Animal Spirits: Subdued, But Still Out There

Between the Queen's birthday in Australia, Whit Monday in parts of Europe, and the lack of fresh trading incentives, the US dollar is caught in narrow ranges and is little changed on the day as North American traders take to their posts. If there is a theme in the global capital markets, it is the outperformance of more volatile assets, which in the fixed income space, translates to demand for higher yield.

The MSCI Emerging Market equity index is up about 0.25% today. Here, Indonesia is a clear under-performer as the Jakarta Composite is off 1%, weighed down by oil and gas and basic materials. Recall that its ban on mineral exports has boosted some metals like nickel and bauxite. European shares are building on last week's gains, up another 0.2% today.

Peripheral bond yields in Europe continue to fall. Italian and Spanish 10-year benchmark yields are off 3-4 bp to new recovery lows and the premium over Bunds continues to narrow. Bunds are flat on the day. Portugal's 10-year yield is off 7 bp and Greek yields are off slightly. Over the past week, the Italian, Spanish, and Portuguese 10-year yields are off 22-25 bp, while Greece's 10-year yield is off twice as much.

In the currency market, the higher yielding and more volatile Australian and New Zealand dollars are easily the strongest major currencies, rising 0.3% and 0.2% respectively against the greenback. The RBNZ is widely expected to raise the cash rate 25 bp tomorrow. There is a greater risk of a dovish surprise; that is for the RBNZ to stand pat, then there is for it to hike by a larger amount.

The Swedish krona is the weakest of the major currencies, off about 0.4% against the dollar and 0.35% against the euro. Yet it is important to note that it is within the pre-weekend trading range. While Sweden's 10-year bond is underperforming (+2 bp), the equity market is among the strongest, rising nearly 1% today.

The focus appears to be on the inflation report later in the week (June 12), which is expected to show a return to deflationary conditions (consensus for May CPI -0.2% year-over-year) and spur the Riksbank to cut rates at its next meeting in July. Separately, we note that the latest polls suggest the center-left opposition is still ahead of the governing coalition. The national election is 3 months away (Sept 14).

The euro itself was confined to extremely narrow ranges (10 pips) for most of the Asian session. It was bid to almost $1.3670 in early Europe and then sold off on the back of the softer than expected Sentix survey. It fell to 8.5 from 12.8, which is the lowest of the year. The consensus was for an uptick to 13.3. Initial support is seen just above $1.3600.

Sterling's price action is broadly similar, but without the impact of the deterioration in sentiment, it is faring better than the euro. The downticks in early Europe left it just above $1.6800, with support noted in the $1.6785 area. This is an important data week for the UK, with industrial output, employment, and the Mansion House Address to be released.

Japan reported a smaller current account surplus and stronger Q1 GDP than expected, but the yen remains uninspired. The dollar has been confined to about a quarter of a yen range thus far today. The April current account surplus, the third consecutive surplus, stood at JPY187.4 bln of about JPY100 bln less than expected. The trade surplus deteriorated by JPY223 bln from March, to JPY1.40 trillion. However, the surplus on the investment income rose to JPY1.833 trillion from JPY1.735 trillion. More recent data warns of further trade deterioration in May, which will likely result in a return to current account deficits. The trade balance for the first 20 days in May shows a continued increase in imports and a fall in exports.

Separately, Japan revised Q1 GDP to show a 1.6% quarter-over-quarter increase, up from 1.5% and contrasting with expectations of a 1.4% rate. Disappointingly, the deflator slipped to 0.1% from flat, suggesting that deflation continues to lurk below the surface. The key to the upward revision in growth came from the revision in capex to 7.6% from 4.9%. Domestic demand rose to 2.2% from 2.1% in the initial report.

Despite the depreciation of the yen, net exports shaved 0.03% off GDP. The economy is expected to contract in the current quarter under the weight of the sales tax increase. The key for policy is the July-September quarter. If there is not a strong economic rebound, speculation will mount again for more BOJ action and possibly a supplemental budget.

There are no reports from the US today. The main report ahead of next week's FOMC meeting is Thursday's May retail sales data. A strong report is expected. Canada reports May housing starts, in what is a relatively light economic calendar week for it too. The disappointing IVEY (48.2 from 54.1 vs.56.0 consensus) and employment report (full-time positions fell by 29k after a 30k decline in April) may see the Canadian dollar underperform. Finally, in North America, counter-intuitively, we expect the peso to do well despite the unexpected 50 bp rate cut before the weekend. Its 3% rates are still attractive and more often than not, recent rate cuts have seen the currency rally.