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Farrell: Don't Count on Europe to Drive Recovery

The euro had strengthened significantly against the dollar in the last few weeks. The message was the Euro Zone economy was picking up relative to the US economy. Capital migrates to stronger economic areas, if for no other reason than the thought that interest rates will rise as an economy grows.

And indeed, the Euro Zone staged a surprising bounce in the second quarter which seemed to justify the euro move. In Q2 the Euro Zone grew 1.7% year-over-year, higher than the estimate of a 1.4% growth rate. It also showed a 1% quarter-over-quarter rate of growth, which was also higher than estimates, and the best gain since 2006.

Not surprisingly, the surge was led by Germany, which grew 2.2% quarter-over-quarter and at an annual rate of 9%. This was the biggest quarterly gain for the combined Germanys since reunification. Favorable weather helped, and, of course, exports led the way—in that well over 40% of Germany's economy is export-derived. But the prospects for tomorrow are not so bright.

Construction spending was stronger than anticipated the past few months, as backed-up projects finally got underway, but are highly unlikely to continue at the same pace. Inventory rebuilding is probably done with as well, and that will cease to be a positive contributor.

The same holds true for the US, as we have been mentioning in this note recently. The true test to me is always the action in the markets, and the euro bond market has turned decidedly negative.

After the European bank stress tests, where only 7 out of 91 banks were shown to need additional capital in a worst-case scenario, the hope was the problems of capital adequacy were at least ring-fenced. We expressed doubt at the time that the tests were rigorous enough, in that some banks were allowed to design their own test.

Give me a self-made test (or a golf scorecard) and watch who wins!

Just last week, Ireland received EC approval to put an additional $12.9 billion of capital into Anglo Irish Bank, on top of about $16 billion already invested. Bank of Ireland, 36% government-owned, then reported a first-half loss that was double what they lost in the same period one year ago.

Both announcements surprised the markets, and credit default insurance costs for Irish sovereign debt surged 36% higher than in the beginning of the month. Ireland was forced to pay investors 2.458% for six-month borrowings compared to 1.367% as recently as July 22. (Track the PIIGS Nations CDSs Here.)

Two-year Irish bonds went from a 2.8% yield to a 3.35% yield in two days, a huge move in the bond world. For comparison, the 2-year US Treasury bond yields about 0.50%. Greek, Italian and Spanish borrowing needs have all been well above expected levels, and the cost of credit default insurance for all countries has risen. The European Central Bank had to buy short-dated Irish bonds at the end of the week to try to calm the market. The Stoxx European bank index is down about 8% in the last two weeks. And the stress test "success" is not yet one month old.

Germany can't pull the whole Euro Zone out of trouble, since they are export-dependent and a goodly share of the exports go to other European countries that are exhibiting worrisome times again.

GDP has decelerated meaningfully in the US: Q4 2009's 5% slumped to a preliminary read of 2.4% for Q2 2010. But the bet is that gets revised to about a 1.4% number, for reasons we wrote about last week. Sentiment has turned even more negative and more "double-dip" scenarios are being painted.

Details about health care costs, financial regulation specifics and tax rates for 2011 are wanting.

Both Democratic and Republican approval ratings are at or near historic lows. (See: Your Taxes, Your Vote: 2010 Races to Watch)

The Federal Reserve is teeing up another round of quantitative easing, which is controversial to say the least, and weekly initial unemployment claims are getting back to the recessionary level of 500,000. Can I go back on vacation? (But if I know it and you know it, the market probably knows it. I still see a trading range with 1040 on the S&P the bottom of the range.)

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