Narrowing Spreads Fail to Lift Euro, Dollar Holds Below JPY100

There are two main developments today.  The first is the disappointing flash PMI readings from China and the euro zone.  The second is a continued rally in European bonds in both absolute terms and relative to Germany.  The reduced risk premium in Europe has not coincided with gains in the euro, but to the contrary, the euro has fallen to two week lows and is threatening its 20-day average for the first time in more than three weeks.  Ironically, the yen is the big winner.  The dollar held below JPY100 again yesterday and failed to even get above JPY99.40 in Asia.  

In the face of the uptick in the yen, Japanese stocks fared well, with the Nikkei slipping about 0.3%, but the smaller cap JASDAQ actually posting a 1.3% gain to bring the year-to-date rise to over 60%.  In contrast, China's shares tumbled and the Shanghai Composite shed 2.7%, making it the region's worst performer.  The HSBC/Markit flash PMI came in a 50.5, down from 51.6 in March.  The consensus was for a 51.4 reading.  Of note, the export component fell to 48.6 from 50.5.  The employment measure fell below the 50 boom/bust level.  Prices also eased.

It is not clear if there will be a policy response to the weakness, which the PBOC Governor Zhou seemed to play down recently, noting that it was "normal".  At the same time, it seems that ideas that the dollar-yuan band was going to be widened imminently are wide of the mark.  Amid uncertainty, Chinese policy makers are unlikely to unveil new foreign exchange initiatives and after grinding higher in recent weeks, the yuan is likely to stabilize.  

Ironically, it was Germany not France that offered the downside surprise in Europe.  Germany's flash manufacturing PMI fell to 47.9.  The consensus had looked for a 49.0 reading after 48.9 in March.  The service sector PMI fell to 49.2 from 51.6.  The consensus call was for 51.0.  After what appears to be a stagnant Q1 (+/- 01/0.2%), the second quarter is off to a disappointing start.  

To be sure France's PMI readings remain dismal, but stabilized in April at well below 50.  The manufacturing PMI rose to 44.4 from 43.9, in line with expectations.  The service PMI rose to 44.1 from 41.9, a bit above the 42.0 consensus forecast, but still deeply in contracting mode.  

We argued that at the ECB meeting earlier this month, Draghi had used word cues to indicate that a refi rate cut was possible in the coming period if the economic data deteriorated.  Several officials have subsequently echoed this sentiment and today's flash PMI reports can only strengthen the speculation of a rate cut as early as next month.  

Meanwhile, the peripheral bond markets in Europe remain on fire.  Italy's 2-year yield is at record lows and the 10-year yield is slipping through 4% today for the first time since late 2010.  Optimism is running high that a new government could be in place in the next couple of days.  Of note the regional election held in Friuli produced a narrow PD victory, but more significant was the waning of support for Grillo's 5-Star Movement, which saw its support fall below 20%.  

Spanish bonds are also rallying, helped by another successful bill auction and news that the EC appears ready to grant it another year to reach the 3% deficit target.  Portuguese bonds also fully participating in the advance, with 10-year yields at new 2 1/2 year lows.   

In the past, many observers saw the premium the periphery had to pay over Germany as a key to euro's performance.  Yet Spain and Italy's premium over Germany on 10-year bonds has narrowed by 36 bp over the past month, the bulk coming in the past week, and yet the euro has found little solace.  

The UK reported poor CBI industrial trends.  The -25 reading was well below the -14 consensus expectation and shows a sharp deterioration from the -11 reading in March.   Sterling itself is flirting with support near $1.5200 and the 5-day moving average is slipping below the 20-day average for the first time since March 19.   

Meanwhile, there is some speculation that Chancellor of the Exchequer Osborne will announce an extension of the Funding-for-Lending Scheme (FLS), which appears to have helped support mortgage lending.  Separately, the sterling overnight index average (SONIA) appears to be discounting the likelihood that the BOE,  under new management this summer, may announce plans to buy GBP80 bln of gilts.  

Sweden reported a dismal employment report and this has renewed speculation that although an outspoken dove may be leaving the Riksbank board, another rate cut cannot be ruled out.  The unemployment rate spiked to 8.8% from 8.5%.   The krona has come under more pressure and the euro is testing the SEK8.60 level for the first time in two months.  This is roughly where the downtrend line drawn off last year's highs comes in.  A convincing break would give SEK8.70 as the next target.  

The Federal Reserve meets in a week's time.  The minutes of recent meetings show that some members are still talking about a gradual exit from QE later this year.  We have consistently argued that the Troika of Bernanke, Yellen and Dudley are the key and that they are clearly argue that it is too early exit.  

A recent Bloomberg survey of 21 primary dealers found a majority (14) do not expect the Fed to taper of its buying until Q1 14; (12) do not expect purchases to cease until mid-2014 or later, and (15) do not expect the first hike in the Fed funds rate before mid-2015.  Of note one investment house does not see the first hike before the beginning of 2016.  Another does not envision any tapering off for two years and four expect the purchases to continue into 2015.   

At the other end of the spectrum, one bank expects the tapering off to begin in Q3 and two primary dealers expect the Fed to end QE at the end of this year.   We do not read any hidden agenda in news that Fed Chairman Bernanke will not attend the annual Jackson Hole confab this year.  His absence will likely dovetail with speculation of his replacement.  As we have argued, there seems to be an informal two term limit in the post-Greenspan era.