Budgets and Deadlines

Today will be a day of budgets and deadlines, including in Greece, the UK, Japan and the US.

  • The dollar pared its gains late Tuesday, when newswire reported that Greece and its creditors are discussing a deal which will be split in two parts; the ECB meets today to review Greece’s ELA
  • The UK government will release the first Conservative-only budget since 1996 and it will likely be, well, Conservative
  • Advisor to PM Abe, Honda, said ahead of a planned sales tax hike in 2017, the government may need to pass a ¥2.5 trln economic package to help cushion the impact on households
  • During the North American session, FOMC minutes are the highlight
  • The Department of Energy will report the latest production and inventory figures for oil and products
  • The sell-off in China continues with the Shanghai Composite down another 5.9%, ending the session just above the 200-day MA
  • BRICS central banks signed an accord on a planned $100 bln foreign currency pool

Price action:  The dollar is giving back some of its recent gains.  The euro bounced back to trade near $1.1050 currently. The New Zealand dollar and the yen are outperforming, with the dollar making its first decisive break below ¥122.0 since May.  The pound is a touch softer going into the UK budget today, around $1.54.  AUD and NOK are underperforming.  Most EM currencies are softer.  Oil has erased earlier losses today, helping RUB recover a bit.  KRW and ZAR are underperforming on the day.  The Shanghai Composite closed down 5.9%, in another sign that official action has not been enough to stem the sell-off.  MSCI EM is down 2.5%, the sixth straight drop and 9 of the past 10 days.  The Nikkei lost 3.1%.  European indices are marginally higher on the day but S&P futures are pointing to a lower open.  10-year yields are down 6 bp in the US and a few basis points lower in most European core and periphery countries.

We have a new official deadline for Greece:  Sunday.  The Greek proposal is expected to be delivered on Friday, and then negotiations begin.  Short-term financing is back on the table so it looks like a potential deal will come in two parts.  A short-term portion would cover the month-end financing needs, including a EUR3.7 bln payment to the ECB.  There would then be a long-term one made within a new ESM program.  If there is no deal, then we start talking about default and humanitarian aid.  Either way, there are no good solutions for Greece anymore.  The question is whether it will be succumbing to the demands of its creditors (more austerity), or whether it will be going its own way (the loss in standard of living associated with a Grexit). We will discuss this Faustian choice in a more in-depth piece later today.

In the meantime, the ECB meets today to review Greece’s ELA.  Draghi reportedly informed the Eurogroup that Greek banks have sufficient funds to last until the end of the week, but not much longer.  Recall that this past Monday, the ECB kept the ELA cap the same but raised the discount applied to the collateral used for the borrowings.  However, some in the media misunderstood this.  It is not, for example, as Bloomberg says, to “protect its balance sheet.”

Today the UK government will release the first Conservative-only budget in nearly 20 years, and it will likely be, well, Conservative.  It’s being called a “lower welfare, lower tax” budget, in line with the ideological leanings of the party.  This shouldn’t be any surprise given: (1) the strong mandate the party received in the last elections; (2) greater degrees of freedom afforded by better revenues during this tax year; and (3) a relatively low unemployment figure of 5.5% (vs. 11.1% in the Eurozone, for example) that should cushion changes in the welfare system.  In practice, this means that lower income families are set to suffer a cut in benefits, but at the same time pay less taxes.  On the other end of the income scale, Chancellor Osborn is resisting calls to cut the top tax rate from 45% to 40%, and is likely to clamp down on the non-domiciled tax avoidance cases.

There has never been any question about the commitment by the Conservatives to pursue their fiscal goal. This includes a falling public debt ratio and the elimination of the structural deficit by 2018-19.  As such, we doubt the budget will have any major impact in financial markets, though lower expected borrowing could pressure gilt yields lower on the margin.

The sell-off in China continues with the Shanghai Composite down another 5.9%, ending the session just above the 200-day MA.  Some 700 companies have suspended trading to “self-preserve.”  Reports suggest that between suspended shares and those halted due to limit down, at one point today only 11% of all mainland shares were available to be traded.  By not allowing the market to find its natural level with these trading restrictions, we fear that the selling pressures will only grow stronger before finally erupting.  We also note that the CNY fixing is trending higher, and so is spot.  But despite some (perfectly reasonable) chatter of capital outflows accelerating with the stock market sell-off, China’s FX markets have been relatively stable throughout.

Commodities remain under pressure even after yesterday’s selloff.  Oil prices recovered from losses earlier in the session, but still look fragile.  The same goes for other commodity prices. As we wrote in a report yesterday, it looks like the risks are still bearish for energy and industrial metals, but not so much for agricultural commodities.  We believe that the currencies and equity markets of the major exporters of industrial metals and energy are likely to continue underperforming.

Advisor to PM Abe, Honda, said ahead of a planned sales tax hike in 2017, the government may need to pass a ¥2.5 trln economic package to help cushion the impact on households.  Bloomberg reports that he said that the government would need to “take a cautious approach” after a sales tax increase last year hurt the economic recovery.  Elsewhere, Japan posted the largest current account surplus since 2007 in May, at ¥1.88 trln.  This is the 11th straight month in surplus.  The adjusted surplus widened to ¥1.64 trln in May.  USD/JPY is trading at its lowest level since late May.  Today’s break below 121.55 sets up a test of the May 14 low near 118.90.

The FOMC minutes are the highlight for the North American session.  The FOMC minutes tend to be noisy as the policy signals are often muted by the cacophony of voices and debates.  Nevertheless investors will look for color on the cuts in growth forecasts and the commitment to lifting rates, which a little more than half of Fed officials still saw two hikes this year as being appropriate at last month’s meeting.

A more important guidepost could be Yellen’s speech on the US economic outlook at the end of the week.  The Chair’s speech will likely touch on the key points she is expected to provide in her testimony the following week before Congress.

Before the FOMC minutes, the Department of Energy will report the latest production and inventory figures for oil and oil products.  Industry figures suggest US output this year will be greater than previously anticipated.  US companies continue to pursue technological improvements that lower the cost of production.  Re fracking (fracking old wells) is apparently among the latest developments.  Meanwhile, the talks that could lead to more Iranian output in the world markets were extended (again) at least through the end of the week.

Alcoa reports its earnings after markets close to formally kick off the earnings season.  Recall the impact from the dollar’s rise in Q1 was less than many analysts had projected as it also cut input costs to US multinational production offshore.  The dollar fell against the major currencies in Q2, except for the Japanese yen (-1.9%) and the New Zealand dollar (-9.4%).  As such, it will be harder for companies to blame the strong dollar for weak Q2 earnings.

BRICS central banks have signed an accord on a planned $100 bln foreign currency pool.  China will contribute $41 bln, while Brazil, India, and Russia will give $18 bln each.  South Africa will contribute $5 bln.  Statement said that the pool is meant to ensure provision of USD in case of liquidity problems in the member states.  From what we can tell, this is similar to the repo lines set up under the Chiang Mai Initiative, making dollars available for borrowing.  We never put much stock in the swap lines because they were really temporary credit lines and didn’t really add to the firepower of the central banks that participated.  Still, we think this is a good indicator that EM policymakers are starting to gear up for further currency losses by putting more firewalls and circuit-breakers into place.

Poland central bank kept rates steady at 1.5%, as expected.  We now await the press conference.  While Poland is still experiencing deflation (-0.9% y/y), we expect it to soon follow Hungary (0.5% y/y) and Czech Republic (0.7% y/y) in moving back to positive inflation.  With the economy fairly robust, this argues for steady rates now.  We do not see any hikes until 2016.  Elsewhere, the government announced a CHF loan conversion plan, with borrowers and lenders meant to share the burden equally.  It estimated the costs for Polish banks at PLN9 bln.

Brazil reports June IPCA inflation, expected to rise 8.93% y/y vs. 8.47% in May.  If so, this would be the highest rate since December 2003.  Right now, markets are pricing in a 50 bp hike in July and another 25 bp hike in September.  Markets have pared back expectations for a potential 25 bp hike in October.  If a hike then does materialize, this would take the SELIC rate up to 14.75% from 13.75% currently.