Two Developments To Note

The capital markets are trading mostly quietly amid a dearth of fresh incentives and summer holidays draining participation and interest. The US dollar is beginning the North American session on a firmer note, but largely within yesterday's ranges. The US 10-year Treasury yield is back of the 2.50% threshold and European bond yields are a few basis points higher as well.

Global equity markets are higher as well. The impetus is coming from China, which is one of the few noteworthy developments today. The Shanghai Composite advanced almost 2% and the H-share index in Hong Kong rose almost 4%, its largest gain since January 2. The key factor was news coverage of indications for Premier Li that officials will not accept growth below 7%. This is important because it indicates the extent to which the new government is willing to sacrifice growth for reforms.

The other main talking point today is the Bloomberg survey conducted between July 18 and July 22 of 54 economists found half expect the Fed's tapering to begin in Sept, up from 44% last month. Half of those surveyed also expect the purchases to stop by mid-2014, with another 24% expecting the program to end in Q3 14. The survey found 15% expect the tapering to begin in Oct and 28% think December. No one in the survey saw tapering at next week's FOMC meeting. Note that the September meeting (17-18) is the next time the Fed will update its forecasts and that Bernanke will hold a press conference.

The Bloomberg survey also found 51% of the respondents think monetary policy is too easy (only 10 say too tight). Nevertheless, some observers seem to be picking up on a comment made by a large fund manager a couple of months ago. He anticipated the Fed tapering later this year but not for economic reasons, but operational reasons. He had linked the Fed's tapering to the more dramatic reduction in the US budget deficit and the reduced supply of Treasuries that it would imply.

Now some observers, mostly in blogosphere, are extending the general argument and have focused on the shortage of collateral issues that the Fed's Treasury purchases may be creating. This is the real reason, so the argument goes, for the Fed to switch from QE to extending its forward guidance. We suspect that if the Fed were more concerned about the economy, it could find other ways to address what appears to be a squeeze on the collateralized lending markets. Moreover, timing of the operational issues (allegedly March) and the tapering talk (May-June) do not dovetail well. It seems many are looking for a sub-text that reveals the truth, while the official explanation is dismissed as a smokescreen. Sometimes, as Freud taught, a cigar is just a cigar.

There have been a few other developments that do not appear to be market movers or significant talking points. First, we note that the Japanese government upgraded its assessment of the economy and the government's victory in the weekend election is not even 48 hours old and the debate about the retail sales tax has begun. An advisor to PM Abe suggested that there should be two consecutive quarters of 4% annualized growth in order to ensure the economy is strong enough to withstand the increase. Hamada also seemed sympathetic to a more incremental approach to the tax increase. Note that the Japanese economy expanded by 4.1% (annualized in Q1). On the other hand, Finance Minister Aso suggested that a supplemental budget may be needed to offset the impact of the sales tax increase.

Second, the Bank of Spain suggested that its economy contracted 0.1% in Q2 after a 0.5% contraction in Q1. The official estimate is due out next week (July 30). Consumption and domestic demand continued to contract, according to the central bank's estimate, while exports was a bright spot, recovering from the 1.3% slide in Q1. Separately, the government reportedly has tapped the social security reserve fund by another 1 bln euros to meet pension payments, having drawn down 3.5 bln euros at the start of the month. Lastly, while PM Rajoy appears to have bowed to pressure and now appears willing to face questioning by parliament over claims of illegal funding

Third, the Letta government in Italy appears poised to resort to a parliamentary maneuver employed repeatedly by the Monti government to ensure and expedite legislation. Letta appears to be preparing for a confidence vote on a number of administrative measures.

Fourth, Canada reports May retail sales. A 0.4% increase is expected both at the headline level and excluding autos. If so, the headline increase will be the strongest in three months. Excluding autos, it will be the first increase in three months.