Four Issues for the Week Ahead
There are four key, but interrelated issues that will shape the investment climate in the coming days:
1. Will geopolitical issues drive the capital markets?
2. Will US bond yields continue to decline?
3. Is the euro area economy beginning to contract again?
4. Is the dollar breaking out--to the upside against the euro and sterling and the downside against the yen?
The downing of the Malaysian commercial plane over the Ukraine last week represents both an escalation of conflict as well increasing the pressure on Putin to bring the insurgents to heel. The tragedy of both the incident and the immediate aftermath may very well prove to be a turning point of sorts in the broader crisis. Russia is likely to find itself more isolated. Russian capital markets are vulnerable, but officials there have incentives and plenty of resources to conceal the extent of the impact.
It could harden Europe's attitude and presage a new round of sanctions. Despite the cynics' dismissal of the strategy, this type of sanctions regime is relatively new, and the asymmetries of exposures and threat perceptions make coordination difficult. Nevertheless, the long-game strategy is raising the cost of Russia's behavior.
Since the Russia's invasion of Crimea, we have taken a contrarian stance, arguing that a country having to use military force to secure an asset that already posses is a reflection of weakness not strength. Isn't this a more robust political assessment than thinking a bully is really strong? Isn't that truer to our personal experience as well?
The enhanced capability of Hamas to strike a major Israeli city with rockets represents a new and dangerous escalation of the unconventional war. Gaza itself is among the most densely populated places on earth. Israel’s massive aerial assault and ground invasion can only lead to more tragedy.
Israeli markets appear largely unperturbed by the latest developments. The dollar recorded four-year lows against the shekel on July 15. It was was not confirmed by technical indicators, setting up what technicians call a bullish (dollar) divergence. The stock market lost about 0.7% last week, but remains well within the trading range that has been carved over of the past three months. The rally in Q1 morphed into a consolidative phase. Israel's 10-year benchmark bond yields 2.80%. It fell by a little more than 3 bp last week and is down almost 4.5 bp over the past month.
Negotiations over Iran's nuclear program were also emerging as a potential factor as the deadline was approaching with little chance of a successful conclusion. At nearly the last minute, the negotiations have been extended four months to November 20. It seems reasonable to suspect a new brinkmanship experience awaits. Among the many wild cards here, the US mid-term election can also change the US reaction function.
In the foreign exchange market, geopolitical tensions often seem to spur yen appreciation. Indeed, in recent days, the dollar retested the lower end of its five-month range near JPY101. The euro fell to nearly six-month lows against the yen. However, this does not mean people are buying yen, which is what the safe haven concept implies. Instead, we think yen's strength may be more a function of short-covering. This hypothesis is supported by the speculative positioning in the futures market.
At the end of last year, the gross short yen position in the futures market was at a six-year high of 158k contracts. As of July 15, it stood at a little more than 71k contracts, falling 6.2k contracts in the latest weekly reporting period. The gross longs contracts fell by almost 3k contracts. With 8.4k gross long yen contracts, the speculative position is the smallest since November 2012.
The real safe haven still is the US T-bill market. Yields are depressed. The three-month bill offers a single basis point in the annualized yield. The six-month yields 5 bp and the one-year bill yields 8 bp.
The US 10-year bond yield fell more than 7 bp last week. It finished the week below 2.50%. The resilience of the US Treasury market in the face of the Fed's continuing tapering continues to be arguably one of the biggest surprises for investors this year. It refutes arguments that no one wants to buy Treasuries but the Fed. It defies once again the arguments that warn that the central bank is falling behind the curve of inflationary expectations.
Yields have not sustained any meaningful traction despite the mounting evidence that the contraction in Q1 was a fluke of sorts. Growth in Q2 appears to be tracking something north of 3%, and the early look at the start of Q3 suggests more of the same. This is not to deny that the housing sector continues to disappoint as was seen with the 9.3% plunge in housing starts. This week's sales numbers should be better. Existing home sales are expected to build on the 4.9% gain in May while any weakness in existing home sales will be seen in the context of the out-sized 18.6% gain in May.
The June CPI figures on July 22 will be closely followed by the bond market. The consensus expects a 0.3% and 0.2% increase in the headline and core rates respectively. The core rate has risen 0.7% cumulative in the three months through May. This is twice the pace for the prior three-month period (December-February). On a year-over-year basis, the headline and core have converged near 2%.
The Fed’s preferred measure of inflation, the core deflator of personal consumption expenditures, tends to run below the CPI measure of inflation. It makes it difficult then to cite the CPI figures to argue that inflation is overshooting. In addition, Fed officials are well aware that there have been many “false positives” or inflation scares since the economic recovery began five years ago. From Fed’s point of view the economy appears to have sufficient slack, even if it cannot be measured very precisely, to allow for the current strategy of gradually slowing the asset purchases to continue.
The recent report that showed that industrial output fell 1.1% in May was a shocker. It more than offset the April gain of 0.7% (revised from 0.8%). German industrial output tumbled 1.8% unexpectedly in May. Sentiment surveys have warned of a deteriorating outlook. The German locomotive does not appear strong enough now to pull the euro area with it. It would be helpful if a couple of other countries, like France and Italy, were pulling their weight.
The flash PMI readings will likely confirm the loss of German economic momentum at the start of Q3. For its part, France is likely to post the third consecutive aggregate PMI below the 50 boom/bust level in July.
At the end of the week, the ECB reports money supply and lending data for June. The lending data may be more interesting, though it is too early to see much impact from the rate cuts early that month, including the negative deposit rate.
The dollar flirted with levels that would potentially signal a breakout of the recent ranges last week: $1.35 and $1.70 for the euro and sterling respectively and the JPY101. The $1.70 level for sterling is not as important as the euro and yen levels. Sterling’s technical position is weaker than the other two currencies, and market positioning is still heavily long.
The UK will be the first of the high income countries to report Q2 GDP at the end of the week. The consensus calls for a 0.8% quarterly expansion, matching Q1’s pace. It will be the sixth consecutive quarterly expansion. Over the past five quarters, GDP has averaged 0.7%.
The strength of the UK economy is ultimately behind why many are bullish sterling. The Bank of England will lead the tightening cycle, with the euro area and Japan, not still on the previous cycle. The rise in June retail sales, which will likely be reported on July 24 after May’s (fluke?) decline, may see short-term players begin to anticipate a robust GDP figure. This warns that barring a significant surprise, sterling’s low may be reached in the first part of the week.
The $54 bln deal announced before the weekend by AbbVie for Ireland’s Shire is a timely reminder of what has been behind the resilience of the euro. For a number of reasons, the euro area is recording a substantial current account surplus, and dollar-based investors are featured buyers of plant and production (direct investment) and portfolios of distressed assets, among other financial assets (portfolio investment).
Although we retain a constructive outlook for the dollar, we are not convinced this is what we are anticipating. We are more inclined to see the $1.3470 weekly trend line hold and for the euro to remain range-bound a bit longer.
The same is true for the dollar against the yen. We see the dollar still confined to the JPY101-JPY103 trading range. The June trade figures and the latest inflation read is unlikely to change that Given the recent inter-market relationships, we think the US Treasury market may be more important than the equity market. That said, it appears the major equity markets can advance in the week ahead.
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