Markets Trying to Stabilize

The capital markets are beginning to show their first signs of stabilizing after follow through selling of equities and major foreign currencies, save the safe haven yen and Swiss franc, materialized. The market remains nervous and the situation remains fragile.

European economic data was poor, but the European bourses are recovering from the steep opening losses as the S&P 500 also recovers from yesterday's slide that brought the much watched index to near 1100, 38.2% retracement of the advance off the early 2009 lows. News that S&P indicated that some local and state governments may retain a higher credit rating that the federal government and that banks rating will not be cut simply because of sovereign cut.

The UK reported much weaker than expected industrial production and manufacturing figures. Industrial output fell 0.3%, while economists had expected a 0.2% rise. Manufacturing output fell 0.4% compared with a 0.2% gain expected by the consensus. The trade deficit of GBP8.9 bln was 10% larger than the market had expected. However, sterling continues to show impressive resilience and this despite the spreading of riots in the UK that has forced the Prime Minister to call parliament back later this week.

Also capturing the attention of the market, which may help explain sterling resilience, the German 5-year CDS rose above the UK CDS for the first time since Jan 2008. The BOE inflation report tomorrow is likely to see a sharp cut in its GDP forecast and the riots won't help. A new round of asset purchases, perhaps in Q4 is looking increasingly likely and more so than a change in the fiscal stance at this juncture.

The ECB continues to buy Italian and Spanish bonds and of the various official action over the past week--SNB QE, BOJ intervention and QE expansion, this has been among the more successful operations. Yields on Spanish 10-year is slipping below 5% and Italy's 10-year yield is holding just above that threshold. Usually, one would expect the sharp drop in equities to support core bond prices, but that is not the case currently as the ECB bond buying is distorting the market as relative value trade are forced to unwind (long bunds short BTPs and Bonos).

Separately, Germany reported a smaller trade surplus in June and an outright decline in exports (1.2% on the month). This reinforces the sense that the German economy has slowed markedly in Q2. Q2 GDP will be reported next week and may slow to 0.5% quarter-over-quarter from 1.5% in Q1.

Attention turns to the FOMC meeting today. Although QE3 is a bridge too far now, the failure to do something will be disappointing. Most expectations focus on the change of wording to provide to include the balance sheet in its pledge to keep rates low for an extended period of time. However, if its action is limited to this, it risks disappointing the market. Although its GDP forecasts--2.8% this year 3.5% next year--are more than a little outdated, it does not officially offer new forecasts until Nov.

The euro did not take out yesterday's low near $1.4130, which was above last Friday's low near $1.4055. The euro has been has high as $1.4288 in the European morning, but $1.4300-50 may be difficult to breech until the market sees if US equity gains can stick.

Sterling did take out yesterday's lows, but as was the case last week,m found support near the 20-day moving average (~$1.6275) and managed to pop through the $1.64 level briefly. It looks more vulnerable than the euro, leading to upside potential in euro sterling.

The dollar returned to levels seen prior to the BOJ intervention seen around JPY77. The BOJ has not been seen again and the G& pledge to take appropriate measures if needs rings hollow to many given the speed at which Europe and the US distanced itself from the intervention. Honda's head warned that multilateral intervention is needed to arrest the yen's appreciation and indicated he would not be surprised if the dollar fell to JPY70.

The Australian dollar completed a 10.3% plunge since the start of the month today, but has reversed sharply. After hitting a low near $0.9930, on the back of the plunging equity and news that the largest mortgage lender was cutting rates up to 50 bp, which ws seen as a prelude of an RBA cut as early as next month, according to the indicative market prices.