Some Thoughts about the Week Ahead

Four central banks meet in the week ahead, and non-manufacturing purchasing managers surveys will be reported. While they are worth assessing, they are unlikely to be the key to the movement in the capital market in the week ahead.  

Some may argue it is always the case, but in the days ahead, market psychology mediated by market positioning may be particularly important.  

The low volatility bemoaned by some banks, hedge funds, speculators and their sympathizers in the media is actually a boon for many asset managers and corporations.  Many investors recognized that the low volatility was not agnostic to market direction.  The low volatility was a function of a steady-to-higher equity and bond (lower bond yields) markets.  

It was also a function of narrow ranges of movement among the major currencies. Consider, for example, that according to Bloomberg data, the dollar-euro pair, the most actively traded currency pair in the more than $5 trillion a day market, was confined to less than a fifth of a cent in two days on the second half of July. 

Unambiguous signs that after recovering from the contractionary fluke in Q1, the US economic momentum has carried into Q3.  Economic conditions consistent with the Fed's mandates are being approached.  Various price measures have firm, and although the labor market may not be healthy ("significant under-utilization" is still evident, according to the FOMC statement), it is on the mend.

This saw the US 10-year bond yields recovered from around 2.45% to 2.60%, the highs since the start of the month.  The equity markets turned down, and the magnitude of the losses inflicted technical damage.  The dollar appears to be breaking out against both the euro and yen.  This was in many ways what investors had generally expected this year.   The implied volatility in the capital markets rose.   Volume appears to have picked up as well.   Turnover on the NYSE moved above its 100-day moving average on July 31 and August 1.  

However, investors have been repeatedly frustrated by the lack of follow-through that characterizes range trading in the currencies and are fearful of another setback.  Similarly, US Treasuries rallied, sending yields back below 2.50%.  Although the S&P 500 finished last week at its lowest level in nearly two months, it managed to finish off the intra-session lows and back near the middle of the day's range.  

The key question is has anything really changed.  The pullback in US yields supports a negative answer.   The US 2-year yield reaches its highest level in three years in the middle of last week before falling back below the 50-day moving average.  In the backup, the 10-year yield did not even make it back to the high in early July before returning toward the recent lows below 2.50%.  

The FOMC statement made it clear that while the downside risk to inflation had lessened, the slack in the labor market favored continued accommodation, and the low Fed funds rate was anticipated to continue for a considerable period.   There was one dissent over that forward guidance, but no one, even those that have publicly argued the Fed was slipping behind the curve, called for a rate hike.    The course that Bernanke put the Fed on remains intact.  

Another way of asking the question is whether the markets are in new trends or poised to consolidate.  Our reading of the technicals favors the latter scenario. The US economy and inflation are not consistent with 10-year yields below 2.5%.  As yields fall below there, buying dries up and shorts are enticed.  This is caps the rallies.  The prospects for the ECB's TLTRO next month and the possibility that Japan provides more stimulus may cushion any significant dollar pullback. 

Although in our narrative, we place much emphasis on yields, we suspect the stock market is the weak link among the capital markets.   A strong view held by many we speak with is a skepticism of the stock market's advance and have been anticipating a pullback.  However, they have been frustrated because it had not taken place.  They may prove too eager to buy this pullback, hence the likelihood of initial consolidation.  However, given the technical damage and market sentiment, the risk is to the downside of equities.

There are four major central banks that meet in the week ahead, Australia, UK, euro area and Japan.  They are unlikely to be instrumental in the shaping the price action.  The BOE is the easiest to dismiss as when it doesn't do anything; it does not talk about it.  The inflation report on August 13 and the MPC minutes on August 20 may be more important.  There is some speculation that the first dissent in favor of a rate hike could take place this month.  We are less sanguine. 

The BOJ may not be as confident that the retail sales tax will not spark prolonged economic weakness, but it is unlikely to tip its hand.  Governor Kuroda has warned that inflation will ease before picking up against in the second half of the fiscal year.  

The Reserve Bank of Australia is unlikely to change the cash rate.  There is some risk that Governor Stevens seizes the opportunity to talk down the currency.  The central bank meeting is followed a couple days later by the Monetary Policy Statement, and this could be an opportunity to discuss how the strong Australian dollar is hindering the economic adjustment process.  Most worrisome recently is signs that the housing market is unlikely to offset the weakness in the mining sector.  

The ECB is still monitoring the impact of its June rate cuts and is awaiting the implementation of its TLTRO facility.  Even though the preliminary July CPI ticked down, there is some risk that Draghi sounds somewhat more optimistic or confident.   The recent credit report and bank survey are promising, with both the lending conditions have eased, and demand has improved.  German retail sales and French consumption surprised on the upside.  

This week's June industrial production report is likely to show some recovery after May's weakness.  Italy's GDP, which contracted in by 0.1% in Q1 may have grown by the same magnitude in Q2.  This would produce a flat H1, but importantly no downside momentum.  This is the same general signal likely from the service sector PMI.  The decline in the euro is also a welcome development for the ECB.  

After a data-packed week, the US calendar in the week ahead generally lacks the market moving potential.  The data will add incrementally to what the market already largely already knows.  The non-manufacturing ISM may be more useful before the national jobs report, but even then often does not elicit a market response. 

Unit labor costs and productivity are derivatives of GDP.  The stronger than expected growth likely translates into slower growth of unit labor costs and higher productivity.  Consumer credit will be reported, but the thing that stands out most is the lack of much growth in revolving credit.  The increase in US consumption is being fueled by the income associated with the 1.6 mln net new jobs created this year, not credit cards.  

China, the world's second largest economy reported July services PMI over the weekend. It slipped to 54.2 from 55.0 in June.  This is a six-month low and appears to be weighed down by the real estate market that continues to soften.  Nevertheless, most data has indicated that the effect of some targeted stimulus measures are putting a floor under the economy and helping to offset the drag from the property market.  

It is an important week for the monthly cycle of China's economy reports, but taken together is unlikely to shed much fresh light on its economic challenges.  Export growth is expected to improve.  Consumer and produce prices were likely little changed from June. Aggregate social financing has been running above its average, but is expected to begin moderating.  In June aggregate funding was CNY1.97 trillion, compared with the three-month average of CNY1.64 trillion and CNY1.47 trillion over the past 12-months.  

On Saturday, Mexico's lower house of Congress approved the final bills that will facilitate the implementation of the historic energy reform, culminated a three-day special session. The bills now go to the Senate, where they are expected to improve.  In fact, the anticipation of the energy reforms has underpinned global investors interest in Mexican debt and peso.  

The stronger US economic data, including Q2 GDP and healthy auto sales, failed to translate into a stronger peso.  To the contrary, the peso was the weakest currency last week, losing 2% against the greenback.  The dollar pushed through MXN13.26 before the weekend to reach its best level in nearly 4 1/2 months.  We anticipate some consolidation, which in this context means the peso is likely to recover somewhat.  

Lastly, geopolitical events continue to have potential to roil markets.  The Portugal bank woe and the Argentina default are seen as isolated events.  As tragic as then events in the Middle East, it too is seen as contained. Israel appears to have signaled its four-week old offensive may be winding down.   In terms of immediate market impact, the Ukraine/Russia situation, which has not yet stabilized, appears to be the greatest risk.