The dog that may not bark

4

The political train-wreck in the US is proving to be a win-win for the US bond market, even though a downgrade is looking ever more likely. Charts of how Japan and Canada were downgraded years ago and still saw yields decline have been trotted out, but these totally miss the point with regards to the US (not to mention all the other factors and forces pushing global yields lower over this period). 

We’ve talked before about the curse of the dollar’s reserve status, limiting the market impact of the ever more likely downgrade. Two factors are more prevalent now. Firstly, the economic impact of a government running on 50% spending capacity which, if sustained, would likely push the US back into recession.  Secondly, there’s the impact of trade unwinds where the dollar/Treasuries is the short-leg.  This will put a temporary downward force on bond yields. Add to this the fact that many investors in treasuries have little alternative for regulatory or liquidity reasons, then the rush for the exits that many have feared may never materialise.

Guest post by FXPro

Commentary

Euro stable after weakening into European close.  The euro stumbled into European close in what looked like a largely order-driven decline. In the background was another downgrade of Greece (ratings hardly matter now), but perhaps more notable was the fact that S&P said it would view the debt exchanges that form part of last week’s package of measures as a “distressed debt exchange” and would therefore be viewed as a default. There’s no great surprise with this judgement, but nevertheless the news did perhaps focus minds back onto the eurozone crisis after a week in which so far, it had very much taken a back seat to the US debt talks.

UK manufacturing out of shape. The latest survey of the manufacturing sector offers little hope that things are getting materially better. Indeed, taking the survey as a whole, it is pretty bearish. Both total orders and export orders fell, whilst stocks rose at the same time that selling prices and business optimism fell. Indeed, we’ve seen a pretty sharp decline in the prices balance over the past three months, the balance here falling from 36 down to 4. Furthermore, business optimism, data which comes out quarterly, saw the biggest decline for ten years. The question going forward is whether this is a transitory phenomenon related to the headlines that have been dominating the eurozone and US in the past few weeks, or whether it’s something more structural. There is probably a mix of both in these numbers; in other words the eurozone crisis probably dented confidence (around half UK exports go there), but we’re also seeing an increasingly synchronised slowdown in global activity which is likely to have a more sustained impact on the manufacturing sector. As one of the first indicators of third quarter activity, the data do not offer much hope that the economy will recover in a meaningful way from the modest 0.2% expansion seen in the second quarter.

About-turn on Aussie rates. We would caution against getting too bullish on the prospect for higher rates in Australia in the wake of the stronger Q2 CPI data. A proportion of the surge in Q2 inflation is likely to be unwound in the coming one to two quarters. Furthermore, there have been plenty of signs so far this year that the pace of domestic activity is slowing, this coming alongside a more synchronised global slowdown in which China is playing a part (which is to be broadly welcomed). Nevertheless, this need not spell the end of further gains on AUD/USD. Whilst correlations with 1-mth rolling interest rate spreads (using 2-yr rates) remain just shy of the year’s highs at 0.56, the Aussie is trading less like a commodity currency, the 1-mth correlation with the S&P metals index having been falling so far this month (down to 0.50). If this trend continues, the Aussie will still have the potential to shine.

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