Capital Markets: "Collective Sigh of Relief Lifts Equities, Yields, and the Dollar"

From Marc to Market:

Overview: A global sigh of relief that the US will not tariff all its imports from Mexico. Equities are all higher, and the weekend demonstrations in Hong Kong over a bill allowing extraditions to the mainland for the first time did not deter investors from bidding up the Hang Seng over 2.3%, the most this year. European equities are following suit. The more modest 0.4% gain through the morning session is the fifth gain in the past six sessions. US shares are trading higher and the S&P 500 looks set to open near the pre-weekend high and test the 2900-level. Bonds are seeing last week's gains pared. European benchmark 10-year yields are mostly two-four basis points higher, but Italy is seeing a six basis point jump after falling more than 30 bp last week. The US 10-year finished last week near 2.08% and is now trading hands near 2.13%. The dollar is doing well, gaining against all the major currencies to recoup some of the ground lost before the weekend on the disappointing employment data. The Mexican peso is soaring over 2%. The US dollar closed around MXN19.62 ahead of the weekend and dipped below MXN19.14 today before recovering toward MXN19.20. Although the PBOC set the yuan's reference rate a little firmer, the market sold onshore yuan to play catch-up with the offshore yuan's move before the weekend when the mainland's markets were closed. Near CNY6.9350, the dollar is at its strongest level of the year against the yuan.

Asia Pacific
Large-scale demonstrations in Hong Kong against a law that would allow China to extradite people, though ostensibly not for political offenses, are unlikely to have much lasting economic impact. The protest is unlikely to be sustained like the Umbrella Movement. However, like the Umbrella Movement, it will do little to endear themselves to people in other parts of China, who often see people in Hong Kong already have more freedoms and liberty than mainlanders. Many suspect that at some point in the future, Shanghai would largely assume Hong Kong's role as a financial center.

Mnuchin said his discussion with the PBOC Governor Yi as "candid and constructive," but apparently it does not represent a resumption of trade talks. Mnuchin was quoted in the press sounding as if Trump's meeting with Xi is a done deal and the unknown is the outcome. Yet we still think the risk is that Xi does not agree to such a meeting where the outcome is not known beforehand. In that particular environment, Xi is at a disadvantage, A meeting between the two, and even renewed talks would allow the US to play the tariff card again and again. This what happened to Mexico: the existing NAFTA agreement did not prevent the US form imposing tariffs on steel and aluminum on national security ground, a levy on tomatoes for dumping, and across-the-board tariffs over migration. The US suspended the tariffs indefinitely, but as Trump made clear, what we had already understood, the tariffs remain on the books, as does the presidential emergency authority, and can be re-introduced at the will or whim of the president.

China's reserves rose by about $6 bln in May to $3.101 trillion. The increase likely reflects valuation adjustments offsetting what was probably a small drawdown. The dollar rose against the other reserve currencies in May and, perhaps more importantly, their bonds rallied strongly. There is much discussion about the CNY7.0 level after PBOC Governor Yi indicated that there was no key level he had to defend. Current implied three-month volatility is near 5% (annualized). If we make a band around spot that is based by the implied volatility, it would suggest a range of CNY6.7430 and CNY7.1450 in three-months time....

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