Preview FOMC

The FOMC's 2-day meeting begins today, with a decision tomorrow around 2:15 pm EST. While the disappointing data in recent weeks raise the prospect of action by the Federal Reserve, most investors appear to be expecting a tweak in the statement to recognize the down shift in the economy and the forward looking guidance, with a action more likely in September than August. 

The market has been adjusting expectations for Fed policy since at least the disappointing June jobs data reported in early July. Since then the implied yield on the Dec 2012 and Dec 2013 Eurodollar futures contract have fallen 15 bp (to about 35.5 bp and 43 bp respectively). The implied yield on the Dec 2014 contract has fallen to 18.5 bp to 59.5 bp. The Fed funds futures contract do not imply an average effective Fed funds rate above 20 bp until Aug 2014.

Great Graphic: Regional Debt Spain (and Italy)

Here is a Great Graphic posted on FT Alphaville.  It illustrates the magnitude of Spain's regional debt challenge.  The regional debt is one of  three separate but related debt problems Spain face.  The other two being bank debt and sovereign deficit/debt.   

There are interesting parallels between Spain and its regions on one hand and the creditors and debtors in the euro area on the other.    Spain has offered limited help to to the regions, but has threatened to link the regional autonomy to solvency, as European officials appear to be doing as well (substitute regional autonomy for sovereignty). In dealing with the regions, Prime Minister Rajoy takes the position of creditor, but when dealing with the EU, Rajoy takes the stance of a debtor.  This is not being hypocritical or duplicitous, but rather illustrates the different interests in different contexts.  This is not a moral question, it is a material question based on whether one is a debtor or creditor.  

The lower chart shows that while Sicily and Naples, (Italy's 3rd largest city had its rating cut by Fitch yesterday to BBB from BBB+) and a few other local governments in Italy are having troubles, the debt problem in Italy is largely on the national level.  Although Italy's GDP is roughly 50% larger than Spain's, regional debt in Spain is more than three times larger than the regional debt in Italy. 

 

FX: Hurry Up and Wait

The US dollar is mixed. Against the dollar-bloc, it is soft, but against the other major currencies, it is consolidating in narrow ranges near the middle of yesterday’s ranges. Of the capital markets, the foreign exchange market seems the more wary of being disappointed this week. Risk assets, like equities, commodities and peripheral European bonds continue to trade higher. The MSCI Asia-Pacific Index was up over 1% today to bring its 5-day rise to about 5.6%. The Dow Jones Stoxx 600 gapped higher yesterday is consolidating today in the upper end of the range, near 4-month highs. Spanish shares are outperforming gaining a little more than 1% to bring the 5-day gain to 16.6%. 

The moves seem defensive after last week’s comments give rise to perceived odds of a “Big Bertha” moment (derived from German artillery in WWI rather than “bazooka” which appears to be derived from the US Army). We worry that ECB President Draghi overplayed his hand. Reports indicate that his comments were not the result of negotiations and consultations and that his remarks surprised many on the governing council. 

Europe: Urgent or Not?

The ECB's Draghi expressed an appreciation for the urgency facing the euro area, but he seems more isolated than he did last week when Merkel and Hollande reiterated their willingness to do what was necessary.

Even though the euro fell more than a 1.5 cents from its pre-weekend high just below $1.24, Spanish bond yields have continued to retreat. The 10-year benchmark is now about 100 bp below the level seen early last week and the 2-year yield is off about 200 bp. 

Currencies Consolidate Awaiting Key Events

The US dollar is consolidating the losses suffered at the end of last week. It remains largely confined to the ranges seen before the weekend. The Swedish krona is the best performer following the better than expected Q2 GDP (1.4% vs 0.3% consensus).  The Australian dollar is the other exception.  Speculation of a rate cut next week have been scaled back.  The Australian dollar's 4-day advance has brought it from under $1.02 to almost $1.05. 

Asian shares responded favorably to the pre-weekend US equity rally, with the MSCI Asia-Pacific Index gaining more than 1%, gapping higher for the second session. However, China’s Shanghai Composite bucked the trend, losing 0.9% to fall to its lowest level since Q1 09. European bourses are higher, with the Dow Jones Stoxx 600 gaining around 0.6% near midday in London, led by the financials (+1.5%). Bond markets are mixed, though Spain yields have continued to fall with the 2- and 10-year yields off about 16 bp. Italy’s bond auctions produced mostly lower yields.

Great Graphic: Capital Flight from Greece Continues

Here is a Great Graphic from Zero Hedge. It depicts the ongoing withdrawal of corporate and household deposits from the Greek banking system.  

There has been no reprieve since the second Greek elections and if anything the pace of capital flight has increased.  Bank recapitalization also seems not to have mattered.  

While ECB President Draghi has asserted that the EMU is irreversible, there are many officials who continue to suggest that the current membership may not be.  The mere talk of a Greek exit by officials raises the re-denomination risk and further encourages flight by depositors and investors.

Currency Positioning and Technical Outlook

Last week was of two halves.  In the first part, the dollar remained strong as the European crisis dominated other considerations.  In the second part, the dollar had its recent gains pared as the seemingly bipolar market shifted its focus to the increased risk of a policy response.  In addition, evidence continued to mount that the world's largest economy is off to a sluggish start of Q3.  

Next week is jammed with key events, back loaded, if you will.  The keys will be the FOMC meeting that concludes on Wednesday and the ECB meeting on Thursday.  In addition, the US reports the market sensitive employment data on Friday.  The poor clue from the ADP estimate last month will make short-term participants less likely to give it much weight and, hence, it is unlikely to steal the thunder of the government's report.  

The Bank of England meets but as it is currently engaged in QE and the "Financing for Lending Scheme", this will likely be a non-event.  And unlike other central banks, when the Monetary Policy Committee doesn't do anything, it doesn't say anything.  The monthly purchasing managers surveys will also be released but are unlikely to provide much fresh insight or challenge current views.    

Great Graphic: Big Mac Update

Here is a Great Graphic from the Economist:  It updates its classic look at purchasing power parity by comparing the price of Big Mac's from around the world  What is of added interest in this reiteration is that is depicts the changes since 2007.  

There are more sophisticated approaches to purchasing power parity as well.  For your interest,  below you will find a table of the over- and under-valuations according to the OECD (courtesy of Bloomberg).  It is interesting to note that recently the euro became the only major currency under-valued according to the OECD. 

A review of the dollar's valuation against a broad range of currencies, suggests that the greenback is largely under-valued against the major currencies and over-valued against the emerging market currencies, with some notable exceptions.   Over time, this would seem to imply that the major currencies will have to depreciate against the emerging market currencies.  This can take on a number of different forms and different combinations of real and nominal adjustment.  

Eight Observations about the Yen

The strength of the Japanese yen continues to befuddle policy makers, investors and observers.   It is often claimed to be a safe haven, even though the country does not have a triple-A rating, has a debt-to-GDP ratio of more than 200% and continues to be plagued with outright deflation.  

Yet the "safe haven" claim, like the "carry trade" claim to explain pre-crisis periods of weakness, lives a mostly unexamined life.  While not pretending on offering a grand explanation for the yen's strength here, we share the following eight observations:

Great Graphic: California Renewable Energy Growth

Today's great graphic comes from brilliant webmaster who the personification of the Millennial Generation green movement, biking to work, owning a soda stream, and only drinking local beer sorta like this:

 

California (that state just south of the great land of Portland) utilities have had a renewable energy boom according to Green Tech Media.

Short Note on US Preliminary Q2 GDP Estimate

The US reports its first estimate of Q2 GDP on July 27.  It is likely to be around the same pace as Q2 last year which was 1.3% annualized.  Last year the second quarter began the recovery from the 0.4% pace in Q1 that continued to the 3% pace in Q4 '11.  

However, this year Q2 will show a slowing in the expansion which was estimated at 1.9% in Q1 12.  There has only been a few surveys and weekly initial jobless claims for Q3 and they have not been very promising. The June durable goods orders data also points to the likelihood of some slowing in shipments in Q3. 

Hidden Water: How much do you use?

Here is a great video on virtual water...if it doesn't work you can check it out here.

Draghi Means Dragon

As European leaders take leave for their summer holiday's, ECB President Draghi has again stepped into the vacuum and has helped spark a recovery in the global capital markets.  Not only has the euro rallied to the highest level in a week, but Spanish and Italian yields have fallen sharply and the short-end has fallen more than the long-end.  

European equities have rallied and the financials are fully participating.  In Spain, at pixel time, the IBEX is up 2.8%, while financials are up 5%.   More broadly, the Dow Jones Stoxx 600 is up1.5%, and the financials are the strongest sector, up nearly 2.4%.  

What Nowotny Did Not Say

There seems to be some confusion in the markets.  Many think that the head of the Austrian central bank and ECB member Nowotny raised the likelihood that the ESM could get a banking license.  This would allow it to borrow from the ECB to supplement its funds and make for a practically unlimited war chest. 

It would help address concerns that the current funding plan is insufficient to meet the potential need, especially if Spain needs a full package and Italy needs assistance.   Moreover, it appears Portugal may need more aid and there is Cyprus and Slovenia in the wings.  

Great Graphic: Tax Code as Tool in Class Warfare

Here are is a Great Graphic that captured our attention.  The first is from the Citizens for Tax Justice courtesy of NPR.  It shows that the return to labor (wages and other earned income) is taxed at a considerably higher rate than the returns to capital (capital gains).  Moreover that gap has widened over the past 20+ years.  

The second chart (below) is from the Economist blog, Democracy in America.  It shows the income share of the top 0.01%.   It illustrates what has happened since the early 1980s.  A super rich (rich always being understood in relative terms) class has emerged in the US.  Of course, there has always been an upper class in the US, but what is different about now is that is has happened to some extent through the manipulation of the tax code. While acknowledging many forces at work, the reduction in the sharp reduction in top marginal tax rates appears to be one of the key factors that have helped shape the disparity of income (which in turn impact the distribution of wealth--though the Economist article sometimes confuses the two.  

This suggests that in addition to being driven by a relentless profit-seeking motive, there is also an element of rent-seeking in widening income disparity in the United States that often goes unacknowledged by observers on both the Right and Left.    

Short Note On FX Market

The general scenario we outlined in our weekly outlook and reiterated yesterday anticipated follow through selling of the foreign currencies at the start of the week before corrective pressures emerged near mid-week.  That is essentially what is happening today.  

Moreover, today's corrective price action is happening despite a continued poor news stream.  The German IFO was considerably worse than expected and reinforces the sense from the flash PMI that the euro zone's biggest economy has lost its momentum.  The UK reported a 0.7% quarterly contraction in Q2 GDP which was below even the most bearish forecasts in the Bloomberg survey.  

Euro Warnings from the Options Market

There are two developments in the options market for euro that one should think about even if one does not trade options.  We have often found that divergences between the spot and options generate important insight into market direction.  

The first development has to do with the pricing of puts and calls equidistant from the money.  These are called risk-reversals.  The standard benchmark is 3-month 25-delta options (recall a 50-delta is at the month, so a 25-delta is a bit out of the money).  

FX: Nervous Consolidation: Correction Pending

The foreign exchange market remains in a heightened state of anxiety, but the majors are mostly trading within yesterday's ranges.  The short sales bans in Italy and Spain have not eased the pressure on the local bourses or bond markets.  In fact, for the first time in eleven years, the Spanish 5-year yield moved above the 10-year yield.   It is tempting to attribute the backing up of the German and Dutch yields to Moody's decision to assign them, along side Luxembourg, negative outlooks, but Finland, who was spared, is also seeing its yields rise in tandem with Germany and the Netherlands.  

Still corrective pressures are building.  The scenario we outlined called for foreign currencies losses in the first part of the week and some stabilization and recovery mid-week ahead of the first look at Q2 US GDP on Friday.  That scenario is still unfolding.

The Significance of the Surprising Canadian Dollar

The Canadian dollar has lost around 0.5% today and that is with the small modest recovery seen across the board since European markets closed for day.   Although my notes in recent days have highlighted the risk of near-term Canadian dollar losses, its weakness today will have many people scratching their heads.  

Consider that two large foreign direct investment deals were announced that is worth almost 1% of Canada's GDP.  The most important transaction is a $15.1 bln acquisition of Nexen by China's Cnooc.  It is a cash transaction and represented a little more than a 60% premium over July 20 closing prices.  This deal represents the largest foreign acquisition by a Chinese company.

Great Graphic: US Federal Spending by President

Here is a Great Graphic that is from MarketWatch two months ago.  MarketWatch is owned by Dow Jones, and is not known for its left leanings.  The information is as stunning as it is counter-intuitive:  federal spending has gone up less under President Obama than any president since Eisenhower.  

Many friends and critics of Obama want to attribute the 17.9% increase in government spending in fiscal 2009 to Obama, but a closer look at the facts indicate that it was President Bush's.  FY' 09 began four months before Obama took office.  

Obama's first budget, FY'10 saw federal spending fall 1.8%.  His second budget, FY '11 saw federal spending increase 4.3%.  This year's budget saw a 0.7% increase in federal spending.  The FY '13 budget calls for a 1.3% decline.

This helps explain why the government sector has been and continues to be a drag on GDP.  The federal spending is insufficient to offset the drag from state and local governments.  This is likely to be evident at the end of the week, with the first look at Q2 US GDP.  

Dollar Opens New Week on Firm Note

The US dollar has opened broadly higher in the early pre-Asian turnover.  The weekend news stream has been poor.  The euro is now likely to see resistance in the $1.2150 area.  Similar resistance is found in sterling near $1.5630 and the Australian dollar in the $1.0360-70 area.  The dollar may find support near CAD1.0120-30.  The greenback is likely to face resistance in near JPY76.80.  

Three items in particular has weighed on sentiment, which was already depressed at the end of last week as illustrated by some in Spain calling July 20, "Black Friday".

First, more regions are going to follow Valencia's request for government aid.  The Rajoy government had earlier this month set up a 18 bln euro fund to help the regions refinance their debt.  However, in order to maintain a high credit rating, one third of the fund is earmarked as a cash reserve.  This effectively leaves 12 bln euro.  There is a clearly a first mover advantage as the regions have 36 bln euros in debt to be refinanced this year.

Great Graphic: Euro Area Sovereign Bond Spreads

Here is a Great Graphic from the blog Global Macro Monitor that provides a useful visual of the change in the sovereign 10-year spreads in Europe over the past week to the left and year-to-date below.  

Some may be surprised that only Spain pays a larger premium over Germany compared to the end of last year.  This  reflects heightened concern that Spain will need a larger aide package and that private sector subordinate creditors of the troubled banks will be subject to haircuts.

The pressure on Greece over the past week is function of heightened concerns that the Troika will be unable to approve the next tranche of aid due to the lack of sufficient implementation of past agreements.  There is also the fear that a Greek exit could still very well be in the cards given the ECB's refusal to accept Greek government bonds and government guaranteed instruments as collateral.

The out performance by France and Belgium reflects investors search for yield and willingness to move outside the FANG (Finland, Austria, Netherlands and Germany) to secure it. 

  

The premium Portugal,  Ireland and  Greece pay over Germany compared with the end of last year has fallen considerably.  It appears to be more a reflection of the past over-shoot than an indication of investor confidence.  For example, most signs suggest Portugal will not be able to return to the capital markets in H2 next year as has been planned, which may mean a second aid package may be necessary. 

FX Positioning and In-Depth Outlook

In the great ugly contest that is the foreign exchange market, a series of disappointingly poor US economic data had threatened to give the dubious honor to the dollar.  The euro had reached a 7-day high on July 19,  just below the key level we identified near $1.2330.   Sterling traded near its best level in a month, near $1.5740.   For its part, the Australian dollar had reached its best level since the end of April.

However, several developments at the end of last week again gave the euro the honor of being the ugliest.  And in turn, the euro dragged down the other major currencies, save the Japanese yen.  The yen is being bolstered even more than the dollar by the turmoil and is trading near its best levels against the greenback since early May.  

The latest developments in Europe are particularly troubling for investors.  First, the memorandum of understanding (MoU) between Spain and the EU and ECB to recapitalize Spanish banks was hardly 24-hours old when the second dimension of the country's debt problems resurfaced:  regional debt.  

Quick note on Price Action: Look Out Below

The euro has been sold off to new two year lows.  It is at the lowest level against the yen since late 2000.  It is at fresh 4 year lows against sterling.  It is also being sold to new lows against a range of other currencies, including the Australian and Canadian dollars.  

There does not appear to be fresh fundamental impetus, though losses in the equity markets are mounting.  The Spanish and Italian equity markets are flirting with 4-5% losses on the session.  Spanish and Italian yields are rising sharply, pushing well through 7% and 6% respectively.  Spreads over Germany are widening dramatically as well.  Italian CDS prices are higher on the day, but well off their extreme highs, Spain is a different,.  The peak in June was near 623 bp and it is currently moving through 600 bp. 

Tug-of-War Keeps FX Choppy

Choppy trading conditions continue to prevail.   Some suspect these conditions are the result of lighter summer conditions.  However, it might instead by a tug-of-war between the poor US data on one hand and the unstable situation in Europe that is pushing Spanish 10-year yields above 7% and 2-year yields above 5%.  Similar Italian benchmark yields are above 6% and 3.5% respectively.

The dollar is trading with a small upside bias today.  With a brief exception, the euro has been confined to the ranges established Monday-Tuesday of this week--$1.2176-$1.2317.   We suggested that the $1.2330 level needs to be taken out to signal a correction rather than consolidation in the euro   Today is the first time since Monday that the euro has not tested the air above $1.2300.  The failure to do so appears to have brought some pre-weekend selling. 

Implications of Summer Drought

The US main agriculture region is experiencing the worst drought in more than half a century.  Corn and soybean prices are being driven through the 2007-2008 highs to new record levels.  

The USDA publishes new food price forecasts on the 25th of each month.   There is no prize for guessing the direction of prices in next week's report.  In June when corn was under $6 (now above $8) a bushel, the USDA expected a 2.5-3.5% increase in food prices, after about 4.8% increase last year and a 2.8% average annual increase over the past 20 years.  

Conceptualizing Europe

The US dollar is  a bit heavier against most foreign currencies as risk appetites across the board appear to have strengthened.  Global equities are mostly higher.  Core bond markets are also a touch heavier.  Spanish and Italian 10-year yields were flirting with the 7% and 6% levels but have since pulled back (however note that Spain's 2-year yield is up 22 bp to push through the 5% level).   It is not about the news stream so much as the disappointing UK retail sales (0.1% in June rather than the 0.6% consensus forecast) has not stopped sterling from trading at its highest level since July 3 or the FTSE from rallying or supporting the gilts.

The factors being suggested that have bolstered the risk appetite seem a bit of a reach and examples of post hoc narratives.  There is heightened speculation of new measures by China, such as a cut in required reserves.  Yet a surprise rate cut earlier this month did not reanimate the animal spirits.  There are reports indicating that the draft of the memorandum of understanding for Spain has the EFSF setting aside some aid funds for buying Spanish sovereign bonds.  This too does not sound auspicious, but rather plays into fears that the bank aid will morph into a full fledged assistance program.

Bernanke and Fed Options

Many observers continue to clamor for a new round of asset purchases from the Federal Reserve. They were disappointed when the FOMC statement and press conference after last months meeting failed to provide fresh clues. They were disappointed again with the minutes from that meeting. They were disappointed again yesterday when Fed chairman Bernanke did not play up the likelihood of QE3.

This does not mean, however, that the Fed is content with the status quo. Indeed the Fed is reviewing its options. Bernanke listed several options for the Fed. These include purchasing Treasuries and mortgage backed securities, changing the Fed's guidance, cutting the interest on excessive reserves, and using the discount window for direct lending.

Great Graphic: US Minimum Wage

Here is a Great Graphic from David Ruccio at Real-World Economics Review Blog.  It captures the fact that in real (inflation adjusted terms),  the US minimum wage is lower than it was 45 years ago.   The pie charts shows that earning minimum wage does not prevent one from being impoverished.  Indeed, the gap between the two has grown considerable.

The problem is not simply about minimum wage and poverty.  It is about aggregate demand more generally.  It is not clear where it will come from.  Wage growth is hardly keeping pace with inflation.  There is political pressure to reduce transfer payments.  Credit had filled the gap, but for numerous reasons, cannot be relied on going forward.   

Dollar Firmer, Euro Worries

The US dollar was flat in Asia, but has rallied in Europe.  The inability of the euro to establish a foothold above $1.23 was a sign of encouragement to the bears.  Rumors of an Austrian downgrade and Merkel's comment expressing doubts about the European project have seen the euro drop more than half a cent in late morning turn-over in London.   The slide in of the major foreign currencies appears to have exhausted itself and as North American dealers return, look for the dollar's gains to be initially pared. 

The debt market does not seem to reflect much concern about Austria, despite the rumors or euro price action.  Austria's 10-year yield is up 1 bp at pixel time, at 1.86%.   The 2-year yield is up 4 bp but at a 3 bp annual yield, hardly evidence of anxiety.  The five-year credit default swap is about 4 bp lower at 135.7 (below France, for example, quoted near 162). 

Dismal US Retail Sales

The June retail sales report was simply dismal.  Not only did  sales decline by 0.5% in June rather than rise 0.2% as the consensus expected, but the April data were revised.  The measure used for GDP calculations, excludes gasoline, auto and building material sales fell 0.3% for the second consecutive month.  

While the May data was unrevised, April's 0.2% decline turned into a 0.5% fall.  April's ex-auto sales were off 0.6% rather than -0.3%.  Economists will likely cut Q2 GDP forecasts and market participants will anticipate additional easing measures by the Federal Reserve. 

Three Observations to Start the Week

There was a brief attempt in early Asia to extend the US dollar's pre-weekend decline, but this proved limited and buying reemerging especially in Europe.  Concerns about the extent of private sector involvement in Spanish aid seems to be the main talking point and is more evident in the equity market, where financials are the weakest sector (off more than 1% near midday), than in the sovereign bond market, where yields are slightly higher and the sovereign credit default swap is a few points lower. 

The euro has moved within 20 ticks of the two year low against the dollar seen before the reversal on Friday, and also continues to be sold on the crosses.  The dollar's heavy tone against the yen is a notable exception to the general greenback strength.  The dollar has dipped below JPY79 for the first time in nearly a month.  Additional chart support is seen near JPY78.60. 

Currency Outlook and Positioning

Global growth and the European debt crisis continue to be the two main factors shaping the investment climate. Monetary policy has been eased this month in countries accounting for large part of world GDP. The list includes China, the euro zone, the UK, Denmark, Brazil and South Korea. The Bank of Japan tweaked its asset purchase program to make it more effective. The Reserve Bank of Australia cut rates last month.

In contrast, the Federal Reserve took a more modest step in extending Operation Twist. The minutes to that FOMC meeting did not give those looking for a resumption of QE much to point to for support. Indeed, if anything, there seemed to a hint that it was looking for something else to do, though a cut in interest on reserves (like the ECB recently did) did not appear to have been discussed. Fed officials are watching closely the BOE’s attempt to reanimate the credit creation process.

Great Graphic: China's GDP and Composition

Here is a Great Graphic from the Wall Street Journal on China's GDP.  Earlier today it reported Q2 GDP expanded by 7.6% from a year ago, which was largely in line with expectations, though it was still the slowest year-over-year pace since early 2009. 

The composition of growth is disappointing.  Even though net exports continued to be a drag, there is little sign that the economy is really evolving to a a more consumption oriented economy.  Consumption actually contributed less to GDP.  The increase in investment is also not necessarily a good thing.  It could be redundant investment that aggravates excess capacity.  Moreover, capital investment appears to have reached a point of diminishing returns.  Every unit of additional investment is not generating the same unit of growth that was previously the case.  

Bottom Line:  China's GDP figure were not horrible, but the economy is still slowing and further monetary stimulus is likely in the coming months.  

FX Update and Adjusting to Zero Deposit Rate

The US dollar is trading little changed against the major currencies, but the dollar-bloc currencies are a bit better bid, perhaps encouraged by China's data, which on the face of it was not as poor as feared when PBOC cut interest rates earlier this month.   Q2 growth was 1.8% quarter-over-quarter, up from a revised 1.6% in Q1.  Year-over-year growth slowed to 7.6% from 8.1%.  Retail sales and fixed asset investment were a bit stronger than expected while the 9.5% year-over-year increase in industrial output was a bit softer than expected. 

Global equities ar mostly firmer.  The MSCI Asia Pacific Index rose almost 0.5%. Most European bourses are higher, with the Dow Jones Stoxx 600 up around the same, with financials the weakest sector.  Italian and Spanish markets are under-performing.  

Negative Interest Rates and the Currency War

There have been some noteworthy developments on interest rates over the past week. The ECB's cut of its deposit rate to zero has pushed some short-term market rates below zero. France sold bills earlier this week with a negative yield. Denmark cut its key two-week CD rate to -20 bp. The Swiss yield curve out 5 year is below 0 (the 2-year yields -0.39%, for example, and the 5-year yield is now -0.01%).

Some observers have suggested this is a new front in the currency wars. While recognizing the competition between countries, this formulation seems to be an over-generalization. There seems to be at least three different reasons that have driven rates so low. First, some countries are contracting or suffering weak growth. This was the key factor behind the ECB's rate cut.

Six Observations about the Euro

1. The odds of a country exiting the euro zone this year have fallen from above 40% on the eve of the Greek election to about 27% today, according to Intrade.Com.  Previously the euro appeared to track the "break up" fear.  However, it has found little succor in the reduced exit speculation.           

2.  We often find that the euro also tends to move in the same direction as the US-German 2-year interest rate differential.  The premium the US offers over Germany is hovering around 28 bp, its best level since late 2007.

Great Graphic: Relative and Absolute Mobility in US

Here is a Great Graphic from Catherine Rampell at the NY Times Economix blog.  She draws on the PEW Economic Mobility Project to look at relative and absolute mobility in the US.  The chart to the right looks at relative mobility.  It answers the question: Can one rise/fall from the socioeconomic class one is born into ?  The chart below looks at absolute mobility.  It answers the question:  Can one earn more than one's parents in real (that is inflation-adjusted) terms ? 

The take away from this data is mixed.  On  one hand, an overwhelming majority of Americans surpass their parents in terms of real income.  Inter-general mobility seems fairly robust.  On the other hand, inter-class mobility seems to be poor.  People born into the top and bottom quintile's tend to remain there.  Moreover, in terms of wealth, about half of Americans are wealthier (adjusted for age) than their parents, which includes house equity. 

Euro Drifts Lower, Yen Higher; Aussie Spanked

The US dollar is broadly higher today.  The drivers continue to be the same.  European debt crisis continues to weigh on sentiment and, separately, world growth worries continue to elicit policy responses, though the lack of stronger support for QE in the FOMC minutes may have also bolstered the dollar bulls.  

Brazil delivered the expected 50 bp rate to bring the Selic rate to a record low 8%.  South Korea surprised with a 25 bp rate cut to 3.0%.   This follows recent moves that include China, the UK, the ECB, and Denmark.    

The BOJ tweaked its asset purchase program earlier today.   It increased the purchases of short-term instruments by JPY5 trillion, but reduced the credit loan program by the same amount.  While this sounds a net wash, there may be more than meets the eye.  The credit loan program was under-utilized and therefore a shift of funds away from it makes increase effective purchases.  Modest adjustment, but the direction is telling. 

Great Graphic: Youth Unemployment

Here is a Great Graphic from CNN.  It captures the high level of youth (15-24 year-old cohort) unemployment.   This excludes those that are in school or receiving training.  The CNN report reviews the findings of the OECD, where the data originates.   There are 34 countries in the OECD and their youth unemployment collectively was 18.6% last year year.  The OECD warns of a "scarring effect" of such high youth unemployment that will impact career paths and earning prospects. 

Spain and the New Model

European officials are devising a new approach to the debt crisis.  The model used for Greece, which was the prototype for Ireland and Portugal, is being replaced by a new approach.  It is being hammered out in Spain.  It is evolutionary in the sense that it is responding to the changing environment and conditions, while at the same time the new approach uses mechanisms and approaches seen in the earlier model but uses them somewhat differently. 

There are three dimensions to the Spanish debt crisis:  the general government deficit, the bank problems and the regional debt.  Spain is moving on all three.

Currency Correlations with the S&P 500 Revisited

The start of the earnings season in the US provides an opportunity to review the currency correlations with the S&P 500. We conduct our analysis on the percentage change of the currencies and percentage change in the S&P 500. What we find then is the correlation of the returns, which is more important to investors then if the levels are correlated. 

We look at a 30-day correlation to see the near-term trend and we look at the 60-day correlation to the slightly longer term. The general take away is that despite a number of other drivers and influences, the correlation between most of the currencies we looked at and the S&P 500 has increased in the recent period.

Great Graphic: Tighter Rental Market may Lift Core CPI

Here is a Great Graphic from Barry Ritholtz blog (The Big Picture) and a post by James Bianco.  It illustrates the decline in the vacancy rate of apartments in the US and the corresponding increase in rents.  This has a couple of implications.  First, the declining vacancy rates, which are evident in single family dwellings as well, provide some evidence that the housing market is bottoming.  Second, the increase in rents will also contribute to the firm core inflation readings, even as headline pressures ease with the decline in commodity and especially energy prices. 

Muted Turnaround Tuesday

The US dollar is sporting a slight softer tone, but within the consolidative ranges seen in recent days.  The dollar was better bid in Asia but softened in Europe following better than expected industrial production figures from the UK, Italy, and Sweden, leaving France as the exception with a disappointing report.  

Similarly, Asian equities were mostly lower, while European equities are advancing, with the Dow Jones Stoxx 600 up about 1% near midday in London, with the financials actually outperforming the overall market.   Spanish and Italian bonds are bouncing back after the recent drubbing.  We have recently been noting the bearish flattening--where the short-end sells off even more than the long-end.  Today's corrective forces have seen a bullish steepening as the short-end of the Spanish and Italian curve are rallying more than the long end. 

Draghi Calls for Bold Action

ECB President Draghi calls for bold action, but it is not clear exactly what he means. He does not mean a resumption of the sovereign bond purchase scheme. He does not mean granting the ESM a banking license. He does not mean boosting the funds available to the ESM. Bold action apparently does not mean accepting any more (net basis) state guaranteed bonds as collateral. Bold action is not opening up the creditor nations' purse strings without conditions or limits. 

Change, as we noted before, change comes in two forms:  bumps and grinds.  Weather and demographics are often associated with grinds; small nuanced changes over a protracted periods.  Bumps are faster and more pronounced changes over a short period, like 9/11 or the fall of the Berlin Wall. 

German Constitutional Court and the Euro

The German Constitutional Court is expected to rule Tuesday July 10 on the request for a temporary injunction against the ESM and the fiscal pact on grounds that it transfers an unconstitutional amount of power to European institutions.  German press reports suggest that it is unusual for the Court to entertain requests for a temporary injunction.  The temporary aspect is sought to give the Court proper time to address the constitutionality of the new laws.  

We have previously noted that the Constitutional Court has shied away from outright rejection of government efforts to address the European debt crisis, but at the same time has insisted on preserving Germany's sovereignty through ensuring a important role for parliament.  

Spain: Deal in the Making?

Spain is on the bubble. The 10-year yield is pushing through 7% and 2-year yield is flirting with 5%. As we noted earlier, the entire curve and CDS pricing is above Ireland's. The Spanish crisis is really a combination of three different debt issues: sovereign, banks and regions.

The Eurogroup of finance ministers meet today and although there will be much talk, no formal decision in expected on Spain. However, this will not prevent some sketching out of the eventual plan that could be ready later this month. The take away is that the model that Europe developed to address the Greek crisis, and then applied to Ireland and Portugal, is being jettisoned in Spain's case, which could be the new model.

Great Graphic: US and Europe Industrial Production

Here is a Great Graphic from Thomson Reuters that captures relative performance of industrial production.  There is a clear difference between the Germany and the US on one hand and every one else on the other.  France and the appear stagnant, while Italy, Spain and Greece are contracting.  The real challenge is what will be the source of aggregate demand when governments and consumers de-leverage. 

Calm before the Storm?

The US dollar is little changed against most of the major foreign currencies today as a consolidative tone emerges pending fresh developments. The euro made a marginal 2-year low in early Asia, but narrow ranges have prevailed and the euro has traded in a little more than a quarter cent range in Europe, mostly below $1.23. The dollar has been in an even tighter range against the yen, where a 14.8% decline in machinery orders (consensus was for around a 3% decline and a current account surplus half of what was expected) played on growth fears. Soft Chinese CPI (2.2% June from 3.0% in May) and weak jobs ads undermined the Australian dollar ahead of the employment figures later in the week. 

Growth concerns are undermining equity prices ahead of the beginning of the US earnings season. The MSCI Asia Pacific Index was off 1.5%, with the Shanghai Composite approaching the lows for the year and the Nikkei posting its biggest decline in a month (-1.4%). European bourses are faring slightly better, with the Dow Jones Stoxx 600 off about 0.35% near midday in London, with financials among the weakest sector off more than twice the index headline. Stress in peripheral debt markets continues with Spanish 10-year yields continuing to flirt with the 7% threshold, while Italy moves through the 6% level. That the 2-year yields are up even more than the longer end of the curve indicates the intensification of anxiety. Note too that Spain’s entire curve and CDS pricing has now risen through Ireland’s.

Great Graphic: Fed Unemployment Projections

Here is a Great Graphic from Brad Plumer at the Ezra Klein's Wonkblog at the Washington Post.  It shows the Federal Reserve's forecasts of US unemployment and the actual performance.  The disappointing performance is why many continue to look for QE3.   Plumer's piece, though, focuses on a version of Q3 where the Fed would target a particular rate (such as the 30-year mortgage rate) that would be enforced by unlimited Fed buying of MBS securities. 

While this is possible, I would continue to  lean against it any time soon.  The Federal Reserve opted for the continuation of Operation Twist.  Barring some major break or event, it seems that the FOMC meeting later this month is too early for the Fed to come up with a new policy response.  In the past, the Fed has completed one stimulus program before introducing another. 

Thoughts on Jobs Data

The US created a net of 80k jobs in June, slightly below expectations, especially after the ADP data rose  hopes in some quarters for a stronger number.  Some of the underlying details were better though and this appears sufficient to keep the talk of QE3 in check.  

The bright spots in the report are two-fold.  First, hourly earnings rose 0.3% for a 2.0% year-over-year pace up from 1.7%.  This, at least in theory, could help support consumption.  That said, the early indications suggest retail sales remained soft in June, even though auto sales were a bit firmer.  Second, hours worked increased by a tenth of an hour.  This is important because output (GDP) is ultimately a function of hours worked and productivity.  The index of aggregate hours worked rose for the first time since February.  

Four Developments Before the US Jobs Data

The US dollar is mixed as the market braces for the last main event of the week, namely the Us employment report.  The greenback is consolidating yesterday's outsized gains against the major currencies and is finding a better bid tone against the dollar-bloc.  

It may be more difficult than usual to anticipate the market's reaction to the US employment data.  Some observers see a weak report increasing the risk of QE as early as August.  Yet given the recently announced Operation Twist extension, it seems to early to anticipate another policy response.  Some houses did increase their forecasts for the non-farm payrolls report after the ADP data yesterday.  Almost half the ADP gain was due to hiring by small businesses, which the national report attempts to estimate.  Other estimates of small business hiring, like SurePayroll reported a decline.   

The Two Drivers

There are two main concerns which appear to be driving the price action.  First, there is heightened anxiety about the global economic slowdown.  This is evident in the fact that easing of monetary policy by four countries (China, the UK, the ECB and Denmark) failed to breathe fresh life into the moribund animal spirits.  

Second, is that the European debt crisis continues, though the deck chairs of what many increasingly believe is a Titanic of sorts have been moved around a bit.  

As BBK President Weidmann’s comments yesterday attest, there is much room in last week’s agreement for interpretation, in both the legal aspects and implementation.  Merkel can honestly tell the German parliament, as she has done, that she did not “blink” or cede any substantive point, including conditionality.  Rajoy,  Monti and Hollande can honestly claim an important victory, as they have intimated.

China Surprises, ECB, BOE Not

Neither the BOE nor the ECB surprised.  Both did what the consensus expected.  The BOE will buy GBP50 bln more gilts.  There was, I thought, some risk of GBP75 bln.  Any additional QE now will have to wait until after the next inflation report in early August, which means an actual increase in QE is September at the earliest.  

The ECB cut key rates 25 bp to bring the refi rate to 0.75%.  The deposit rate, which is really the floor, was cut to zero.  The euro has come off hard with the as expected move.  We had identified the $1.25 are as key to the technical outlook and this was convincingly violated.  With today's losses, the EU Summit gains have been unwound in full.

Dollar Firm Ahead of Key Events

The US dollar is trading near its best levels for the week against the euro, Swiss franc and sterling ahead of ECB and BOE meetings, and US ADP and service ISM.  New market moving developments are scarce and the market has largely traded within the ranges set at the end of last week.  The Australian and Canadian dollars have seen some follow through gains in recent days, but this is the exception to the general rule.  

 News that funds for Spanish banks will not be available on July 9th as initially anticipated and may not be ready until July 20th, and Finland's insistence on collateral for Spanish access to EFSF/ESM, coupled with the new ECB collateral rules have undermined Spanish bonds, with the benchmark 10-year yield rising more than 20 bp and the 2-year yield up 25 bp, in a bearish curve flattening.  Italy's 2-year yield  is also up more than the 10-year, underscoring increased investor anxiety. 

Great Graphic: ECB Balance Sheet and Composition

This Great Graphic set comes from Sober Look.  Two important points are illustrated.  First, the ECB's balance sheet continues to expand to new record highs, even after the LTROs.  Since late May there has been a dramatic increase in bank borrowings at the ECB's weekly refunding operation.  It was averaging around 40 bln a week in May before rising to 180 bln euros in late June.  Second, the quality of the assets on the ECB's balance sheet has deteriorated.  This deterioration, which extends to collateral, is becoming a new front in the battle between creditor and debtors.

Higgs Boson and FX: What Matters

The scientists at CERN's atom smasher have reported discovering a new particle. The scientists themselves avoid calling it the "God Particle", though it does not stop the media. Essentially, this particle, called Higgs Boson, is believed to create an invisible field that gives mass to matter. 

Prior to the Big Bang, it is thought that all the particles did not have mass and moved around at the speed of light. The Big Bang changed everything. The Higgs Boson appears have been formed by two protons and it has a mass 100 times larger than would have been expected. This created an invisible energy field that is manifest as mass. Higgs Boson particles are believed to be the source of invisible energy that fills the vacuum in space. Some theories postulate several kinds of Higgs particles, yet to be discovered. 

Currencies Continue To Consolidate

The holiday abbreviated US equity and bond session today will likely ensure that the major currencies continue to trade in narrow ranges.  With the BOE/ECB meeting outcomes Thursday and the US employment data Friday, the price action could very well resemble a coiling spring, with a big move to follow this consolidative phase.  

There have been a few developments that shape the larger macro picture, but do not really provide new trading incentives.  In addition to the macro-economic developments, the tensions with Iran are rising, with its threats to close the Strait of Hormuz.  Brent crude is rising, as is the premium over WTI.  Note that many commodities have quietly rallied.  Gold is up almost 4% in the past three sessions.  Copper is up 1.4%, at a couple week highs.  Corn prices are at 10-month highs and soy is trading near 4-year highs.  

Ten Observations on Europe

Currency in Crisis

1.  The fact that access to the EFSF/ESM requires unanimous approval from the seventeen participants means that Merkel preserved the German veto.  This circumscribes the victory claimed by Hollande, Monti and Rajoy.   Germany also successfully resisted pressure to increase the size of the funds, even though many, if not most, observers suspect they are not be sufficient.   There was no agreement to give the ESM a banking license, which is another way resources could have been boosted.    

2.  It is unreasonable to expect the ECB to be the bank supervisor in Europe.  It does not seem to welcome this role.  Instead, what is likely to emerge is the ECB becomes the supervisory of systemically important banks.  The problem with this formulation is that, depending on the definition of "systemically important", Greek banks, possibly all of Ireland's banks, and most of Spain's banks, including Bankia, would probably not fall under the ECB's supervision.

Currencies Consolidate Pre-Weekend Moves

The major foreign currencies were unable to build on the euphoric gains seen before the weekend in response to the EU Summit developments.  Even before it was clear that the Netherlands and Finland were not keen on the direct bank access to ESM funds, the euro's gains were being trimmed.  

In part, this is a learned behavior.  Participants have seen euro gains on the back on the EU summit progress quickly unwind.  In fairness, the major foreign currencies are holding on to the bulk of those gains still. Thus, the price action is more consolidative (at this juncture) than corrective, we'd argue.

Positioning and Currency Outlook

The US dollar bulls had ceded control for the better part of the first three weeks in June as corrective forces took hold.   They had regained the whip hand subsequently, but lost it again at the end of last week as markets responded euphorically to the EU summit. The dramatic reaction has resulted in a significant deterioration of the dollar's technical underpinnings.

In terms of fundamentals, much of Europe's "bad news" including the stalling of the German economy, easing of price pressures in the area, the likelihood of a 25 bp rate cut by the ECB, and new gilt purchases (GBP50 bln) from the Bank of England, have largely been discounted.  On the other hand, evidence is mounting that the US economy is slowing more in Q2 than previously expected.