Firmer Dollar, Rising Equities To Start The Week

The US dollar is broadly firmer, with some notable exceptions, like the Australian dollar, which may have found succor in the battery of Chinese data and news that its own vehicle sales rose 4% in June, the strongest since last August. Among the freely traded emerging market currencies, the Turkish lira, South African rand and Mexican peso are firmer today.

While the euro is trading within last Friday's ranges, sterling and the yen are retracing a bit more of the gains scored in the second half of last week in response to comments from the Fed's Bernanke. Sterling has approached the 50% retracement which comes in just below $1.5020. The next retracement objective is about half a cent lower. The dollar has marginally surpassed the 50% retracement level of its losses against the yen near JPY99.75 as it stretched to almost JPY99.90, with the next retracement objective near JPY100.10.

The 50% retracement would bring the euro down to $1.2980. The news stream from Europe is light today. We note that the 2-year interest rate differential that tracks the euro-dollar exchange rate fairly tightly, has come off since peaking in the first half of last week near 29 bp. Today it is near 22 bp. On the other hand, we note that the 10-year interest rate differential is at new highs and at 103 bp is the highest since mid-2006.

The most important news of the session came from China. Broadly speaking it was in line with expectations, with Q2 GDP estimated at 7.5%, which means a sequential improvement to 1.7% from 1.6% in Q1. Industrial output was softer than expected in June at a 8.9% annualized pace compared with a consensus forecast of 9.1%. Retail sales though were stronger than expected at 13.3%. The consensus had forecast a 12.9% increase. Fixed investment remained strong at 20.1% (year-to-date). This is in line with expectations and represents a slight slowing from the 20.4% pace reported in May.

The new Chinese government appears to be willing to sacrifice what it expects to be short-term growth for structural reforms. This is reflected in the downward revisions to Chinese growth this year and next that have been issued by a number of houses. It is also reflected in increased expectations that the PBOC will begin cutting reserve requirements by the end of the quarter. We note that last week's lending data suggests that there has indeed been progress in reining in non-bank financing (shadow banking).

China's fixed asset investment continues to grow at a heady pace, but has reached the point of diminishing returns and has created excess capacity challenges. That excess capacity pushes prices below the cost of production, forcing many Chinese companies in a wide range of industries to operate at a loss. That spare capacity is also exported in the form of deflation.

The North American session features three US economic reports: July Empire Manufacturing survey, which is expected to soften (to 5 from 7.84); June retail sales, which are expected to have been lifted by the strongest auto sales figures since last 2007 and higher gasoline prices (headline 0.8% excluding autos and gas, 0.4%); and May business inventories (expected flat after 0.3% in April).

The unexpected weakness in last week's wholesale inventory report prompted downward revisions to estimates of Q2 GDP. That report warns of downside risks to today's business inventory report and the April figure could be revised down. In theory, the lack of inventory growth could point to stronger growth in Q3. However, that was the logic used for forecasts for Q2 growth--that inventories would be rebuilt. While there is much to be said about just-in-time inventories, inventory stocking and de-stocking still plays an important role in the short-term swings of growth and are difficult to forecast.

Lastly, before the close of Europe, around 10:00 EST, the IMF is expected to issue a report on the Spanish banking system. Recall that last week, the EC encouraged extending the end of the year expiry of the 100 bln euro back-stop for Spanish banks. Spanish banks have drawn down about 41.3 bln euro. The Spanish government and the EC argue that no more is needed. The EC wants the line extended on a precautionary basis.