Markets Limp into Weekend

An eerie calm, after yesterday's dramatic swings, has settled over the capital markets. The US dollar itself is little changed against the major and most emerging market currencies, consolidating yesterday's losses. The selling pressure that took the S&P 500 down 1.4% yesterday eased in Asia where the MSCI Asia Pacific Index was off about 0.4%. Of note the Shanghai Composite jumped nearly 6% at the open, inexplicably (some derivative expiries and exchange platform problems cited), before trending lower to finish off 0.65%, cutting the week's minor advance almost in half.

The pressures are even more diluted in Europe, where the major bourses are mixed and the Dow Jones Stoxx 600 is little changed. Similarly, in the bond markets, yield sin Asia were mostly higher, reflecting the sell-off in US Treasuries yesterday, but benchmark yields are a little lower today.

Despite the intra-week moves, the dollar is finishing the week mostly higher, by less than 1%. The main exception is the British pound, which has been the strongest currency, gaining 0.9% against the greenback, on the back of strong economic data that underscore the market's emphasis on the conditionality provided for the forward guidance. Sterling is trading at 2-month highs.

The other exception is the New Zealand dollar. Strong data has encouraged the market to price in a rate hike by March and as much as 85 bp over the next 12-months. The New Zealand dollar was initially knocked by earlier today on news of a 6.6 earthquake and strong aftershocks. The Kiwi, however, continues to show amazing resiliency, as it did following the recent tainted milk story. It was trading at 2-month highs before the earthquake and, as the North American session is about to begin, it is little changed on the day.

The euro area confirmed the preliminary July CPI, which fell 0.5% for a 1.6% year-over-year increase (unchanged from June). The core rate was also unchanged at 1.1%. Separately, the euro area recorded a 16.9 bln current account surplus in June, down from the 19.5 bln surplus in May. The financial account is more interesting. An 18 bln euro surplus was recorded. This reflected a new inflow of portfolio capital of 23 bln euros and a new outflow of 5 bln in direct investment.

There was a net inflow of 27 bln euro in equity investment. Euro area investors sold 18 bln euros of foreign shares, while foreign investors bought about 9 bln of euro area equities. There was a net outflow of almost 5 bln euro in fixed income investment. Foreign investors sold 33 bln euros, while euro area residents sold 28 bln euros of foreign fixed income.

In the larger picture, this means that in the 12-month through June, the euro area recorded a net inflow of 65 bln euros. This contrasts with an outflow of 60 bln euro in the 12-months through June 2012. Yesterday's US TIC data (also for June) showed a $70 bln net sale of long-term investments in the US, which appears to be the second largest on record, and extends the streak to an unprecedented 5-months of net sales.

The main narrative that is being told is that after the market has become more confident of Fed tapering next month and that this led to pressure on US Treasuries, which weighed on equities, and the sell America theme weighed on the dollar.

While this may seem intuitively clear, the problem is that when the dollar turns bid, as it did immediately following the news of the new cyclical lows in the weekly initial jobless claims, that too was attributed to tapering ideas. It seems a bit contradictory that the same cause (anticipated tapering) is used to explain both dollar gains and dollar weaknesses.

The US finishes the week with Q2 productivity and unit labor costs, alongside July housing starts and permits. The productivity and unit labor costs report are derived from the Q2 GDP data and a modest rise (~0.5%) is expected by the former, while the latter is expected to have risen 1.2% after a 4.3% decline in Q1. Housing starts are expected to have risen almost 8%, helped by a recovery in multifamily starts. Permits are also expected to have recovered from a 7.5% decline in June. The preliminary University of Michigan consumer confidence report is expected to be largely stable around the July reading of 85.1.

India's Sensex 4% drop, the largest in more than 4 years, essential offset the previous four day advance. Basic materials and banks were the hardest hit sectors. Many reports attributed the sharp losses to renewed weakness of the rupee, which fell to new record lows against the dollar, despite official efforts to tighten restrictions on capital outflows. We note that the Indonesian rupiah also remains under pressure and new multi-year lows were seen ahead of the weekend. Turning to Brazil, the central bank will start rolling over $5 bln + in swaps today as the BRL has fallen out of favor and is now at 4.5 year lows.