Markets Calmer into Weekend

The global capital markets are calmer and the US dollar is somewhat firmer, as the volatile week draws to a close. With the help of a Wall Street Journal article, more participants have come over to our view that talk of tapering by the Federal Reserve as early as next week is premature and exaggerated.

The article helped spark the biggest rally in US Treasuries in a few months. This helped support the US equity market, which may be the only major bourse to finish higher on the week. The S&P 500 is up just shy of 1% for the week going into today's session. Yesterday's recovery, allowing it to post an outside up day, helped lift the global equity markets today. The MSCI Asia-Pacific Index gained about 1% and the European markets are paring the week's loss with gains of about 0.5%, pending whatever leadership is provided today by the US markets.

The rally in US Treasuries has also had knock-on effects on the global bonds. The 10-year JGB yield is off almost 2 bp this week. A fragile stability has emerged there. With a few exceptions, the yield has been confined to a 10 bp range between 0.80% and 0.90% since mid-May. The yields have slipped to the lower end of that range. European bond yields are broadly lower. The periphery recouping ground lost earlier in recent days, with Spanish and Italian yields now lower on the week.

The US reports producer prices and industrial output figures before the weekend. There is downside risk to both reports, especially the former, after yesterday's unexpectedly large decline in import prices. To be sure, the softness in US prices is not simply confined to the wholesale level or commodity prices. This is also consistent with the softer price measures in most of the regional Fed surveys and the ISM reports. We note that within the import price data, investors learned that consumer goods imported prices fell 0.3% in May, the largest monthly decline since late 2010 and is flat on a year-over-year basis.

Although the Fed talks about inflation expectation anchored and there are still some in the blogosphere who argue that inflation remains a threat. However, the real story that has emerged in H1 is easing of price pressures. While we acknowledge that market-based measures of inflation expectations have been distorted by the QE operations, we think the decline in the TIPS breakevens (inflation expectations) cannot be simply written off as QE-induced. The 5-year break-even has fallen more than 60 bp in recent months and is now near 1.75%. The 10-year break-even has fallen nearly as much and is near 2%. The longer-dated break-evens have fallen 50-55 bp.

Earlier today, the euro area confirmed that May consumer prices rose 0.1% for a 1.4% year-over-year rate. This is the lowest since mid-2010. The core rate stands at 1.2%, essentially the same as the US core PCE deflator. Japan, Switzerland, Sweden, and Greece are experiencing deflation--negative year-over-year CPI.

For only the second time this month, the dollar has been confined to the previous day's range against the Japanese yen.  It is trading in about a 50 pip range on either side of JPY95.00.  The euro is also within yesterday's range, while sterling has broken down to a three day low.  That said, technically, the euro and sterling are poised to trade firmer in North America today.

For the first time The Australian and New Zealand dollar's seeing yesterday's gains pared back, but barring some dramatic action in North America, the Australian dollar is likely to snap a five week losing streak and the New Zealand dollar is poised for its strongest week in a year, gaining a little more than 2% against the US dollar.

Elsewhere, we note that China has experienced an auction failure, the first in two years. It tried selling CNY15 bln of 273-day bills, but only sold CNY9.53 bln. There is nothing nefarious about the failure. The PBOC experiences difficult in managing the banking system's liquidity needs. It injected CNY92 bln this week after CNY160 bln last week. The scramble for quarter-end funds as seen the 7-day repo rate, which is a measure of interbank liquidity, has doubled. The PBOC is expected to ease the shortage by adding liquidity next week. Separately, the PBOC reported that the CNY positions at the banks, which reflects sales of foreign exchange, which in turn is a measure of capital inflows, slipped to CNY66.8 bln in May, the least in six months.