Time for cool heads

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  • Attention on the response to North Korea’s action may refocus on UN sanctions.

  • Dovish Fed stance already well discounted and perhaps too a hawkish ECB.

Stocks surrendered gains made in the previous two sessions, US 10-year Treasury yields finished near 12-month lows, credit spreads rose and gold posted new 1-year highs as concern builds around events in North Korea and in the run-up to the meeting of the European Central Bank (ECB) on Thursday and the Fed in two weeks’ time. Adding to tensions, Hurricane Irma was upgraded to a Category 5 storm, leading Florida to declare a state of emergency.

Stock markets were rattled by suggestions that an intercontinental ballistic missile had been moved to the west coast of North Korea and that the leadership might conduct a weapon test around 9 September, when the country celebrates its founding day. Separately, “in principle approval” was given by the US to South Korea to scrap the limit on warhead weights. Nevertheless, absent unexpected military actions, policy focus remains on the 11 September UN Security Council vote on a bill proposing heavier sanctions on North Korea, but we note that yesterday Russian and Chinese officials were again at pains to emphasize de-escalation and the need for a “responsible and constructive” approach. This should help temper losses in stocks.

Yesterday, US Treasury gains came from a bid for safe-haven assets, but attention also focused on comments from Federal Reserve (Fed) Governor Lael Brainard, who suggested that the Fed should delay tightening sufficiently to allow prices to move modestly above 2%. This would be bullish but for the existing gap between the Fed “dot plot” and market expectations of rate hikes, whereby the former has interest rates at 2.9% in 2019 versus the latter at 1.5%. The market is already pricing in a much more dovish Fed than the “dot plot.” We also note that the trend in US economic surprise indices suggests more upward pressure on yields absent current geopolitical risks, so with today’s release of the Fed Beige Book, attention will be on wage growth, which is running above core inflation.

On the other side of the Atlantic, the key event this week is the ECB meeting on Thursday. Though EUR/USD was little changed yesterday and may remain so today, interesting economic data will be released in Europe, with German factory orders expected to accelerate but Italian retail sales in July thought to decline. Retail PMI surveys will provide some detail on forward-looking expectations. A strong currency and any weakness in data could lead some to ask if too much hawkishness is expected of the ECB. We look forward to ECB President Mario Draghi’s statement on Thursday.

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