FX DAILY: Heading for a summer storm in peripheral debt markets

16th May 2014

  • ONS data showed around half of all the wealth in the UK is owned by just 10% of the population. (The Times)
  • Fed’s Yellen praised small business owners for their role in hiring since 2010, and said Fed members “are keenly aware of your vital role, and we pledge to continue to do our part in promoting the recovery so that you can continue to help America grow and prosper.” (MNI Market News)
  • The Japanese will discuss reinterpreting the constitution to enable its defence forces to assist allies under attack, Prime Minister Shinzo Abe said yesterday, bringing the country a step closer to playing a more active military role overseas. (Nikkei)
  • Yao Yudong, deputy head of monetary policy at the PBoC hit back at comments that China is on the brink of a Minsky Moment. Minsky Moments happen when corporate debt hits 250% of GDP, while China’s is only at 140%.
  • Chinese regulators are working on a license system for banks to issue Wealth Management Products which may leave some weaker lenders unable to sell the popular products. This is another crack down by regulators on the industry who are scrambling to mitigate systemic risk in the Chinese financial system. (Financial News)
  • China’s Direct Foreign Investment (YoY) rose 3.4% in April, beating expectations of 1.0% and a previous decline of -1.5%.
  • Japan March Final Industrial Production was upgraded to 0.7% from 0.3%, following a February decline of -2.3%.
  • European New Car Registration rose 4.6% in April, following a 10.6% gain in March.

Yesterday was a worrying day for risk and confirmed previous optimism for growth – a new high on the S&P 500 and Dow Jones Industrial Average in the space of a week- as nothing more than a short-term bounce not a long-term reversal. Trade took its cue from the scramble in debt markets with traders continuing to be hypnotised by the US 10 year. The yield dropped below the psychologically important 2.5% level to touch 2.47%, a seven month low. The fact the yield failed to reverse its losses later in the session and closed below the 2.5% level was an added concern for equity traders. While the market was looking West to the US Treasury market, dissecting the data and equity price action, a rout was happening in Eurozone periphery bonds. Clearstream newswire reported that Greek tax authorities were threatening to retroactively introduce a capital gains tax on foreign holders of corporate and government bond holdings. Greece thought they could harness investor demand for their assets to help fix their financing problems. They were wrong. Capital inflow is fickle at the best of times, as Greece should have learned by now, let alone if you threaten them with retroactive taxes. The Greek 10 year yield jumped 55basis points. The effects spilled over to the rest of the peripheral market. Italian and Spanish 10 years were both up 20 basis points. If you were complacent enough to think the days of bond market contagion were over, you were wrong. Eurozone is full of systemic risk. Big accounts were pulling funds out of the periphery and into US Treasury market for safety. The sell-off in markets eventually forced Greek authorities to come out and deny the report.

The bond market scramble yesterday is an alarming preview of potential upcoming risks. For anyone who thought recent demand of peripheral debt was based on fundamentals, they were wrong. An all time low in Italian 10 yield is out of sync with an economy that contracted -0.1% last quarter and whose debt burden is still rising. The peripheral bond market rally is nothing more than a speculative bet on ECB QE, driven by nothing more than flighty capital. Draghi has talked a good game in trying to convince markets of imminent action. Euro-dollar as low as $1.3650 after reaching $1.3993 just over a week ago is a testament to his success in convincing markets asset purchases are just around the corner. The ECB isn’t mechanically set up for QE. The central bank has little appetite to do the measure as it is still convinced there is no deflation problem in the eurozone. What is more, the measure may actually support the euro not weaken it, due to bond market capital inflow. We may be heading into a summer bond market storm as the situation in peripheral debt markets is unsustainable if Draghi fails to announce QE. Yesterday’s bond market action shows how fragile peripheral debt markets are. We could be on course for eurozone debt crisis, the sequel.

Yesterday finally brought a relatively clear read on the US’s economic momentum post the winter freeze. Industrial production contracted -0.6% in April, albeit from March’s reading revised 0.2% higher. Expectations for an economic rebound into the second quarter were sorely disappointed, as these reads put the US firmly in the confines of a “moderate” recovery, not the economic momentum needed for earlier rate hikes. This will keep the US dollar soft in the near term. The US Census Bureau reports housing start and building permit today, following a string of lousy data for the sector. The Fed Chairman recently singled out this sector as underperforming in her recent testimony, as unusual move for a Fed Chairman. There has even been talk of loosening credit terms for mortgage lending in the US- is this sub-prime crisis part 2?. Housing data should be followed closely as its now part of the Fed’s dash border of indicators for when rates should rise.