Market Takes China’s Response In Stride, Risk Appeased

China's Response
 

Overview

The market is mildly evaluating China’s response to Speaker Pelosi’s visit. The market has rediscovered its appetite for risk. Although China’s Response shares are down, equity markets are still up. Europe’s Stoxx 600 is now moving higher after two days of minor losses, while US futures show a stronger bias. Yesterday’s surge of US rates has slowed. The US 10-year yield is stable at 2.76%. However, the 2-year yield is just a few basis points higher at 30.07%. European yields are about 4 to 5 bp higher and the peripheral premium has fallen a little. Today’s dollar is generally less volatile than yesterday’s rate rise. The Scandis led the move, while the Swiss Franc (and New Zealand dollars) are slightly softer. As expected, the Swiss CPI increased to 3.3% from 3.2%. This reduces the chance of the SNB interfering. Both the Asian currencies and Turkish lira performed poorly among emerging market currencies. Yesterday’s drop in gold to $1788 was reversed today. It found support at $1755. September WTI remains steady at $93-$95 a barrel. This is the same range as Monday’s. OPEC+ has yet to announce September quotas. Although the US natgas market crashed yesterday by 7% it is now about 1% higher. Europe’s benchmark oil is now about 1.25% higher after rising 4.5% over the past two sessions. Iron ore has dropped 3.8%, roughly equal to the decline over three sessions. Copper rallied for six consecutive days Monday. Yesterday, the price of copper traded slightly lower than yesterday and is currently trading slightly higher. September wheat is desperately trying to reverse the nearly 5.5% drop in price over the last three days. It is currently trading at 1.7% above its previous close.

Asia Pacific

China protested the visit by Taiwan’s third highest-ranking official from the United States. This is the highest-ranking US official to Taiwan since Gingrich visited 25 years ago. China announced that it was conducting live-munition drills and missile tests as it sent ships around Taiwan. A total of nearly two dozen aircraft were also flown into Taiwan’s air defense identification zone. This may be the most provocative military move in almost 20 years. Beijing also announced trade restrictions to Taipei. Contemporary Amperex Technology is a Chinese-based manufacturer and exporter of electric vehicles. It has stopped plans for new facilities in North America. Beijing’s response has been viewed as mild by the market. It is not clear how this will unfold in Chinese domestic politics.

According to reports, four US warships and one aircraft carrier were sent into the region by the US. Pelosi stated in a Washington Post editorial that her visit was a sign that Washington supports the island’s self-governing democracy and that it has a sacred promise to support its defense against growing threats from Beijing. The underlying question isn’t about her intention, but the timing. The Commander-in-Chief did not seem to coordinate the visit. It does not seem to be part of an American strategy. This signal has been repeated numerous times via different channels. It is unlikely that Beijing will be willing to cooperate in any cooperative ventures, so the benefits of repeating this signal can be negligible. China seems to be a free-rider, and the US seems like it has reduced its price. Ironically and critically, both the US and China share some justice. However, both countries claim that Taiwan is being unilaterally altered by the US.

China’s Caixin Service PMI performed better than expected. Markets expected some weakness after the official version. From 54.5, it rose to 55.5. However, it was not enough for the manufacturing sector to have an impact. From 55.3, the composite reading was 54.0. The composite and final services PMI in Australia helped to reduce the preliminary report’s weaknesses. The services PMI fell to 51.1 (flash) from 52.6. It was not 50.4 (flash). The composite now stands at 50.9, not 50.6, after June’s 52.6. Australia saw an additional 1.4% rise in Q2 retail sales. This was slightly more than was expected but it was offset by Q1’s downward revision to 1.0%, from 1.2%. Tomorrow, Australia reports June trade figures. Flat exports will likely cause a slight decrease in the trade surplus. Contrary to Australia’s initial estimate of 51.2, Japan’s composite PMI was lower than the final index. The services PMI fell to 50. Composite was close to 50 boom/bust with 50.2 flash (50.6 flash), and 53.0 previously.

Yesterday’s 17-bp rise in the US 10-year yield lifted dollars from JPY130.40, which was its lowest level for nearly two months. Just before the North American close, the dollar surged to JPY133.20 and is currently at JPY133.90. This almost reversed half of the slide in the dollar since its July 27 high (JPY136.45). JPY134.75 will be the next target for retracement (61.8%). Yesterday’s decline in the Australian dollar was nearly 1.5%. This is its largest drop in three weeks. The Aussie hit its highest point at $0.7045 on Monday. Yesterday it dropped to $0.6915. The Aussie reached $0.6885 today after a follow-through sale. It then rebounded to $0.6940. Technically, an increase of $0.6950-60 could improve the mood. There is a risk that the buying mood in Europe will wane and the price could rise to $0.6950-60. The Chinese yuan recovered yesterday and is little changed today in a narrow range (~CNY6.7450-CNY6.7600). The PBOC set the dollar’s reference rates at CNY6.7813 vs. CNY6.7806 median expectation (Bloomberg survey).

Europe

Many market participants believed that the ECB data confirmed their suspicions. Officials are already making use of the flexibility that was agreed at the end last year to recycle proceeds from maturing bonds under the Pandemic Emergency Purchase Program. The ECB reports the data in two-month intervals. Between June and July, the Eurosystem’s holdings of Greek, Spanish and Portuguese bonds increased 17.3 billion euros. French, Dutch, French and German holdings declined by 18.9 billion Euros. As an emergency tool, the Transmission Protection Instrument is available.

France and Germany’s composite PMIs were higher than the preliminary reports. Spain’s composite reading wasn’t as low, but Italy’s was disappointing. Italy’s composite reading is also below 50, just like Germany. Germany’s composite was updated to 48.1 from 48.0. Italy’s composite was 47.7 (median prediction Bloomberg survey was for 49.7). France’s PMI service has been revised to 53.2 from 52.1 in order to decrease the drop of 53.9 from June. Now the composite is 51.7 rather than 50.6 as per the flash estimate or 52.5 in June. The aggregate composite now stands at 49.9, which is slightly less than the initial 49.4 estimate. Flash estimates of 53.3 and 52.8, respectively, showed that the final services and composite PMIs for the UK have been revised to 52.6 & 52.1. Also, the German trade balance has increased to 6.4 Billion Euros from a revised 1 Bln Euro deficit in May. Imports rose 0.2% while exports rose 4.5%. Italy’s retail sales declined 1.1% in June, while imports increased 0.2%. The unexpected drop in Germany’s retail sales of 1.6% was reported earlier this week (the median forecast of Bloomberg’s survey was for an uptick of 0.3%).

Yesterday’s euro’s main downside reversal was observed (traded at both ends of Monday’s range and settled below Monday’s low). Today’s follow-through selling was restricted to the $1.0150 area, where options for nearly 700 million euros expire. The session high is just above $1.02, where another set of expiring options (1.14 billion euro) has been reached. Today saw some follow-through selling of Sterling, but only in the $1.2135 area. A break in the $1.2120 area could cause further losses. The BOE meeting tomorrow could limit sterling sales. There is a 80% chance that the swaps markets will experience a 50-bp discount.

 


America

JOLTS’ June report confirmed that there is mounting evidence that the labor force is slowing down. We have tracked the four-week moving average of jobless claims. It is slightly lower that 250k. The unemployment claims peaked at 170k in the latter part of March and early April. Raw numbers indicate that unemployment claims peaked at 170k in the late March/early April, when the Fed began its tightening cycle. However, they were at 256k in the week ending July 23. The June drop of job openings was 605k. This is the highest level since Covid’s era. This is the third consecutive month with a decrease in job openings. The cumulative drop has been close to 10.7 millions. Nearly 10.7 million is the nine-month low. As the Fed’s Waller/Figura revealed, the nearly 10% decline in job opportunities has not reduced unemployment. Let’s see what happens with another 10%. Despite this, both the JOLTS data and the rise in weekly job claims during surveyweek point to downside risks to Friday’s 250k median July jobs report (Bloomberg Survey).

Market reaction to tightening financial conditions by the Federal Reserve has been recent. Last month’s 9.1% gain by the S&P 500 was its highest since November 2020. The yield on 10-year notes plunged 36bp in July while that of the two-year notes dropped nearly twice as fast despite the Fed’s second consecutive 75bp rate increase. However, the Federal Reserve is moving in a positive direction as the dollar has appreciated by 2.2% since March 2020. The Goldman Sachs Financial Conditions Index dropped 0.47 percent last month. It has alternated between tightening and loosening financial condition monthly for the past six months.

It is understandable that the Fed doesn’t want to see financial conditions get too tight. But the market knows that this isn’t the end. Futures on Fed funds project 100 bp more increases this year. This would raise the target to between 3.25 and 3.50%. According to the Fed’s Summary Economic Projections, the June median dot was 3.38%. This divergence will be a story for 2023. The median dot is 3.75%. The implied yield for December Fed Funds futures briefly exceeded 3.75% in the middle of July. It traded at 2.65% last week. It rose to 2.92% yesterday after Bullard, Kashkari, and Evans informed the market. Although they don’t have votes, the two former are cited because of their consistency in the message. Although the implied yield for December 2023 Fed funds contract is more than 40 bp higher than that of December 2022, it is still over 40 bps lower. More of the same is happening for Fed officials today, with Barkin joining Bullard, Daly, and Kashkari. This data includes the final PMI, ISM services, factory orders, and the final durable goods report.

The Canadian dollar was slightly higher than the US dollar on Monday as it fell to CAD1.2765. Yesterday’s close saw it back at CAD1.29. It edged up today, but it was still below CAD1.29 and has been offered CAD1.2850 to be tested. Support can be found in the CAD1.2815-30 area. Yesterday’s 2.2% increase against the Mexican peso marked its highest gain since mid-June. Today, it gained momentum and was able climb slightly higher (MXN20.8335), but sellers came in to drag it below MXN20.64 this morning in Europe. Support is being shown by the MXN20.55-20.59 band.