Markets Take Another Step Away from the Edge

The angst that characterized the first several weeks of the year continues to dissipate.  Major equity markets are extending their two-week recovery into a third week. Immediate concerns about the US falling into a recession have eased. 

The market have withstood some downward pressure on the Chinese yuan.  Late yesterday Moody's cut its outlook for China's credit rating to negative from stable, and this did not cause much of a ripple in the capital markets.  In fact, the Shanghai and Shenzhen Composites rallied a more than 4% today, fully participating the global advance.  The MSCI Asia-Pacific Index advanced 3.4% today to reach its best level since January 13.  

Moody's cited rising government debt, falling foreign currency reserves, and uncertainty about the reform agenda.  The rating agency expressed concern about the weakening of China's fiscal strength and saw a growing risk that some of the government's contingent liabilities materialize, such as aid to local governments, policy banks and/or state-owned enterprises.  At the same time, Moody's affirmed It Aa2 sovereign rating. 

The US dollar is little changed against most of the majors.  There are two exceptions today.  The first is the Japanese yen.  The sharp rise in US yields and the equity market advance are weighing on the yen.  The dollar has risen to almost JPY114.50, its highest level since February 17.   Above there, the dollar races resistance in the JPY115.00 area.  

We note that interest rate differentials are moving in the US dollar's favor.  The US premium over Japan on two-year money is near 106 bp today, the best level for the year.  The 10-year premium is a little bel0w 180 bp today, up from 163 at the low point on February 11 when the dollar briefly dipped below JPY111 to record the low since October 14.  

Although the euro is little changed against the dollar today, its recent drop back to a $1.08 handle has also coincided with a widening of the US premium over Germany.  The premium today is pushing through 140 bp.  This is up from 117 bp on February 11 when the euro peaked near $1.1375.  It reached its cyclical high at the end of last year near 142 bp.  

Initial resistance for the euro is seen in the $1.0880 area.  On the downside, the market appears to need something more to encourage it to drive the euro back below the $1.08 are the floor of the previous trading range.  Even a strong employment report (ADP estimate today, national figures Friday) are unlikely to sway participants into expecting a rate hike by the Fed later this month.  Concerns expressed by NY Fed Dudley suggests officials are concerned about the decline in inflation expectations and the tightening of financial conditions.

On the other hand, soft economic data, including the return of CPI into deflation territory, boosts speculation of ECB action next week.  Many participants feel burnt by the ECB's mild action in December and are now well aware of Draghi's limitations.  At the same time, speculative positioning is not nearly as extreme as it was then, allowing, perhaps, for less "sell the rumor buy the fact" type of activity. 

Also encouraging investors to step away from the edge are better than expected growth reports from both Australia and Switzerland today.  Australia reported Q4 GDP rose 0.6%.  The consensus was for 0.4%.  It is a respectable 3.0% year-over-year pace.  While the terms of trade eroded, the domestic economy, led by consumers picked up the slack.  Household spending rose 0.8%, contributing 0.4 percentage points to GDP. Residential investment rose 2.2.  Domestic spending was partly fueled by a drawdown in savings (savings rate fell to 7.6% from 8.7% in Q3).  Non-residential construction, which also picks up the slowdown in mining activity, fell 7%. 

The Australian data, coupled with the RBA statement from its meeting earlier this week, suggest the chances of a rate cut in the coming months has diminished.  This is lending support to the Australian dollar.  It is the strongest of the major currencies today, gaining about 0.5%.  It is trying to establish a foothold above $0.7200.  A nearby cap is seen in the $0.7250-$0.7260 area. 

Switzerland reported its economy expanded by 0.4% quarter-over-quarter in  Q4 15.  The consensus was for a 0.1% gain. However, some of the shine enthusiasm was dampened by news that the revision to Q3 GDP put it into negative territory (-0.1%).   The year-over-year pace slowed in every quarter in 2015 after finishing 2014 at a 2.1% pace.  The 0.4% year-over-year rate in Q4 15 is half of the Q3 pace and a third of the Q2 rate. 

Brexit fears in the UK are the main weight on sterling.  It is now in the middle of the $1.3840-$1.4040 range that is prevailing for the sixth session.  UK data is not doing sterling any favors either. The weaker than expected manufacturing PMI has now been echoed by the disappointing construction PMI.  It fell to 54.2 from 55.8.  The consensus was for a minor slip to 55.5.  

Today's political focus in Europe though is not on the British referendum but on Spain's ability to put together a government.  The Socialist-Ciudadanos coalition will seek parliamentary support today.  It is unlikely to secure an absolute majority on the first round.  The markets do not seem to perturbed by this likelihood.  Spanish stocks are up the most among the major bourses in Europe, and the bonds are in line other European bonds markets today, with a heavier tone.  The real test will likely come Friday, where a simple majority is needed.  This is a closer call.  The failure to secure a simple majority would set the stage for a new election.  

The US session features the ADP private sector job estimate.  The consensus calls for a 190k increase after 205k rise in January.  Note the ADP also announced their annual benchmark revisions.  Later in the session, the Beige Book will be released for the FOMC meeting on March 15-16.   The US government oil inventory figures will also be watched.  The industry estimate out late yesterday showed a 9.9 mln barrel surge, which stopped the oil rally.  Oil prices are almost 2% lower today.  The consensus estimate looks for 2.6 mln barrel build in the official projection. 

After the markets close, Brazil’s central bank concludes its meeting.  We expect the Selic rate to remain unchanged as concerns about growth overshadow inflation challenges.  

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