The market decided that the big fear over Italy was overdone yesterday after the country successfully completed 5- and 10-year bond sales. Both auctions were oversubscribed, with higher bid-to-cover ratios than at the previous auction.
As a result, markets reversed most of the spread widening that had taken place the previous day. That is, for Spain and Portugal, spreads narrowed back to slightly less than they were on Monday 28th
of May, before Tuesday’s 29th
of May 2018 big panic. Italian and Greek spreads also fell back, but remain wider than on Monday. This shows some less panic, more thinking – these are after all the countries that are having problems, not Spain and Portugal, which are well on their way to economic recovery.
Note how the Italian two-year bond spread had gone from being much narrower than the 10-year spread to suddenly being wider, but is now back to being narrower. (2yr was 157 bps over Germany on Monday vs 234 bps for the 10y year; 353 bps over vs 290 bps on Tuesday; and now back to 235 bps vs 254 bps.) Two-year yields had soared 186 bps on Tuesday but fell back 107 bps yesterday 30th
of May 2018. Amazing volatility! This indicates that people see the Italian crisis as a relatively short-term phenomenon – they’re more worried about the next two years than the next ten.
Political developments are the driving force behind the market relief. President Sergio Mattarella and his designated Prime Minister, Carlo Cottarelli, are trying to find some agreement on a new government that would enable the country to avoid another general election. Five Star Movement’s leader, Luigi Di Maio, appears willing to nominate a finance minister who won’t try to take Italy out of the euro, which is a big relief too. Of course, all political developments are subject to change without notice.
USD was the worst-performing currency. It’s noticeable that it did even worse than the supposed safe-haven JPY and CHF, even though one might have imagined that the return of a “risk on” environment would have hurt those currencies even more.
The economic news in the US was mixed. On the one hand, Q1 Gross Domestic Product (GDP) was revised down and the ADP report missed expectations. If Q1 GDP isn’t revised back up, then the US will need to average 3% growth for the rest of the year in order to hit the market and the Federal Reserve System (Fed’s) expectations of 2.8% growth for the year as a whole. That’s likely to be tough. A downward revision to growth expectations is likely to bring a downward revision to rate expectations too, and that’s likely to weigh on the dollar. On the other hand, the Beige Book was relatively upbeat – it said manufacturing “shifted into higher gear” and “many firms” raised wages to attract workers -- and the US trade deficit narrowed slightly.
Having said that, it was noticable that the dollar lost ground yesterday even though US bond yields rose. This suggests to me that much of the recent strength of the dollar was a reflection of the US’ position as “safe haven of last resort,” not just higher yields. Also, the trade issue is flaring up again, which is likely to pressure USD further. The split between US President Donald Trump’s trade negotiators with China came out in the open after White House trade adviser Peter Navarro criticized Treasury Secretary Steven Mnuchin’s recent comment that the US-China trade war was “on hold.” It was that comment that calmed down sentiment around the trade issue. Meanwhile, the WSJ reported that the US is likely to implement tariffs on European steel and aluminum, which is sure to worsen relations there too.
CAD was the best performing currency after the Bank of Canada came out with a relatively hawkish statement. Although they left rates unchanged as was uniformly expected, they said that “…developments since April 2018 further reinforce Governing Council’s view that higher interest rates will be warranted to keep inflation near target.” As a result, expectations for a rate hike at the July 2018 meeting have risen to 76% from 53% the day before the meeting. CAD looks likely to undergo a fundamental rethink based on this view, although oil prices have the potential to put downward pressure the currency if they fall further. Watch for Bank of Canada Deputy Governor Sylvain Leduc’s speech tonight (see below).Today’s market
We get an update on the targeted inflation rates of both the EU and the US today.
First we get the EU-wide Consumer Price Index (CPI). Following yesterday’s much-higher-than-expected German harmonized CPI (+0.6% mom vs +0.3% expected, +2.2% yoy vs +1.8% expected, 1.4% previous), expectations are that today’s EU-wide CPI may beat expectations too, if that makes sense. The market is looking for EU-wide CPI to rise 1.6% yoy. But given the higher-than-expected German CPI, and assuming France and Italy hit their consensus estimates, all other EU countries could see zero mom rise in prices and the EU-wide inflation rate could accelerate to 1.9% to 2.0%, which would put it right at the European Central Banks (ECB’s) target of “close to, but below, 2%.”
Of course that’s the headline number, which has been inflated by the recent rise in Brent prices and the resultant rise in gasoline prices in Europe. Core German CPI isn’t released at the same time so we don’t know how that performed.
It’s not clear though whether higher inflation would be good or bad for the euro. Expectations are shifting towards the ECB delaying the end of its Quantitative easing (QE) program because of the turmoil in Italy. If inflation hits the target, then it may make for a more difficult decision. Probably the market wouldn’t want to see the ECB backing off its purchases, or even its rhetoric, while the Italy crisis is under way – higher Italian yields are a flashing red “sell euro” signal.
Then later in the day we get what should be the most important indicator of the month: the US personal consumption expenditure (PCE) deflators. These are even more important than the nonfarm payrolls, because the Federal Open Market Committee (FOMC) has already met its employment mandate – the unemployment rate is well below what it believes is the long-term rate of unemployment, 4.5%. However, it’s still waiting to see if it meets its other target, 2% inflation, and the PCE is the inflation gauge that it uses, not the CPI. So whether the PCE comes in “close to 2%,” as they said after their last meeting, or at 2% or even maybe above 2% is the other shoe left to drop.
In this case, the shoe isn’t expected to fit. The headline PCE deflator is expected to remain at 2.0%, which will be another month at that level, but the rate of growth of the core PCE deflator, which most analysts assume is their real target, is forecast to slow slightly to 1.8% yoy. That still qualifies as “close to” 2%, but given their focus at their last meeting on a “symmetric 2% objective,” meaning allowing overshoots as well as undershoots, close to isn’t good enough. A slowdown in the core PCE deflator could be negative for USD.
The PCE deflators are of course part of the personal income & personal spending data. These are played up in the press as more important, and they may well be for the stock market, but they aren’t particularly big for the FX market. And this month they’re likely to be even less important, as they’re both expected to grow at exactly the same pace as the month before. Income would be at +0.3% mom for the third month in a row – This could be neutral for USD.
Canada Q1 GDP is a bit confusing. Canada does a monthly GDP figure as well as a quarterly one. The monthly series is expected to slow slightly from the previous month, but the quarterly series is forecast to accelerate from the previous quarter. Just to make things even more interesting, the monthly data has a year-on-year change too, and that’s expected to be unchanged at the previous month’s growth rate of 3.0%.
A lot will depend on the composition of growth. If the small slowdown in growth in March 2018 was due to weak external demand, but domestic demand remains strong then the market should overlook the drop and the figure could likely be considered positive for CAD.
Luckily we should be able to get an expert assessment of the GDP data just a few hours later when Bank of Canada Deputy Governor Sylvain Leduc will speak on “Economic Progress Report.” Coming a day after the Bank of Canada’s meeting, her comments will be closely watched for more detailed explanation of their optimistic view on the outlook. An upbeat assessment could be the impetus for a further rise in CAD.
US pending home sales is an erratic series. It’s hard to see any trend here. Nonetheless, if the April 2018 figure comes in slightly higher than the March 2018 figure, as the market expects, it could be taken as another sign that the housing market isn’t being affected by higher interest rates. This could be positive for the dollar.
Atlanta Federal Reserve System (Fed) President Raphael Bostic speaks in a moderated Q&A, but since he just spoke on Tuesday 29th
of May 2018 and last week as well, I doubt if he’ll say anything new or market-affecting.
Federal Reserve System (Fed) Governor Lael Brainard’s speech however is much more important. She’s a voting member who hasn’t spoken in a while. When she last talked about monetary policy, a little over a month ago, she said the outlook was consistent with “continued gradual increases” in the Fed funds rate. Several Fed officials have recently reaffirmed their expectations for three hikes. This may be the last opportunity before the June 2018 Federal Open Market Committee (FOMC) meeting for a Fed official to signal a shift to expecting four hikes, if indeed she does.
Overnight, Japan announces its capital spending figures. They’re expected to be slightly softer, which would go along with the recent downturn in growth in Japan. The data could be modestly negative for JPY, unless of course it sends the stock market lower, in which case it could be positive for JPY regardless of what the actual macroeconomic implications are.
Finally, the Caixin China manufacturing Purchasing Managers’ Index (PMI) is expected to rise one tic. This compares with the official manufacturing PMI, released overnight, which was up a surprisingly strong 0.5 point to 51.9 (51.4 expected).The Fundamental Analysis is provided by Marshall Gittler who is an external service provider of Claws and Horns (Cyprus) Limited, an independent analytical company. Any views and opinions expressed are explicitly those of the writer. Any information contained in the article, is believed to be reliable, and has not been verified by STO and is not guaranteed to be accurate. References to specific products, are for illustrative purposes only and are not a form of solicitation, recommendation or investment advice. Past performance is not a guarantee of future performance.