New Week, Same 4 Drivers

We continue to identify four main macro issues shaping the investment climate: The tapering anticipation in the US; the stabilization of the Chinese economy; a cyclical recovery in Europe; and the long awaited Japanese purchases of foreign bonds.

Last week's news, and the anticipated data stream this week, are expected to either reinforce these issues, or at least not challenge them.

Participation has thinned and volatility has generally trended lower. However, looking further down field, events next month promise to inject fresh volatility into the market, and we expect it to be in a dollar positive direction.

Japan's Prime Minister Abe will make a decision whether to modify or block the controversial retail sales tax, the first of two stages is to be implemented at the start of the new fiscal year. Germany holds its national election, and although German policies are unlikely to change significantly, there is a sense that in the run-up to the election (and, perhaps partly a function of the summer holidays) many issues have been simmering, which may turn to boil afterwards.

Issues like the funding gap in Greece, Italy's fragile government, Spanish banks, and their vulnerability to continued falling real estate prices and Portugal may command attention. Moreover, there is a potential exogenous shock in the form of Fed tapering, with many still expecting it to begin as early as next month.

For the purposes here, though, let's just update the four current themes:

1. Fed Tapering: The only voting FOMC member to speak last week was Evans, who while seen as a dove, towed what appears to be the party line and that is tapering next month has not been ruled out. Bullard speaks this week. Recall that after dissenting in June because he did not think the Fed has showed proper concern with falling prices, Bullard gave up his dissent in July as the FOMC statement was expanded to reflect his point.

There is a full slate of high frequency economic reports , including both inflation measures, retail sales, industrial production, and the first regional surveys for the current month (Philadelphia Fed survey). However, none will change participants expectations for the Fed; that will depend on the next batch of jobs data.

Judging from media reports, the salience of next month's budget issues has increased. To some this issue is rivaling the Fed tapering story. The US 10-year yield have largely been confined to a 2.46%-2.66% range since early July. A break of this range will be noteworthy, though this week's data calendar makes it unlikely.

2. China Stabilizing: The recent string of official data lends more support to our understanding that China's economy stabilized in late Q2 and early Q3. The lending data shows that officials have been successful in reining in the shadow banking activity.

The yuan has been drifting slightly higher and, far from protesting, the PBOC has actually fixed it higher each day last week. Of the commonly traded and referenced currencies, the yuan is among the strongest this year still, appreciating about 1.8% against the dollar. Recent gains have turned the euro and the Danish krone higher (~1.1%). The Shanghai Composite has been range bound so far in Q3 between roughly 1950 and 2100. A break of this range will draw attention.

3. European recovery: The euro area is expected to report a quarterly expansion in Q2 that ends the three-quarter contracting phase. The consensus calls for a 0.2-03% Q2 GDP, though the pre-weekend release of disappointing French industrial output figures, may warn of downside risks. Essentially, what has happened is that the periphery has shown a slower contraction, while the core, especially Germany and France strengthened. The consensus anticipates that Germany expanded by 0.8% and France half as much.

In the UK, this week's data, which includes prices, employment and retail sales, are unlikely to change the general view that Q2 recovery has continued apace in Q3. As noted previously, the base effect works very much in the BOE's favor, especially starting in August.

One point that has arisen from recent discussions, and suggested by the changes in the positioning in the futures market, is that the euro bears have not changed as much as the latest entrants have been playing with the short-term trend higher. In recent weeks, the gross long euro positions have grown twice as fast as the gross shorts have been covered. The issue now seems to be, at what level will the euro shorts capitulate? We suspect it is above $1.35. Also at issue is what level will the bulls acknowledge the uptrend is over. We suspect that is near $1.3280 initially and maybe $1.3200 itself.

4. Japanese flows: Japanese investors have bought foreign bonds for the past five consecutive weeks. On this run, MOF data shows net purchases of JPY3.6 trillion worth of foreign bonds. What this has done is nearly offset the net sales of the prior five weeks (JPY4.1 trillion). On the other hand, foreign investors' appetite for Japanese shares has waned. Although they have been net sellers over the past two weeks, it has been in small amounts. Rather, the pace of buying has slowed considerably. The four week average is now new JPY161 bln, down from JPY754 bln at the end of April, half of the end of May pace of JPY334 bln.

Ironically, just as the portfolio flows are leaving Japan, the yen has strengthened to trade at its best level against the dollar since late June. The yen's gains do not appear speculative in nature. The gross short positions, for example, in the futures market remain elevated at almost 100k contracts. The recent high was in late May near 118k contracts.

Instead, the yen's rise seems more linked to the stock market, where a statistically significant inverse correlation exists. Consider that over the past month, the Nikkei was off around 6%, but the yen appreciated by about 5% against the dollar, suggesting some investors likely found hedging to be disadvantageous.

The main report of the week is the first estimate of Q2 GDP early Monday in Tokyo. The consensus forecast is for a 0.9% quarterly expansion, and 3.8% annualized. This contrasts with 1.0% and 4.1% respectively in Q1. There is some concern that the economy has lost some momentum at the end of Q2 and early Q3.