Evidence is starting to build that Japan's housing market is experiencing a significant pick up in activity with May's housing start data estimating 1,027K home being built on an annualized basis, well above expectations for 950K starts. The NSA monthly report showed 79K homes being built in May, which is the strongest May reading since 2008 and a 14.5% increase on the pace of activity a year ago. What is perhaps most interesting is that the both the headline and NSA data now show a clear trend of improvement, with the trailing 12 month ma of starts rising to its highest level since early 2009. Given that starts still remain approximately 30K below their pre-crisis level, there is plenty of room for further acceleration in the months ahead.

The US Pending Home Sales for May is the latest excellent set of data to be released for the US Housing market during the key spring selling season. The headline index rose to 112.3 from 105.2 in April (2001=100), generating the strongest reading since December 2006. However, since the data is seasonally adjusted and May is typically one of the strongest months of the year it is perhaps more interesting to look at the NSA data, which rose to 132.6, the strongest May report since 2006.

This again suggests a substantial acceleration in activity took place in May, although it must be considered that the bulk of the month was completed before interest rates and mortgage rates started to move sharply higher. Nevertheless we believe that activity has remained strong in June, although we would be unsurprised if this volatile measure gave back some of May's strong gains next month. Even if this were the case the trend in housing is towards a rapid pick up of transactions in both the existing and new home markets, which has positive implications for homebuilders, construction material manufacturers and regional banks going forwards.

Weblink for non Bloomberg users:
www.bloomberg.com/news/2013-06-26/bernanke-was-clear-fed-s-crystal-ball-is-cloudy.html

An excellent article that outlines many of the same arguments that we made in this morning's Weekly Speculator commentary. Much of the discussion around the recent sell off in fixed income is at best muddled. The suggestion that investors "stay the course" ignores the point that current yields do not offer sufficient incentive to ignore the substantial interest rate risk (for the developed world) and credit risk (for emerging market debt) that is currently embedded in the fixed income marketplace.

This week's Initial Claims report came in almost exactly at expectations with 346K Claims estimated and a 1K upward revision to last week's total (now 355K). This serves to keep the 4 week trailing ma at 345.8, underlining that the data has made a healthy transition to the sub-350K range during what is traditionally the toughest time of the year for seasonal adjustments. As can be seen on the attached chart this week's NSA estimate was 335K, which is the best reading since the corresponding week in June 2007, and this compares to a reading of 370K in the same week a year ago. Thus Initial Claims have joined other data (most notably housing related) in reporting a significant YoY improvement during the most important time of the year and this seems likely to be reflected by a decent set of domestic earnings for Q2. The improvement in Claims also suggests that further progress can be made in Unemployment over the rest of 2013, particularly once we start to enter the more favorable period for seasonal adjustments after Labor Day.

Despite the sharp rise in US mortgage rates, mortgage applications for home purchases continue to show clear signs of improvement, with the MBA Home Purchase Application Index moving slightly higher to 214.80 this week, taking its trailing 10 week ma up to 212.93, its highest level in three years. As we have explained before this is by far the most important portion of the year from a seasonal perspective, and the timing of the improvement in the headline data translates into some quite powerful acceleration in the nominal non seasonally adjusted activity.

As we had anticipated the reason why purchase activity has remained robust is that borrowers are starting to switch from the exclusive use of the 30 year fixed mortgage into the cheaper adjustable rate mortgage alternative (ARM). The last week saw 7.3% of applicants use an ARM, the highest proportion in any week since August 2008, although usage rates remain well below the levels seen from 2002-2008 (see chart). Given that even after the surge in rates the 5/1 ARM is available at 3.39% (close to the record low rate reached by the 30 year fixed mortgage in late 2012), whereas the 30 year Fixed rate is now 4.58% we would expect to see a sharp increase in ARM usage in the coming weeks. This would allow the housing recovery to remain intact, and potentially even accelerate as confidence builds in specific markets.

We note that the homebuilding sector has been something of a punch bag for the market during the recent sharp increase in rates, but the data available to us from all sources suggest that the 2nd quarter will have been the strongest 3 months for sales since the collapse of the sub-prime lending industry in early 2007 and we would therefore expect a very strong set of earnings to be released by homebuilders over the summer months.

Weblink to interview:
www.bloomberg.com/video/pboc-has-declared-war-on-shadow-banking-YodNtZRDR0mhH2DRpd~F2w.html

Interview discusses the recent improvement of US economic data and the aggressive shift in PBOC policy towards shadow banking.

From our perspective the sudden steepening of the US yield curve is more a rational response to a clear firming of US economic conditions than anything else. The fact that this transition to higher medium and longer term rates will inevitably cause some distress amongst investors does not disguise the fact that it is basically a response to good economic news, and as such is likely to be followed by a period in which it is generally beneficial to own risk assets that are sensitive to the US domestic economy.

Some further evidence of improving conditions came in the form of the Conference Board Consumer Sentiment Index for June, which surged to 81.40, its best reading since January 2008, while the Present Situation sub index moved up to 69.20, its best reading since May 2008. Although at extremes we regard Consumer Sentiment to be a contrary indicator, the breakout of opinion regarding the present condition of an economy is normally a pretty good real-time indicator that not only are conditions getting better but also that this is now generally being recognized to be the case. The latter is important since it is this change in opinion that tends to drive retail allocations, as the bond market has discovered to its cost in recent weeks.

We also note that under the surface a steady improvement in Employment Sentiment can be observed. The "Jobs Plentiful" index for June rose to 11.7, its best reading since September 2008 while the "Jobs Hard to Get" index held onto its recent improvement at 36.9. This suggests that respondents are finally starting to sense a change in the direction of the employment cycle, which in turn improves the odds of further upside data surprises over the course of the summer months.

Although the May New Home Sales report does not cover the period in which US interest rates moved sharply higher it is still a very positive report that underlines the extent to which the US New Home market has started to renter a period of seasonal "normalcy" after 5 years in which little increase in springtime activity was registered.

Overall Sales were estimated at 476K, above expectations of 460K while April's data was revised higher from 454K to 466K (this positive revision has been a steady factor in recent months, suggesting that Census Bureau initial estimates have generally been too conservative). This is the highest level of sales seen since July 2008 and a 28% gain from the level of activity seen in May 2012. Looking at the single month NSA data we see an estimated 45K of homes sold, which is the best May report since 2008 when 49K homes were sold (see NSA chart). All of this suggests that Q2 earnings for homebuilders will be extremely robust, making the recent sell off something of a buying opportunity.

Perhaps the most interesting portion of the report dealt with Inventory. Overall Inventory grew to 161K homes, which is the highest level seen since September 2011. However, the Inventory of Completed Homes (red portion on Inventory chart) actually fell from 39K to 37K, a new all time low and an indication of how tight "ready to go" inventory has become. As would be expected this is starting to encourage builders to increase activity in expectation of future sales, and the number of "Houses Started Not Completed" (green) rose to from 90K to 92K, the highest since September 2009, while the number of "Houses Not Started" rose sharply from 26K to 32K, the highest level seen since September 2009.

This suggests that the pick up in building activity going forwards should start to outstrip home sales, as builders move towards normalizing inventory. This build up of inventory may cap some of the robust price increases we have seen in recent months (which would be no bad thing for the length of this cycle) and we would also expect a higher level of inventory to itself allow a higher level of sales in some of the tighter regional markets.

Brazil's outstanding bank credit continued to rise in May as Total Loans outstanding rose to 2,487 bln BRL, up from 2,449 bln BRL in April. Rising at an annual pace of 16.1% total credit is growing far faster than the pace of overall activity outlining the degree to which Brazil's economy has become substantially more credit dependent than it was in the early years of this economic cycle. Once more State Banks were largely responsible for new credit creation with Total State Bank Loans rising 27 bln BRL to 1,229 bln BRL while Private Banks increased lending by 11.1 bln BRL to 1,257 bln BRL (see chart). We would expect State Bank loans to exceed the Private Bank loans by the end of summer, which would represent something of a milestone for the Brazilian banking system and underline the degree to which the political imperative for growth has heavily influenced lending activity in recent quarters. We are concerned that the acceleration of State Bank lending will have come at the expense of underwriting standards and that the eventual losses from recent lending will be considerable.

In terms of sector activity little has changed, with Housing credit continuing to dominate new lending up 33% YoY, although at 336 bln BRL it remains one of the smaller sectors. Personal Loans remain the largest category at 731.5 bln BRL and had a relatively strong month growing 1.03% for an annual growth rate of 9%. We note that the recent improvement in delinquency levels for Personal Loans stalled at 7.50% this month and we still expect this metric to start moving higher again as the local employment environment starts to deteriorate.

There are increasing signs that the UK housing market has started to recover after several quarters of bouncing along the bottom. May BBA Mortgage Applications rose to 36.1K, well above expectations of 33.2K and last month's reading of 32.9K (revised up from 32.1K). This is the largest number of approvals seen since January 2012 and an increase of 7K (24%) over activity seen in May 2012. We would still need to see further improvement in this data for a clear signal that a strong recovery is underway and would view a reading above 40K that is sustained for two or three months as decisive evidence. However, given the strongly cyclical nature of the UK housing market and the length of time in which activity has been depressed, it would make sense if we saw a marked uptick in transactions over the summer months which would have significantly bullish implications for the overall economy and the banking sector in particular.

Away from the chaotic gyrations of Japan's financial markets, evidence continues to build that the domestic mood is turning substantially more positive. This morning's Small Business Confidence Index (published monthly by Shoku Chukin Bank since 1985) rose to 49.6 in June, pulling the trailing 6 month ma (roughly the period since QE was announced) up to 47.9, its best reading since November 2007.

The index is yet to push its way into positive territory above 50, but there would seem to be a reasonable chance that this transition will take place later this summer. The real question is whether the index can then extend up to a strongly positive reading around the 55 level, something that has not been seen since the great boom of the late 1980's expired. It will probably take a few more months for this question to be answered one way or another, but we are increasingly encouraged by the stream of decent domestic economic data being released in Japan.

It is somewhat surprising that with the local equity market falling to a new 4 year low and the worst public disorder seen in many years Brazil's consumer confidence index for June remained at a relatively buoyant 112.90, down from 113.40 in May. Although this is the lowest reading seen since March 2010 it is hardly the sort of negative plunge that we would associate with the bottom of an economic or market cycle and we note that the November and December 2008 lows registered at 94.90.

Of course it may be that the survey was conducted earlier in the month before matters deteriorated, but our sense is that the average Brazilian (or at least the polled population) is not yet aware of the duress in which the overall economy is under at the present time. The divergence between confidence and the market's performance is partly explained by the withdrawal of foreign capital, and an index of the "world's confidence in Brazil" would presumably have shown a much sharper decline than consumer confidence.

From our perspective the problems facing Brazil are much more "local" in 2013 than they were in 2008, and are therefore substantially less likely to be resolved in the abrupt manner that took place in the recovery of 2009. We would expect this realization to dawn upon the local populace in the weeks ahead and to be reflected by sharply lower consumer confidence readings and a difficult environment for financial markets.

We note that Italy's consumer confidence for June rose strongly from 86.4 (revised up from 85.9) to 95.7, well above expectations for an 86.2 reading. This sudden recovery is typical of the way that confidence reacts with a lag to the actual event. As we argued a couple of months ago, it seemed that Italian consumers were unwilling to admit that any progress had been made since the dark days of 2011 and 2012, with confidence hugging its crisis level despite a decent recovery in the local equity market and a tolerable solution to the election debacle.

In our experience once a substantial turn in confidence takes place, the road is opened to substantial further progress over the medium to longer term. Of course this progress may not be smooth, and we note that the recent back up in global fixed income yields has spilled over into the sensitive Italian sovereign market, which in turn has led to losses in equities. Nevertheless, we would argue that Italy participating in a global shift higher in yield is very different from that country being singled out as a financial pariah by the bond market.

Indeed the higher starting yield for Italy (and other peripheral Eurozone sovereigns) means that their price sensitivity to the recent back up in yields is relatively low. Indeed the Italian 5¾% 2023 bond has held up far better than the basket of long dated EM USD credit that makes up the EMB ETF (see chart). The concept of Italian credit as a "safe haven" may seem bizarre but an investor holding this bond would still be up 2.97% YTD on a total return basis which beats the vast majority of other fixed income instruments. We continue to believe that Italy's prospects are better than the dismal outlook portrayed by its equity market level and that the current sell off should create opportunities for patient investors.

Readers with decent memories may recall that the correction of 2010 started off with concerns of a dislocation in Eurozone sovereign markets before progressing into a mini-panic over a supposed double dip in the US. 2011 saw the reverse course, as concerns over weak US economic data in the spring were overwhelmed by the Eurocrisis in the summer. It is starting to appear that 2013 will see a similar transference of concern, away from concerns over the intentions of the Federal Reserve and towards a reappraisal of the relationship between the PBOC and Chinese financial markets. Indeed we note that last week's dislocation of Chinese money markets resulted in a record number of stories being written mentioning the PBOC (see chart), although the Federal Reserve still overall garnered much more attention.

Certainly to our eyes the events in China are far more significant. From the day that QE3 was announced, we have argued that it would create a bull trap in fixed income markets that would be sprung whenever it became clear that the US economy was in much better shape than the FOMC appreciated last autumn. As ugly as the recent sell off in fixed income markets has been, the longer term effects of a much steeper yield curve are as likely to be positive as negative at the level of the overall economy (although clearly different sectors would experience different results from this shift), and the equity market once the period of turbulence has passed.

On the other hand the realization that the new Chinese administration has signaled their wish for the PBOC to finally crackdown on China's massive shadow banking system strikes us as a much more momentous change in circumstance. Unlike the eventual removal of QE3 the PBOC's (in)action threatens to have substantial effect on the local economy, which we have argued has become excessively reliant on domestic credit growth in recent quarters. This substantially changes the balance of risk and reward for China and its main trading partners since in our experience once a credit bubble becomes starved of new sources of funding the economic fallout is substantially larger than most observers expect. Assuming that the recent dislocation in money markets, together with the collapse of IPO demand for corporate credit results in a substantial drop in Total Social Financing for June and going forwards, the clock would be ticking for a substantial slowing of activity in China's real estate and construction markets.

Brazil's CAGED index (the equivalent of the BLS Non Farm Payroll report) continues to show a marked deterioration in local employment growth. May's estimated job creations were 72K, well below expectation of 150K. May is traditionally a solid month for job creation and since the data starts in 2003 there has never been a reading under 130K for the month. This indicates that April's strong report (197K) was almost certainly an abberation and that the trend lower which has been established for approximately 3 years remains in place.

This downward trend has taken the 12 month ma down to 55.3K, the lowest level since October 2009 and down from a 2010 peak of 184K per month and a reading of 105K in May 2012. We would expect to see an eventual shift into negative territory with the recent market turbulence and consequent sharp rise in local interest rates likely to take a further toll on employment going forwards.

Brazil's Current Account and FDI data for May offers a partial explanation for the substantial weakening of the BRL in recent quarters since although the report contained few surprises it does underline the substantial deterioration in Brazil's funding position that has taken place in recent years.

The Current Account Deficit for May was $6.42 bln, in line with expectations and this took the cumulative 12 month deficit to -$72 bln, a new record and -$22.2 bln wider than the deficit in May 2012. This represents -3.2% of Brazil's GDP, making it the largest 12 month deficit measured on that basis since the middle of 2002.

Total FDI for May was $3.8 bln, slightly better than expectations of $3 bln but we note that this data was compiled before the very sharp decline in Brazil's currency and asset markets. This although the cumulative 12 month FDI has recently stabilized around $64 bln this may now start to deteriorate once June's data is published.

Even with FDI flat-lining the gap between FDI and the Current Account continues to widen on a 12 month cumulative basis, reaching -$8.75 bln its most negative reading since November 2010 (see chart)

We continue to monitor the turmoil in Chinese money markets and it is starting to become increasingly clear that in large part the sudden tightening of funding markets is a result of a deliberate attempt by the monetary authorities to send a blunt message to the shadow banking industry that it is time to sharply constrain their activities.

This has been made apparent by the very targeted manner in which the PBOC has chosen to inject liquidity into grid-locked financing markets and the lack of official comment in spite of several media requests for information. In response to this limited intervention there was at least some improvement in some of the more egregious rates, with the 1 month REPO rate declining from its record 17.0% to 12.0%. 1 month SHIBOR (which was fixed before the injection of funds) rose 30 bp to 9.70, a new record (see charts).

Looking ahead we are less worried about the short term effects than the long term consequences of this episode. The PBOC, under instructions from the new administration, seems intent to sending a very blunt message to the financial system that rampant credit creation needs to be rapidly constrained. We assume that they will try and ensure sufficient liquidity to avoid an immediate collapse of a significant entity but that they will make it much more difficult for shadow banking sources to provide capital going forwards.

This, and the collapse of the IPO market for corporate credit, means that going forwards Total Social Financing will be substantially lower than recent months and will once more be dominated by bank loans. Although this will give the PBOC much more control over the process the shutting off of certain areas of liquidity is very reminiscent of what took place in the US in early 2007 when the sub-prime market blew up, removing a large number of borrowers from the housing market, and the simultaneous collapse of a number SIV's destroyed demand for commercial paper (see chart).

Although most commentators followed Henry Paulson's view that the damage was "contained", within a matter of months it became apparent that losing the key funding sources of the housing bubble had created a massive destabilizing of the entire financial system. This is the danger which the PBOC now faces should it decide (or be forced by political masters) to forcibly shut down large portions of the shadow banking system.

US Existing Home Sales were released in the midst of this difficult session and confirm our sense that rising interest rates have had little to no effect thus far on the robust recovery for US housing. Total Sales were estimated to have reached 5.18mm units (SAAR) in May, above expectations for 5.00mm units and the strongest monthly report since May 2007 (excluding the periods with tax credits in 2010). Single Family Sales were 4.60mm units, the strongest since April 2007 and a 12.7% gain in activity over the last year.

Inventory levels remain tight at 1.98mm homes, the lowest May reading (inventory is quite seasonal and generally increases considerably during the spring) since 2002. This represents 5.2 months of sales, unchanged from last month. We still await house price and New Home data which is due out next week but the evidence seems clear that the US housing market has strengthened considerably over the first half of the year and continues to run well ahead of expectations.

As we anticipated Brazil has proved to be the large emerging market which has led the entire complex lower, and we believe that following Brazil closely in the weeks and months ahead will at least give some guidance as to how this rolling bear market may play out over a large number of other countries.

Most clearly the dual destruction of value in both the currency and equity market (now joined by sharp losses in corporate and sovereign credit) have served to combine into extremely large cumulative losses for USD holders of Brazilian financial instruments. This morning's decline by the IBOV index to a new 4 year low of 46,000 (breaking support at the 2011 low at 47,400 in the process) and the decline in the currency to 2.25 (also a 4 year low) means that the total loss for a USD holder of the IBOV index since the 2011 peak is now almost 52%, which exceeds the maximum drawdown seen in the entire 2000/2 bear market in the SPX index.

Based on the experience of that earlier bear market it is around now that the severity of Brazil's credit problems should start to become apparent, with a significant spike in corporate and personal delinquency levels likely to be seen in the coming months. Meanwhile the decision to raise the SELIC twice since April is proving to be as ill thought as we described at the time and we would expect this to be reversed as soon as currency markets show some stability.

It is becoming increasingly clear that the change of administration in China is resulting in a substantial change in the relationship between the government and the financial sector. China's State Council met last night amidst increasingly fragile money markets and simply issued a statement that the financial system must better support economic growth, a clear admission that the last 5 years of frenzied credit growth has led to a growth of domestic risk that has not been balanced by overall economic output.

The odds of the PBOC undergoing any meaningful loosening measures, such as a cut in reserve requirements (still very high at 20.0%) or a decrease in the benchmark 12 month lending rate (currently 6.0%) seems very low, while a concerted crackdown on abusive "wealth management" products now seems much more likely to proceed. At best the PBOC can be expected to inject batches of liquidity into the market whenever money markets become dislocated and we note that today's surge of SHIBOR rates to an all time high and the 1 month rate we track reached 9.39%, up 1.78% (see chart) was followed by an injection of 50 bln CNY ($8.16 bln) into the financial system this morning.

This change of policy emphasis significantly increases the possibility of a credit crunch taking hold in the coming months, particularly if it is combined with a greatly constricted IPO market for corporate credit. It may take another 3 to 6 months for the effects of this policy change to become apparent in actual economic activity but the odds of China slowing sharply later this year have appreciated considerably in recent weeks.

The emerging market currency and bond complexes continue to be at the heart of the current period of turbulence, which indicates that it a meaningful liquidation of emerging market securities my foreign investors is underway. The destruction of value in the bond market strikes us as particularly important, since the issuance of new corporate securities to foreign investors has been a vital source of liquidity for the private sector in a number of economies where tight domestic liquidity conditions remain in effect.

The collapse of currency rates is more complex. Over the short to medium term it has the unpleasant effect of sharply reducing returns for foreign investors who are generally unhedged in both their fixed income and equity investments. It also substantially increases credit risk for USD (or other DM currency) denominated credit as the cost of both debt service and eventual repayment increases significantly. Should currency levels remain depressed this is likely to be a source of a substantial increase in corporate credit delinquency and also lead to a widening of fiscal deficits in a number of heavy USD debt issuing countries. We note that the price of a number of benchmark sovereign USD bonds have started to fall very sharply in recent days as investors head for the exits (see chart).

Over the longer term a much lower currency rate will at least allow local industry to become more competitive, but this reward will not help those struggling to service large amounts of credit at what are likely to be significant higher interest rates. History suggest that a long period of digestion will be required to deal with the excess of recent years, and that whenever a sustainable recovery cycle takes hold in EM it will be led by a very different list of corporate entities to the often bloated and debt laden leadership of today.

It is hard to know where to start this morning with a synchronized collapse taking place in emerging market currencies bonds and equities, gold breaking down to a new 2013 low and an ugly session taking place in Europe (although one that has much less technical significance than the losses in EM).

None of this should come as a great surprise to our readers since we have been quite vocal about our concerns for the potential of a collapse of popular but under-performing assets towards the end of this quarter as a multitude of investors attempt to withdraw capital from the same asset classes at the same time. We note that the media and much of Wall Street are placing the blame at the foot of the FRB and its Chairman but it seems to us that the calendar has much more influence over current events than the FRB, although we remain very critical of the flawed decision to embark on QE3 in the first place.

However, given the attention on the FRB we will start this morning with a review of the US yield curve, which has started to steepen appreciably in recent weeks. Attached is our chart which shows the entire yield curve split into 4 portions, 1-2 Year (blue), 2-5 Year (green), 5-10 Year (purple), 10-30 Year. Each of these portions has its distinct characteristics that come into play at different points of the cycle but as can be seen on the chart it is the short to medium end of the curve which has seen the most yield compression during the FRB's unprecedented intervention, with both the 1-2 and 2-5 year portions of the curve much flatter than the longer end.

Clearly the 1-2 year end of the curve remains under tight FRB control, since by publicly stating that it has no intention of touching the FDTR for several quarters it effectively anchors the 2 year note yield close to the FDTR. The 2-5 year portion of the curve is much more interesting, since this is the area in which the FRB can exert much more INFLUENCE than CONTROL. This was seen most clearly under QE2 which saw the 5 year yield collapse in the run up to the announcement and then rise steadily for the first 6 months that QE2 was in effect, despite the fact that this was the very portion of the curve that the FRB was purchasing.

As one might expect it is this portion of the curve which has shown the most steepening over the last 4 weeks, with the spread widening from less than 60 bp in mid May to 100 bp this morning. This has caused some distress on bond funds that had concentrated on "riding the belly" of the curve (for example purchasing a 6 year note and holding it until it is a 3 year note), which has probably been the most popular strategy to enhance returns in recent quarters by plain vanilla funds. By contrast the 1-2 year portion of the curve has only risen by about 7 bp to 20 bp, the 5-10 year portion is unchanged around 110 bp and the 10-30 year spread has actually come in from about 120 bp to 105 bp over the same period.

Should yields continue to push higher we would expect to see more of the same, and we are reminded that in February 2011, right in the middle of QE2 we saw a yield curve that included a 1-2 year spread of 47 bp, a 2-5 year spread of 150 bp, a 5-10 of 137 bp and a 10-30 of 109 bp. In other words it is the belly of the curve which has the potential to change its characteristics by the most in the weeks ahead, and that the overall curve could easily steepen another 75 to 100 bp. Although we expect this period to be dominated by discussions regarding the FOMC's intended policy we continue to believe that the market is likely to take matters into its own hands well before any genuine clarity over timing emerges from the Federal Reserve.

Link to statement
www.federalreserve.gov/newsevents/press/monetary/20130619a.htm

Although the June FOMC statement attempts to whisper its message it contains clear indications that the committee now recognizes that the US economy is in significantly better shape than it would have expected both at the turn or the year, when the Fiscal Cliff dominated discussion or last summer, when QE3 was placed on the launchpad.

This week's MBA Mortgage Application report continues to suggest that home sales have been largely unaffected by the recent rise in long term rates, while refinancing activity has declined significantly, with the MBA Refinance index falling to 3208.5, its second lowest level since November 2011.

By contrast the Purchase Mortgage index remains robust (at least in terms of its post crisis range) at 210, which has allowed the trailing 10 week ma to improve to 2011.6, the highest reading since July 2010. Once more an uptick in the use of ARM mortgages has taken place, with the percentage of applications using this option rising to 7.1%, matching the post crisis high seen September 2011 and beating all other data points since August 2008. Given that the 30 year fixed rate is 4.01% and the 5/1 ARM 2.82% we would expect to see the use of the latter increase markedly, particularly if the long end of the yield curve continues to move higher in the manner we anticipate. Should this shift take place it would indicate the determination of new entrants to the housing market to find a way to purchase a home, another indication that genuine appetite by actual home owners and occupiers has started to become a force in the US housing market.

The sharp downturn in the Spanish domestic economy has had the effect of unleashing a boom in export activity that until recently had gone unnoticed by most observers. April's data suggests this process is continuing, with exports rising 18.6% YoY to reach €20.4 bln. This compares with the prior cycle high for an April report which was €17.9 bln back in 2008 and is thus a very strong report.

Imports grew more modestly at 7.23%, reaching €22.04 bln. This is a somewhat larger pick up in pace than we have seen over the last 2 years but given the volatility of monthly data it is too early to conclude that this represents a pick up in activity in the domestic economy. The slower growth of imports led to another improvement in the trade deficit which at -€1.642 bln is at its lowest level for an April report since 1998 and compares to a deficit of -€3.355 bln in April 2012. This has allowed the trailing 12 month ma to rise to -€1869.4, registering the smallest 12 month deficit since February 1999. What is perhaps most impressive is that Spain's export turnaround has taken place without the aid of a dramatic depreciation in its currency, underlining that its industrial complex has become genuinely competitive in recent years.

The last four weeks have seen a significant repricing of money market liquidity in China with the 1 month SHIBOR rate surging from 3.25% on May 15th to 7.16% this morning. There is little doubt that a good portion of this rise is due to seasonal factors since money markets historically tighten towards the end of the second quarter as companies start to window dress their balance sheets by hoarding cash. However, the average rise in 1 month SHIBOR between May 15th and June 18th over the last 5 years has been 100 bp (from 2.77% to 3.77%), which hardly compares to this years 391 bp increase (see attached chart).

Only 2011 saw a similar surge in money market rates, but back then the PBOC was at the height of its macro-prudential tightening and the Eurocrisis was causing a general tightening of global money markets. We would therefore conclude that liquidity conditions have started to worsen considerably in recent months despite the fact that credit creation, at least through April, remained at record pace, and were reduced but still buoyant in May. This is perhaps the first sign that the clampdown on wealth management products is having a tangible effect on Chinese liquidity conditions, but we also note that the IPO market for Chinese corporate credit has suddenly started to be much less receptive to new issues, cutting off a second source of "shadow banking".

Meanwhile the news that house prices have risen in 69 of the 70 largest Chinese cities represents a serious constraint on the PBOC's ability to address the strains of the money market and we doubt any dramatic moves will be taken. Money is therefore likely to remain very tight through the end of the quarter and even though we would expect to see SHIBOR rates fall sharply thereafter we do not expect them to settle back down at their April/May levels.

Should June's Social Funding and Loan data confirm our concerns then the clock would begin ticking on the effects of a severe credit crunch becoming apparent in Chinese economic activity, with the lag likely to be around 6 months based on the experience of other cycles.

We had anticipated that the US housing recovery would accelerate even as long term interest rates moved higher and clear evidence of this was provided by the NAHB Sentiment Index this morning with an outstanding June report,

The overall NAHB index rose to 52, indicating that a majority of polled homebuilders now see conditions improving for their business. This is the strongest reading since March 2006 (as is the case for all the main sub indexes). Present Sales (red) were slightly stronger than the overall index at 56, while Future Sales (blue) were a sprightly 62. Traffic remains more subdues at 40, but is starting to show signs of improvement.

Based on prior experience we would expect this surge in the NAHB to translate into decent housing numbers for May and (more importantly) they indicate another excellent set of quarterly earnings can be expected for the second quarter. We continue to regard the recent weakness in homebuilding equities as a buying opportunity.

The reason's behind the RBI's decision to halt its series of rate reductions became clear once May's Trade report was released since this dismal set of data shows Imports growing 7% YoY to $44.6 bln (a new May record) while Exports slipped -1.1% to $24.5 bln. This created a monthly trade deficit of -$20.1 bln, the second largest on record for any month, and a record for any May data (October is seasonally the weakest month in the year). This takes the trailing 12 month for the deficit to -$16.7 bln, a new record.

Viewed in INR terms the data is even worst. The monthly deficit reached -110.8 bln INR, matching the October 2012 report, while the trailing 12 month ma has widened to 90.4 bln INR (see chart). May 2012 saw a monthly deficit of 93.352 bln INR and a trailing 12 month ma of -$75 bln INR, underlining the increasing reliance of India's financial system on the generosity of foreign investors.

Sales data for Tokyo Condominium Sales in May 2013 suggests that a meaningful recovery in transactional activity may be taking place. Total contracted sales were 3879 in May, the largest number since May 2007 and a gain of 54% over last year's level. The trailing 12 month ma of sales has now risen to 3,075 units, which is the largest number since April 2008. This compares with 2001 - 2007 activity of between 5,000 and 6,000 units (the data does not go back to Japan's booming late 1980's), suggesting that further progress can be made in the months ahead. As ever we would be patient with this sort of volatile monthly report, but this is not the first positive data-point from this series and there is growing evidence that the Tokyo condominium market is turning the corner.

The sudden weakening of the INR caused the RBI to refrain from cutting the REPO Cut Off Yield below 7.25% this morning, disappointing the consensus view which generally favored a cut to 7.00%. This makes the RBI the latest EM central bank to be forced to address the danger of capital withdrawal at the expense of local economic conditions.

As the attached chart shows in recent months as the economy has slowed the bulk of the adjustment process for India has been born by the currency, which has weakened considerably, while domestic equity prices have remained in a more moderate decline since peaking in late 2010. In no small part this is due to the massive inflows of foreign capital, which have remained strongly positive since late 2011 (see chart).

Indeed YTD 2013 flows topped $15 bln by late May, by far the strongest start to the year. Despite this major boost to buying power the SENSEX has struggled to make progress and is down -1.19% in local and -6.29% in USD terms. The danger now is that flows either halt or turn negative, causing the latent weakness amongst local investors to become revealed in the benchmark index. We note that the BSESMCAP index, which tracks small cap performance and is therefore far less sensitive to foreign flows, broke down again last week and is now down -21.7% YTD in local terms (see chart). This suggests that Indian economic and liquidity conditions have continued to deteriorate even as Western capital has flowed into large cap equities and bonds. The decision of the RBI to pause at 7.25% (understandable as it is) will only serve to increase these pressures.

The Bank of Indonesia surprised markets by raising its Reference Rate to 6.0% from 5.75% last night. Although we do not view this as a significant change to monetary policy in terms of its direct effect, as a statement of intent it is much more significant and comes on the back of a host of other measures taken in the emerging market complex to protect plunging currencies.

Brazil for instance has hurriedly unwound its ill thought macro-prudential taxation measures that sought to restrict inbound capital in 2010 and 2011, while India has discussed increasing the cap on foreign investments in a number of key industries. At the same time the pace of direct intervention in FX markets has increased markedly.

Thus far the steps taken have been relatively benign, and could even be taken as a helpful removal of unnecessary restrictions on capital flows. However, should outflows continue to gather pace and overwhelm intervention efforts we would not rule out some much less market friendly actions that seek to lock external capital into emerging market economies as part of an "emergency measure". Things would clearly have to get a lot worse for such a draconian step to be considered, but it is not something we would rule out given the degree to which hot money flowed into this complex in recent years, and the potential for disruption should these flows reverse.

The effect of the Memorial Day holiday finally fell out of the Initial Claims report this week and Claims fell sharply to 334K, below expectations and last week level which were both 346K. This took the trailing 4 week ma back down to 345.3K and suggests that the tick higher in recent weeks is nothing more than statistical noise.

As we have pointed out before, Claims have stayed solid in what is the most demanding period for seasonal adjustments, and NSA Claims for the week were 330.9K, the best early June report since 2007 (see chart). Based on prior cycles there is still some room for Claims to fall over the summer and autumn months. Although BLS Payroll data has improved in recent months, it still somewhat lags the improvement in Claims. Historically the latter has the better predictive record and we continue to expect better BLS data to be reported in the coming months, perhaps via revision to prior reports as much as improved future data.

Homebuilders have been a notable victim of the recent rise in interest rates, based on the assumption that a higher yield in long dated treasuries will inevitably lead to a slowdown in home purchases. As we argued last week this ignores the fact that there remains an attractive alternative to the standard 30 year fixed rate mortgage in the form of adjustable rate mortgages (ARMs), which historically have been a widely used source of funding for home purchases.

This week's MBA Mortgage Application Index supports our thesis. The Purchase Index rose to 217 (seasonally adjusted) allowing the trailing 10 week ma to rise to 211.18, its highest level since late June 2010 (at the expiry of tax credits). As we had expected the proportion of mortgage applications for ARMs rose to 7% from 6.4% (note this number includes refinancing application which are nearly all done on a 30 year fixed basis), which is the highest proportion seen since September 2011. With the 30 year fixed at 4.04% (still very low on a historical basis) and the 5/1 ARM offered at 2.88% it is easy to see the logic behind the switch. Should the long end of the curve continue to rise in the coming weeks (something we expect to see) then we would expect to see much wider use of the ARM mortgage, thus neutralizing any negative effect on home purchase demand.

With our screens a sea of red this morning it is nice to be able to report on some encouraging data from the Spanish real estate market. Total House Transactions in April rose to 23.58K, a 10.8% gain from April 2012. This is the latest in a number of positive YoY comparisons, and this has allowed the trailing 12 month ma of this metric to finally push into positive territory for the first time since April 2011 (see chart) suggesting that a bottom has finally been put in place in terms of activity.

April is traditionally one of the weakest months for sales and this month's report is still the second worst on record and compares with April 2007 sales of 60K. Spain's property market therefore remains in the grips of a historic collapse. Nevertheless recoveries have to start somewhere, and halting their 6 year decline House Transactions have at least made a start in the recovery process.

With the IBOV index having pierced the 50,000 level this morning and now targeting the October 2011 low at 47,993 we are publishing an update of the chart we have used to track this bear market since it started in July 2011.

This chart shows the price of the IBOV in USD and thus represents the return for an unhedged USD investor in Brazil's benchmark index. We have overlaid this return on the same chart as the progress of the 2000-2 bear market in the SPX index during which approximately 50% of the index's peak value was erased, and both indexes are rebased to 100 at their peak values.

As can be seen although the index in BRL terms remains about 4% above its 2011 low, the fact that the BRL is much lower today than two years ago means that USD returns have broken down into new bear market territory, with the index now worth 54.29% of its peak value. We would expect the current decline to extend to at least the 50% level, with both the currency and the local equity market likely to add to the decline.

Readers should note that the 2000/2 SPX bear market is merely a guide which was designed to guide us on timing and patience as much as levels to expect. There is therefore no guarantee that a 50% decline would mark the termination point, particularly if the BRL continues to weaken in the face of investor outflows.

The EM FX markets continue to exhibit clear signs of capital flight away from high carry currencies in particular with the 4 currencies we track all seeing spot rates break out to multi-year highs, or in the case of the INR an all time high this morning.

As would be expected this extreme weakness in underlying currencies is starting to feed into sharply lower asset prices in equity and fixed income markets, with US based ETFs trading lower in anticipation of further losses ahead. We remain particularly concerned about the state of fixed income markets which have not had to absorb a decline of this speed and ferocity since local currency and USd EM credit became the asset class of choice for those reaching for global yield with the illusion of safety provided by a low debt to GDP ratio.

Unsurprisingly Brazilian bonds have been particularly hard hit with the Brazil 7 1/8 2037 bond now down -13.7% YTD (total return), about twice the loss of the overall complex. This popular issue has now lost its entire 2012 gain as well, reminding investors down quickly gains can unravel in an unruly liquidation.

The final piece of the May China data dump was provided by the release of estimated Industrial Production, Retail Spending and Fixed Asset Investment. This continues to show a steady deceleration in activity with Industrial Production slipping to 9.2% from 9.4%, Fixed Asset Investment to 20.2% from 20.4% and Retail Sales steady at 12.6%. We doubt any of these numbers represent reality but we do believe that the industrial sector in particular is suffering from a reduced pace of activity driven by a collapse in export growth.

The effect of the overall tenor of May's data seems likely to bring expectations regarding China a little closer to reality. Given that the emerging market complex was already wobbling on the edge of a full blown correction the response of markets will be very interesting to follow.

China's May Loan and Monetary data suggests that a concerted effort to slow rampant credit growth has finally begun to take hold in that economy, with clear and negative implications for the overheated local property and infrastructure sectors.

Total Loan growth was 667.4 bln CNY, well below estimates of 815 bln while Total Social Financing was 1,190 bln CNY (approximately $200 bln), well below last month's pace of 1,747 bln CNY which appears to have been inflated by a rush to beat the crackdown on the issuance of "wealth management" products. On the other hand this still leaves credit issuance at a very high level and the trailing 12 month of Social Financing rose to a new record of 1,571 bln CNY, an annual pace above $3 trln.

The danger now is that credit starts to shrink more rapidly, with the back-up in global yields threatening corporate bond issuance on top of regulatory efforts to slow bank loan and shadow banking activity. Should this take place China's internal liquidity may start to deteriorate quite rapidly. In this regard it should be noted that although M1 and M2 have increased in recent months, the rebound has been much less forceful than the surge which took place under the post Lehman stimulus in 2009.

Indeed at 11.3% M1 growth appears to be only just sufficient to meet China's needs and any sustained slowdown in credit issuance can be expected to force money supply growth to deteriorate appreciably. Should M1 growth fall back to mid single digits YoY, or simply post a number of negative single months the alarm bells would be ringing.

When we first pointed out a large discrepancy between the acceleration in China's Exports to Hong Kong and sluggish data for other cross border trade over a year ago we were very much a lone voice in the market. Over the next few months a number of other commentators made the same point and two months ago a trade official briefly admitted there may be an issue with the data, with artificially large exports to Hong Kong being claimed in order to mask hot money flows into China and also qualify for export credits.

Rumors of a crackdown on this practice have been rife in recent weeks and May's data would appear to show that it has been brought to a halt, revealing in the process a far more alarming picture for China's trade activity than was previously the case. May total Exports grew by a mere 1.0% YoY overall, with Hong Kong Exports growing 5.8% compared to last months pace of 53% (which we assume indicated a rush to file before the crackdown). Imports also showed no growth up 0.3% from the level of a year ago.

This really helps emphasize the point we have been making in recent months, namely that China's economic growth is now wholly dependent on its internal real estate and infrastructure spending, which in turn are driven by excessive local credit growth (which we comment on separately this morning). This is a very different economy from that of 5 or 10 years ago, which significant ramifications for trading partners and investors alike. Although we believe that the market had begun to price in some of this in recent weeks we believe that publication of official data may act as a catalyst for many investors to change their stance on China.

Given all the turbulence in fixed income markets in recent days it was something of a relief to see this morning's non farm payroll report come in close to expectations for a solid if unspectacular set of data.

Total Payroll gains were estimated at 175K compared to expectations of 163K, while net revisions to April and March's data took -12K jobs from prior estimates, exactly canceling out May's consensus beat. As an aside this mean that the April and March reports will now go into the history books as being virtually identical (149K vs 142K) whereas when originally published April had almost twice the estimated gains (165K vs 88K), a reminder of how the data is not only volatile but also often subject to massive revision.

Private Sector gains were 178K and it should be noted that this has started to converge with Total Payroll, perhaps a sign that public sector hiring is starting to finally stabilize. The trailing 12 month ma of Private Sector gains is now 181K a level equivalent to May 2005 in the midst of the last FOMC rate hike cycle. In other words Private Sector job gains in recent months have been typical for a recovery, but of course have yet to reduce the overall Unemployment rate down to an acceptable level.

Speaking of Unemployment, despite a strong Household survey report of 319K the rate actually ticked higher to 7.6%, while the Underemployment rate ticked lower to 13.8%. Neither represents a significant change and we continue to expect further progress to be made on both measures over the summer months.

How the "taperati" interpret this report is anyone's guess, but our view is that global bonds are coming under liquidation pressure towards the quarter's end because of the PRIOR poor YTD returns rather than any obvious immediate shift in FOMC policy. It would have taken a weak BLS report to have reversed this selling pressure and our expectation therefore is that yields continue to edge higher going forwards.

For our last note before we leave for a client roadshow we will update the progress of the 4 high yielding emerging market carry currencies that we have been following. Recent sessions have seen increasing attempts by local authorities to stabilize currencies including a removal of the IOF tax on foreign bond purchases and outright auction of currency swaps in Brazil and an increase in gold import duty to 8% (from 6%) in India. Unfortunately these moves have been met by continued selling of local equities and bonds by foreign investors meaning that currencies continue to look vulnerable.

At the time of writing all 4 currencies are at or just above key resistance levels with the ZAR (green) threatening to move back above 10 (it briefly reached 10.28 last Friday), the TRY (red) moving above 1.90 and threatening the all time high at 1.922, the INR (orange) testing resistance at 57, above which a breakout to a new all time high would be indicated and the BRL looking likely to move back up and retest key resistance at 2.15. Of the four central banks the Bank of Brazil may have the most fire-power at its disposal, but it also has to contend with by far the worst performance by its local equity market (now down 42% in USD terms from its level in 2011), meaning that investor outflows may become quite violent towards the end of the quarter.

The fact that all 4 currencies are weakening at the same time greatly increases the overall effect since together they represent a large proportion of total EM debt instruments held in passive investment vehicles. The losses becoming visible in a large number of mutual funds and ETF's are starting to approach -5% YTD, a level which may be considered unacceptable for what is supposed to be a safe and stable portion of investor allocations. The risk of redemption pressure feeding into these markets should not be underestimated.

US Initial claims for the week ending May 31st were estimated at 346K, in line with expectations and a little better than the 357K report from last week (revised higher from 354K). This kept the 4 week ma at 352K, meaning that we are still on the verge of moving into a strong employment environment (at least as defined by Claims data) but have not yet managed to complete this transition.

However, it must be remembered that this remains one of the toughest periods for seasonal adjustments in the annual calendar and simply treading water can be considered to be an accomplishment. Interestingly the NSA report estimated Claims had dropped to 293K, making it the best late May report since 2007 and the lowest number of unadjusted Claims for any week since late September 2007. This suggests we may start to see a greater reduction in headline Claims as the seasonal adjustments ease a little in the coming weeks.

None of the above gives us much insight as to what to expect in tomorrow's BLS report. Given the obsession with "tapering" this has taken on the mantle of a "mega report", something we suggested was bound to take place when the FOMC elected to specifically target unemployment at the end of 2012. Our guess is that it will take a significant miss (below 125K vs expectations of 165K) to calm the bond market's nerves while anything above 185K would probably spark a renewed wave of selling, particularly if it were accompanied by another tick down in Unemployment.

Quite why anyone on the FOMC felt this change in policy would lead to calmer markets is beyond us. Anchoring policy explicitly to data as quixotic as BLS employment estimates was always likely to inject volatility into the marketplace, particularly since the FRB has a dismal record of predicting shifts in the data.

Readers should note that we will be traveling tomorrow meaning that an immediate response to the data's release cannot be guaranteed but we trust we have communicated our views on the overall situation with sufficient clarity that a glance at the data will give a sense of our reaction.

Evidence is beginning to mount that the UK economy has reentered a period of economic expansion with today seeing positive data released in the key housing and automobile sectors together with improving employment confidence.

UK Vehicle Registrations in May reached 180.11K, an increase of 11% YoY and the strongest May report since 2007. Registrations remain around 10% below their pre-crisis level, which would allow for further acceleration in the months ahead.

UK Home prices also now look to be back in a period of steady appreciation with the Halifax House Price Index rising 2.6% YoY, the 5th consecutive month of annual price gains for UK house prices and the largest annual gain since September 2010. The index is now back to the level reached in August 2010 meaning that the Euro-crisis dip in prices has been erased. The index remains approximately 15% below its pre-crisis level allowing for significant future gains.

Finally employment confidence amongst consumers would seem to be improving which tends to be an accurate real time gauge of actual changes in employment. The Lloyds TSB Consumer Barometer reached -37% (16% of respondents saw improved prospects, 53% worse prospects) which is the second best reading since March 2008. The trailing 12 month ma of this measure reached -44, the best reading since October 2008. This means that although the UK employment situation remains poor in historical terms there are growing signs of sustained improvement.

Overall we would describe the situation in the UK economy to be somewhat similar to that in the US 12 to 18 months ago. This would suggest that further improvement should be expected in the months ahead, and that some of the more cyclical sectors in the UK economy may experience a more concentrated bout of acceleration.

The ISM Non Manufacturing Index for May was reported at 53.7, slightly better than expectations of 53.5 and April's 53.1 reading. This indicates steady growth continuing to unfold in the US service sector without suggesting any meaningful acceleration. Slightly greater strength was seen in New Orders, which reached 56 (up from 54.5) and Business Activity 56.5 (up from 55). International business showed itself to be a little weaker with Imports 49.5 (from 58.5) and Exports 50 (from 53.5). It is not clear whether this represents fluctuations in fairly volatile sub indexes or an actual divergence of domestic and international activity, but we suspect the former is likely to be true for Imports while Export activity would seem to be in a more obvious declining trend.

Overall though this is a positive report, although the secondary nature of this survey means that we would expect to see little market reaction to the data.

Brazil's "currency war" would appear to be over, and with it the credibility of the entire macro-prudential experiment that encouraged a much greater degree of interference in capital markets by the Bank of Brazil.

The IOF imposed a 6% tax on foreign purchases of local bonds designed to limit the massive inflows of foreign capital into local bonds and was introduced in October 2010 in anticipation of the FRB introducing QE2 (which was not formally implemented until November). At the time the Bank of Brazil accused the FRB of conducting a "currency war" designed to devalue the USD against other currencies. For all the faults with FRB policy there is no evidence that weakening the USD was ever their intention (unlike policies followed the SNB or Band of Israel) and of course the USD has generally strengthened since late 2010 against developed currencies and more substantially against emerging market currencies.

It is therefore ironic (but unsurprising) that the repeal of the IOF comes at a time that the BRL has come under substantial selling pressure, falling to a 4 year low of 2.1495 last Friday. The immediate response to this announcement was to take the spot rate back down to 2.086, but it has subsequently moved back higher to 2.107. The problem now is that the very poor performance of Brazilian equities (which have lost over 40% for a USD investor over the last 2 years) and Bonds (which have suffered significant losses in recent weeks) means that there is much less appetite for Brazilian financial assets on the part of foreign investors. The repeal of the IOF is therefore a sensible policy, but one that will have rather less effect than the local authorities will have hoped for.

This week's MBA Mortgage Application report appears to offer conclusive proof that the year long refinance boom has been terminated by the sharp move higher in long dated treasury yields. This spike has caused the 30 year fixed mortgage rate to soar higher from 3.40% in early May to 4.16% yesterday causing this week's Refinance Index to drop -15.04% to 3,163, the lowest reading since November 2011. Even allowing for Memorial Day distortion this is far enough below the key 4,000 level (which to our eyes marks the lower end of boom conditions) to terminate the current cycle and at the very least this means that the long end of the treasury curve can now expect much less support from MBS holders buying treasuries to mitigate the effect of refinancing removing loans from their portfolios.

Whether rates move high enough to create a true selling "vortex" remains to be seen but we would expect that Friday's BLS report will ultimately have a large say in this matter. We note that the GSE debacle of 2003 (hidden at the time by accounting malpractice) involved a collapse of the MBA Refinance index from almost 10,000 to under 2,000 between May 30th and August 31st and we doubt that anything as dramatic will take place this time around. On the other hand the sensitivity of bond prices to interest rate moves is likely to be much greater this time around given the starting point for yields.

While rising rates have greatly influenced refinancing activity they have had a much more muted effect on the Purchase Applications index. This slipped from 210.6 to 207.3 this week, which is within the bounds of statistical noise while the trailing 10 week ma actually rose to a new 3 year high of 201.65. This meant that the percentage of Total applications generated by Refinance applications fell to 68%, the lowest level since May 2011. This is still a relatively high proportion, but we would expect it to continue to fall sharply over the course of the summer potentially to somewhere between 50-60%.

This resilience of Purchase applications to rising yields may come as a surprise to readers but as the attached chart shows Purchase applications (unlike Refinance applications) have generally been POSITIVELY correlated with the 30 year fixed mortgage rate over the last 10 years. This is partly because house purchase activity itself is a powerful influence over long term interest rates but also because as the fixed rate moves higher home purchasers become more likely to switch into cheaper variable rate financing.

Indeed there is already evidence that this is taking place since last week saw a spike in the percentage of ARM applications to 6.4% of Total Applications, up from 5.4% the week before and the highest percentage since May 2011. With the current 5/1 ARM mortgage rate still only 2.76%, only 18 bp higher than its May 1st level and now 140 bp below the 30 year fixed rate, it is unsurprising that we are starting to see a shift towards the use of this much cheaper source of funding. Going forwards we would expect to see a much greater use of ARMs, which back in the last housing boom represented over 30% of applications. This should enable house purchase activity to remain much more solid than many would expect during a period of rising long term interest rates and we would therefore view any further weakness of home-building equities (something we would expect to accompany rising rates) as a buying opportunity.

Spain's dismal unemployment cycle would finally appear to be turning for the better. May saw a very sharp drop of -98.3K registered unemployed, significantly better than the -50K expected. Although May always sees a substantial pick up in employment as the tourist season gears up for peak activity a drop of -98.3K is the largest May drop since the data starts in 1996 and the second sharpest drop for any month on record (June 2012 saw a drop of -98.85K). This takes the trailing 12 month ma of Unemployment down to 14.7K which is its lowest pace of increase since August 2011 just as the Eurocrisis started to bite into Spain's rebound from the 2008/9 collapse.

Of course this still keeps the total unemployed at an unacceptably high 4.89mm, compared to a pre crisis level close to 2mm. This total has increased by 3.75% over the last 12 months, the slowest pace since June 2011. We do expect however that the next few months will show sufficient improvement to take the YoY change back into negative territory which would be the first time this has occurred since May 2007.

Japan's Monetary Base grew by ¥10.9 trln ($109 bln) in May, an increase of 7.48% for the month and underlining the determination of the BOJ to carry through on its promise of massive quantative easing. This is the second largest every injection of liquidity and has only been bettered by the one month emergency response to the 2011 tsunami which lacked the permanence of this current policy shift.

The publication of this data allows us to also consider the changes to the JPY, NKY and 10 year yields over the course of May as a whole and what is interesting to note is that for all the emotion surrounding the last few weeks essentially each of these ended the month roughly where it started. Clearly the momentum of the move that took the NKY to its high and the JPY to its low in mid-May led to a substantial degree of overshoot but the savage correction that followed did little other than rub out the excess. From a technical perspective this left the longer term picture open to interpretation, with both the bulls and the bears left with plenty of ammunition for a protracted argument.

Our view remains that the introduction of QE has the potential to mark a key "sociological" turning point for Japanese society, and that if genuine economic and fiscal reform takes place Japans intermediate future will trn out better than anyone would have imagined 12 months ago. We do accept that May's decline probably marks the end of a straightforward correlation between QE and a rising equity market and falling JPY and going forwards actual economic and corporate data will probably be more important drivers since the BOJ's determination will be taken for granted. We also believe that if the positive shift in activity we forsee takes place the inverse correlation between the currency and the equity market will moderate, and that while longer term yields will rise they will not burst higher in the manner predicted by some observers.

All of the above will take time to play out and there will be a great deal of contradictory economic data and market action along the way. Readers should be prepared to be patient and to ignore the stories suggesting that the BOJ is "pushing on a string" that will inevitably accompany any period in which the market lags, provided some evidence of a rebirth of entrepreneurial spirit is observed amongst businesses and a willingness to consider reform appears the political class.

Brazil's trade position continues to erode although at least it remains in surplus for the time being. Total Exports for May were $21.824 bln, a drop of 6% from May 2012 while Imports rose 4% over the same period to $21,064. This created a monthly surplus of $760 mm, somewhat less than expectations of a $1.8 bln surplus. This takes the trailing 12 month ma of the Balance down to $650 mm, the smallest surplus since August 2002. Today's data is a further reminder that the sharp devaluation of the BRL has its root in a deterioration of Brazil's external balance. Even with buoyant commodity prices in the energy and agricultural sectors (though the same is not true of iron ore) Brazil has seen almost its entire surplus erode from its 2007 peak when it averaged almost $4 bln a month.

The ISM May Manufacturing report was a surprisingly weak set of data with the headline index slipping back into modest negative territory at 49 compared to expectations of 51.0 and April's reading of 50.7. Lower numbers were seen in most of the major sub-indexes with New Orders (red) falling to 48.3 from 52.3. Production (blue) to 49 from 50.7 and Prices Paid (not shown). Employment (pink) was more steady at 50.1 (down from 50.2) while Inventory (olive) draw down diminished with the index rising from 46.5 to 49.

Much comment will no doubt follow this release but we would caution reading too much into fluctuations around the 50 "break even" level. It should be remembered that as a cycle matures the rate of improvement inevitably decelerates and the meaning of a modest negative reading in mid 2013 is very different from one taking place 2 or 3 years ago. This month's report indicates at most a small degradation of manufacturing conditions but given that domestic demand remains robust (as today's car sale data confirmed) in consumer goods, capital goods and housing it is hard to believe that the Manufacturing cycle has suddenly turned.

One possible influence on this report is a reduction in foreign demand and in the comments on the conference call the ISM spokesperson did specifically mention some weakness reported in Chinese machinery demand. Another is seasonal adjustment since the ISM does use the heavy handed official seasonality measure when constructing its survey. We note that since 2010 May's ISM report has seen a drop from April every year ranging from -5.9 in 2011 to -1.1 in 2010 and with an average of -2.6 (see heat view chart). We therefore suspect that even if some moderation of foreign demand has taken place this report overstates its effect and we would caution reading too much into it without other corroborating evidence.