Euro, Rate Squeeze, US CPI and Japan Woes

The euro is center stage today. It is gaining on nearly all the other currencies today, including the Scandi-bloc, which had actually been the best performer in recent days. Technically the move above the 100-day moving average is thought to have spurred new model-driven demand.

In addition, there seems to be a squeeze being exerted by a sharp jump in European money market rates. The Sept Euribor futures contract implied its highest yield since the first week in May. The 3-month rate as reported by the EBF rose about 15 bp today to about 0.86%. The US-Germany 2-year interest rate differential has done a fairly good job of tracking the euro-dollar exchange rate over the past several quarters and that spread has widened out another 6 bp this week to stand at 20 in favor of Germany. The spread favored the US by almost 34 bp in late May. The reversal is one of the less appreciated factors behind the euro’s recovery and dollar’s slide. Over the past 29 sessions the euro has appreciated by 11 cents or 9.3%.

The US economic data has clearly soured over the last couple of months. The end of the tax credits has taken a toll on housing, but the sector that seems to be the main culprit in the slowdown is manufacturing, which had been a bright spot. Yesterday the US reported the largest drop in manufacturing output of the year (-0.4%). The NY and Philly Fed surveys indicate the manufacturing weakness has continued into early July. Drilling a bit deeper, it seems that manufacturing weakness is particular acute in the consumer goods sector. Auto output was cut 1.9% in June and overall consumer goods production fell 0.6%. The output of appliances, furniture and carpeting fell by 1.7%. However, the output of business equipment remained strong. The 0.9% increase follows a 1.4% increase in May. Computers and semiconductor output was the strongest and this is consistent with the recent corporate guidance. The CEO of Novellus was quoted on the news wires near midweek suggesting that businesses are engaged in a major overhaul of their PCs. Bookings, he said, we up 20% in Q2 over Q1 and shipments trailed, which suggests output will remain strong.

Weakness of the US consumer is one challenge, but there is another—will disinflation morph into deflation. The June CPI will be reported today and it is likely to post the third consecutive monthly decline. Last June saw a 0.7% jump in the CPI. This will drop out of the year-over-year calculation. The year-over-year rate will fall sharply from the 2% level of May to something closer to 1.1-1.2%. Core CPI is considerably less volatile. Excluding the 0.1% decline in Jan, the month-over month moves have been between 0.0 and 0.2 since August 2008. And look at what has happened over the past few quarters. Q3 09, the core CPI rose 0.4%. In Q4 09 it rose 0.3%. In Q1 10 it was flat and in Q2 core CPI may have risen by 0.2%.

Even if one makes allowances for the impact of the weakness in the housing market, nearly every inflation gauge is at undesirably low levels that are arguably too close to deflation. This is rivaling the slowing economy as a major talking point. Look for Bernanke to be peppered with questions in next week testimony about how the Fed can combat deflation and avoid Japan’s fate.

Japan reported a somewhat larger than expected 0.9% decline in the May tertiary index. The decline warns that the Japanese economy may be losing momentum as the second quarter progressed. This will likely be reflected next week with the all-industries activity index contracting against after the 1.8% rise in April. Often over the past couple of years, the first month of the quarter is the strongest. This pattern is likely to be repeated. The consumer remains constrained and June department store sales fell 6% after a 2.1% decline in May.

The performance of the equity market arguably reflects concerns about the impact of the yen’s strength. Over the past three months, the yen has appreciated 5.6% against the dollar and 9.5% against the euro and the Nikkei has fallen 15.25%. The yen is the best performer in the G10 and the Nikkei is the worst. Japanese government and central bank officials have been surprisingly circumspect about the yen’s appreciation. Initially Prime Minister Kan was seen as favoring a weaker yen. However, thus far little has been said. This seems to be a momentary lull. The outcome of last weekend’s upper house election will likely give more voice to smaller parties and several seem to 1) favor yen depreciation and 2) inclined to lobby the BOJ for additional QE measures. There is talk of semi-official bids around JPY87, but Japanese exporters are believed to have interest to sell dollars into modest upticks into the JPY87.60 area.