Italian Politics Complicate the ECB’s Task

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Marc Chandler
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Overview: The appetite for risk seen earlier this week is fading. Yesterday’s US equity gains helped lift most of the large markets in the Asia Pacific region, but China’s CSI 300 fell 1.1%, giving back most of this week’s gains as credit issues from the property sector haunt sentiment. Europe’s Stoxx 600 is trading heavily ahead of the ECB meeting outcome. US futures are also trading off. Benchmark 10-year yields are firmer with the US Treasury near 3.05%. European yields are mostly 3-6 bp higher, but Draghi’s second resignation is weighing on Italian bonds, where the 10-year has jumped 15 bp. The US dollar is trading higher against most currencies. The New Zealand dollar (~-0.8%) and the yen (~-0.45%) are the weakest. The Swiss franc and euro are fractionally lower. Emerging market currencies are mostly lower, lead by the Russian rouble (~-2.5%) and the Hungarian forint (-0.9%). The Turkish lira is off by around 0.4% ahead of its central bank decision (expect one-week repo to be unchanged at 14%). Gold is making a convincing push below $1700, which it frayed in recent days before closing below it yesterday. Today, it has approached $1682. Last year’s low was near $1676. September WTI has been turned back near its 20-day moving average (~$100) and fell to around $95.50. A break of $94.60 could see a return to this week’s low around $92.90. US natgas rallied 10.2% yesterday amid the heatwave but is off 3.3% today. The Nord Stream 1 pipeline restarted today at 40% capacity and Europe’s natgas benchmark fell 4.4%. Iron ore fell by 1% after rising 2.9% yesterday. September copper has given back yesterday's 1% gain and is off nearly 1.9% today. Lastly, September wheat is trading quietly in yesterday’s range.

Asia Pacific

Japan reported another large trade deficit while the Bank of Japan announced no change it its monetary policy. The trade deficit of JPY1.38 trillion was a little smaller than expected, as exports rose more than anticipated and imports a touch less. Exports rose 19.4% year-over-year. The median forecast in Bloomberg's survey was for a 17.0% gain after a 15.8% increase in May. Imports are up 46.1% year-over-year. The median forecast was for a 46.3% rise after almost 49% previously. Oil, coal, and liquid natural gas led imports. Exports were paced by mineral fuels, steel, and semiconductor parts. On a value basis, exports rose 4% month-over-month. Still, the deterioration of Japan's trade balance may not be fully appreciated. Consider that last year, Japan recorded a JPY1.67 trillion trade deficit. The combined trade deficit for May and June this year is JPY3.77 trillion.

The Bank of Japan kept its monetary policy stance. The first thing tomorrow, Japan will report June CPI. Excluding fresh food and energy, the year-over-year rate is expected to remain below 1%. As had been tipped, the BOJ raised its inflation forecast while shaving its growth projections. This year's CPI forecast was raised to 2.3% from 1.9%. Next year's projection was lifted to 1.4% from 1.1% and in FY24 1.3% from 1.1%. This year's growth forecast was trimmed to 2.4% from 2.9%, which is still impressive on a per capita basis, given the shrinking population. Growth next fiscal year edged higher to 2.0% from 1.9% and FY24 to 1.3% from 1.1%. It seems to be recognized that monetary policy is unlikely to change until Governor Kuroda's term ends next April. However, given the subdued price pressures, it is not clear that the next governor will be in hurry to change policy. There can be tweaks, like targeting a short-term interest rate than the 10-year, as the IMF has previously suggested, but easy monetary policy may not be simply a function of Kuroda's personality as some imply.

The US dollar rose to a four-day high against the Japanese yen near JPY138.90. For the fifth consecutive session, it has remained within the range set last Thursday (~JPY137.25-JPY139.40). Ahead of next week's FOMC meeting, the greenback looks poised to challenge the upper end of that range and perhaps pushed closer to JPY140. Japanese officials have expressed concern about the pace of the move rather than the level. With divergent monetary policy and the Federal Reserve's recognition that a strong dollar is part of its effort to contain domestic inflation, material intervention still is unlikely. The Australian dollar's three-day bonce ended yesterday, and it is under pressure today. After bouncing about 2.5 cents, the Aussie faltered yesterday near $0.6930 and is near $0.6865 now. A break of the $0.6835 area likely signals a deeper correction toward possibly $0.6775, initially. Credit issues in the property market is weighing on sentiment toward China. The greenback is near its best level in five sessions, just shy of CNY6.77. A return the CNY6.80 area in the coming days seems likely. That area was probed in mid-May, the held on a closing basis. The PBOC set the dollar's reference rate at CNY6.7620, slightly higher than the CNY6.7615 median projection in Bloomberg's survey. Note that the Asian Development Bank cut its forecast for Chinese growth to 4% from 5%, but mostly pushed the activity into next year. The forecast is still optimistic compared with many private sector forecasts.

Europe

The ECB meeting is center stage. The swaps market recognizes a 50 bp hike is a real possibility today as the central bank launches its first tightening cycle since 2011. The swaps market has roughly a 40% chance of a 50 bp hike instead of 25 bp. This might understate the case a little as the market has 144 bp of tightening priced in over the next three meetings starting today. In addition to the rate hike, the market anxiously awaits details about the new Transmission Protection Mechanism.

What has changed between now the Open Market Transactions (OMT) developed during the Great Financial Crisis is that the ECB now sees an unreasonable divergence of rates as an impediment of its monetary policy. The OMT needed to be triggered by the country under pressure, but the conditions were too severe, and it was never triggered. While much discussion of the interest rate spread focused on the 10-year, the transmission of monetary policy would seem to have more to do about the short-end the curve. Since the end of June, the Italian two-year premium has nearly tripled to 130 bp today. While some of the increase may have to do with the general rise in rates and belief that debtors like Italy do worse in a period of slow growth and high rates. It may be linked to the political uncertainty and the high costs if snap elections were necessary. President Lagarde may also say something about the favorable terms of the Targeted Long Term Refinancing Operations, the three-year loans from the ECB that was a separate channel from QE that expanded the central bank's balance sheet.

The last elimination round cut Mordaunt in the race to become the next Tory leader. That means that Sunak faces Truss as it goes to the rank-and-file members. Truss is seen as the favorite even though Sunak did better among MPs, Truss is seen more popular among the party members. It looks to be a bitter, vicious campaign as Sunak and Truss battle it out. Italian politics are a bit less clear-cut. Draghi called a vote of confidence without changing the coalition and seemed to undermine efforts that would have struck a compromise and allowed a cabinet reshuffle. The 10-year Italian government bond yield reversed an earlier decline of 16 bp to up six basis points. It is up another 17 bp today. Draghi survived the confidence vote, like he did last week, except the three big parties boycotted the vote. That indicated he has lost support of the majority of the Senate, but it is still a macabre political dance. Draghi submited his resignation again. President Mattarella will likely ask Draghi to see if he can form a new coalition government. There is still strong pressure to avoid an early election until three objectives are accomplished: electoral reform, next year's budget, and the reform needed to secure EU funds. 

The three-cent short-covering rally in the euro stalled in front of the 20-day moving average (~$1.0275) and (50%) retracement objective of the leg lower that began in late June. The risk is that the ECB disappoints or "buy rumor sell fact" type of activity. The depth of this anticipated decline will shed light on the medium-term outlook. If the $1.0070-$1.0100 does not hold, the risks favor a retest on the $0.9950 low recorded on July 14. Sterling was also turned back from its 20-day moving average yesterday (and Tuesday). It is trading at a three-day near $1.1920. A break of $1.1870-$1.1900 warns of a possible test on the low seen near mid-month around $1.1760.

America

While the US housing data this week has disappointed, the resilience of the US economy likely will be seen in today's July Philadelphia Fed survey. Recall that the Empire State survey out last week rose to 11.2 from -1.2. Economists had looked for a decline. The Philadelphia survey is expected to rise to 0.8 from -3.3. It would the first increase since March. On Friday, the flash PMI is due and the composite is expected to be little changed from 52.3 in June.

When it comes to inflation, Fed Chair Powell says there is one number that best captures it (leave aside the fact that he led a rate hike based on the less-than-best measure, CPI). However, Powell argues the labor market is sufficiently complex that there is no single number that reflects its multi-dimensions. The unemployment is still in its trough, but jobless claims are rising. The four-week moving average is at almost 236k. It bottomed three-and-a-half months ago slightly above 170k. At the end of 2019, the four-week moving average was at 238. However, continuing claims have barely increased. They stood at 1.33 mln as of July 1. They bottomed at 1.306 mln in late May. This would seem to suggest that people are not staying on unemployment benefits long. Yes, the labor market is slowing, but no, not to the point that it would persuade officials it has broken.

Canada's June CPI accelerated by less than expected and the market responded by slightly downgrading the chances of a 75 bp hike when Bank of Canada meets again on September 7. The swaps market has gone from pricing in a 75 bp hike almost fully to about 80% chance. The decline in equities also did the Canadian dollar few favors, snapping a three-day advance. The 30-day rolling correlation of the changes in the Canadian dollar and the S&P 500 (proxy for risk) is slightly less than 0.70 and the 60-day rolling correlation is slightly above 0.70. Canada reports May retail sales before the weekend and a strong gain is expected. Mexico reports May retail sales today. After rising by 0.4% in March and April, retail sales are expected (median Bloomberg survey) to rise by 0.5%. The average in the first four months of year has been 0.6%, half of the pace seen in the January-April period last year. On Friday, Mexico reports the first half of July CPI, which is expected to drift higher. 

After falling from last week's high near CAD1.3225, the greenback found support in the CAD1.2855-CAD1.2870 area. The broader US dollar gains, and the mild risk-off mood are weighing on the Canadian dollar today. The US dollar reached CAD1.2925 in the European morning, stretching the intrasession momentum indicators. A move above CAD1.2950 re-targets the CAD1.30 area. The Mexican peso is on the defensive. The dollar is holding above MXN20.50 and in a narrow range below MXN20.60. Recall, the greenback peaked last week near MXN21.05. The MXN20.60 area is the (38.2%) retracement target. The next one (50%) is near MXN20.6560.