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Once again the US bond market is slap bang in the centre of the moves in the capital markets; as the US ten-year had its biggest one-day gain since September 2008 on Friday, Asian investors have started the new week by unwinding further carry positions with strong outflows of emerging markets, with China at the centre.
Friday’s payrolls number was strong, with the six month average improving to just over 200,000, enough to warrant a cut in the pace of asset purchases according to Chicago Fed President Charles Evans’ recent narrative. On the unemployment rate side, the 160,000 increase in the alternative household survey was more than offset by a 177,000 increase in the labour force; hence with an improving participation rate the actual unemployment rate rose modestly to 7.557% (if you want to be exact). With the ten-year bond closing at 2.73%, Asian traders initially joined the band wagon, selling on open, before fund managers saw value at the current elevated yields, while technical buying also played a part with the yield trading just shy of the downtrend drawn from the 2007 high at 2.75%. Given the raft of Fed speakers this week (Bernanke, Tarullo, Plosser, Bullard and Williams), we would not be surprised to see lower bond yields in the short term as the Fed pushes back on the current levels, which in theory could see a round of long USD profit taking. On a slightly different note, this week’s University of Michigan confidence survey will be interesting to see if confidence has been shaken given big moves in US treasuries.
Of course the moves in US yields have been the cause of the ECB and BoE altering monetary policy as these banks push back on the recent back-up in their own longer-dated bonds. A rise in yields would be manageable in the US as growth is in an upward projection, while ten-year inflation expectations have increased to 2.07%. However, in the UK and Europe where growth is much more subdued, a rise in yields can have extremely negative consequences, and a break above the downtrend (2.75%) for the US ten-year bond would almost certainly see EUR/USD and GBP/USD trading to much lower levels, as the market prices in much more aggressive action from both banks, potentially even negative deposit rates in Europe. Interestingly, with a sizeable 102 basis points (bp) yield advantage over German bunds (the most since 2006), one would say EUR/USD should fall over the coming weeks, effectively playing catch-up anyhow.
So, despite a positive US lead, Asia has struggled. China seems to be the key catalyst here with the Shanghai Composite and the CSI both lower by 1.6%, although both have come off their lows. Resource stocks have been sold off the most, although the selling across the market has been broad based. Chinese growth is once again being called into question, and while next week’s Q2 GDP is likely to show the pace of expansion falling to 7.5%, the market is thinking longer term and how a reduction in credit growth north of $100 billion will impact the economy. This is occurring at a time when rising US yields could have the impact of hot money outflows, although the countries closed current account should limit any major outflows.
Japan started off on the right foot, with the Nikkei rallying to 14497 (+1.3%), but has drifted lower as USD/JPY reacted to the modest US treasury buying. It’s worthy of note that USD/JPY has rejected the former uptrend drawn from the November low at 101.60 and we feel there are risks the pair pulls back to 100.00 in the short term, although we would look at buying opportunities around here. It has to be said Japan and Japanese markets are looking more and more compelling as a trading and investment destination by the day. The LDP party looks set to do very nicely in the July 21 Upper House elections (which should assist the ease at which structural reform can be implemented). Growth and business confidence are also improving and importantly inflation expectations are growing, with Friday’s BoJ June consumer survey showing 80.2% of respondents expect higher prices in twelve months. As mentioned in previous reports, increasing inflation expectations ultimately create negative real yields, which is JPY negative and highly Nikkei positive.
In Australia, the ASX 200 saw sellers from the outset, bottoming at 4786 (down 1.1%), before rebounding as China stabilised. Materials names have been under pressure all day, with gold stocks at the heart of the rout. We are fairly neutral on the Australian market at present, although a move through the June 19 high of 4861 would be positive, while on the downside, support is seen at 4765 (the uptrend drawn from the June 25 low). AUD/USD would most likely be sold on rallies up to 0.9200, while momentum traders will look to sell on a break of the recent low of 0.9037.
So, with a stronger finish in the US and mixed Asian markets it looks as though Europe will open on a constructive footing and a fitting end to an amazing sporting weekend (Lions, Murray and Froome). Europe will focus on Mario Draghi’s quarterly hearing of the Committee on Economic and Monetary Affairs of the European Parliament, while European finance ministers meet to discuss all things Portugal, Cyprus and Greece, with the latter looking less concerning after the Greek Finance Minister Yannis Stournaras said the government will reach a deal with creditors in the short term. German industrial production is anticipated to fall 0.5%, while in the US Alcoa is expected to earn 6 cents in what is considered the unofficial start to US earnings season.
Ahead of the European open we are calling the FTSE at 6440 +65, DAX 863 +57, CAC 783 +30, IBEX 7937 +69 and MIB 15613 +80.