Torn Between Two Drivers

The same two issues continue to vie for dominance in the global capital markets. On one side, there is the unresolved European debt crisis.  The ink is not even dried on Greek 2.0 in the sense that government's need to ratify the agreement and implementation must begin, and already it is evident that to bring Greek debt burden to more sustainable levels a Greek 3.0 will be needed at some point. On the other side is the brinkmanship tactics in the US over raising the debt ceiling and agreeing on a longer term strategy to put the US on a more sustainable fiscal path.  On Monday and Tuesday the dollar suffered; Wednesday and Thursday the dollar has come back

The euro posted an outside down day on Wed (engulfing pattern in Japanese candlesticks) and there has been follow through today.  The last important low for the euro was on July 12 near $1.3833.  The trend line off that low comes in near $1.4355 today and has been clearly violated.  It is also below the 20-day moving average which is found near $1.4285.   The next important levels to keep in mind are the $1.4269 area, which has been taken out intra-day and represents a 38.2% retracement of the euro's bounce from July 12. The 50% retracement is found near $1.4187 and the $1.4140 area is the low recorded before the market's reaction to the draft EU statement on July 21.

The big economic news from the euro zone were the sentiment indicators and like the flash PMI readings, a more significant erosion was recorded than had been anticipated, and the tightening of bank lending standards.  Italy's bond auction produced sharply higher yields, as one would have expected, but it did manage to raise what it wanted.  Ironically, despite the backing up of peripheral yields, and overall decline in European equity markets, the Dow Jones Stoxx 600 bank index is posting modest gains on the day.  

In the ugly contest, the US and German 5 year CDS prices are near parity, though the US 10-year spread over Germany is near 33 bp, the widest since late Feb.  Tn terms of the 10-year maturity, the US trades inside of the German-French spread.  However, in the short-end of the coupon curve, the US yields remain at a discount to Germany, though the 81 bp discount is also the smallest since late Feb.  

The UK data has been simply horrible this week.  Today's CBI industrial trends survey follows on the heels of the distributive trades and the 0.2% Q2 GDP.  While Q2 US GDP will reported tomorrow and it is most likely not going to be impressive, US growth is likely to be something like twice the UK pace.  The UK appears poised to take the dubious honor of being the worst performing G7 economy.   Sterling itself is faring better that the euro.  Key support is seen near $1.6260.  Poor data, and, according to some, an increased risk of new asset purchases later this year (QE2) have helped underpin gilts as a core bond market alternative to US Treasuries and German bunds.  

Another theme that remains evident is that the Japanese economy is recovering.  The June retail sales gain of 1.1% was roughly twice the gain the consensus forecast and is the first year-over-year rise in four months. Japanese consumers restricted consumption after the tragedy in March.  In prior posts, I contrasted this reaction to the US reaction after 9/11, when the President encouraged Americans to go shopping and auto companies provided new incentives to purchases.  In any event, Japan's economy appears to be following the traditional pattern of strong bounce back after a tragedy as supply chains rebuild and recovery/rebuilding takes hold.  

The dollar is trading inside yesterday's ranges against the yen, but 3-month implied volatility is still drifting higher and now flirting with the 100 and 200 day moving averages.  Near 10.85%, it is at the highest level since the first half of May.  If my assessment is correct, that intervention is more about volatility than level, the drift higher in volatility would increase the risks of intervention.  Yet, the bar to joint intervention is very high and the odds of success of unilateral intervention are slim.  It seems that officials are best served by stepping up the verbal intervention and trying to bide time until the US debt ceiling issue is resolved--one way or the other.  

Japanese stocks are the best performing in the G7 over the past month, rising about 2.6%, more than twice the UK FTSE and more than 3 times the S&P 500 going into today.  Foreigners were larger buyers of Japanese shares in the first four months of the year and have cooled off considerably, but have returned to the buy side this month, according to weekly MOF data.