Euro and Yen Resilience Helped by Lower US Yields

The euro and yen's resilience stand out today. Both have reported important data that was shockingly weak. Japan reported a whopping 19.5% decline in May machinery orders. The Bloomberg consensus called for a 0.7% increase after the 9.1% decline in April. The year-over-year figure plunged to -14.3% from +17.6%.

The dismal news from Europe came in the way of industrial production figures. Neither the PMI readings nor even the somewhat softer German data had prepared the market for today's shockers. French industrial output was expected to rise 0.2% in May. Instead it collapsed 1.7%, led by a 2.3% decline in manufacturing (large drop in refining and coke-making--not a joke--too easy--especially given the methodological revisions to include some underground activity into GDP calculations).

Italy reported a similar story. Industrial output was expected to have risen 0.2% but instead fell 1.2%. The April estimate was revised down for both Italy and France. The Dutch news was more of the same. Industrial production fell 1.9% in May. Expectations were for a 0.3% increase. A consolation in the Netherlands is that the April series was revised to show a 2.4% increase (rather than 2.3%).

There has been some sense that foreign flows were shifting from the European bond market to equities, but that cannot be explaining the euro's resilience today. Major European markets are off 1%+. The Dow Jones Stoxx 600 is off 1% near midday in London led by financials, industrials, energy and materials. Meanwhile, a softer reception than hoped fora new 3-year Greek bond and the ongoing concerns Banco Espirito Santo following the Luxembourg-based parent missed payments on short-term paper. Reassuring words from the central bank have done little to ease anxiety.

A weight on the dollar appears to be emanating from the strength of the US Treasury market. The 10-year yield traded near 2.70% at the end of last week as the jobs data showed stronger than expected improvement in the labor market. Yields, even amid the large official supply ($13 bln 30-year bonds finish this week's sales today), have fallen every day this week and are extending yesterday's decline by another 3 bp to 2.52%. At the 2-year, the US premium had approached 50 bp at the end of last week and now is back at its 4-week average of 44 bp.

We do not see the FOMC minutes being dovish or hawkish. We characterize it as "steady as she goes". The more interesting parts were about operational issues, like completing the tapering (to be announced in October assuming the economy stays on course) with a $15 bln more. Final decisions on tools and timing after QE have not been decided, but interest on reserves appears to be moving up the of central tools while the reverse repos may have fallen out of favor a bit. It also looks as if the Fed will not halt reinvestment of maturing issues until rates are being hiked.

We recognize that there are a number of participants who argue that the labor market has tightened considerably, and inflation has firmed and that the Fed should have done more to acknowledge this. Yet those expectations seem to place too much emphasis on the unemployment rate and do not appreciate that this metric has been downgraded. Earnings growth, for example, does not show a tight labor market. The broader measure of unemployment (U-6) stands at 12.1% compared with 9% in the early 1990s.

The bottom line here is that the course that Bernanke put the Fed on remains intact. Tapering will be completed later this year and the timing of the first hike still seems, most likely to us, in Q3 15. Note that Vice Chairman Fischer speaks today on reform in the financial sector after the markets close today.

The UK did report a larger than expected May trade deficit, though the April shortfall was revised to the better. Sterling has moved broadly sideways against the dollar since the start of the month. Since posting a key reversal on Monday, the euro has made higher highs and higher lows against sterling in the three sessions since. It has entered the band between GBP0.7960-80 that we suspect offers a lower risk entry level.   Outside of the BOE meeting, which is a non-event (likely unanimous decision to keep rates steady), there are three other developments to note. 

First, China’s trade surplus was nearly 20% smaller than expected at $31.6 bln in June. Exports rose 7.2% from a year ago, which is a slightly better than the 7.0% reported in May, but not as good as the 10.4% expected. Imports rose 5.5%, not the 6% expected. It follows a 1.6% decline in May. Generally, the data supports ideas that the Chinese economy has stabilized.

Second, the Swedish krona and Norwegian krone have been in play recently as the former surprised with a 50 bp rate cut, and the latter sounded dovish. Today’s inflation reports showed a stronger than expected rise in Sweden in both the core and headline rates and this has helped the krona outperform. It has gained nearly 0.4% against the euro. Near SEK9.22, the euro has unwound most of its Riksbank-inspired gains. Norway’s CPI was in line with expectations, with the headline ticking up to 1.9% from 1.8%, and the underlying rate (exclude s taxes and energy) ticking up to 2.4% from 2.3%. 

Third, the rise in the New Zealand PMI to 53.3 from 52.6 can only solidify expectations of another (fourth) rate hike on July 23. Australia reported a 15.8k increase in jobs but there were all part-time jobs. Full-time jobs actually fell by almost 4k. This was enough to push the Australian dollar from its perch above $0.9400.