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China slips into deflation

A disappointing set of China trade numbers for July saw European and US markets selloff sharply yesterday, reinforcing concerns that the Chinese economy is struggling, undermining hopes that the slowdown in Q2, was simply a one-off.

If anything, the signs of a slowdown have been there for months for China, given that PPI inflation has been negative all this year, with headline CPI following it at a distance.  

This morning headline CPI inflation in China followed the PPI measure into outright deflation for the first time in 28 months, increasing fears that for all the promises of further stimulus measures, Chinese authorities may be facing limitations in the type of stimulus they can implement when it comes to kick starting domestic demand.

CPI inflation fell from 0.2% in June to -0.3% in July, while PPI came in at -4.4%, the 10th month in a row that prices have been negative.

Chinese deflation has been the proverbial elephant in the room when it comes to recent tightening measures from the Federal Reserve, the ECB, and Bank of England. How many more rate hikes can we expect in the coming months when there is a clear deflationary impulse coming from Asia, and where is the tipping point when it comes to the risk of overtightening.

With recent rebounds in oil prices prompting a rebound in gasoline/petrol prices, along with the clear lags when it comes to the effects of previous rate hikes, does the risk of overtightening outweigh the risks of signalling a pause, and waiting to see the effects of previous rate hikes on consumers as fixed rates roll off.

Tomorrow’s US CPI, and Friday’s PPI numbers could go some way to answering this question, however it is becoming clearer that central banks are leaning more towards pausing in September, which means we could well have seen the end of the rate hiking cycle for all three, the Federal Reserve, ECB, and Bank of England.

Tighter credit conditions for banks were also behind yesterday’s sell-off after Italy unexpectedly slapped its banking sector with a 40% windfall tax on its profits for this year. This raised concerns that other European countries like Germany, France and Spain may follow suit.

UK banks also fell back although the prospect of a UK tax is lower given that the banking sector here already pays a higher rate due to the 3% banking levy, on top of the 25% corporation tax rate, although there have been some misguided calls for the UK government to follow suit in a similar fashion to the energy profits levy on energy companies.

That would be unwise given it could prompt banks to cut back on lending, and in turn become more risk averse which in turn could impact profits growth, as well as cutting credit into the real economy.   

EUR/USD – having failed to consolidate its move above 1.1000 the euro has slipped back with the lows last week just above 1 0900, a key support. We currently have resistance at the 1.1050 area which we need to break to have any chance of revisiting the July peaks at 1.1150.

GBP/USD – gave up its Monday gains having failed to move above the 1.2800 area, however while above the lows last week at 1.2620 area the bias remains higher. We need to see a move back above the 1.2800 area to ensure this rally has legs. Below 1.2600 targets 1.2400. Resistance at the 1.2830 area as well as 1.3000.    

EUR/GBP – continues to struggle near the 0.8650 area but we need to see a move below the 0.8580 area to signal a short-term top might be in and see a return to the 0.8530 area. Also have resistance at the 100-day SMA at 0.8680.

USD/JPY – looks set for a retest of the 144.00 area having rebounded from the 141.50 area. While below the 144.00 area the risk is for a move towards the 140.70 area. Main resistance remains at the previous peaks at 145.00.


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