Market Takes China’s Response in Stride, Risk Appetites Recover

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Overview: The market is judging China's response to Speaker Pelosi's visit in a mild way and risk appetites returned. Equity markets are higher, even though Chinese shares weakened. Europe's Stoxx 600 is edging higher after two days of small loses, and US futures enjoy a firmer bias. The surge in US rates yesterday has calmed. The US 10-year yield is firm near 2.76% and the 2-year yield is up a couple of basis points near 3.07%. European yields are 4-5 bp higher and the peripheral premium has narrowed a little. The dollar, which was buoyed by the jump in rates yesterday, is mostly softer today. The Scandis lead the move, while the Swiss franc and New Zealand dollar are softer. Swiss CPI was in line with expectations, with the EU-harmonized measure, rising to 3.3% from 3.2%, easing fears of an intermeeting move by the SNB. Among emerging market currencies, Asian currencies underperformed, along side the Turkish lira, sandbagged by another rise in CPI (79.6%). Gold reversed lower yesterday from $1788 and found support today near $1755. September WTI is consolidating $93-$95 a barrel, inside yesterday’s range, which was inside Monday’s. OPEC+ announcement is awaited on September quotas. US natgas collapsed 7% yesterday but is around 1% higher today. Europe’s benchmark natgas is around 1.25% higher after rising about 4.5% over the last two sessions. Iron ore is off 3.8%, roughly matching the decline of the past three sessions. Copper snapped a six-day rally on Monday. It edged lower yesterday and is trading slightly heavier today. September wheat is trying to snap a three-day, nearly 5.5% drop. It is trading about 1.7% better today. 

Asia Pacific

China escalated its protest of the third highest US government official's visit to Taiwan. It the most senior visit since Gingrich 25 years ago. Beijing announced live-munition drills and missile tests as it sent ships surrounding Taiwan. It also sent nearly two dozen aircraft into Taiwan's air defense identification zone. It is thought to be the most provocative military activity in as much as 20 years. Beijing has also announced some trade restrictions with Taipei. A Chinese-based electric vehicle battery manufacturer, Contemporary Amperex Technology has halted plans to build plants in North America. Nevertheless, on balance, so far, the market is judging Beijing's response as mild. How it plays out in Chinese domestic politics is not clear. 

Reports suggest that the US has sent four warships into the area, including an aircraft carrier. Speaker Pelosi defended her visit in a Washington Post op-ed piece claiming that her trip was a "signal to the world that Washington stands with the self-governed island’s “vibrant, robust” democracy and has a “sacred vow” to support its defense amid growing threats from Beijing. The underlying question is not about her intention but the timing. It seemed not to have been coordinated with the Commander in Chief. Nor does the visit now seem part of the broader American strategy. Moreover, the signal has been sent numerous times and various channels. That is to say, the benefits are repeating the signal seems minor compared with the costs, which will likely include any hope that Beijing participates in cooperative ventures, including a cap on Russian oil prices. The US appears to have lowered the price of China being a free rider. Ironically, and importantly, both the US and China share one thing and with some justice, both claim the other is trying to change the relationship with Taiwan unilaterally.

Meanwhile, China's Caixin services PMI held fared better than expected.

The market had expected some weakness after the "official" version. Instead, it rose to 55.5 from 54.5. However, it was not sufficient to overcome the drag from the manufacturing sector, and the composite reading eased to 54.0 from 55.3. Australia's final services and composite PMI trimmed the weakness in the preliminary report. The services PMI fell to 51.1 not 50.4 (flash) from 52.6. The composite stands at 50.9, not 50.6, after 52.6 in June. Separately, Australia also reported a 1.4% rise in Q2 retail sales. This was a little better than expected, but it was blunted by the downward revision in Q1 to 1.0% from 1.2%. Tomorrow, Australia reports June trade figures. Flattish exports are expected to see the trade surplus narrow a little. In contrast to Australia, Japan's final services and composite PMI worsened from the preliminary reading. The services PMI fell to 50.3 from the 51.2 initial estimate from 54.0 in June. The composite drew close to the 50 boom/bust level at 50.2 from 50.6 flash and 53.0 previously.

The 17 bp jump in the US 10-year yield yesterday helped lift the dollar from nearly two-month lows near JPY130.40. It jumped back to almost JPY133.20 before the North American close and has edged higher today, reaching JPY133.90. That nearly retraced half of the dollar's slide from the July 27 high (~JPY136.45). The next retracement objective (61.8%) is closer to JPY134.75. The Australian dollar fell almost 1.5% yesterday, its biggest decline in nearly three weeks. The Aussie peaked on Monday around $0.7045 and fell slightly through $0.6915 yesterday. Follow-through selling today saw it approach $0.6885, before bouncing back to $0.6940. A move above $0.6950-60 would lift the technical tone. However, the buying enthusiasm has waned in Europe, and the risk is a return to the lows and possibly a test of the $0.6865 area. 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 rate at CNY6.7813 vs. median expectations (Bloomberg's survey) for CNY6.7806.

Europe

Data from the ECB confirms what many in the market suspected. Officials are already drawing on the flexibility negotiated at the end of last year for recycling the proceeds of maturing bonds bought under the Pandemic Emergency Purchase Program. The ECB reports the data in two-month intervals. In June/July, the Eurosystem's holdings of Italian, Spanish, Portuguese, and Greek bonds increased by 17.3 bln euros. The holdings of German, French, and Dutch fell by 18.9 bln euros. The Transmission Protection Instrument is an emergency tool.

Germany and France's final July service and composite PMIs were higher than the preliminary reports. Spain's reading was not as weak as expected, but Italy's disappointed. Italy's composite, like Germany's, is below the 50. Germany's was revised to 48.1 from 48.0, while Italy's came in at 47.7 (median forecast Bloomberg's survey was for 49.7). France's service PMI was revised to 53.2 from 52.1, to pare the decline from 53.9 in June. The composite is at 51.7 rather than 50.6 of the flash estimate and 52.5 in June. The aggregate composite is at 49.9, down from 52.0 in June but slightly better than the 49.4 initial estimate. The UK's final services and composite PMI were revised down to 52.6 and 52.1 from the flash estimates of 53.3 and 52.8, respectively. Lastly, we note that the German trade balance jumped to 6.4 bln euros from a revised 900 mln euros in May, which was initially reported as a 1 bln euro deficit. Exports rose 4.5% while imports crept up by 0.2%. And Italy's retail sales dropped 1.1% in June, while earlier this week, Germany reported an unexpected 1.6% plunge (the median forecast in Bloomberg's survey was for a 0.3% increase).

The euro posted key downside reversal yesterday (traded on both sides of Monday's range and settled below Monday's low). However, follow-through selling today has been limited to the $1.0150 area were options for nearly 700 mln euros expire today. The session high is just shy of $1.02, where another set of expiring options (for 1.14 bln euros) have been struck. Sterling also saw some follow-through selling today, but it was limited to the $1.2135 area. A break of the $1.2120 area could spur further losses. However, ahead of tomorrow's BOE meeting where the swaps market has about an 80% chance of a 50 bp hike discounted, sterling sales may be limited.

America

The June JOLTS report added to the accumulating evidence that the labor market has lost momentum. We have been tracking the four-week moving average of jobless claims. It stands slightly below 250k. Jobless claims bottomed in late March/early April near 170k. In raw terms, jobless claims bottomed around 166k in mid-March, the week that the Fed began its tightening cycle, and were at 256k in the week ending July 23. Job openings collapsed by 605k in June, the most on record outside of when Covid first struck. It is the third consecutive monthly decline for a cumulative drop of 1.16 mln, and near 10.7 mln are at a nine-month low. In the Summers/Blanchard debate with the Fed's Waller/Figura, the nearly 10% drop in job openings has not boosted unemployment. Let's see what happens with the next 10%. That said, the JOLTS data and the rise in weekly jobs claims during the survey week warn of downside risks to the 250k median forecast (Bloomberg survey) for the July jobs report out Friday. 

The Federal Reserve is tightening financial conditions and the market pushed back recently. The S&P 500 rallied 9.1% last month, the most since November since 2020. The 10-year note yield tumbled 36 bp in July and the two-year yield fell by nearly twice as much, even though the Fed delivered its second consecutive 75 bp rate increase. On a broad trade-weighted basis, the dollar appreciated by the most since March 2020 (2.2%), on the other hand, moving the desired direction by the Federal Reserve. The Goldman Sachs Financial Conditions Index eased by 0.47% last month. It has been alternating between tightening and loosening of financial conditions on a monthly basis for the past six months. 

It is understandable, and should be expected, that the Fed pushes against pre-mature easing of financial conditions. The market clear recognizes that the Fed is not done. The Fed funds futures are pricing in another 100 bp in hikes this year. That would raise the target to 3.25%-3.50%. The median June dot (Fed's Summary of Economic Projections) was at 3.38%. The divergence is a 2023 story. The median dot is 3.75%. The implied yield on the December Fed funds futures briefly approach 3.75% in the middle of July. It traded near 2.65% last week. It rose to 2.92% yesterday as the market heard the pushback from the Fed's Kashkari, Evans, Daly, Mester, and Bullard. The former two do not have the vote but cited to illustrate the uniformity of the message. Still, the implied yield of the December 2023 Fed funds contract is more than 40 bp below the implied yield of the December 2022 contract. More of the same in terms of Fed officials today, with Barkin and Harker joining Bullard, Daly, and Kashkari. Data includes the final PMI, ISM services, and factory orders with the final durable goods report.

The US dollar bottomed on Monday against the Canadian dollar slightly ahead of CAD1.2765 and by the end of the yesterday it had recovered to almost CAD1.29. It edged a bit higher earlier today but remained below CAD1.29 but has come back offered to test CAD1.2850. Support is seen in the CAD1.2815-30 area. The greenback jumped 2.2% against the Mexican peso yesterday, its biggest advance since mid-June. The momentum carried it a little higher today (~MXN20.8335) before sellers emerged to knock it back below MXN20.64 in the European morning. Support is seen in the MXN20.55-59 band.

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