Dollar Remains Firm But Equities Slide

There have been important developments over the past 24 hours, and the net response has been a generally firmer US Dollar and weaker equity markets. Bond yields are mixed, but U.S. Treasury yields saw their biggest single day rise yesterday this year. Asia followed suit, but European bond yields are mostly lower.

There were three important signals from the US yesterday that will continue to influence the investment climate. First, in terms of GDP, the key measure, real private final purchases, which covers almost 85% of the economy, excludes inventories, net exports and government spending. It tends to be less volatile and a better gauge of the underlying economy. It rose 3.1% in Q2 and 1.0% in Q1. That puts H1 growth at 2%, which is probably a more accurate description of its pace.

For the economy to achieve the FOMC's central forecast of 2.2% this year, the economy needs to grow 3.5% in H2. While possible, this seems unlikely, especially given what appears to be the rise in Q2 inventories All the data for Q2 has not been reported yet, which makes the initial estimates subject to significant revisions.

The other two signals come from the Federal Reserve. The statement following the FOMC meeting contained two noteworthy assessments. First, the FOMC recognized that the risk that inflation is persistantly below 2% has diminished "somewhat". This is the say that the perceived risks of deflation have eased. Second, the FOMC still insisted the under-utilization of the labor market is still "significant". This means that while the economy continues to evolve in the desired direction, it has not been sufficient to alter the Fed's course. It will finish the tapering in October. A rate hike still seems a couple of quarters or so away.

Euro area news has been mostly constructive. Yesterday, investors learned that the credit environment in the euro area has improved, on both the supply and demand. Today investors learn that both German and French consumption picked up in June and by more than expected. In Germany retail sales rose 1.3% (vs 1.0% expected). French consumer spending rose 0.9%. The consensus was for a 0.4% declinethough the May series was revised to show a 0.7% gain instead of 1%.

The market also learned today that labor market improved in both Germany and Italy. In Italy the unemployment rate slipped to 12.3% from 12.6%. The consensus did not expect it to have changed. This matches the lowest rate since last August. In Germany, the unemployment rate was steady at 6.7%, but the number of unemployed fell 12k, whereas the market had expected only a 5k decline.

On the inflation front, yesterday's news from Germany and Spain warned of downside risks to the reading for the region as a whole. Sure enough, the preliminary aggregate reading came in at 0.4, whereas the consensus had forecast an unchanged pace of 0.5%. The core rate was unchanged at 0.8%. This will be disappointing to the ECB where the staff had forecast a 0.7% rate for this year. Nevertheless, it most likely will not elicit a policy response at next week's meeting.

The impact of the TLTROs, which will be launched in September must be monitored first. In addition, the weakening of the euro is also helpful. It has declined 6 cents against the dollar since early May and is off about 3.2% on a trade weighted-basis since peaking in March.

The euro has struggled to resurface above $1.34, and a break of yesterday's low just below $1.3370 would likely target $1.3300 and then $1.3230. As the euro has entered territory not seen since Q4 13, implied volatility has risen. For example, 3-month implied vol has risen to about 5.5% from 4.75% in the middle of the month.

Sterling continues to under-perform and this is reflected in the euro's gains on the cross. The euro is trading at two-week highs against sterling and is pushed through the 20-day moving average (~GBP0.7925). It has not closed above this average since late March. Although the euro is holding above yesterday's lows, sterling has not. The target appears to be a retracement objective near $1.6830, and a break of that could spur another cent decline. The economy appears to have lost some momentum and the longs which had built up a large position in the futures market, are bailing out. Also, the Scottish referendum draws closer, and this may also curb the bull's appetite.

The Australian Dollar is also under-performing today. It has been pushed below $0.9300 for the first time since early June. The ostensible trigger is the unexpected 5% drop in building approvals. The consensus expected a flat report. This is an important piece of data because it had appeared that the housing market had picked up the slack emanating for the contraction in the mining sector.

In addition, Australia reported disturbing tends in import and export prices in Q2. Import prices fell twice what was expected. The 3% decline nearly offset the Q1 gain of 3.2%. Many economists will see this as evidence that the Australian dollar is over-valued. Exports prices also fell almost twice what was expected. The 7.9% decline (after a revised 2.8% gain in Q1) likely reflects the decline in commodity prices, especially iron ore.

The Australian dollar has fallen through the 100-day moving average (~$0.9322) for the first time since March. The 200-day moving average is found just near $0.9185, just below the bottom end of the four-month range ($0.9200).

The North American session features the US Q2 employment cost index, which is one of several measures of labor market price developments. It is regarded as among the most useful. It is expected to have risen 0.5%. This would be just above the longer-term average (5-years), but after a 0.3% rise in Q1, the H1 average is spot on the average. The weekly initial jobless claims and the Chicago PMI may also draw attention, but the real interest is of course in tomorrow's non-farm payroll report. Canada reports May GDP, and it is expected to rise 0.4% for a 2.3% year-over-year pace. The US dollar is holding just below CAD1.0920. Last month's high was set near CAD1.0960, and although this is the risk, the market is looking a bit stretched.

Lastly, two other issues to note. First, we do not think an Argentina default will have the kind of immediate contagion that its previous default sparked. However, we are concerned about the precedent's being set for sovereign restructuring more broadly.

Second, we continue to put significance in the gap lower opening in the S&P 500 last Friday after setting record highs last Thursday. This gap was entered yesterday but was not closed. The longer the gap is unfilled, the more bearish it is, we have argued. Now we see the 5-day average is poised to fall through the 20-day average, something that has not taken place since late May. A break of 1950 would be seen as an ominous development.