Stocks and Bonds Mostly Heavier While Dollar Little Changed

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  • Attention now turns to Yellen’s semi-annual testimony to Congress next week, followed by the July 25-26 FOMC meeting
  • The EU and Japan reportedly have reached an agreement on a free-trade pact ahead of the G20 meeting
  • The market awaits the record from the ECB meeting
  • ADP jobs and ISM services dominate the US economic reports today
  • EM FX remains under pressure; Banco de Mexico will release its minutes

The dollar is narrowly mixed against the majors as markets consolidate. The Scandies and sterling are outperforming, while the yen and Antipodeans are underperforming. EM currencies are broadly weaker. RON and HUF are outperforming, while TRY and KRW are underperforming. MSCI Asia Pacific was down 0.2%, with the Nikkei falling 0.4%. MSCI EM is down 0.1%, with the Shanghai Composite rising 0.2%. Euro Stoxx 600 is down 0.6% near midday, while S&P futures are pointing to a lower open. The 10-year US yield is up 4bp at 2.37%. Commodity prices are mixed, with oil up 1.4%, copper up 0.2%, and gold down 0.2%.

The US dollar is narrowly mixed against the major currencies after being confined to tight ranges through the Asian session and European morning. Equities are nursing small losses, and interest rates are pushing higher. The yield on the 10-year German Bund reached 50 bp for the first time since early 2016. Oil prices have steadied after yesterday’s slide.

The FOMC minutes from last month’s meeting failed to shed fresh light onto the timing of the beginning of gradually reducing its balance sheet. However, it seems as if an agreement on it could be achieved before the next move on the Fed funds target. That said, the minutes were explicit: “most” thought that the recent softening of prices was due to “idiosyncratic” developments.

In terms of Fed policy, the market’s attention now turns to Yellen’s semi-annual testimony to Congress next week, followed by the July 25-26 FOMC meeting.   The Fed has yet to adopt the tactics under the otherwise plain-spoken Chair that would maximize the degrees of freedom in terms of meetings. Specifically, the Fed seems only comfortable to announce policy changes at meetings followed by press conferences. It could hold press conferences after every meeting, which is what the Bank of Japan and the European Central Bank do, for example.

Although the minutes do not clarify the situation, we expect the Fed to be content monitoring the economy until the September FOMC meeting. It will have a better sense of the trajectory of prices, including wages. It can have a better sense of the true signal being generated by the broader financial conditions.

The Fed has already put the markets on notice that it will begin “relatively soon” not reinvesting all the maturing Treasuries and MBS. We expect the economy to evolve in such a way as to allow the Fed to carry through with this commitment at the September FOMC meeting. This will allow the balance sheet to shrink by what seems like an inconsequential $30 bln before the end of the year.

US 10-year inflation expectations crept higher (breakeven) despite the 4.1% drop in August light sweet crude oil prices, which ended an eight-day, nearly 13% rally with an exclamation point. The ostensible trigger was a report suggesting Russia had no appetite to increase its efforts with OPEC to bolster the prices, while Libyan and Nigerian output, which is excluded from the output cuts, have boosted OPEC’s output.

News that API estimates that US oil stocks fell a sizable 5.8 mln barrels is helping prices stabilize today ahead of the DOE’s estimate later in the US morning. Support is seen near $44 a barrel and a break would re-target the low from late June near $42.

Germany reported a smaller than expected recovery in factory orders. After a 2.2% slide in April, economists had expected nearly a full recovery in May. The actual increase of 1.0% was about half of the gain forecasts. Orders for basic and consumer goods fell, while foreign orders for investment goods rose 6.0%.

Despite the disappointment with today’s report, the strong German manufacturing PMI for June blunts any negativity. Germany reports May industrial output figures tomorrow. The median guesstimate of a 0.2% rise, following a 0.8% increase in April, will suffice to lift the year-over-year, workday adjusted rate to 4%, the highest in three years.

The EU and Japan reportedly have reached an agreement on a free-trade pact ahead of the G20 meeting. It is important not just as a trade agreement between the two that account for a quarter of the world’s GDP. It is important because even though negotiations began several years ago (2013), it suggests that the potential defection of the US from the liberal trade regime that it was instrumental in creating will not necessarily mean the end of that regime.

The trade agreement will eventually eliminate 99% of the tariff barriers to trade, according to reports. At the heart of the agreement is a phasing out of the EU’s 10% duty on auto imports, while Japan opens up its agricultural market. Japan’s Prime Minister Abe had seen in the TPP an opportunity to the agriculture coops which remain resistant to his reform agenda, and this agreement with the EU achieves perhaps on a smaller scale the same effect.

The theme of the G20 summit in Hamburg is free and fair trade. North Korea’s test of an intercontinental ballistic missile threatens to overtake the agenda. The US strategic goal of denying North Korea nuclear capability and a delivery mechanism appears to have largely failed. None of the key stakeholders have much of an appetite for military action to remove that capability. Effectively tightening and enforcing sanctions requires cooperation for which the US does not appear inclined to offer fresh inducements.

Separately, and looming over the G20 meeting, is the US threat of imposing tariffs (and possibly quotas) on steel imports on the grounds that they pose a national security risk. The investigation has reportedly been completed, and the debate has shifted to the precise policy response. There appears to be a small window of opportunity to persuade US President Trump to use the WTO’s conflict resolution mechanisms. It may take a bit longer, but the US does win the lion’s share of cases it brings.

There are already around 200 countervailing tariffs or anti-dumping duties already “protecting” the US steel industry, pushing domestic prices above world prices. Defense needs absorb a small part of US capacity, and so additional unilateral action will likely be contested. In some ways, the US appears to be trying to decide if this is a good test case for its trade initiative.

There can be two outcomes. The WTO finds against the US, and the US chooses to ignore the ruling, which it has threatened to do. This could potentially spur a crisis of the multilateral institution. Alternatively, the WTO could grant a liberal interpretation to its national security exemptions, which would likely spur copycat behavior elsewhere, creating a new loophole for protectionism.

The market awaits the record from the ECB meeting. It is keen for insight into the timing of the next policy step. We expect that at the September meeting, the ECB will announce that it is extending its asset purchases into next year, but at a slower pace than the current 60 bln euros a month.

To make these purchases, the ECB appears to be deviating from the capital key, which is supposed to be one of the controlling rules shaping the sovereign bonds/agencies being purchased. Although some deviations have been sustained for several months (Finland and the Netherlands, for example), we are reluctant to read too much into it, and instead, view at as a minor technicality. The ECB can change and modify its rules as it sees fit, and although it is not likely, it can boost its purchases if needed.

Private sector data in the US in the form of the ADP private sector jobs estimate and the ISM/PMI service sector readings dominate the US economic reports today. The ADP may catch the large trend of the BLS estimate, but on a month-to-month basis, large gaps do arise. The employment and price components of the ISM/PMI will likely garner the most attention. Separately, the market will also get official data (the May trade balance and the DoE energy report). Canada reports building permits and trade ahead of tomorrow’s employment report, which will be the last important data ahead of next week BOC meeting where a 25 bp rate hike is now widely anticipated.

EM FX remains under pressure. The global liquidity outlook has turned more negative for EM, as rising DM rates and steady (or lower) EM rates will narrow the differential between the two. ZAR can be viewed as the canary in a coalmine, as abundant global liquidity is really the only thing propping it up this year. South Africa policymakers have not helped matters with their random (and negative) outbursts in recent weeks, but other high beta EM currencies confirm our growing negative bias on EM.

Banco de Mexico will release its minutes. At that meeting, the bank hiked 25 bp to 7.0% but signaled that the tightening cycle was over. Mexico then reports June CPI Friday, which is expected to rise 6.34% y/y vs. 6.16% in May. Next policy meeting is August 10 and no change is expected then. We think the easing cycle might start in Q4, but much will depend on global developments.

Why is MXN getting caught up in this EM sell-off? Well, lower oil isn’t helping but we think much of it is due to positioning. CFTC data for the week ended June 27 saw a big drop in gross shorts, as MXN continued to rally and stopped the weak shorts out. As a result, net longs jumped 32k that week to 81k even as gross longs made a new cycle high just above 126k. Since then, the peso has weakened sharply and we think many week longs have been stopped out as the position skew has caused MXN to underperform again.