Month End Flows and Position Adjustment Dominate

There are two main forces at work in the capital markets today. First is the month-end flows and position adjustments. These are weighing on the dollar and global bonds and, for the most part equities, though European bourses are mixed. Second is the macroeconomic news that shows a greater than expected impact of the Japanese sales tax increase, poor German retail sales, and softer than expected flash readings of Spain and Italian May CPI.

The euro and sterling still appear to be set to record their poorest monthly performance in a year with losses of 1.8% and 0.85% respectively. The Canadian dollar was the strongest of the major currencies appreciating 1.2%, followed by the yen's 0.6% gain. They are joined by the Australian dollar's 0.3% increase as the only majors to have gained against the greenback in May. These three currencies are also the strongest on the week, led by the Australian dollar's 0.9% rise and the yen and the Canadian dollar's 0.3% rise.

The most important event on the horizon is the June 5 ECB meeting. Today's data can only reinforce the conviction that action will be taken. Most expectations appear to be for a 10-15 bp cut in key ECB rates and possibly some new facility to foster credit to small and medium businesses. Both Italy and Spain reported flash CPI readings for May that were below expectations at 0.4% and 0.2% respectively. Both are 0.1% below the April readings and the Bloomberg consensus forecast unchanged reports.

Separately, following on the heels of a disappointing employment report earlier this week, Germany reported a seemingly poor April retail sales. The market expected a 0.2% increase and instead learned retail sales fell 0.9%. Yet the March series was revised to show a 0.1% gain rather than the 0.7% decline initially reported. Nevertheless, the general understanding is that the German economy has lost some momentum after growing 0.8% in Q1. Recall that earlier this week, France too reported disappointing consumer spending. It fell 0.3% in April, whereas the market expected a 0.5% rise.

Japan also reported a slew of data earlier today. These are the first comprehensive economic reports that cover the period since the retail sales tax was hiked. Essentially, the labor market was not impacted. However, consumption fell (household spending fell 4.6% not the 3.4% economists expected). Inflation jumped (headline April CPI of 3.4%, in line with expectations), though when the effect of the sales tax is removed from the core rate, which is what the BOJ targets, it rose to 1.5% from 1.3% in March. The Tokyo May CPI on this basis actually slipped to 0.8% from 1.2% in March. Lastly, industrial output fell 2.5%. The consensus expected a decline of 2.0% after the 0.7% rise in March.

The market and Japanese officials are seeing the data differently. Japan's Finance Minister Aso suggested that the economy is weathering the tax hike better than feared. This also seems to capture the spirit of the BOJ which has shown no inclination to provide more stimulus. The IMF essentially said the same thing. However, many economists are not as sanguine. There remains expectations that the BOJ will have to ease further.

Ultimately it is the official view that counts most in terms of the trajectory of policy. Officials appear to have written off the current quarter as various economic agents adjust their behavior in light of the tax hike. The for policy makers is Q3 not Q2. Only if the economy does not rebound will new policy measures be contemplated. Therefore, we continue to believe that the expectations for a move by the end of July is premature.

With a cacophony of Fed comments, it is important that investors keep their eye on the true signal. That signal is coming from Fed leadership and in the current context it is Yellen and Dudley that are key. Both Lacker, who speaks again today, and George have largely echoed Bullard's sentiment, advocating earlier rate hikes. However, the signal may a majority still seems to be signaling a later move and a gradual one at that. Williams also speaks today on monetary policy, and he is more aligned with Yellen and Dudley.

There are two important US economic reports today: the April income and consumption figures (0.3% and 0.2% are expected) and the Chicago PMI.  Given the strength of the Markit flash PMI readings, there would seem to be upside rise to the consensus expectation of a 61.0 reading (after 63.0 in April). We tend not to put much weight on the Milwaukee ISM or the Univ of Michigan consumer confidence report.

We do note, however, that the core PCE deflator, the Fed's preferred inflation measure (though clearly not the only one Fed officials scrutinize) is likely to tick up to 1.4% from 1.2% in March. This would be the highest in a little more than a year. While this may send some chins wagging, there is a base effect that is at work. Last April was the only month in 2013 that saw a negative core PCE deflator. This will be dropped out, and likely replaced with a 0.2% gain.

US Treasury prices are a touch lower. Prices retreated yesterday after the third lackluster auction of the week. After the markets closed yesterday, the Federal Reserve published its custody holdings. There has been some suspicion that part of the US Treasury rally was a function of official demand. The Fed’s custody holdings are one place to look for this activity. Custody holdings of Treasuries were essentially unchanged on the month, following a saw-tooth weekly pattern that alternated increases with draw downs over the course of May.