of the east coast storm fades.  The newly introduced Markit PMI reading was above consensus forecasts.  The University of Michigan’s final consumer confidence measure for November was a bit softer than the preliminary report, but still is at 4 1/2 year highs.

Admittedly, the key issue in the US is not how the economy is performing now, but the looming fiscal cliff. The noises and signals emerging from Washington seemed to be a source of some confidence that the worst of it will be averted, though we continue to suspect that brinkmanship tactics will make for only a last minute deal (if not a slightly later one)  Yet the optimism was frequently cited for the S&P gains last week.

Recall that the S&P 500 rallied about 16.5% from early June through mid-September.  We turned cautious here (Sept 22), anticipating a decline to at least 1400.   The S&P overshot this, but staged a reversal on Nov 16 and saw impressive follow through last week.  In fact, the S&P’s 4.1% advance last week, was the best since June and all the main industry groups, save utilities, participated.

With the pre-weekend advance, the S&P 500 has retraced 50% of its two month slide.  The next retracement level is near 1424 and the month’s high comes in near 1434. These are the main two technical barriers ahead of a return to the year’s high near 1475.  We note that the 5-day moving average of the S&P 500 is poised to cross above the 20-day average early next week.  In addition, what could be a head and shoulders bottom projects toward 1435.  The correlations between the foreign currencies and the S&P 500 has declined over the past few months, but has begun to increase again recently.

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The days ahead will help clarify whether the US dollar’s somewhat firmer tone last week was simply corrective in nature, before a new leg lower, or the carving out of a bottom of a downtrend that began in June against most of the major currencies and July for the euro.
The key may not lie with the economic data.  The important steps announced by the ECB, Federal Reserve, and BOJ has stolen the thunder from the near-term economic performances. Instead, we suspect politics and positioning may be more important.

As we have noted, the signals coming from European officials indicate that there has been an important climb down from pushing Greece out of the monetary union and the indications from intrade.com, where the odds a country leaving the euro zone this year has fallen to the lowest in at least two years, suggest investors recognize this.

Exactly how the proverbial circle can be squared–how Greece’s debt outlook can be judged to be on a sustainable path–is not clear.  Yet this is not the top issue on the agenda.  In fact, since earlier this month, European officials appear to be playing for time, and not just for the mid-Oct EU summit, which had previously seemed to be the case.  Instead, expectations have been massaged and now a November decision is more likely.

Instead of Greece, the political spotlight in Europe is on Spain.  There are two conflicting impulses.  On  one hand, Spain is reportedly engaged in negotiations to design a structural reform package that could be adopted prior to formally asking for assistance that would in fact meet the Troika’s conditionality.  These structural reforms, which may not include new taxes or spending cuts, could be announced toward the end of next week.

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Last week was of two halves.  In the first part, the dollar remained strong as the European crisis dominated other considerations.  In the second part, the dollar had its recent gains pared as the seemingly bipolar market shifted its focus to the increased risk of a policy response.  In addition, evidence continued to mount that the world’s largest economy is off to a sluggish start of Q3.

The Bank of England meets but as it is currently engaged in QE and the “Financing for Lending Scheme”, this will likely be a non-event. And unlike other central banks, when the Monetary Policy Committee doesn’t do anything, it doesn’t say anything.  The monthly purchasing managers surveys will also be released but are unlikely to provide much fresh insight or challenge current views.