Global Angst Spurs Treasury Buying

Aug 15, 2018

Treasuries are the beneficiaries of a risk-off move that comes despite a strong July Retail Sales Report.  The rally in Treasuries this morning, (10yr at 2.85% up 12/32nds in price), got its start when Chinese tech giant Tencent Holdings posted its first profit drop in more than a decade and is another sign the Chinese economy is slowing. That heightened concern with the second largest global economy spawned selling in raw materials producers with copper falling to the lowest level in a year. Meanwhile, Turkish bank regulators moved to limit banks’ ability to conduct currency swaps; thus, inhibiting investors attempts to short the lira. While that has provided a brief currency boost more substantive actions—like raising rates—will need to be taken to begin to turn the tide on the crisis.  Back in the U.S., the July Retail Sales Report was better-than-expected with sales increasing 0.5% versus the 0.1% forecast and the Control Group (a direct feed to GDP) was also up 0.5% versus 0.4%. Tempering some of the market enthusiasm for the results are two things: (1) June’s results were adjusted lower; and, (2) the report is in nominal terms, not inflation-adjusted as they will be in GDP. Thus, with the bump in July CPI, the  inflation adjustment will take some steam out of the retail numbers.   That being said it’s still a solid report that implies the consumer was alive and well as the third quarter began, and that will keep the Fed confident regarding its quarterly hiking schedule.


  Economic News


The retail sales numbers for July are one of the few releases this week that provide the market with fundamental economics for trading. Everything else this week is being driven by the Turkish/emerging market concerns, possible China slowdown, additional repercussions stemming from trade war rhetoric, and continued euro-angst. In the emerging market case, the impact of Turkey alone is not enough to materially impact the U.S. economy.


On Friday, Trump accelerated the decline in the Turkish lira when he announced the U.S. would double tariffs on imports of Turkish steel and aluminum, and drawing a complaint from Turkish President Erdogan that the United States is waging “economic war” on his country. Yet unlike the E.U., China, Canada and Mexico  with the ability to inflict pain on a broad array of American businesses in retaliation to U.S. tariffs, Turkey bought just 0.6%of U.S. exports in the first half of this year ranking it 28th among foreign markets and it’s 33rd as a source of imports. Thus, President Trump can feel emboldened to threaten increased tariffs on Turkish  goods without real blowback to U.S. economic interests. Those risks exist but mainly in Europe.


When it comes to banks, the risk is clearly with the Europeans. Ian Shepherdson, Pantheon Macro’s chief economist, wrote in a note to clients Monday, U.S. banks’ claims on the country totaled $38 billion at the end of the first quarter this year, “not much more than claims on Finland and just 0.6% of all cross-border claims. Even if all these claims were to be written off — and they won’t be — the impact on the U.S. banking system would be minimal.”


By way of comparison, Spanish banks are owed more than $82 billion (mostly BBVA), French lenders have $38 billion in exposure (BNP Paribas), and Italian banks (Unicredit) $17 billion.  In addition, most of the lending is done in foreign currencies (euro and U.S. dollar)  so the 45% drop in the lira this year is causing real pain to Turkish borrowers who will no doubt struggle to service their borrowings given the local currency collapse. Over-borrowing in Turkey led to unsustainable growth and now those debts are becoming a huge burden in an economy that is both slowing and racked by increasing inflation. Other emerging markets followed a similar path. Eventually Erdogan will need to raise rates to defend the currency, perhaps employ capital controls to stem outflows, and seek IMF help. None of those options he will find pleasant but alternatives are few and far between.


Because the impact from  Turkey alone to the U.S. economy will be minimal don’t expect the Fed to slow its expected hike in September and most likely December. If the run on the Turkish lira, however, spreads to other emerging markets, and developed ones too, that would be another story altogether. For now, the Fed will probably note the international turbulence and comment that they are watching for signs of financial condition tightening and/or increased volatility but don’t expect the current developments to alter their quarterly hiking schedule.


Turning from Turkey to Italy, the third largest economy in the Eurozone, the response from the new populist government in the wake of the Genoa bridge collapse portends increasing questions over the perceived benefits of remaining part of the E.U. Even before the tragedy, senior government officials were growing increasingly agitated that the Turkish crisis was causing yield spreads to widen on Italian debt versus German bunds without a offsetting response from the ECB. Then, with the bridge collapse, Deputy Premier Matteo Salvini seized on the tragedy to question whether the country should respect European Union budget constraints. Quoting Salvini, “If external constraints prevent us from spending to have safe roads and schools, then it calls into question whether it makes sense to follow these rules.”


With years of austerity budgets constraining all manner of spending, the current government was elected in part to revisit Italy’s entire relationship with the E.U. and the de-facto control that Brussels exerts on fundamental government decisions. The populist government looks more than eager to use this tragedy to further its aim to wrest some control from Brussels and that has all manner of implications for the long-term viability of the E.U. If this divisive rhetoric is followed by more concrete actions, expect the result for the U.S. to be a flight-to-safety trade into Treasuries.




Market Update  Agricultural Export Prices Drop by the Most in 7 Years


Looking for signs the trade war is having an impact on goods and services? Look no further than the export numbers for July. In that report, agricultural exports fell 5.3% in July, after decreasing 1.0% in June and rising 1.6% in May. The fall in July was the largest monthly decline since the index fell 6.5% in October 2011. Can you guess the biggest contributor to the drop? If you said the now famous soybean you would be correct. Edamame suffered a 14.1% drop in prices as the tit-for-tat sanctions with China hurt sales of the bean. Prices for corn, wheat, fruits, and nuts also decreased in July.  In fact, Ag export prices decreased 2.0% over the past year, the first 12-month drop since the index fell 1.8% in July 2017. 


Agricultural Export Prices Drop by the Most in 7 Years



Agency Indications Agency Indications — FNMA / FHLMC Callable Rates


Agency Indications — FNMA / FHLMC Callable Rates



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