Capital Market Developments on Monday

One of the key fundamental developments that have helped spur the downside correction in the US dollar in recent weeks has been the divergence of economic data between the US and Europe. This trend is continuing and the contrast is clear with today’s purchasing managers’ surveys.

The euro zone reading of 56.7 was a little above the flash reading of 56.5 and well above the June reading of 55.6. Of note, Spain and France surprised on the upside, while Italy was a bit softer, while Germany was spot on. While the pace of the manufacturing recovery is expected to slow by many economists, there is little evidence in today’s data. And Spain’s showing (51.6 vs 51.2) included a strong rise in the output sub-index, would seem to dilute, at least on the margins and for the moment, the IMF’s concerns expressed last week that Spain’s deficits projections were based on too optimistic of growth forecasts.

Sterling has pushed above the $1.58 level for the first time since February even though the July CIPS PMI was slightly lower than the June reading. The headline eased to 57.3 from 57.6 (initially 57.5), but was still above consensus forecasts. The pullback from the 15-year highs (58 in April and May) is quite modest. While new orders and employment sub-indices remained firm, export orders slipped to 50.8, the lowest reading since last August. The next near-term target for sterling come in near $1.5865, a retracement objective of the Nov ’09 through May’10 downdraft. Medium term trend followers also note that sterling moved above its 200-day moving average last week for the first time since January. It comes in this week in the $1.5540 area. It requires a break back below this to make sterling bulls reconsider.

The euro cannot keep pace with sterling and has broken the GBP0.8300 level for the first time in a month. More stops are thought to below GBP0.8245.

The unexpected strength of the UK economy and the resilience of inflation pressures spurs speculation that 1) the UK will grow faster than the US, euro zone and Japan and 2) the BOE may have to raise rates before the other major central banks. The MPC meets this week. While no one is expected a change in stance yet, the voting will attract attention as there is talk that A.Sentance, the lone dissenter, may find company.

Japanese government officials have been quoted indicating they are closely monitoring the foreign exchange market. However, the risk of material intervention continues to seem quite modest. Three month implied volatility is at the lower end of its six-month range. The premium the market pays for yen calls over yen puts equidistant from the forward rate is also at the lower end of its four-month range.

Moreover, the yen’s strength is better understood in the context of the weakness of the US dollar rather than yen strength per se. The euro for example has appreciated more than 5.5% against the yen since late June. Sterling has gained nearly 8.25% against the yen since it bottomed in late May.

On a separate front, note that as of today new margin rules go into effect for retail accounts in Japan and this is important for institutional investors because retail is thought to account for 25%-40% of the yen turnover in Tokyo. The new margin rules allow retail to borrow a maximum of 50-times collateral. Previously there was not limit. Some have been playing with as much as 400x leverage, according to some reports. In fact, some local observers had linked the yen’s surge at the end of last week (the dollar went from JPY88.12 on Wed to JPY85.95 on Friday) in part to the squaring up of some of those positions.

Economists and investors are still digesting the implications of the advance Q2 US GDP figures released before the weekend. Most discussions, however, did not seem to appreciate the general volatility of the advance report. Over the past 23-years the average difference between the advance report and the final estimate is about 1.3%. Over the past 13 quarters, the difference has averaged 0.7%. This average difference produces a likely potential range of Q2 GDP at 1.1%-3.7% on the wide and 1.7%-3.1% on the narrowed average. Real consumer spending came in at 1.6%, but good consumption (3.4%) and even durable goods consumption (often done on credit) was good at 2.5%. The weakness was in the consumption of services. These rose a disappointing 0.8%. These services include health care, financial services and utilities.

While goods consumption may slow in the current quarter, services consumption may have risen (on utility spending if nothing else). One big surprise was the surge in business investment, which included spending on structures as well as equipment. This pace is unlikely to be sustained. Exports rose a healthy 10%, but imports surged 29%. This is not sustainable. Some link the surge in US imports to Chinese exporters front loading shipments ahead of the mid-July expiration of VAT export rebates. Note that the Bloomberg consensus forecasts 2.75% Q3 US GDP and 2.8% Q4 GDP.