The best way for markets to rally is with imagination. Clothing plays an important role today in UK CPI, in the advisory role for all beachgoers as they play in the ocean but risk the tide going out. Some things are best left to imagination and trading positions in a choppy FX market is one of them. The world returned to an old favorite story for USD strength – FOMC rate divergence. FOMC Powell testimony was sufficient to drive down gold, JPY, and oil yesterday. The US rate curve focus becomes more intense as the yield on 10-year U.S. Treasuries rose 1bp to 2.87%, while that on 2-year notes touched 2.62%, its highest since August 2008. Today it’s about the GBP and the CPI data casting doubt on the BOE August hike. Key to CPI was that clothing sales fell making beach going that much more interesting. Also, it’s about the political risks for UK May as she wins the Brexit battle at home but may lose the war with the EU.  The threat of new elections was one tool she used to win those votes and it’s unsettling today. As for the EUR, it’s weaker as core CPI drops lower and the US talks with the EU look to start up again as Juncker visits Trump next week. The weakness in FX in Europe has helped stocks bounce there but this didn’t do much for Asia as they remained troubled by trade and the cost of borrowing. There is a lesson of divergence at play today and that maybe the key for trading a market of stocks as opposed to a stock market with earnings the focus along with FOMC Powell part 2 of his testimony. The EUR and USD maybe the headlines but the breakout for diving in risk naked is probably EUR/JPY with the 200-day at 131.90 looking very important for a bigger rally in USD/JPY and equities.

Question for the Day: Is Bernanke right about the US yield curve?  In a roundtable interview yesterday, the former FOMC Chair said: “Everything we see about the near-term outlook for the US economy is quite strong.” This counters many that see the yield curve looming inversion as a signal of a recession in the months ahead.  He raised 3 key points:

• Forward Guidance. The current narrowing of the 2Y-10Y or 5Y-30Y rates is in large part driven by Fed rate rises and the expectation that more are coming.
• Benign CPI. The still-low inflation and the expectation it will stay that way is one of the factors helping limit the rise in long-dated bonds.
• This time its different. Bernanke acknowledged that an inversion is “a good forecaster of economic downturns,” but said the Fed must look at a broad array of factors to think about the future of the economy.

Perhaps the most used by the present FOMC members in explaining away the flat curve issue is the role of the rest of the world – BOE, BOJ, ECB and SNB in keeping US long-end rates lower. “There’s an argument” that maybe inversions aren’t the signal they once were because long-term interest rates “are unusually low,” as is the market-based compensation for risk, Bernanke said. He added that bond buying by other central banks and regulatory changes are also altering bond-market levels. The yield curve “is one indicator, but you wouldn’t want to religiously consider that being the only indicator,” Bernanke said.

What Happened?

• Australian June Westpac-MI leading index rises to 97.77 from 97.76 –but 6-month deviation from trend -0.33% after +0.05% first time negative since September 2017. Westpac's chief economist Bill Evans said the signal from the leading index is in line with their own growth forecasts, and he continues to expect that the RBA cash rate will remain on hold throughout both 2018 and 2019.

• UK June PPI output 0.1% m /m, 3.1% y/y after 0.4% m/m, 3% y/y – as expected.The core PPI output was up 0.2% m/m, 2.1% y/y unchanged from May but less than the 2.3% y/y expected. The June input PPI rose 0.1% m/m, 10.2% y/y after 9.2% y/y – more than the7.6% y/y expected – highest since May 2017 - with crude oil prices up 50.7% y/y.

• UK June CPI flat 0% m/m, 2.4% y/y after 0.4% m/m, 2.4% y/y – less than 0.2% m/m, 2.6% y/y expected. The UK core CPI rose 0.1% m/m, 1.9% y/y after 2.1% y/y – also less than 2.2% y/y expected – lowest since Mar 2017. Upward pressure from elevated fuel prices and domestic utility price hikes was offset by clothing and footwear promotions and computer games. Cumulatively, fuels and electricity and gas prices were responsible for 0.19pp for the monthly change in CPI, but extensive promotions pushed clothing prices down by 2.1% -- the biggest May-June fall since 2012 -- knocking 0.08pp from the change in CPI. Games and toys, as in May, also provided downside pressure, to the tune of -0.06pp. The RPIX was 0.3% m/m, 3.4% y/y flat to May while the CPIH was 0% mm, 2.3% y/y also flat to May. House prices rose just 3.0%, the joint lowest increase since August of 2013. However, London prices slipped by an annual pace of 0.4%, the fourth consecutive decline.

• Eurozone June final HICP unrevised at 0.1% m/m, 2.0% y/y after 0.5% m/m, 1.9% y/y – as expected - but the core revised lower to 0.9% y/y after 1.1% y/y - weaker than 1% y/y flash expected. Energy was up 8% y/y after 6.1% y/y while food/alcohol/tobacco rose 2.7% y/y after 2.5% y/y.
• Eurozone May construction output rose 0.3% m/m, 1.8% y/y after revised 1.4% m/m down from 1.8% m/m preliminary.  Structural construction rose 0.2% m/m, civil engineering 0.4% m/m.

Market Recap:

Equities: The S&P500 futures are up 0.08% after a 0.4% gain yesterday. The Stoxx Europe 600 is up 0.6% after opening up 0.3% with earnings and US growth key focus. The MSCI Asia Pacific was off 0.1% with Japan gains on JPY offset by rest of region.

• Japan Nikkei up 0.43% to 22,794.19
• Korea Kospi off 0.34% to 2,290.11
• Hong Kong Hang Seng off 0.23% to 28,117.42
• China Shanghai Composite off 0.35% to 2,788.44
• Australia ASX up 0.65% to 6,329.10
• India NSE50 off 0.25% to 10,980.45
• UK FTSE so far up 0.65% to 7,675
• German DAX so far up 0.75% to 12,757
• French CAC40 so far up 0.55% to 5,452
• Italian FTSE so far off 0.2% to 21,940

Fixed Income: UK and Italy focus with UK CPI driving Gilt rally and BTPs lower after LCH called for higher margins. UK odds of an August hike drop from 90% yesterday to 75% today. 10Y UK Gilt yields off 4.5bps to 1.215%, German 10Y Bunds off 1bps to 0.33% and French OATs off 1bps to 0.615% while periphery suffers with Italy up 0.5bps to 2.465%, Spain up 1bps to 1.255%, Portugal up 0.5bps to 1.725% and Greece up 1.5bps to 3.81%.

• German DFA sold E0.822bn of 30Y 1.25% Oct 2048 Bunds at 1.02% with 1.4 real cover – previously 1.26% with 0.7 cover. After Bundesbank, cover was 1.7 from 1.1 previously. 
• Portugal IGCP sold 1.75bn of 6M and 12M bills at mixed rates and higher demand – E400mn of Jan 2019 T-bills at -0.339% with 2.41 cover – previously -0.351% with 1.73 cover – and E1.35bn of July 2019 T-bills at -0.28% with 2 cover – previously -0.272% with 1.65 cover.
• US Bonds are bid tracking EU and waiting for Powell take 2 – 2Y off 0.4bps to 2.611%, 5Y off 0.7bps to 2.756%, 10Y off 0.6bps to 2.855%, 30Y off 0.5bps to 2.965%.
• Japan JGBs steady with focus on long-end BOJ buying – 10Y flat at 0.04%, 30Y up 0.5bps to 0.68%. BOJ super-long buying in focus for tomorrow.  The MOF sold Y597.7bn of 5-15.5Y JGBs in a liquidity auction with 3.95 cover up form 3.03 previously.
• Australian bonds rally with focus on AOFM supply calendar, China growth – 3Y off 2bps to 2.09%, 10Y off 2bps to 2.64%.
• China PBOC adds net CNY90bn on the day, after injecting CNY60bn in 7-day and CNY20bn in 14-day reverse repos. Money market rates are lower with 7-day off 2bpsm to 2.66% and O/N off 8bps to 2.48%. 10Y bond yields flat at 3.48%.

Foreign Exchange: The US dollar index is up 0.4% to 95.31 with focus back on 100-week at 95.535 as key resistance for 96.62 target against 93.71 base. In Asia EM FX, USD trades bid: KRW at 9-month lows – off 0.75% to 1132, TWD off 0.25% to 30.582, INR off 0.25% to 68.61. In EMEA, RUB off 0.7% to 63.042, ZAR off 0.4% to 13.319, TRY up 0.15% to 4.7925.

• EUR: 1.1615 off 0.35%. Range 1.1607-1.1665 with focus on 1.16 then 1.1550 again with 1.1720-50 resistance. ECB vs FOMC rate policy.
• JPY: 113.00 up 0.1%. Range 112.85-113.14 with EUR/JPY 131.30 off 0.25%. Equities up but rates driving with 112.50 base building.
• GBP: 1.3030 off 0.65%. Range 1.3010-1..3120 with EUR/GBP .8915 up 0.3%. Brexit and BOE doubts after CPI with 1.30 pivotal for 1.28 again.
• AUD: .7355 off 0.4%. Range .7343-.7395 and NZD .6755 off 0.3%. Rates and China with metals driving .7250 target.
• CAD: 1.3245 up 0.35%. Range 1.3191-1.3251 with risk for 1.3350 as oil and rates drive.
• CHF: 1.0000 flat. Range .9994-1.0035 with EUR/CHF 1.1620 off 0.35%. Italy margins, ECB post CPI and fear rising on China 1.00 tent with .9920-1.0080 key.
• CNY: 6.6914 fixed 0.14% weaker – down for 5th down, fixed at 11-month lows– from 6.6821 yesterday, opens 6.7080, trades at 6.7350 off 0.35%, after touching 6.7440, despite China banks selling USD at 6.7150 and 6.7200 – touches 1-year lows. CNH off 0.4% to 6.7495 – weakest since July 2017.

Commodities: Oil lower, Gold lower, Copper off 0.85% to $2.7585

• Oil: $67.62 off 0.7%. Range $67.37-$67.87. WTI watching $65.98 the 100-day then $64.55 and $64 for supp.6ort against $67.61 Monday highs and $68.40 55-day as resistance. Brent $71.79 off 0.5% watching $71.12 Apr 20 lows then $70 against $73 and $74 resistance. A surprise API crude build set oil lower early overnight
• Gold: $1223 off 0.4%. Range $1222-$1229. Watching 200-week at $1234 as resistance then $1204.0 July 2017 lows as next support. USD driving. Silver off 0.85% to $15.444, Platinum off 1.3% to $806.85 and Palladium off 0.75% to $907.85.

Conclusions: Are Investors more concerned about trade than earnings? The Day 2 of FOMC Powell testimony is a chance to clarify and twist anything said yesterday. So far, most heard what they wanted to hear – that the US economy is fine, that FOMC hikes will remain gradual and are not “tightening” but “normalizing” still. The focus on trade and deficits maybe something that returns today. The BofA fund manager survey grabbed headlines today as profit fears drive on trade concerns according to the July report.

More respondents now thought global profits would not improve over the next 12 months than expect them to get better, the closely watched survey showed. A net 9 per cent expect them to stay the same or get worse — the gloomiest assessment since February 2016, and a swing of 53 percentage points from January, when the majority expected profits to rise. A trade war was named by 60 per cent of respondents as the biggest tail risk to markets, the highest level of concern over any tail risk in the BofA survey since the days of the EU sovereign debt crisis in 2012.

Economic Calendar:

• 0830 am US June housing starts 5%p -3%e / SAAR 1.35m p 1.323 e / permits 1.301m p 1.328m e
• 1000 am FOMC Powell Congressional Testimony
• 1030 am US weekly EIA crude oil stocks -12.63mb p -6.18mb e
• 0200 pm US Fed Beige Book