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. 

The market awaits the ruling by the German Constitutional Court.  Any delay in the ESM is significant.  Recall that to get the critical mass of participation, to allow the ESM launch, Germany must agree.  The Court, which jealously protects German sovereignty, has in its past rulings, seemed to suggest that Germany has ceded as much sovereignty as it can.  While it is likely to support parliament's approval of the ESM (and fiscal pact), it may require a referendum or constitutional changes in order for more sovereignty to be ceded. 

China's trade surplus swelled to $31.7 bln from $18.7 bln in May.  Exports were stronger than expected, rising 11.3% (the consensus was for a 10.6% increase after a 15.3% year-over-year rise in May).  Imports were weaker than expected, rising 6.3% from a year ago (the consensus was for an 11% increase after 12.7% in May).  Given that China imports raw materials and semi-finished goods and exports final product, the continued slowing of imports and exports reflects not just the world's second biggest economy, but also weaker world demand.   

Three European countries reported better than expected industrial output figures for May today.  The UK reported a 1% increase in industrial output compared with expectations of a 0.2% decline after a 0.4% decline in April.  Manufacturing rose 1.2% on the month.  The consensus was for a flat number.  Italy also surprised with a 0.8% increase in industrial output.  The consensus was also for a 0.2% decline.  Sweden surprised as well with a 3.5% rise in industrial production.  The consensus was for a 0.3% increase.  France was the exception.  May industrial output was expected to fall 0.95 and instead it fell 1.9%, following the 1.4% increase in April.  Sterling and the Swedish krona reacted positively to the news. 

Separately, note that Norway's government has moved to stop the oil workers strike and the planned lock out by forcing arbitration.  Norway reported a larger than expected fall in June CPI (-0.5% vs consensus call for a -0.1% reading).  This brought the year-over-year rate to 0.5%.  The consensus expected 0.8%.  This seems to have weighed on the krone, which is under performing today. 

The Bank of Japan starts a two-day meeting tomorrow amid ongoing political pressure to take more action to combat deflation.  A small improvement in the Tankan survey and the upgraded regional economic outlook suggests the BOJ will resist such pressures.  A surprise expansion of its asset purchase program cannot be entirely ruled out, but the odds seem slight at this juncture.  It continues to struggle to implement its current asset purchase program.  Some tweaking of the existing program seems more likely. 

In some ways, Spain is a microcosm of EMU. The government is seeking to support the regions, many of which have been locked out of the capital markets, but need to refinance around 36 bln euros of debt. With Valencia threatening default, the government is being spurred into action. Reports suggest a mechanism will be unveiled Thursday based when the regional budget chiefs meet. The national government is expected to guarantee regional debt issuance. 

However, regions seeking state guarantees will be subject to a high level of conditionality. Ironically, domestically, the Rajoy government takes a similar position as the creditors within the EMU, yet at the EU level, Rajoy represents a "region" and articulates the interests of the debtor, pressing for light conditionality. Domestically, Rajoy is tightening the link between solvency and sovereignty for the regions. Those regions seeking aid will cede some of their autonomy to secure funding. Increasingly this seems to be the model on euro area level. 

Catalonia, one of the wealthiest regions, appears to be seeking alternative financing and reports suggest that it is in talks with a number of banks about a syndicated credit line of at least 500 mln euros. The market remains concerned about Spain's banking sector, and even with the corrective bounce in Spanish stocks (and bonds) today, the financial sector remains the weakest sector.