Capital Markets: "Dollar Consolidates Gains while Yields Continue to Rise"

From Marc to Market:

Overview: The US dollar is consolidating yesterday's gains against most of the major currencies, though the dollar bloc is underperforming. Bond yields are moving higher, and equities are lower. With a light data and events stream, the price action itself is the news.

US yields: The main force is the rise in US yields. At the short end, the market has begun pricing in a small chance of a third hike next year, having been comfortable with two for some time. It has taken a modest bite from the apple and appears to be discounting almost a one-in-four chance that the Fed maintains its one hike a quarter pace through Q3 19. This expectation, of course, has been encouraged by the Fed's latest projections but also by yesterday's data showing more private sector employment than expected (ADP) ahead of tomorrow's government report. Also, the non-manufacturing ISM report signaled the strongest business activity since 2004, with the employment sub-index at a record high, and new export orders at a five-month high. Merchandise trade is more affected by the trade conflict than services trade. Yields at the long-end of the curve are rising partly as a result of the short-end and partly as a function of rising term premium. Some attribute this to the Fed seemingly eschewing the r* anchor on monetary policy. Rising oil prices suggest a role for inflation expectations as well. Moreover, the 2-10-year curve is steepening. US yields are a couple basis points firmer, and the yield curve is also continuing to steepen. Now, now at 33 bp, it is up about eight basis points for the week and at levels not seen since early August. Cross-currency swaps push up the cost of hedging dollar exposure, but the steepening of the yield curve may blunt it.

Oil: The loss of Iranian output seems to be a major consideration behind the rally in oil prices, which are consolidating today after yesterday's 1.50%-1.75% gain. The US sanctions, which for oil do not go into effect until next month, has been more effective than anticipated and this has prompted many to reconsider the loss of supply. It is now thought that it could remove as much as 1.5 mln barrels day. Bloomberg's oil tanker traffic data indicates that OPEC is struggling to off the loss of supply, and suggest OPEC (including Iran) last month may have shipped the least amount of oil this year. Saudi output is near a record, though it says it has more capacity. Russian output is reportedly reaching levels not seen since the Soviet era. The unexpectedly large build in the US (EIA 8 mln barrels) was insufficient to offset the larger supply issue. There is some concern of pipeline bottlenecks and the limitations on refinery capacity to handle the shale product in lieu of the heavier crude. Tomorrow's US rig count, which has edged lower over the past two weeks, will attract attention.

Equities: Equities are struggling to the higher interest rate environment. That said, the S&P 500 closed less than 0.5% from its record high yesterday, though the poor close yesterday is fueling follow through selling today. Note that Q3 earnings season formally begins tomorrow and many companies have lowered their guidance. Support is seen near 2900. Still, some worry of a deeper pullback amid signs that the leadership has lost momentum. It is now a month since any of the FANG shares made new 52 week highs. The MSCI Asia Pacific Index is off for the fourth consecutive session. Australia's stocks are the notable exception, helped perhaps by the weakening currency and the larger than expected trade surplus (A$1.6 bln vs.A$1.55 bln in July and expectations for a decline). Although Chinese markets are closed this week for a national holiday, the dollar's strength and equity losses warn of the risk of a dramatic start to trading next week. Hong Kong shares were off 1.7%, but the H-shares index was off 2.2% today and off 4% this week. The offshore yuan is about 0.3% weaker this week. European equities are weaker as well, though there Spain appears to be holding its own. Europe's Dow Jones Stoxx 600 is off 0.6%, with gains in only the financial and energy sectors. Since the middle of last week, it has been alternating between gains and losses. Over these six sessions, it is off net-net about 0.8%, which given the rise in yields, seems minor.

Bonds: The yield of the benchmark 10-year JGB rose to almost 15 bp today....

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