Euro Rebounds on Greek ‘Plan B’

Positive sentiment emerged in US trading on hopes that Greece will pass an austerity budget and news that Europe is working on Plan B if the vote fails. The euro was the top performer while AUD and NZD lagged on the day. Japanese retail sales are the highlight of Asia-Pacific trading.

EUR fell in early trading and overall sentiment was negative after Moody’s warned that deposits are rapidly being pulled from Greek banks but the trade reversed on talk that Europe may incentivize its banks to rollover Greek debt with a Brady bond-like structure. Greek PM Papandreou also predicted HE WILL HAVE ENOUGH VOTES to pass the austerity budget required for bailout funds. A vote is likely on Tuesday. The ECB’s Stark said the central bank is “very vigilant.” A JULY HIKE IS ALREADY PRICED IN but this helped traders feel a bit more confident about it.

US personal spending was flat compared to the +0.1% expected. Core PCE rose 1.2% y/y compared to the 1.1% expected. Although this is well below the Fed’s threshold, it is moving in higher and we believe it must fall below 1.0% before the Fed considers QE3.

Treasuries fell badly pushing yields higher by 5-9 bps across the curve. The selloff accelerated after a soft 2-year auction. The rising yields underpinned USD against JPY and CHF. Auctions continue on Tues (5yr) and Wed (7yr). The S&P 500 climbed 0.9% to 1280. Gold fell $5 and closed below $1500 for the first time since mid-May.

Comments from the Fed’s Kocherlakota (voter) did not relate to current policy, instead he called on the gov’t to lower the tax deduction on mortgage interest – something that has zero chance of happening in the next five years.

Japanese Retail Sales

Japanese retail sales are expected to be down 2.2% y/y in May compared with a 4.8% drop in April. PM Kan appears to be closer to resigning at the end of the current Diet session in mid-August. Nikkei News reports he has offered to quit once bills are passed authorizing a supplementary budget and deficit financing.

 

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Bernanke Frustrated With Recovery, No Hints of Action

The US dollar fell and stocks declined for the fifth consecutive day after Fed Chairman Bernanke lamented the recovery and retained a dovish tone. The euro was strong on speculation Trichet will stress inflation risks on Thursday. We look at the warning signals in the bond market and the chance of a double dip.

Sentiment about the US economy continues to deteriorate and it is dragging down the dollar and stocks. The S&P 500 was higher with 1.5 hours remaining in the session but fell and then fell further after Bernanke delivered his remarks. Dollar bulls were hoping the Fed Chair to would dismiss economic weakness as transitory or that inflation was accelerating but Bernanke was cautious and said US growth so far this year is “somewhat slower than expected” and that inflation was a concern but doesn’t see much evidence it is becoming broad-based. Stock market participants were hoping Bernanke would leave the dollar open for QE3 but he gave no hints at further stimulus.

In a separate speech, Atlanta Fed President Lockhart (voter) said there is a high bar for QE3 even though he is “troubled” by the slowing recovery. In order for the Fed to buy more bonds (beyond re-investments) he said there will need to be a dramatic GDP reversal, more unemployment or the risk of deflation.

EUR/USD rose to the highest since May 5 as it pushes up against 1.47. Strong EZ economic data and speculation Trichet will signal rate hikes on Thursday were behind the move higher. The pound also had a strong day while AUD lagged on the dovish RBA.

The bond market continues to flash concerning signals. A three-year auction was very strong and 10-year yields fell back below 3% despite supply later this week. Two year yields fell to just 0.41%. The bond market is flashing signs of more than just a dovish Fed; there is a demand for safety. Indications are also that Treasury dealers are positioned for bond yields to rise. This trade has gone badly against them, which tells us: 1) They will have to unwind the trade 2) Something they didn’t anticipate is happening in the economy (Weakness? Disinflation?)

This is one of the five or so times that the US has looked like it could tip back into recession since the crisis ended. It has proven resilient but this time neither the Fed, nor the Federal government is in a position to provide support. Remember that the bond market moved far before the crisis and that the USD weakened for some time before it became clear that the problems far exceeded US borders.

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Foreign exchange analysis from Adam Button