It is Mostly about the US in the Week Ahead

The main drivers in the week ahead will come from the United States.  Rarely does the Federal Reserve Open Market Committee meet in the same week as the monthly jobs report.  In addition, the government will publish its first estimate of Q2 GDP and the Employment Cost Index. For extra measure, auto sales and the manufacturing ISM are also due. 

The capital markets appear to be at potential turning points.  The US Dollar Index posted its best weekly advance since March as the euro fell to new lows for the year.  The S&P 500 posted record highs on July 24, but gapped lower the next day.  The Russell 3000 peaked on July 3, the retest last week faltered, and it too gapped lower before the weekend.  

Major European markets have already turned lower.  The UK's FTSE peaked in mid-May, the French CAC in early-June and the German Dax in late-June.   The Nikkei made is high at the start of the year.  In contrast, the MSCI Emerging equity market is at its best level since early last year. weiThe MSCI Asia-Pacific Index is at its best level in six years.  

US Treasuries remain firm, and the 10-year yield spent most of last week below 2.50%.  We see two main sources of demand that are worth underscoring.  The first is from US banks.  Their Treasury holdings have increased sharply in recent months.  The second is from foreign central banks.  The evidence is largely circumstantial, but is consistent with the recent TIC data (May).  It appears they are extending duration ostensibly as a strategy to cope with a change in monetary policy.  

The US 10-year yield has fallen almost 7 bp over the past month.  Most sovereign bond market.  Most euro zone benchmark yields are off between 10 and 13 bp lower, with the 7 bp decline in the 10-year Gilt is an exception.  Portuguese bonds have rallied for the past two weeks, but the yields have not returned to levels seen before the scare.  

It appears that demand for European debt has slackened somewhat.  Some of the flows appear to have been re-directed toward the dollar-bloc and emerging markets.  The Canadian 10-year yield has fallen 12 bp over the past month, Australia 15 bp and New Zealand 21 bp.  The EMBI+ has is bouncing along its recent trough, which just above 280 bp, it is off 100 bp since the start of the year and just above where it bottomed (~250 bp) in 2010 and again early last year.

Despite the active US diary next week, the risk is we do not learn much new and that which we do learn is disappointing.  Given Yellen's recent testimony before Congress and the absence of updated forecasts and a press conference, the FOMC meeting is as likely as these things can be to a non-event.  Minor tweaks in the statement and another $10 bln in tapering is expected.  No more and no less.  

With the weekly jobless claims recording new cyclical lows and regional Fed surveys all improving in July, another, the sixth, consecutive non-farm payroll gain over 200k is understandably widely anticipated.  Yet in the current context this is not sufficient to change expectations.  The ADP estimate steals the thunder, and the other components of the employment report are slower moving.  

Average weekly earnings may tick-up on a year-over-year basis, but this does not represent true acceleration of wages.  Average weekly earnings have risen by an average of 0.2% a month over the last 3-months, 12-months and 24-months.  They are expected to have risen by 0.2% in July.  

The Q2 Employment Cost Index is due out the day before the monthly jobs report.  It covers wages, salaries and most benefits (excludes stock options) for the private sector and local and state governments.  It appears that of the various measures of labor costs, the ECI has the strongest correlation with the core PCE deflator.  

The Q2 ECI is expected to have risen at a 0.5% pace after 0.3% in Q1.  While this may pose some headline risk, such an increase does not represent an acceleration of inflation.  Consider that the four-quarter average is 0.44, and the 8- and 20-quarter averages are 0.44.   We should not exaggerate short-run fluctuations around a long-term average.  

The risk for disappointment seems greater from the other data.  The regional Fed surveys for July have been upbeat, but the flash Markit PMI (both manufacturing and services) eased.  There were two more auto selling days in July than in June, but it might not be sufficient for auto sales to top the 16.92 mln pace in June, which was the highest in eight years.  

The biggest risk of disappointment comes from the GDP estimate.  Recent data warns that Q2 ended a dip in momentum.  Economists had thought that Q2 growth would more than offset the unexpectedly dramatic 2.9% contraction in Q1.  It does not look like such a sure thing anymore.  In addition, there will be benchmark revisions going back to the start of 1999 that will change the historical profile.  

Turning to the euro area, last week's money supply and credit report showed a small improvement. Some linked it to the June rate cuts.  The ECB's lending survey may shed more light.  The flash July CPI demands attention as well.  The debate over whether inflation has bottomed is unlikely to be resolved by the July print which is expected to be unchanged from June at 0.5% on the headline and 0.8% at the core.  The ECB's staff which lowered this year's CPI forecast seems to assume that the CPI bottoms near current levels.  

Both Spain and Italy have large bond maturities in the days ahead.  Spain has almost 16.4 bln euros maturing on July 30th.  Its 10-year bond yield fell to record lows last week.  Italy has about 36 bln euros of debt maturing, of which 27 bln, the largest of the year, takes place on August 1.  Italy is hoping that the freed up funds are simply recycled into the new supply offered in the first half of the new week.  Some observers linked the recent chunky LTRO repayment to these maturing issues.  

Spain and Belgium are the first euro zone members to report Q2 GDP.  With the Bundesbank warning the that German economy may have stalled in Q2, if Spain reports the 0.5% as expected, it will likely be the fastest growing of the large euro zone countries.  

Japan reports economic data every day next week.  Most of the data is for June.  In many ways, officials appear to have written off Q2 due to the sales tax hike.  It is betting, as it were, that the economy rebounds in Q3.   The preliminary July manufacturing PMI, reported last week,  slipped to 50.8 from 51.5 in June, though, of note, the export orders component rose above the 50 boom/bust level for the first time since March.   

The June industrial output figure will be reported, but it is not expected to confirm the recovery in the PMI from May's 49.9 reading.  The Bloomberg consensus is for a 1.2% decline.    July vehicle sales figures to be released on August 1 may be an indication of whether the Japanese consumer has recovered from the tax increase.  Auto sales fell each month in Q2 after rising sharply between last September through March.    

Many participants expect that the BOJ will be forced to provide more stimulus.  As it was a fiscal shock the is the culprit, we suspect that if the July data is as weak as we suspect that a supplemental budget will be considered for the second half of the fiscal year.  Given the economic conditions and the erosion of public support for Prime Minister Abe, we suspect the government will chose not to implement the second leg of the retail sales tax increase.  

Geopolitics remains a wild card with the focus on both Gaza and Ukraine.  Gold in particular looks supported, but out-performance of emerging market equities (over developed equity markets) and the gains in the peripheral and dollar-bloc bonds does not speak to a risk-off period.  Lastly, of the emerging market central banks that meet in the week ahead, only the Philippines and Columbia are expected to hike rates.