Heads Up: Developments before the New Week Begins

There are four developments to note before the new week's trading begins.

1. China's official May manufacturing PMI was reported better than even the most optimistic forecaster in a Bloomberg survey at 50.8. It was 50.6 in April. Recall that HSBC's flash version, which tends to be more representative of small businesses, show the first sub-50 reading (49.6) since last October, giving rise to fresh concerns about slowdown in the world's second largest economy. The final version is due out early Monday in China (as is the official non-manufacturing PMI). 

Some details of the official measure are worrisome, even if the headline surprised. The employment sub-index remained below 50 for the 12th consecutive month. New export orders fell for the fourth time in five months. The small business index which is more similar to the HSBC survey fell to 47.3 from 47.6.

The problem with China's manufacturing is crystallized in the steel industry Output rose 8.4% in the Jan-Apr period according to data released at the end of last week. A little more than half (54%) went into inventory. This has had knock on effects on the price of iron ore, which is nearly 30% below the Feb peak. China's steel industry is taking capacity off line. At least ten furnaces have been idled, which cuts production by 1.1 mln metric tonnes. The largest Chinese steel maker indicated that as the end of next week, one of its 2500 cubic meter furnaces would be taken off line for 11 days and that alone would cut output by another 120,000 metric tonnes.

2. The Turkish government's poor response to protests over a local development project that would have uprooted dozens of trees needlessly aggravated the situation. This seemed to be last straw of a number of simmering grievances, including developmental projects that rode roughshod over local views, new restrictions on the consumption and sale of alcohol, and the government's controversial support for opposition groups in Syria.

However, talk of a Turkish Spring or more seems hyperbolic. Indeed, PM Erdogan still appears poised to win next year's election, though he suffers the hubris of politicians that have served for a decade. He is too ready to dismiss those who disagree with him as "provocateurs" and jail journalists, for which Turkey, with its democratically elected government has moved into first place.

The fortunes of Turkish bonds and lira were more a reflection of broader capital market developments. The Turkish lira lost 1.5% against the dollar last week, which is quite modest given the sharper losses of many of the freely traded emerging market currencies.

The dollar has gained about 6.5% against the lira since mid-April and is at the upper end of where it has traded over the last five years. Turkey's 10-year dollar bond was a strong performer before the weekend. The 12 bp decline in yield (to 3.43%) cut the week's rise nearly in half.

3. Germany and France issued draft proposals on fiscal and banking union issues, which they called a "contribution".  It tries to pull the euro zone in a direction that appears to be substantially different than the European Commission's intent, especially in terms of a banking union.

The compromise struck between the two pillars of Europe is for greater fiscal sovereignty to be yielded to Brussels, while national authorities retain important responsibilities for the resolution of troubled banks.   Germany insists that current treaties do not grant the EU the authority to conduct bank bailouts on its own.  

France has sought to preserve a greater role for the national resolution authority and the German position was not inconsistent with this, but at odds with the EC and ECB.  The ECB will still have the authority, it appears to declare a financial institution insolvent, but has limited power to do anything about it.

German seemed to recognize in principle that the European Stabilization Mechanism backstop should be available to all national governments, but precisely how this would work was left for a future negotiations.  It successfully blocked direct recapitalizations pending additional agreements on banking regulation.

Germany and France, each apparently for their own reasons, have become disenchanted with the functioning of the euro group of finance ministers.  They endorsed a permanent presidency of the euro group.  Although this may seem like a dis of Dijsselbloem, the Dutch finance minister that replaced Juncker as euro group head (and it might be to some extent), it is part of the institutional evolution, that France has long advocated, to provide a political balance to the ECB's monetary leadership.

4.  Amid fear of that the Federal Reserve may begin exiting from its unconventional easing program; US Treasuries recorded their worst month since in more than two years in May.  The 10-year yield rose nearly 50 bp.

In turn, the increase in US yields lifted global interest rates and emerging markets were particularly hard hit.  Mexico and Brazil benchmark bond yields rose 85-90 bp, for example.  The sell-off in US Treasuries was the most significant driver of the 20-35 bp increase in most European 10-year bond yields.   Despite the substantial changes in the world economy, the US Treasury market continues to exert significant influence over global interest rates, like no other country, including China, Japan and Germany.  Yet the fact that the business cycles are not synchronized means that the some economies are less positioned to cope with higher interest rates.  

That said, the discussion of tapering off  its purchases has had a salutary impact from the Fed's point of view as many critics and advisers to the Federal Reserve having increasingly expressed concern about the rise of asset bubbles.    The S&P 500 posted its first two-week decline since last November, paring the May gains to 2.1%.   Some observers detect a rotation to cyclical shares from high dividend issues.  

Tapering off, which we do not expect to actually take place until late Q4 at the earliest, is not a cessation.  It may be tantamount to driving a car 45 miles an hour instead of 85.  It is most assuredly not putting on the breaks.  Moreover, the Fed has consistently maintained that the stimulative impact is from keeping those risk-free assets off the market, not simply in the flow of purchases.    

The trajectory of Fed policy is data dependent and there are five considerations that suggest that tapering itself is not imminent.  First, we expect the US jobs report at the end of next week to show job growth has slowed with another month of sub-200k growth in non-farm payrolls to bring the 3-month average down from over 200k to less than 160k.  Second, price pressures are low (e.g., core PCE deflator, GDP deflator).  Third, recent consumption is weaker than expected.  Fourth, mortgage rates are rising and there may be some cooling off of housing activity.   Fifth, credit growth is considerably weaker than it appears, when adjusted for the corporate borrowing related to share buy backs.