What Happened While US was Celebrating Independence

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US markets were closed on July 4.  Asian and European equities moved lower as did most bond yields.  The MSCI Asia Pacific Index fell a third of one percent.  It was the third consecutive losing session and five in the past six.  European markets were mostly lower, and the Dow Jones Stoxx 600 fell 0.3%, after rising 1% on Monday.  It too has fallen in five of the past six sessions. 

The German 10-year Bund yields remain near the 50 bp ceiling that has capped yields in late January, mid-March, and mid-May.  Above there, and yields can rise to 65-70 bp.  A year ago (July 6), the yield bottomed a little beyond minus 20 bp.  The 10-year Japanese government bond yield traded heavily as the BOJ’s 10 bp tolerance band (around zero) turned the market cautious.  Japan’s 10-year bond auction was well received.   The nearly eight basis point yield was twice the yield of the last two 10-year bond sales.  The bid-cover was over four, while in the previous two auctions generated an average of 3.7x.  

The US dollar itself was mixed, but against the euro, yen, and sterling, it mostly consolidated Monday’s advance.  The biggest mover was the Canadian dollar.  It gained a little more than 0.5% against the US dollar.  In the futures market, it is clear that the speculators were caught with a record gross short Canadian dollar position and are dramatically covering shorts.  However, new longs appear distinctly unenthusiastic.    Despite narrative that suggests a concerted effort by central banks to take away the proverbial punch bowl, we only see the Bank of Canada with a reasonably good chance of hiking rates (July 12).  

The weakest performing major currencies were the Australian dollar (~-0.75%) and the Swedish krona (~-0.45%).  Not coincidentally perhaps, the respective central banks met.  Sweden’s Riksbank, as expected left policy on hold, but cautioned that there was less of a chance of lower rates than previously.  Nevertheless, the krona was sold off.  The pressure appeared to emanate from the cross against the euro, which had begun recovering Monday against the krona and accelerated Tuesday.  

The Reserve Bank of Australia was a bit more dovish than expected.  It did not remove the downside risk (to rates) that other central banks are in the process of doing.  Governor Lowe’s concerns centered on the household and consumption under the condition of record debt and weak wage growth.  Recall that before the weekend, the Australian dollar had briefly poked through $0.7700 for the first time since March.  Since the middle of 2015, this general area has proven difficult to the Australian dollar to overcome.

Some observers linked the yen’s modicum of strength to nervousness following what North Korea claims were a successful test of an intercontinental ballistic missile (ICBM).  The greenback had reached nearly JPY113.50 on Monday.  Tuesday’s low of JPY112.75 was a little bit above last Friday’s high (~JPY112.60).  That said, the Korean won was off about 0.35%, and the Kospi was down nearly twice as much.  The Kospi rallied for seven consecutive months through June.    The conventional wisdom argues against the “rational actor hypothesis”  being applied to North Korea, and the treatment of their own people is despicable, but in foreign policy, it has the world’s two largest powers seem as powerless to prevent from acquiring the delivery mechanism after being unable to prevent it from developing such a weapon in the first place.  

Also on Tuesday, Italy took another step toward addressing it troubled banks.  The EU approved a 5.4 bln euro capital injection (from the state) as part of the pre-cautionary re-capitalization for Monte Paschi,  that is reserved for troubled banks that have not failed.   Shareholders and junior bond holders got bailed-in to the tune of 4.3 bln euros.  There are some retail investors for whom the bonds may have been misrepresented, and can seek restitution, which is thought to cost as much as 1.5 bln euros.   

The government’s money (20 bln euros) was approved last year, and that fund will be used here as well as for the two Venito banks. Prime Minister Gentiloni has been making this decision by decree, and these decrees have to become law shortly.  However, reports suggest there have been something on the magnitude of 700 amendments, more than half of which come from the Five-Star Movement deputies.  Gentiloni may be forced to make it into a confidence vote, which given the lack of an electoral law, the failure would end the political calm ushered in by Macron’s victory in France and Merkel’s recovery in Germany.  

US markets will re-open, and the US two-year note yield at 1.41% is at its highest level since mid-2009.  US data has been mixed.  Auto sales disappointed, and last week the US rig count fell for the first time in 24 weeks.  However, the manufacturing ISM was strong, with forward-looking news orders up to 63.5 (from 59.5), a three-month high.  Export orders increased.  Employment was at its second best level since 2011.  Admittedly, the Markit manufacturing PMI was its weakest in nine months.   

The US yield curve has steepened.  Over the past week, the 10-year yield is up more than 14 bp, while the two-year yield is up 4.  The 10-year breakeven has risen from 1.67% on June 20 to 1.76% on July 3.    We have identified rising US interest rates (and premium over Germany and Japan) as a necessary condition of the dollar to resume what we think is the third significant dollar rally since the end of Bretton Woods.  

Wednesday features non-manufacturing PMI reports and US factory goods orders and the FOMC minutes from last month’s meeting.  Like the manufacturing PMI, the UK’s construction PMI was weaker than expected.  Making it a trifecta with a weak service reading will likely weigh on sterling.   There is potential toward $1.2860 initially.  It may take a break of $1.28 to confirm that the $1.3855 area, the 38.2% retracement of the drop that began with the referendum held again.   The flash European PMIs steal much of the thunder of the final readings, and we note that the stronger than expected manufacturing report failed to inspire euro gains.

The FOMC minutes will be scrutinized for details to give a better sense of the extent of the cautiousness expressed by at least one Governor and a few regional presidents in light of the decline in price pressures in recent months.   We suggest that the most likely scenario is for the Fed to announce in September plans to begin not rolling over the full maturing issues in October, and waiting for confirmation that inflation remains on course until the December meeting.