What Happened While US was Celebrating Independence

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. 

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