In recent weeks we have identified four main elements to the investment climate: Speculation about Fed tapering, the cyclical recovery in Europe, the stabilization of China and a resumption of capital exports from Japan.
These remain very much intact, except that in the latest reporting period, Japanese investors sold foreign bonds, breaking a six-week buying spree. Foreign investors also resumed buying Japanese shares after conducting light sales over the prior three weeks.
Previously, flows out of emerging markets and commodities were largely headed for US and Japanese equities and floating rate note products. Since late June/early July, the destination of those flows appears to have shifted toward Europe, where many were understandably underweight given the six quarter economic contraction.
The safe haven flows into German bonds were reversed and that reflation story in Europe trumped the tapering talk in the US to spur a dramatic narrowing of the US-German 2-year interest rate differentials that track the euro-dollar exchange rate. The differential has been halved over the past month to 10 bp, with the 2-year yield in Germany rising 12 bp to the US 2.
This has coincided with the euros' advance from near $1.2750 in early July to a high last week near $1.3450. Judging from the Commitment of Traders positioning in the CME futures, we have noted that speculators have added long euro positions in recent weeks roughly three times faster than they have covered shorts.
This means that despite the euro's appreciation, there remain substantial short positions. More broadly, the gross short and long positions are twice as large as any of the other currency futures. It is the raw material for a large move. Looking at the skew of the pricing of calls and puts (25 delta risk reversals), it appears that the longs had sold calls for protection. However, at the end of last week, it appears that calls were being bought again and the risk-reversals staged an important recovery.
The US premium over Japan at the 10-year sector has widened dramatically. It has more than doubled since early May to reach about 216 bp last week, before the US Treasury short covering rally after the disappointing new home sales data before the weekend.
While the spread remains near 2-year highs, the dollar, for its part, is trading at its 100-day moving average (~JPY99). Indeed, in the larger picture, the dollar has spent the last few months (since late May) consolidating the dramatic gains recorded in the anticipation of Abenomics and then the aggressive BOJ easing announced in early April. This is reflected in the lower volatility (3-month implied) from near 16% in early July to straddle the 12% area in recent weeks.
Although the 10-year interest rate differential and the dollar-yen movement are tied tightly, we suspect that the yen will continue to be particularly sensitive to disappointing economic news from the US. It may also benefit if, as we suspect, the fragile calm of recent weeks will be dramatically interrupted next month.
That is really our most important insight for medium-term investors. There appears to be another week or so before the eventful period begins. Several emerging market countries, like Brazil, Turkey Indonesia and India recently took measures in response to the capital outflows. Although the recent developments in Syria are troubling, the response of Russia and Iran is not yet clear, with the lack of much data and the UK bank holiday at the start of the week, there may be a reprieve for the selling pressure.
The emerging markets are not the only ones to push back and the week ahead will likely see BOE Governor Carney (August 28) push back against the rise in UK yields (is it despite or because of the forward guidance?), and the rise in sterling.
The implied yield of the December 2014 short sterling futures contract has risen by roughly 30 bp in the past two and a half weeks. On the BOE's calculation of its broad trade-weighted measure, sterling has appreciated about 3.25% here in August, which is also tantamount to a tightening impulse in monetary conditions. While his performance has won him high marks among the commentariat, the actual achievement is less glowing.
Next month's events will make for treacherous investment conditions. These include the sensitivity the market has to US data, ahead of what is widely expected to be the announcement of tapering the so-called QE-infinity on September 18, a year after it had begun. In addition, the US debt ceiling and related issues are set return to headline news.
Even before getting to the long awaited German election on September 22, there are two elections (Australia September 7, Norway September 9). The German election is interesting in its own right. The polls continue to show Merkel and her traditional allies, the CSU and FDP, are unlikely to secure a majority of seats. This will require some proverbial horse trading. The Social Democrats and Greens apparently prefer calling Merkel chancellor again than calling the Left party comrades and finding the common ground. If there was one person in particular to watch, we think it may be Jorg Asmussen, the German ECB governing board member, a Social Democrat, but nominated by Merkel.
The German election is also important because it clears the air, so to speak, and corresponds to the seasonal resumption of various policy negotiations. Among these are whether Portugal needs a new aid package, Greece's funding gap and additional efforts of the banking union.
Italy's Berlusconi has never been comfortable in Merkel's shadow and next month his drama will return front and center as his immunity is tested. The Senate is expected to vote in early September whether to enforce his ban from political office. The center-left, which has rarely been able to defeat Berlusconi at the polls (for various reasons and only some of which are a function of his media domination), sees this as this opportunity to get rid of their nemesis once and for all.
However, this could lead to a political crisis if the center-right pulls out of the fragile and unprecedented right-left coalition government. Even if that blow is not the coup-de-grace, the Letta government may be too weak to contain the forces that will likely be unleashed during the debate over the 2014 budget.
Next month, the Abe government is expected to formalize its intentions regarded the controversial retail sales tax increase. There seems to be a willingness to go ahead with it, though probably not in its present form. Reports suggest that a smaller increase, and perhaps mitigated by a supplemental budget, are being debated by the cabinet.
Provided the string of data from China confirms the stabilization of the world's second largest economy, the biggest risks may emanate from China's capital markets. There appears to be a cluster of wealth management products that mature at the end of the month. The quarter-end is also expected to see a concentration of other contract settlements, which may cause strains in the money markets.
While September will be eventful, next week's data should cause much of a stir. Japan is likely to report an increase in both industrial output and prices (with the end of consumer deflation solidifying). Overall household spending appears to be holding up better than retail sales. In June, Japan's unemployment rate fell below 4% for the first time since late 2008. This improvement is expected to be confirmed with the July reading this week.
The German IFO should be broadly consistent with recent survey data pointing to improvement. The money supply report may be the most interesting. It is not so much the lackluster growth of money supply that will draw our attention but the private sector lending.
Recall that the June report that was released last month showed the 14th consecutive monthly decline and the largest since the advent of the single currency (-1.6% year-over-year). With concern about the drawdown in excess liquidity compatible with near zero EONIA, as banks continue to pay down ECB borrowings, and a 30 bp backing up of the implied interest rate of the December 2014 Euribor futures contract, the ECB may be increasingly concerned about the tightening in financial conditions.
The US data is likely to continue to be uneven. US Treasuries rallied before the weekend in response to the more new home sales report. On Monday, the July durable goods orders will likely show a full reversal of the gains posted in June, starting Q3 on weak footing. Less important for speculation on tapering is the revision to Q2 GDP. Most economists are assuming an upward revision due to the new trade data. However, the risk is that they are not giving sufficient due to the inventory component, which is really the wild card and difficult in any event to forecast.
The week ends with the Chicago PMI and the July personal income and consumption figures. The manufacturing sector appears to be enjoying a new upswing and this is expected to be reflected in the Chicago PMI. Personal income and consumption are likely to have slowed from the 0.3% and 0.5% gains reported for June.
Meanwhile, the core PCE price deflator is expected to be unchanged at 1.2% year-over-year pace. Greater sensitivity to the soft inflation readings were the most significant change in the latest FOMC statement. Ironically, core PCE is lower now than it was when Bernanke, as a Fed governor, warned of the threat of deflation.