Security And Prices

By Jane Foley, Senior FX Strategist at Rabobank

The market received the news that it has been preparing for, namely that China has succumbed to deflationary pressures. The release of the July CPI inflation data recorded a fall of -0.3% y/y, a touch better than expected. The PPI inflation number hit a softer than expected -4.4% y/y.

The data failed to provide a huge market reaction. It was, after all, well billed. It also followed yesterday’s shockingly weak Chinese import and export data. Additionally, there is speculation that the economic importance of China has slipped. Last month, the US Commerce department indicated that both Mexico and Canada now send more goods into the world’s biggest economy than China. This data suggested that US imports from China between January and May dropped around 25% y/y. Within that, imports of semi-conductors plunged by around 50%. Reports suggest that the Biden administration is today expected to announce new restrictions on US investments in certain advanced industries in China. This will reportedly include investments in quantum computing, AI and advanced semi-conductors.

Looking ahead, some commentators have warned of a prolonged Japan style period of deflation in China. Others remain hopeful that, with more concentrated stimulus, the government can still promote a quick return to inflation. The latter view will be more difficult to hold on to in the wake of the latest news from Chinese property Developer Country Garden, the country’s largest by sales. Reflecting the difficulties faced by the sector amid falling property prices, it has not yet paid interest payments on two international bonds, due August 6. Both bonds are already trading at distressed levels. Shares of the developer plunged on the news, but contagion into the rest of the sector is a bigger concern for investors. Last week Moody’s downgraded Country Garden to B1, citing continued constrained funding access and a sizable amount of naturing debt over the next 12 to 18 months.

While equity futures are mostly pointed higher this morning, Moody’s announcement at the start of the week to cut the ratings of 10 small to mid-sized US banks continued to reverberate yesterday. The agency also warned that it had placed six large US banks on review for potential downgrades. US equity indices were dragged lower yesterday by bank stocks in the wake of the news and commentators started to question the implications for the broader US economy. Moody’s had cited a slowdown in deposits, higher funding costs and asset quality risks, particularly in the commercial real estate sector. The news rekindled some of the fears sparked earlier in the year by the collapse of three regional US lenders.

Financials were also under pressure in Europe in the back of this week’s announcement from the Italian government of a 40% windfall tax on banks that have profited from higher interest rates. Ministers followed the initial announcement with clarification that the impact may be limited for some banks and the levy will not exceed 0.1% of a firm’s assets. The government has pledged to use the extra revenue to help families and small businesses. A few other European countries, including Spain, have already introduced a windfall tax on banks. Fears have heightened that similar action will spread through the region.

The US Treasury likely breathed a sigh of relief on the back of yesterday’s 3-year refunding auction. The stellar results helped dampen some of the recent concerns about US supply stemming from the Fitch downgrade of the US credit rating, concerns that the Fed’s rate hiking cycle may not be over and the possibility of reduced overseas interest on the back of higher JGB yields in Japan. The volumes of the August supply have been increased in tune with the worsening US budget deficit.  Although the solid results of the 3 year auction are encouraging, demand for longer dated paper is more likely to be impacted by the concerns over the US fundamental backdrop.  As a result, the 7yr and 10 yr auctions will still be closely watched this week.

Comments from the Fed’s Harker yesterday that the FOMC may be able to cease interest rate increases, barring any surprises to the economy, provided some reassurances following the more hawkish sounding commentary from Fed officials over the weekend. The Fed’s Barkin argued that it was too soon to say whether another rate hike in September would be appropriate.