Big Week Ahead

This is a big week for the global capital markets. It is likely to prove to be the most significant week of the not only the first half of the year, but perhaps even the entire year. There are four major central bank meetings and the US employment data. The euro zone reports the flash reading of May's consumer prices and there are is the monthly cycle of purchasing manager indices.

1. ECB:  In this eventful week, the ECB meeting is by far the most significant. Draghi came the closest the ECB does to pre-committing to moving this week, with the new staff forecasts in hand. There is some uncertainty of precisely what the ECB will do. However, the range of options appear be narrowed to interest rate adjustment, forward guidance, and perhaps a targeted funding-for-lending scheme. There does not seem to be a consensus for outright asset purchases, but Draghi is likely to emphasize in his press conference that the ECB is prepared to do more if necessary.

A move to negative deposit rates is the most important of the measures that may be announced. It is unprecedented among key central banks. Even combating deflation for years, the Bank of Japan never charged banks for depositing money with it. Most observers do not seem to think it will have much impact. We remain concerned about the knock-on disruptive indicators to large economic agents, including the government itself, money market funds and businesses. In a perverse way, a negative deposit rate may also aggravate the contractionary impulse in the financial sector by leading. The flash May CPI will be released on Tuesday. After softer Italian and Spanish figures before the weekend, the risk would seem to be on the downside to the April 0.7% reading.

We suspect the 4 cent decline in the euro over the past month to have largely discounted a 10-15 bp cut in key lending rates. Such a rate cut is unlikely to cover in full the reduced inflation estimates the ECB staff is likely to project. Technically, the euro may be poised to bounce. The event has long been anticipated. "Sell the rumor, buy the fact" behavior is not uncommon. It was also what appeared to be the case in the US. A case in point is the dollar's sell-off in anticipation of the third round of QE. It recovered after it was announced.

2. US Jobs:  The monthly US employment data always attracts attention. However, we argue that this report has lost some of its market impact. The Federal Reserve appears to be on something close to auto-pilot. It will take more than a 1% contraction in quarterly GDP to prompt the Fed to reassess its tapering. At the same time, the modest rise being seen in a broad range of inflation indicators does not appear likely to increase the pace of tapering.

According to a Reuters survey, the consensus is for a 220k increase in non-farm payrolls but sees the unemployment rate ticking up to 6.4% from 6.3%. Yellen has encouraged market participants to look beyond the usual headlines and toward more nuanced measures of the labor market. These include weekly earnings, the participation rate, and the taking part-time jobs because they cannot find full-time work.

3. Bond Rally: Until now there was not compelling evidence that short-covering was driving US Treasury prices. However, latest the Commitment of Traders for the 10-year Treasury note future a large adjustment to positions. The shorts appeared to capitulate. The gross short position was slashed by 131k contracts to 398.4k, which was highest since before the financial crisis. The short covering was the largest since December 2012. The net short position fell to 19.1k contracts from 97.9k. At the same time, the longs took profits. The gross long position was cut by 52.1k contracts to 379.3k. Separately, at the end of last week the FDIC confirmed that US banks had boosted their Treasury holdings by nearly a quarter in Q1, the largest increase since before the crisis. The regulatory pressure that leads bank and pension funds to hold more Treasuries is taking place at the same time the deficit is falling, and the issuance schedule had been reduced. The issuance schedule increases now and price pressures have stopped falling and may have begun increasing (albeit slowly)

4. Reserve Bank of Australia: The cash rate is expected to remain stable at the record low 2.5% for many months ahead. Guidance from the central bank has been clear on this. On a trade-weighted basis, the Australian dollar rose in late Q1 and into early Q2 and has since gone broadly sideways. RBA comments on the Australian dollar are headline risks but do not typically have lasting impacts.

At mid-week, Australia reports its first estimate of Q1 GDP. The market expects the economy expanded at a 0.9% quarter-over-quarter pace. However, below the surface, the domestic economy remains weak. The key is the external sector likely accounted for the bulk of the growth as iron ore exports increased while the imports of capital equipment likely fell. This is not sustainable. Iron ore prices have collapsed. In part, the decline in capital equipment shows the economy is struggling to transition away from mining.

5. Bank of Canada: The mid-week meeting is unlikely to result in a change in policy or the general neutral bias. Core inflation ticked up to 1.4% since the BoC last met, and the year-over-year growth in average weekly earnings (3.1% year-over-year in March), coupled with benchmark effects suggests the low point in consumer inflation be likely behind Canada. The unexpected decline in industrial prices (-0.2% vs. consensus +0.4%) and the weaker than expected raw material prices (0.1% vs. consensus 0.5%) may be constructive for producer's margins. Separately, Canada reports May employment figures at the end of the week. After being surprised by a decline in jobs in April (-29k), the consensus is sticking to its guns that it was a fluke and believes the job loss will be completely recouped in May (Bloomberg consensus is for 32k new jobs).

6. BOE:  The Bank of England meets Thursday. As it is not expected to do anything, no statement is expected. Carney may have a similar experience as his predecessor King. King, as it will be recalled, was outvoted repeatedly by a less dovish majority. The debate over the extent of spare capacity, which is difficult to measure in any event, suggests the opposition will grow to Carney's dovish tilt in favor of earlier rate hikes. We suspect that it is likely several months too early to be expressed in dissents at the MPC.

7. China PMI:   China reported its official manufacturing PMI over the weekend. The 50.8 reading was slightly above expectations and the rise in May was the third consecutive increase. It stands at a five-month high. Of note, the forward looking new orders rose to 52.3 from 51.2. Export orders, however, only ticked up to 49.3 from 49.1. This underscores our argument that the decline in the yuan is not aimed to boost exporters and, that in terms of orders (rather than profit-margins), they do not appear to be benefiting much from the weaker currency (even though it appears export bottomed in February with an 18% year-over-year decline--Lunar New Year and crack down false exports to hide capital inflows). HSBC will report the final reading for its PMI (initially 49.7) and the service readings will start the week, while the latest trade figures are at the end of the week.

China has taken a number of stimulative measures, including cutting required reserves for more banks and boosting housing and railway investment. Some spending is being accelerated. In other areas, administrative measures, such as encouraging banks to expedite the mortgage approval process, also offer greater support for the economy. We note a number of economists have begun revised up Chinese growth forecasts.

8. South Korea reported surprising May trade figures over the weekend. The consensus expected exports to have risen 1.4% on a year-over-year basis, according to a Wall Street Journal poll. Instead, they fell 0.9%. Imports were expected to have risen by 6.5% and instead rose by a negligible 0.3%. We do note their were few working days, but calendar effects are not usually the cause of big forecasts errors. Of interest, South Korea imported 71.3 mln barrels of oil in May, down from 77.5 mln barrels a year ago. This may point some economic weakness more than energy efficiency. The won rose to new multi-year highs against the dollar, despite reports of central bank intervention, at the end of last week. South Korea report PMI, CPI and GDP figures this week.

The disappointing trade figures may encourage a bout of profit-taking on long won positions. Foreign investors have bought $1.7 bln of South Korean equities in May after having bought a net $100 mln in the first four months of the year. Initial dollar resistance is seen ahead of KRW1030.

9. G7 and European Politics: This week’s G7 meeting was to have been a G8 meeting before Russia annexed Crimea. With the Ukrainian elections having taken place and Russia withdrawing some troops from the Ukrainian border, many including Obama will seek to credit the sanction regime. Rather than announce new policies, on his numerous visits in Europe, Obama will try to convey a pragmatic course in between isolationist and interventionist.

While the US mid-term election is not until middle of Q4, the implication of the recent European elections are still not clear. We recognize that it is in interests of the partisans to play up the significance. Objectively, about four of ten who were eligible voted and then about one of those voted for an anti-EU party. Note most countries have their own anti-EU party. We also see some truth in the observation that the EU parliamentary elections serve as a venting mechanism for domestic angst, without having to bear direct impact from it.  Many of UKIP voters, for example, want the UK to remain in the EU.  There is also difference between an anti-austerity agenda and anti-EU.  Simply put, the opposition to the EU is fragmented. Even if they were to cooperate, which seems highly unlikely on any kind of large scale, they will be marginalized by the two main party groupings.

Juncker must be considered the front-runner to be the next EC President, it is not done deal by any means. There are many forces at work, and one of the key ones, which might be under-appreciated is the balance of power between the Council of Ministers (representing the nation-states) and the EU parliament (which presents some supra-national authority).

Lastly, the EU delivers its convergence report at mid-week. In addition to the annual check up, which is always worth a look, the report is likely to endorse Lithuania’s candidacy for monetary union as of Jan 1, 2015. Besides being important for Lithuania itself is also is important for governance issues. The ECB may move to rotating voting scheme, for example.