Broken Transmission

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 |  Includes: FXA, FXB, FXC, FXE, FXF, FXY, JYN, UDN, UUP
by: Marc Chandler

The US dollar is little changed against the major currencies, but as was the case yesterday, is sporting a softer profile against the dollar-bloc. Despite a continued push back from Germany, the market seems to favor Draghi and Spanish and Italian bonds markets continue to trade firmly and with yield curves steepening as the 2-year yields fall faster than the 10-year yields.

Equity markets are more mixed. Although China's official manufacturing PMI eased to 50.1 from 50.2 (though 10 of 11 components fell), the Shanghai Composite recorded its biggest rise (~1%) in three weeks off of three-year lows reportedly on speculation that the government will soon announce measures to promote growth. This was not sufficient for the MSCI Asia Pacific Index, which lost about 0.3%. European bourses are mixed and the Dow Jones Stoxx 600 is up fractionally. Of note, Spanish shares are under-performing, with the IBEX off more than 1% and financials are an even bigger drag, following Fitch's downgrade of Spain's 5th largest banks (Banco Sabadell) below investment grade.

The main news today, ahead of the FOMC decision later, is release of the manufacturing PMI reports. There were no significant surprises that will alter the general view that the global economy is in a weak state and is showing no lift in early Q3. The euro zone PMI came in at 44.0 from the 44.1 flash reading and 45.1 in June. Spain and Italy actually did better than expected, but both reports (42.3 and 44.3 respective) remain well below the 50 level.

Germany actually did a bit worse, coming in a 43.0 down from the 43.3 flash and 45.0 in June. Separately VDMA reported German engineering orders were off 1% year-over-year. France's PMI ticked up to 44.3 from the 44.2 flash report, but was at 44.6 in June.

The UK's PMI fell to 45.4 from a revised 48.4 (from 48.6). It is the lowest since in a little more than 3 years. Output collapsed to 43.3 from 51.1 and export orders saw their biggest fall in more than 3 years. The BOE is unlikely to respond at tomorrow's MPC meeting as gilt purchases and the funding for loan scheme is ongoing, but rate and an extension of QE is increasingly likely.

Turning to ECB, Draghi justified buying sovereign bonds if the transmission mechanism of monetary policy was not working properly. The rise in peripheral yields and the decline (into negative territory in some core countries), however, may not reflect a faulty transmission of monetary policy.

Instead another transmission mechanism may have gone awry. It is the transmission mechanism why which the creditors in the north recycle their surplus to the debtors in the south. That transmission mechanism cannot be fixed by interest rate cuts, another LTRO, or a change in the collateral framework. The breakdown reflects financial disintegration--cross border financial flows are going in reverse.

Look again at the Spanish data that was reported yesterday, but was overshadowed by the FOMC and ECB meetings. Capital outflows from Spain are accelerated in May as 41.3 bln euros were taken out of the country by domestic banks sending money abroad, foreign banks pulling out cash and foreign investors selling domestic assets. In the first five months of the year 163 bln euros have been exported, which is about a sixth of GDP. The 100 bln euro backstop Spain has been promised by officials is not enough to offset the private capital strike.

During the same 2011 period, Spain experienced a net inflow of 14.6 bln euros. Foreign investors held 51.5% of Spanish government bonds at the end of last year. By the end of the first half, their share had fallen to 36%. Spanish banks' share doubled to 32%.

The Troika and the creditor nations argue, in effect, that the in order to restart the recycling transmission, Spain and other debtors have to win back investor confidence and the way to do that is to boost savings and implement structural reforms. Spain is doing that. The Rajoy government has announced several budget cutting packages totaling more than 100 bln euros, despite the record high unemployment and contracting economy. Yet Spanish interest rates continued to raise until Draghi's threats (promise?) last week. German Finance Minister Schaeuble says the markets do not yet appreciate Spain's efforts, but they will. Why? It is stated as an article of faith, not an argument. Investors see the situation as unsustainable.

The more Spain cuts spending and raises taxes, the deeper the economic downturn and then more austerity is demanded. German SPD's Steinbrueck, who is seen as Merkel's likely challenger next year, warned that the crisis was pushing German democracy to its limit. Well, imagine the backlash in Spain where unemployment is four times higher.

A resumption of ECB bond purchases may have the opposite of the desired effect. First, a resumption of the SMP program been discounted in recent sessions as reflected in the sharp drop in Spanish yields. Second, given the ECB's grab for senior creditor status, any purchases of Spanish bonds will simply encourage further transfer of private sector holdings to the public sector. Through the subordination process, any investor who does not sell their bonds to the ECB will be at a disadvantage.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.