Markets Stabilize, Await New Developments

The global capital markets have stabilized. Chinese and Japanese shares initially sold off, but both recovered.  Chinese officials have thrown everything but the kitchen sink at the stock market in hopes of stabilizing it.  There was some success today.  The Shanghai Composite finished 5.8% higher and the Shenzhen Composite was 3.8% higher.   

The heavy hand of the government succeeded in engineering a key reversal day:   Prices made new lows for the move only to reverse and close above the previous day's highs.  Although Americans are fond of cautioning against "fighting city hall", one can but one needs to choose one's shot carefully.  The Chinese government's determination is overwhelming.  

The Nikkei held the 100-day moving average, as we noted yesterday, but was sold dramatically through it (19713) to reach a low near 19115.  It then recovery dramatically, pulled perhaps by the Chinese market.  It closed on its high (19855), which is also a constructive technical signal.  

In terms of economic data, China reported slightly higher CPI but deepening deflation in producer goods.  Consumer inflation ticked up to 1.4%, besting expectations for 1.3%, after 1.2% increase in May (1.9% food prices and 1.2% non-food prices).  Producer prices fell 4.8% from a year ago, matching the deepest contraction since 2009.    For its part, Japan reported a larger than expected jump in machine orders.  The 19.3% year-over-year increase in May is the largest rise since January 2014.  The consensus was for a 16.7% increase after 3.0% in April.  

Separately, Australia's June report was stronger than expected.  It created 24.5k full-time jobs after 15.1k in May.   It lost 17.2k part-time jobs.  Overall, there were 7.2k new jobs.  The consensus was for a flat report.  The participation rate ticked up to 64.8% from 64.7%.  The unemployment rate edged to 6.0% from 5.9%.  

The Australian dollar has stabilized above $0.7400.  Yesterday's spike below $0.7375 may have exhausted the immediate selling pressure.  A recovery in commodity prices (iron ore, copper, and oil) are contributing to the steadier tone.   The market's growing confidence of a rate cut next month was also undermined by the employment report.

Against the yen, the dollar retested the JPY120.40 area. One it looked like it would hold, bottom pickers emerged.  The immediate key is the JPY121.70 area.  A move above there would begin repairing the technical damage.

Europe is largely in a wait-and-see mode.  Today's Greek drama should include more detailed proposals that could serve the basis for negotiations of a new assistance program.  The ECB maintained the ELA yesterday.  It intends to review it again on Monday.  That would seem to imply that the bank holiday lasts through July 13 at least.  As it did in Cyprus, the ECB wants a guarantee from the governments to enable ELA funding if the negotiations continue.  Remember that ELA lending is done with the ECB's approval but with the sole risk of the national central bank.  The ECB's move, therefore, seems like political cover as the ECB's (Eurosystem) balance sheet is not at risk. 

European stocks are following Asia's lead to enjoy a broad recovery.  The premium that the peripheral countries pay over German continues to unwind lower.  The euro peaked near $1.1125, the highest level since last Wednesday, but participants are cautious, recognizing the vulnerability to headline risk.  There are also large option strikes ($1.12, $1.11, and $1.10) that expire today and tomorrow that may be impacting activity.  The consolidative tone can persist provided the $1.10 level holds.  

For the first time in seven sessions, sterling has not fallen through the previous day's low.  This too illustrates the consolidative tone that has emerged.  Short-term UK rates have also ticked up.  Partly this began as a reaction to the UK budget, where the reduction in the projected Public Sector Borrowing Requirement was half of what was expected.  A tighter budget was thought to have encouraged participants to continue to push out the first BOE hike.  That the budget did not appear as tight, though its cash requirement fell, suggesting lower gilt issuance.  Separately the RICS house price balance rose to 40% in June from 34% in May.   The Bank of England meets today, but it is a non-event.  

There were two points from the FOMC minutes that are worth noting.  First, Fed officials seemed somewhat more confident about the US economy, even though GDP forecasts were revised lower. The concern about weakness in consumption has been superseded by revisions and new economic data.  Second, officials seemed concerned about external shocks from Greece and China. 

We suspect there will be greater clarity on both these risks by the July 28-29 FOMC meeting.  By then it will be clear if Europe can avoid a disorderly chain of events that leads to Greece's exit from the monetary union.   While the Chinese economy appears to have slowed, the government's various efforts appear likely to stabilize it.  On the other hand, the recent dramatic drop in the stock market could have real sector consequences, but this is yet to be seen.  It seems more likely that while a few economic sectors, such as luxury goods, may suffer,  consumption is not as much of a driver of the world's second biggest economy as it  is for the US, Japan and western Europe.   

By our calculation, the December Fed funds futures contract continues to imply that the market has discounted one rate hike this year (though we read of others claiming that a hike has been pushed into next year).  Our calculation is as follows.  For the first 16 days in December the Fed funds average 13 bp, the middle of the 0-25 bp range.  The Fed hikes rates on December 16 and the funds rate averages the mid-point of the new (25-50 bp) range for the last 15 days of the month.  This implies an average effective rate of 24.6 bp.  The December contract currently implies a yield of 25.5 bp.  

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