Marking Time Ahead FOMC

The US dollar is little changed as the foreign exchange market awaits the outcome of the FOMC meeting and further developments in Europe, where a Greek government may be announced.  Most of the major currencies are trading within yesterday's ranges.  Global equity markets are higher.  

Of note the MSCI Asia-Pacific Index gained 1%, despite losses in China and reached its best level since mid-May.  MSCI emerging markets index is at 5-week highs.  European bond and CDS markets are subdued.  Of particular interest, Spanish and Italian bonds yields are lower as are CDS prices.  To be clear, though these seems to be technical in nature and does not reflect a shift in underlying conditions.

There has been some talk that the EFSF/ESM will be allowed to buy sovereign bonds.  The ECB of course would prefer some one besides it buys bonds, if they are to be bought.  However, we are skeptical that the FANG countries (Finland, Austria, Netherlands and Germany) are about to capitulate. There are moral hazard as well as treaty issues involved.  

Indeed, it is not clear the resources available from the EFSF/ESM because if Spain is to get aid, it seems counter-productive for it to also be contributing the form of guarantees (EFSF) or cash (ESM). While Spain's Rajoy has been pushing for the ECB to resume its bond purchases, Monti, perhaps recognizing the steadfast position of his countryman Draghi, has begun, according to reports, pushing for the ESM to buy bonds. 

It assumes that purchases of sovereign bonds will lead to a sustainable decline in yield, but given the subordination issues, if an investors knew that bonds were being bought by the official sector, given what happened in Greece, the private sector may be more inclined to sell their holdings. Note that just yesterday, for the second time in a month, LCH Clearnet raised the margin on Spanish bonds.  Some contacts link the steadier tone of Spanish bonds to some arbitrage plays between the bonds and the sovereign CDS.  Spain plans on selling 2, 3 and 5 year bonds on Thursday and that could be the next immediate test.  

On the assumption that a Greek government gets announced today, which is the third day since the election, which is the length of ND's Samaras mandate, the FOMC meeting is the main event of the day.  The recent string of poorer than expected US data heightened concerns that the economy has lost momentum and that the labor market is stagnating (yesterday's JOLT report was exceptionally weak). 

While there continue to be calls form notable participants for QE3, it appears that most have come to the same conclusion we have and that is simply that an extension of Operation Twist, in some form or fashion, is more likely that renewed expansion of the Fed's balance sheet as in QE3.  The roughly 7.7% increase in the S&P 500 since June 1 weak employment data was arguably helped by anticipation of Fed action.  

Anticipation of Fed action may have also encouraged some dollar negative position adjusting in the foreign exchange market.   There is some scope for a reversal of these actions after the FOMC decision, either on disappointment or "buy the rumor, sell the fact" type of activity. 

The UK released the BOE minutes from earlier this month and the May employment report.  The unemployment rate was unchanged but the number of new claims for unemployment compensation rose by 8.1k whereas the consensus had forecast a 3k decline.  Average earnings for April (reported with a month lag) were stronger than expected, but at a miserly 1.4% (3m year-over-year) it his hardly inflationary.  

The employment data dovetails with the dovish minutes.  Yet the market had anticipated the dovish tone after last week's announcement by the UK Treasury and BOE on new measures to easing credit conditions and King's signal that gilt purchases may be resumed shortly.  

As it turns out the vote to keep policy steady earlier this month, when we had played up the risks of easing, was considerably closer than many anticipated (5-4) and very revealing BOE Governor King was on the losing side.  This is not the first time it has happened in UK where the governor is out voted, but King over time has been proven right more often than not.  

The minutes do reveal a discussion over cutting the base rate and it seemed that many thought that the results of either QE or a rate cut were largely the same.  Still, on balance, the minutes and last week's announcements have served to encourage expectations that QE will resume next month and a rate cut may also be delivered.  

Sterling's performance since last Thursday's Treasury/BOE announcement has been impressive.  It has been the strongest major currency, behind the Australian and New Zealand dollars.  Today sterling is trading within yesterday's ranges(roughly $1.5615-$1.5760).  Some participants take note that the 200-day moving average comes in near $1.5752 today.  Although the 200-day moving average was breached in the initial reaction to the Greek election, sterling has not closed above it since May 21.  

Japan reported a larger than expected trade deficit in May of JPY907.3bln, after a JPY522 bln short fall in April.  While investors appreciate the shift taken place in Japan, especially with its increased energy imports and what seems to be the makings of the second consecutive annual deficit.  However, the details are noteworthy and the implications of which are much broader than just Japan. 

Consider that Japanese exports rose 10%, the fastest pace since December 2010.  Exports to Asia, which absorbs more than half of Japan's exports rose 4.5%, and exports to China showed the first increase in 8 months (3% year-over-year).  Recall Chinese trade figures showed both imports and exports rising more than twice the consensus in May, which seemed to be a bit of an anomaly as it did not seem to jive with other trade figures in the region.  Japan and Chinese figures now suggest better regional activity. 

Separately, Japan recorded its first trade deficit with Europe.  Exports to the US were up more than 38% from a year ago and appear to be largely a function of the rebound in auto and auto parts trade.  The dollar itself remains confined to narrow ranges against the yen and continues to trade within Monday's range (~JPY78.65-JPY79.35).  There is potential for dollar gains later today if the Federal Reserve disappoints.