Greenback Remains Firm

The US dollar remains firm following the much stronger than expected service PMI yesterday, heightened concerns around Ukraine and uninspiring European data.  The US 10-year yield is off a few basis points to 2.45%.  Recall that at the end of July, it had briefly yielded more than 2.60%.   Since late May, the yield has held above 2.43%.  

However, despite the drop in yields, and the weakness in the equity markets, the dollar is thus far holding up better than one might have expected against the yen.  Thus far this week, the greenback has been confined to last Friday's range.  The dollar's low was around JPY102.35.   

Even though speculative community has built a large short euro position, participants continue to sell into upticks.  Resistance is seen near $1.3380 and then $1.3410.  On the downside, there seems little preventing a near-term move toward $1.3300.  On the eve of the ECB meeting, data disappointed.  The disappointment was two-fold. 

First, German manufacturing orders fell 3.2% in June.  It is the largest decline since September 2011.  The consensus had forecast a 1.0% rise after a 1.6% decline in May.  The year-over-year rate slumped to -2.4%, the first contraction since last May.  The report warns that the euro area locomotive ended Q2 on a weak note, and that to the extent that orders are a leading indicator, suggests Q3 may be poor as well.  The Bundesbank has already warned that the economy stalled in Q2.  

Foreign orders were off 4.1%.  Some, including the German Economic Ministry are linking this to sanctions on Russia.  It is possible, but it strikes us as a bit unlikely to have much impact yet, though as the Ministry noted it could lead to a "clear reticence in orders" in the coming months.  However, more attention should, arguably be given to the 10.4% decline in orders from the euro area.  At the same time, it is not simply foreign demand, but domestic orders fell 1.9%. 

The second disappointment from the euro area was Italian GDP.  The economy had been expected to return to slow growth after the Q1 contraction of 0.1%..  Even the earlier (today) release a 0.9% rise in June industrial output figures lent support to such hopefulness.  The consensus was for a 0.7% gain after the 1.2% decline in May.    However, the preliminary Q2 GDP was reported at -0.2% quarter-over-quarter.  

Given that euro area's third largest economy contracted for the second consecutive quarter, there will be some talk of recession.  This definition of a recession--two consecutive quarters of contracting GDP-- is not really a technical definition of a recession, and it is surely not what the US uses.  In any event, the key take away since the ECB met last, survey data continues to run ahead of actual performance, but there have been some preliminary signs of better news from the survey of bank lending, and the euro has pulled back.  It seems unreasonable to expect the ECB to do anything more until the implementation of the TLTRO next month.  

Data from the UK may act as a headwind to the hawks.  There is suspicion in the market that tomorrow's MPC meeting could see the first dissent in favor of a rate hike.  We have thought this was a bit early.  Today's data provides more fodder.  First, BRC shop prices fell by a1.9%, the largest drop since the series began in last 2006.  Deflation on High Street suggests there need not be a sense of urgency to change policy.  

Not only are prices soft, but the economy also appears to be moderating at the end of Q2.  The 0.3% rise in June industrial and manufacturing output  was half as much as the consensus expected for each.  In May, industrial production fell 0.6% and manufacturing output fell 1.3%.  ONS said that this will not impact the Q2 GDP estimate. 

UK interest rates backed off and sterling eased.  The June 15 short-sterling futures contract has recouped what it lost in response to the strong service PMI report.  The 10-year gilt yield is off nearly 6 bp to its lowest level in three months (~2.52%).   The gilt rally is also part of the rally in bonds, while European peripheral bonds are under some pressure.   Separately, on balance it appears that those favoring Scotland remaining part of the UK in next month's referendum had the edge in last night's debate.  

Geopolitical tensions are lurking below the surface.  Reports suggest Russia has amassed as many as 20k troops in battle formation on the Ukrainian border.  At its request, the UN Security Council met last night to discuss the humanitarian situation.  With the insurgents being pushed back, Russia is being forced to make a hard decision.  There is also talk of Russian counter-sanctions, with airlines and airspace under consideration.  

Yesterday, we noted another front in the US/EU confrontation with Russia in Armenia and Azerbaijan.  Russia may have opened a third front with reports of a large oil deal with Iran.    The impact on the the general investment climate has been largely localized so far.  Yet, there is no sign that the situation is stabilizing, and to the contrary, the risk is toward greater escalation.  

Canada and the US both report June trade figures today.  Canada is expected to report a small surplus after two months of deficits.   Canada has reported only three trade surpluses since the beginning of 2012.  Exports has increased, but slower than the central bank deems necessary.  Canada exports about a third of GDP, and the US is the destination of about three quarters of those exports.  The U S trade balance is expected to be little changed from the $44.4 bln shortfall in May.  To calculate GDP, the Bureau of Economic Analysis assumed a deficit of just shy of $45.  A modest deviation could have a large statistical impact.