Capital Market Drivers

There have been two overarching forces that have driven the global capital markets in recent weeks. Within the context of substantial positions established on the basis of both US and Japanese unorthodox easing, the markets have responded dramatically to speculation of near-term Fed tapering and concerns that BOJ is caught in a contradiction; a reduction in the dangerous volatility in the bond market comes at the price of a stronger yen and weaker Nikkei.

These forces remain very much in play. The Nikkei slumped another 3.7% today to bring its 10-day decline to 17%. Today's decline was led by a 6.1% decline in financials and a 5.2% decline in consumer services. 

The yield on the 10-year JGB eased 4 bp while the dollar fell to almost JPY100 and recorded its lowest level since May 9. This general area provided formidable resistance on the way up and is expected to offer support. With the RBA, BOE and ECB meetings this week and US jobs data, news from Japan itself may be overshadowed, but on Wednesday, Prime Minister Abe is expected to unveil a new growth strategy.

The US reports the ISMs, ADP and factory orders, while the Fed releases the Beige Book, but the employment report at the end of the week has taken on greater significance, given the heightened speculation of tapering. 

We have argued that market is getting ahead of itself and do not think any slowing long-term asset purchases until late this year at the earliest. Even then the issue is the pace of purchases not stoppage or reversal.  The consensus forecast of about 165k non-farm payroll would be the third consecutive month below 200k.   If close to the mark, would likely diminish tapering ideas.  

In this broader context, we place the three central bank meeting this week.  Neither the RBA, BOE nor ECB are likely to change policy.  The slide in the in Australian dollar and the fact that banks passed on the last rate cut in full has discouraged expectations of a back-to-back rate cuts.   This is BOE King's last meeting.  He will likely go out in a minority voting for additional gilt purchases.  Carney takes the helm next month and many are looking for new guidance and perhaps new gilt purchases in August.  

The ECB will be gratified by the small uptick in the euro area manufacturing PMI to 48.3 from the 47.8 flash and the 46.7 reading in April.  While still below the 50 boom/bust level, it is the highest since Feb last year.  Moreover, the gains were broadly experienced.  Germany and France improved from their flash readings (and German output and orders were above 50 for the first time in 3-months).  Italy, Spain and the Netherlands all reported stronger gains than the consensus expected.   The ECB is likely to see the news as consistent with it expectation that the recovery will solidify in H2.  

We note that this modest improvement is European wide.  Switzerland, the UK, Norway and Sweden also reported better than expect May PMIs.  The improvement extends to central Europe, except for Hungary, which slipped back below 50.  

Lastly in Europe, we note that the fourth day of widening protests/demonstrations in Turkey has seen the lira not benefit from the recovery seen in other emerging market currencies, including the South African rand.   The lira bonds are being crushed and yield on the 10-year bond is up 23 bp to almost 7%.  The Turkish stock market is off nearly 6.7%. 

Another force that has helped shape the investment climate has been the slowing of the Chinese economy.  The official May PMI data suggests some stabilization as the manufacturing reading rose to 50.8 from 50.6 and the service reading slipped slightly to 54.3 from 54.5.   On the other hand, the HSBC measure, with its emphasis on small businesses fell to 49.2 from the 49.6 flash and 50.4 reading in April.  

The Chinese news seemed to help lift the Australian dollar from the start of today's activity.  With the first US-China summit between US President Obama and new Chinese President Xi speculation that China will widen the dollar-yuan band are running high, but may be disappointed.   We note that up a minor 1.6% this year against the US dollar, makes the Chinese yuan the strongest among the emerging market currencies this year.