A brief period of quiet, which some may have confused with a change in
posture, North Korea followed up the weekend’s test of three ballistic missiles
with what appears to have been an intermediate missile that flew over
Japan. South Korea responded with its own
symbolic display of force by dropping bombs by the DMZ.
In recent notes, we have explained that the US-South Korea annual
military exercises antagonize North Korea. Last year, during these
exercises it launched a missile from a submarine, which in military signaling,
show second strike capability. That means that the first strike on North Korea risks a retaliatory strike.
If a military option is not practical, it does not appear that pressure or
sanctions work either. Japan condemned the North Korean action and
calling for an emergency UN Security Council meeting. The US response is awaited.
The US dollar’s sell-off that began before the weekend continued
yesterday and is accelerating today. North Korea’s provocations have
added to fuel to the fire that was already burning. Coming out of
Jackson Hole, the consensus scenario of ECB tapering and Fed allowing its
balance sheet to begin shrinking, and fading prospects of tax reform and an
infrastructure initiative in the US, the greenback was vulnerable. In our
assessment both fundamental and technical conditions had aligned that warned
that the dollar’s recent consolidation was over and a new leg lower had
begun.
Interest rates remain at the center
of our focus. The US 10- year yields are
off more than six basis points to new lows for the year below
2.10%. Our concern has been that if the so-called Trump trade
is being unwound, and the underlying
trend growth of the US economy is not about to materially improve, the US
10-year yield may return to status quo ante, to where it was before the Trump
trade, which we see as closer to 1.85%.
Politically, we are concerned that Trump’s coalition is unraveling.
The business wing is peeling off as more
advisory boards face departures. A group of business leaders also wrote
to Trump linking their support for the NAFTA renegotiation to preserving the
trade tribunals, which the administration wants to jettison. Several links between the administration and the
Republican Party have also been severed by personnel changes.
The President has also come out swinging, critical of the Republican leadership
in Congress.
The debt ceiling and spending authorization also have to be resolved in
the coming weeks. The uncertainty is also distorting the bill
market. And look at the US CDS. It has fallen to 20bp at the end of
July and now is near 26 bp. That means it costs 26k euros to insure 10 mln euros worth of Treasuries against
default. To be sure this is still low in absolute terms, though the
highest among the G5.
In addition to the tensions on the Korean peninsula and the poor dollar
backdrop, there is another force at play. Over the last couple of
week, the UK issued nearly a dozen position papers that laid out its emerging
views on a range of issues that largely related to the post-Brexit
relationship. As we looked through the topic and papers, it dawned on us
that the UK was missing the EU’s point and, since in our understanding, once
Article 50 was triggered, the initiative went to the EU, we thought this was
significant. Yesterday’s the EU’s chief negotiator Barnier called the UK
to the task, arguing that it had still
not addressed the preliminary issues.
These preliminary issues which the EU insists on addressing first involve
the terms of the separation, which given the organic growth over the last 40
years, and the complexity of the issue, we suggest is more like an amputation
than a divorce. Juncker echoed these remarks. This is important because the EU Summit is
about eight weeks away, and it is then that if there was sufficient progress on
the preliminary issues that the next phase could begin, which involves the issues
that are dear to the UK. While brinkmanship tactics can be expected, the chasm is still wide.
A Bloomberg reporter captured the UK’s exasperation: “The UK
camp believes negotiations could progress if Barnier’s team did not follow its
mandate to the letter.” If a fair assessment, it suggests a
certain naivete and unpreparedness on the part of the UK. At the very
least, one should expect one’s adversary to stick to the letter of the law in
these matters. Of course, other scenarios may be considered, but isn’t the letter
of the law the base case?
The US dollar has been sold across
the board. The Swiss franc, rather than the yen, is the strongest
currency against the dollar, gaining a little more than 1% (~CHF0.9450).
The yen is up about 0.6%. The dollar approached the year’s low (April 17
~JPY108.10)., but caught a bid near JPY108.30 in the European morning.
Resistance is seen in the
JPY109.00-JPY109.20 band. The euro surge continued with the single
currency reached $1.2070, its highest level since 2015. Recall that the
$1.2170 area corresponds to a 50% retracement of the euro’s depreciation from
mid-2014 until the start of this year.
The weak dollar environment is allowing sterling
to continue to recover. It had recorded two-month lows last week near
$1.2775 and had strung together a
four-day advance that carried it to nearly $1.2980. However, it is no
match for the euro and other European currencies. The euro reached
GBP0.9300 today. However, it is the dollar bloc that is underperforming
today. The Australian dollar is the only major currency slipping lower on
the day, and the New Zealand dollar is up 0.25%, which is the second weakest of
the majors. The Canadian dollar began weakly
but has come back bid, with the greenback posed to test the July low near
CAD1.24.
Global equities are lower. Asia markets recovered from steeper
losses and the MSCI Asia Pacific Index managed to close only 0.15% lower.
Korea’s Kospi was off 1.6% at its worst and closed only 0.2% lower.
European shares are down for a third session and lose have accelerated. The Dow Jones Stoxx 600 is off 1.4%,
led by telecoms, financials, and
industrials. Bond markets have rallied. Core European yields
are off 4-5 bp. Italian and Portuguese bonds are not participating in the
rally. Japan’s 10-year benchmark yield is below zero for the first time
since April.