Macro Overview

The US dollar is consolidating the gains seen at the end of last week.  The greenback briefly pushed through the JPY102 level in Tokyo, but this was not sustained.  Meanwhile, the global equities are mostly lower, though the Nikkei tacked on another 1.2% to reach a new 5.5 year high.

Softer Chinese data may have weighed on emerging market stocks, which for the lower for the third consecutive session. In Europe, most bourses were lower the Dow Jones Stoxx 600 off about 0.4% near midday in London, led by a 1.3% decline in financial.  A lower close today would break a four -day advance that had carried the index to new five year highs last week. 

Global bonds are mixed.  Japanese government bonds extended last week's drop.  The benchmark 10-year yield rose almost 6 bp and now near 75 bp, the yield is near a 3-month high.  Spanish bond yields are extending last week's increase, while Italy's 10-year bond yield is up 5 bp, though little changed after the government's auction that raised 8 bln euros with 3, 5, and 13 year tranches.  Core bonds are firmer, with yields 2-4 bp lower. 

There are four developments at the end of last week are shaping the investment climate.

First, there was a sharp sell-off in US Treasuries and Japanese government bonds, albeit for different reasons.  The US sell-off seems to be driven by renewed ideas that the Fed could taper of purchases earlier and by the move further out on the risk frontier, illustrated by the decline in the yield of an industry benchmark for junk bonds below 5% for the first time.    

Some in the financial press give more emphasis to Philadelphia Fed President Plosser's comments that he favors reducing QE as early as next month than we would.  Plosser is neither a voting member of the FOMC nor representative of a majority of Fed officials.  

However, we did read with interest a speech that Federal Reserve Chairman Bernanke delivered before the weekend.  Amid concern that QE is producing bubbles in other parts of the capital markets, Bernanke explained that the  Federal Reserve was watching "particularly closely" investors "reaching for yield".   He seemed sensitive to Minksy's insight that the relative stability of (ie, low volatility?) may encourage investors to take greater risks than the macro-economic conditions warrant.  At this juncture, this seemed meant to reassure the market that the Fed is sensitive to the risks implicit in QE and not a signal of a near-term shift in policy.  

The sharp dramatic decline JGBs appears to be a function of officials still wrestling with the implementation of its aggressive JGB purchase project and the kind of disruption it is causing.  All else being equal, a sharp decline in the yen would tend to lift bond yields.  In addition, competitive investments, like the equities, may also be drawing investors out of the fixed income.  

Second, after first approaching it a month ago, the dollar finally broke through the JPY100 level.  The move continues to appear largely driven by hedge funds and other speculators, though Ministry of Finance data did show Japanese investors bought about $5 bln in foreign bonds in a two-week period ending in early May.  After breaking of key chart point the yen's decline accelerated and G7 meeting said nothing that poses an obstacle to additional losses.

The next key chart points are in the JPY104-JPY105 area.   We suspect that by the end of the summer, perhaps after Abe would have secured a 2/3 majority in the upper house elections, the G7 may grow less accepting of additional yen weakness, especially if structural reforms are unconvincing.    

Third, the US dollar staged a broader rally against the major and emerging market currencies.   The Federal Reserve calculation of the dollar's value on a trade-weight weighted basis are only updated at month end, and of course, the Dollar Index is not reflective of US trade patterns, with two of the US main partners, Mexico and China not represented at all.

The Bank of England offers a real effective trade-weighted measure in real time.  It finished last week at its highest level since July 2010.  In the QE-era, more questions have been raised about the use of paper money to measure other paper money, but surely the 20% drop in gold prices from the peak in Q4 12, is not suggestive of a weak US dollar either.  

Fourth, the extension of the Fed's QE program to $85 bln a month was announced in December and has been digested by market participants.  Investors continue to grapple with the implications of Japan's aggressive QE (~$75 bln a month).  As Japanese investors have purchased foreign bonds in two of the past three week, foreign investors, who had bought around $64 bln of Japanese equities this year have taken some profits in two of the past three weeks.  

Over the past week or so, Australia cut rates and has made it clear that it has not exhausted it scope for additional rate cuts.  In Asia, both India and South Korea lowered official rates.  In Europe, Poland cut rates at the end of last week and the ECB, which cut rates earlier this month, is also holding out the possibility of addition conventional (refi rate cut) and unconventional (e.g., measures to boost the ABS market and some talk of directly buying distressed bank bonds, for which we are highly skeptical).  

Turning to this week's data stream, the US is likely report the second consecutive decline in retail sales today, with the headline dragged down by a decline in gasoline prices and auto sales.  The measure used for GDP calculations, which excludes these two components and building materials may eke out a small gain.  The decline in factory employment and, more importantly, the reduction in the work week, points to a decline in manufacturing when the industrial production is reported at mid-week.

Both PPI and CPI will be reported this week.  So-called pipeline inflation remains mild and CPI is likely to post its second consecutive monthly decline, which is something not seen in five years.  Lastly, the both the Empire State and Philly Fed surveys will be released and they offer among the first readings of the US economy in May and both are expected to stabilize after the recent declines. 

The data highlight from the euro area and Japan will be Q1 GDP estimates near midweek.  The Japanese economy is expected to have been the strongest in the G7 in Q1 with a 0.7% quarterly expansion.  After contracting by 0.6% in Q4 12, is expected to have contracted by a 0.1% in Q1 13, helped by a rebound in the Germany economy.    In contrast, in the core, the French and Dutch economies are believed to have contracted in Q1.   

The UK releases its April jobs report on Wednesday, but the BOE's quarterly inflation report the same day may garner more interest.  In addition to an update on how the BOE sees the trajectory of prices before Carney takes the reins in July, the market is also keen on the official assessment of the Funding-for-Lending Scheme which does not appear to be bolstering lending to small and medium sized businesses very much, though encouraged to by the government's Help to Buy Scheme,  mortgage lending may be supported.