Don’t Confuse Calmer Markets with Resolution

italy

  • Global capital markets stabilize for the second day. Equities are mostly higher as are core bond yields. Peripheral European bond yields are softer.
  • The US dollar is mostly lower.
  • China’s PMI was stronger than expected.
  • The euro was unable to extend is gains after firmer CPI
  • Trade tensions increase

Corrective forces grip the foreign exchange market. Month-end adjustments are also seen weighing on the dollar. The fact that the Swiss franc is the strongest of the majors in what feels like a risk-on day also points to the corrective nature of the price action. Equities in Asia and Europe are higher and the MSCI Emerging Market Index, which will include Chinese A-shares tomorrow (MSCI estimates $!7 bln inflow from passive funds) rose 0.8% to retrace three-quarters of yesterday’s decline. Indonesia, which hiked rates yesterday for the second time in tow week helped the rupiah lead the emerging market currencies higher today. The Turkish lira is off nearly 1%, while the rand and Mexican peso are off 0.5%.   Oil is pulling back a bit (0.5%-0.8%) after Brent rallied 2.8% and WTI 2.2% yesterday.

The global capital markets that were in panic mode on Tuesday stabilized yesterday, and corrective forces have carried into today’s activity.  However, the underlying issues in Italy and Spain are hardly clarified in the past 48 hours.  Moreover, the US push on trade is intensifying again.  The temporary exemptions for the EU, Canada, and Mexico from the steel and aluminum tariffs are set to expire.  The US has signaled its intention to go forward with the tariffs on $50 bln of Chinese goods in retaliation for the violations of intellectual property rights on the eve of Commerce Secretary Ross’s trip to Beijing for more talks.

The euro is enjoying its biggest bounce since the sell-off began in late-April.  The euro bottomed on Tuesday near $1.1510.  It approached $1.1725 in Europe today, retracing a bit more than the 38.2% we had anticipated.  Corrective pressures in Italy and month-end related demand seemed to provide the fuel.  However, we suspect that if the bounce is not over, it is nearly so.   The euro was unable to extend its gains after the higher than expected preliminary May inflation figures were reported.  Headline inflation rose to 1.9% from 1.2% in April. Country reports favored a strong number, but the core rate, which the national estimates typically do not identify in the preliminary release, rose to 1.1% from 0.7%,.   Separately, eurozone unemployment was firmer than expected.  The March series was revised to 8.6% from 8.5%.  In April, it slipped to 8.5%.

Month-end sees a flurry of large option expirations:  $1.1650 (1.8 bln euros), $1.1700 (2.2 bln),  $11.725 (1.4 bln), $1.1745-$1.1750 (1.8 bln).   There is also 3.5 bln euros struck at $1.1700 which expires tomorrow.

China reported somewhat better than expected PMI.  The manufacturing PMI rose to 51.9 from 51.4, and the non-manufacturing PMI edged up to 54.9 from 54.8.  The composite stands at 54.6 from 54.1 and matches the high for the year.  Manufacturing output reached a six-month high, while new orders rose to an eight-month high.  Caixin’s surveys will be reported on Friday.  Separately SWIFT reported that the yuan’\s share of payments rose to 1.66% in April from 1.62% in March.  It matched the January high, which was this year’s peak thus far.  Last April it was at 1.60%.  The highest share last year was 2%.

Exports were expected to have helped lift Japanese industrial production in April, but today’s reported 0.3% gain disappointed.  The Bloomberg median forecast called for a strong 1.4% gain to match the March rise.  We note that the weekly MOF data shows that last week, while the yen appreciated by more than 1.2% against the dollar, the most in three months, rather than seek the ostensible safe haven of Japanese assets, foreign investors sold Japanese bonds and stocks (~JPY600 bln).

There has been little new apparently from Italy.  A technocrat government led by Cottarelli appears to be waiting in the wings, as the President gives the M5S and League a last chance to see if they could put together a government.  The former seems more willing to put forward another candidate for finance minister while the League, whose support has risen in the polls since the March election, continues to take a more strident position.  Given the incredible magnitude of the moves seen earlier this week, it is difficult to be too confident of what the market is saying, but investors seem to prefer a new government to new elections.

Two polls out confirm that a majority of Italians prefer to stay in EMU.   Di Maio and Salvini may be sincere in saying that they don’t want to leave either. What is not said, is that they are demanding that the EMU changes in profound ways in favor of the region’s largest debtors.  And if those changes are not made?  If the EC rejects the proposal to lower the retirement age?  What if the EC rejects that proposal that the bonds that it has authorized the Bank of Italy to buy no longer count toward the debt-GDP ratio?   Some portray the League’s plan to leave the monetary union as some kind of innocent contingency plan.  This seems to risk being naive.

Spain’s parliament is debating today ahead of a confidence vote tomorrow.  It may be that  Rajoy’s fate is in Basque Nationalists’ hands.  If they support the Socialists, Podemos, one of the Catalan parties in the non-confidence motion, Rajoy might simple resign, forcing elections.  Instead, if Rajoy were to lose a confidence vote, then the head of the Socialists (Sanchez) would become Prime Minister.  New elections would seem to benefit the centrist Ciudadanos.

The MSCI Asia Pacific Index rose 0.85%, stabilizing after the 1.8% fall in the previous two sessions. The Dow Jones Stoxx 600 is posting a minor gain, but it would be the second day of gains, after dropping 1.7% on Monday-Tuesday.  US shares are building on yesterday’s gains.  Core bond yields are slightly firmer, while European peripheral bonds, led by Italy, are falling, paring this week’s rise.

The US dollar is down against all the major currencies and most of the emerging market currencies today.  There are $1.2 mln in options struck between JPY108.90 and JPY109.00 that expire today.  The dollar is trading inside yesterday’s range against the yen, which was inside Tuesday’s range.  This kind of pattern is often associated with continuation of the near-term trend, which warns of a re-test on JPY108.  Sterling rose to new highs for the week today just shy of $1.3350.  There are GBP640 mln in options struck at $1.3395-$1.3400 that expire today.  The intraday charts warn that if a high is not in place today, it came close.   The Canadian dollar rallied more than 1% yesterday after the Bank of Canada signaled it was nearing another rate hike.  There has been no follow-through buying today as yesterday’s US dollar low near CAD1.2835 has held.  The large option ($2.9 bln) struck at CAD1.29 that expires today no longer seems relevant.  However, there are large Aussie options that are still in place.  There are A$1.8 bln struck $0.7600-$0.7605 that expire today.