Yesterday's bounce in U.S. equities may have been another bear trap as several tech favorites reported disappointing earnings after the close. Asian shares fell, with Hong Kong, Korea, and Singapore markets losing more than 1% today. The MSCI Asia Pacific Index is lower for the fifth week, during which time it has lost around 12%. The MSCI Emerging Market index has lost about 10% during the five-week slide. Europe's Dow Jones Stoxx 600 is also off about 10%, having fallen in four of the past five weeks. Coming into today's session, where the early call is for than a 1% decline at the opening, the S&P 500 has also fallen in four of the past five weeks, for about an 8% decline. Weak stocks appear to have helped give bonds a bid. Core bonds yields are mostly one or two basis points lower. The US 10-year yield is slipping below 3.10%, representing a 10 bp decline on the week. The decline was matched or bested by the UK, Spain, Australia, and New Zealand. In the foreign exchange market, the U.S. dollar is firm against the majors (except the yen) and most emerging market currencies (the notable exceptions being the Philippine peso and the onshore Chinese yuan).
The continued drop in equity prices is nearly overwhelming other drivers of the global capital markets. Most diagnoses seem to focus either on the earnings outlook ((peak)) or the rise in interest rates. Some link it to Fed Chief Powell's observation earlier this month that the Fed target was far from neutral, which implied a sustained campaign of hikes. Others suggest that de-emphasizing "r*" conceptually removed an anchor of monetary policy. A few economists are pointing to the Fed's balance sheet reduction as gradually pushing the effective Fed funds rate higher within the target. Meanwhile, Clarida, the new Vice-Chairman of the Federal Reserve, appointed by Trump, was upbeat on the economy yesterday and fully endorsed the Fed's path of gradual rate hikes. This seemingly suggests that the Fed's independence remains intact despite the unorthodox public criticism by the President.
The idea is fairly straightforward. Financial conditions, broadly understood, play an important role in gauging the appropriate monetary policy. A sharp fall in equities tightens financial conditions. At what point do the tighter financial conditions produce a response by Fed officials? A reasonable starting point is the January-February stock market slide that saw the S&P 500 surrender 12%. The Fed still hiked rates in March. A similar drop now would take the S&P 500 a little below 2600 (vs. yesterday's close @2705). Some analysts see the put's strike price in the 2300-2400 area.
US GDP and S&P Review of Italy
The news stream is light and the economic calendar in Europe and Asia was mostly bare. There are two things, besides the performance of equities, that will draw attention. The first is the initial estimate for Q3 US GDP. The Atlanta's Fed GDPNow tracker had been at 5% at the start of August and was cut to 3.6% yesterday from 3.9% previously due to weaker real residential investment. In contrast, the NY Fed's GDP tracker has not been updated for a week, and it has Q3 data tracking a 2.1% pace. The Bloomberg consensus is for a 3.3% increase. Late in the day, S&P will announce the results of its credit review of Italy. It was given the BBB rating a year ago, which was a surprise for many observers. Moody's took away its equivalent rating recently. However, after having just raised it a year ago, S&P may be loath to reverse themselves, and most look for it to put Italy on review, which would buy it enough time to see how the budget battle is resolved. The 3.5 bp increase in Italy's 10-year benchmark yield does not sound like much, but yields fell nearly every place else, meaning Italy's premium continues to grow. The premium for Germany is finishing the week a little above 315 bp. It was below 120 bp in the spring before the national elections.
In Latin America, note that Mexico is due to report its final estimate for August trade balance. It probably narrowed more than initially estimated that showed a decline from nearly $2.9 bln in July to a little less than $2.6 in August. That could be revised below $2.0 bln today. Still, Mexico's trade deficit has grown this year. Consider that through July, the monthly shortfall averaged $1.06 bln this year compared with a little more than $655 mln for the first seven months last year and an average of almost $915 mln for the entire year. That said, exports and imports are rising at a strong pace (10.1% and 9.4% year-over-year respectively in preliminary August figures). Next week, Mexico reports Q3 GDP. It looks like it may have edged higher after a 2.6% pace was reported for Q2. The U.S. dollar is straddling the MXN19.50 level. Brazil holds the run-off for the presidential election. Investors are confident of the outcome, and both the Brazil real and the Bovespa have outperformed. The dollar has eased against the real for four consecutive weeks now, though, in fairness, it has been consolidating its gains for the past couple of weeks. Brazil's equity market is one of the few that is holding to (minor) gains this week (but may be challenged today).
For the first time in seven years, the heads of the second and third largest economies will meet. Quietly, Abe has moved into the vacuum left in the wake of what we would argue is unilateralism, not isolationism. He was a vital force in keeping TPP on track after the U.S. withdrawal and negotiated a free-trade agreement with the EU. Xi is seeking alternative suppliers and markets. Many in the American press are inclined to see the meeting as fueled by common opposition to U.S. tariffs, or as the Bloomberg editors do, an opportunity for Japan to "nudge China" to accept the global norms, by which they seem to mean that status quo. It is hard for many to conceive of a narrative that the U.S. does not occupy a central place. However, both Abe and Xi can use each other for their domestic purposes, and there is room to expand their collaboration on infrastructure projects in Asia and trade. Trade ties are growing, and Japan's direct investment in China rose for the first time last year in five years. China and Japan revived the dormant swap lines of CNY200 (~$29 bln). High-end department stores in Tokyo will have Chinese language signs, along with English (and Korean). However, the historical scars and territorial disputes mean that ideas of some kind of political alliance seem a stretch. And the extent of the economic ties will be checked by the U.S. demand that if there is a to be a bilateral free-trade agreement, Japan must agree, as has Mexico and Canada, not to enter a trade pact with China non-market economies.
The Dollar Index is holding above 96.00. The next important target is around 97.00, which checked the rally in August. The euro is also trading at two-month lows. Expiring options at $1.1350 (~866 mln euros) and $1.1375 (1.2 bln euros) may stymie the price action. The euro is off about 1.4% this week. Sterling's minor loses today brings its fall for the week to a little more than 2%. It convincingly broke both the $1.30 and $1.29 marks this week. The $1.2780 area it the last chart support ahead of the August 15 low near $1.2660. The dollar lost about 0.5% against the yen this week. Weakness in equities and lower global yields has seen the dollar turn back from approaching JPY113 to looks to retest the recent lows near JPY111.60. The dollar-bloc currencies are underperforming. The Australian dollar has fallen to new two-year lows to approach $0.7000. The New Zealand dollar is not there yet, but it has moved lower every day this week for a nearly 2% loss.
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