Sentiment Healing, but Remains Spooked

Last week's drama was not the beginning of something as the pessimists and cynics would have it.  Our inclination that it was the end of something--that the pendulum had swung unreasonably far unreasonably quickly has is panning out   

Equities have trended higher.  The S&P 500 was turned back yesterday after it had retraced 61.8% of the losses from the record high on September 19 to the October 15 low.  Today's price action is important from a technical perspective.   Important technical support in the 1905-1910 band.  It houses the 200-day moving average (~1907.5) and the gap from Tuesday's higher opening (1905.03-1909.26).   A break of these levels suggests the recent gains were part of a counter-trend, not the resumption of the bull move.  

US benchmark 10-year yield is stabilizing.  It has been straddling the 2.20% area for several days.  It does looks increasingly like some kind of capitulation last week.  German bund yields have risen almost as much as US yields over the past five sessions (5 bp vs 7 bp). 

However, market sentiment remains fragile.  The pendulum of expectations about the trajectory of Fed policy has not corrected very much.  The December 2015 Fed funds futures contract is implying a 45.5 bp effective Fed funds rate at the end of next year.  Forget the dot plots that say 1.375%.   At the low point last week it had fallen to 32 bp.    

Consistent with this is the fact that the breakevens have also not corrected much either.  Tomorrow Treasury auctions 30-Year TIPS.   The breakeven near 2.0%, is the lower end of where it has traded for the last three years.  It finished last year near 2.4%, which is just above the two-year average.  Participation in the auction will be important to monitor.  If investors agree with our assessment that while inflation expectations have eased, the liquidity differences between Treasuries and TIPS exaggerates the decline, then there could be relatively healthy auction.  In turn, a good auction would suggest that investors will sell Treasuries against the newly acquired TIPS. 

Oil prices are also pinned on their lows.  The Fed may not focus on headline CPI for policy purposes, but that is what matters to TIPS.   Though reporters can find economists who still want to link the drop in oil prices to the stronger dollar, most recognize the driver is the rising supply. Yesterday's inventory data showed an increase in US oil stocks of over 7 mln barrels, more than twice what the market expected.   

At $80 a barrel for Brent, there is an estimated transfer of some $200 bln from OPEC countries to oil importers.  More broadly, for the world economy, the drop $80 a barrel oil would be tantamount to an easing that is roughly the magnitude of the BOJ's operation.  The drop in the price of gasoline, which the average American household spent almost $3,000 on last year, is worth about $575.  To the median household this is about 1% of its income.   

Meanwhile, the news from Europe is mixed.  The UK disappoints with September retail sales (-0.3% vs consensus -0.1%) and Oct CBI Trends (-6 vs consensus -3).   The market continues to push the first BOE rate cut out, and yesterday's PSBR data suggests the Chancellor has little scope for some pre-election tax breaks.  Sterling has been pushed back to $1.60.  A break below $1.5950 now would likely signal a resumption of the down move, with a break of last week's $1.5875 low likely.  

Germany's manufacturing flash PMI unexpectedly held above the 50 boom/bust level, rising to 50.7 from 50.5 in September.  The service PMI declined to 52.4 from 52.8, but was still above the consensus (51.7).   

France was not as fortunate.  Both the manufacturing and service PMIs sunk deeper below 50.  The manufacturing PMI slipped to 47.3 from 48.8.  The market expected 48.5.  The service fell to 48.1 from 49.4.  The consensus forecast 48.2.  

Today may be the first session since October 10 that the euro spends it entirely below its 20-day average (~$1.2691).  It did make a new six-day low near $1.2615 earlier today, but market still seems a bit cautious.  It does not appear that the ECB is ready to decide on new asset purchases yet, but clearly is thinking about contingencies, as it ought to.   

The Asset Quality Review and stress tests will published on Sunday before Asia-Pacific markets open on Monday.  This is may also encourage arguments extending purchases of covered bank bonds with uncovered bank bonds.  It is understandable why France, for example, would be pushing for the ECB to buy corporate bonds.  French corporate bonds account for nearly 45% of the eurozone corporate bonds that would be eligible to be purchased by the ECB.  

Japan's preliminary manufacturing PMI unexpectedly rose to 52.8 from 51.7.  The consensus had expected an unchanged reading.  It is the highest since the sales tax was hiked.   This jives well with ideas yesterday's stronger than expected exports (6.9% year-over-year vs consensus 6.3%, and -1.3% in August).  This points to a constructive industrial production report next month.  

The dollar reached a new 9-day high against the yen today near JPY107.65, which also corresponds to a 50% retracement of the decline seeing JPY110 on October 1.  The 20-day moving average is found just above here at JPY107.88.   The dollar has not closed above its 20-day average against the yen since October 6.  Above there, look for JPY108.00-20.  

US weekly jobless claims will be of some interest after last week's new cyclical lows were reported.   As other data points to some moderation of US economic activity, it would not be surprising to see some softening in the preliminary US manufacturing PMI.   The data likely serve second fiddle to the performances of the equity and bond market today.