Weekly Recap | Markets Churn as violence in the Middle-East escalates

– Events in Iraq stunned the world this week, as the militia Islamic State in
Iraq and the Levant (ISIS), which has been fighting in the Syria conflict and
in northern Iraq for years, rapidly advanced on and seized Mosul, Iraq’s second
largest city. Tens of thousands of Iraqi army soldiers dropped their weapons
and fled without firing a shot, casting doubt on the morale and loyalty of the
entire armed forces. 

– BoE Governor Carney began positioning the BoE to join the Fed in the policy
exit club this week. Just as the World Cup was kicking off, Carney gave a
speech in which he warned that rate hikes might come sooner than expected.
Carney said the bank had no preset course for raising rates and clarified that
the timing of hikes would be entirely data dependent. The UK has already seen a
string of improving economic data and the BoE has been ahead of the curve on
normalizing policy, but Carney’s remarks still came as something of a surprise.
Following the speech analysts suggested that expectations for the first rate
hike have moved to late 2014 from the first quarter of 2015. The BoE June
meeting is next week.

– Two big Fed doves made comments this week that could be seen as conceding the
time was drawing near to start tightening policy. Bullard said the Fed was
closer to achieving its policy objectives than it has been in most times since
1960 and observed that the economy is more normal than it has been for five
years. The potential for GDP grow in excess of 3% in the final three quarters
of the year would “adjust rate-liftoff timetable.” He also warned
that the last tightening cycle, in 2004-06, was too methodical and failed to
respond to economic developments. Rosengren said he would be in favor of
raising reverse repos and interest on excess reserves when the time came for
tightening. Interestingly, he also said he would favor a seamless continuation
of tapering to reduce the Fed’s balance sheet. And while attention was focused
elsewhere, one of Janet Yellen’s favorite economic indicators blew out
expectations. The April JOLTs job openings report was +4.5M v +4.0Me, providing
more evidence that the labor market is truly healing. The pre-recession high
was +4.7M in March 2007. The prior month’s number was revised up to +4.2M from
+4.0M. 

– Airlines had a very turbulent week after the World Bank cut global growth
forecasts, the Iraq situation sent oil higher and Lufthansa and Aer Lingus cut
guidance. Lufthansa cuts its FY14 profit forecast to €1.0B from the €1.3-1.5B
outlook offered at the beginning of May, warning that it had negative pricing
in May due to stiff competition from low-cost carriers. Price weakness and
overcapacity on North Atlantic routes impacted the airline’s cash cow premium
seats. Aer Lingus’s problems stem from ongoing cabin crew strikes, which have
impeded operations. Aer Lingus warned that profits would fall 10-20% y/y in
2014. At one point, shares of American Airlines were down as much as 14% on the
week before recovering a bit. Delta dropped 7% on the week and United was down
12%, with domestic-focused carriers Southwest and JetBlue down 5% a piece.

– Tech had some brighter news thanks to Intel raising Q2 and FY14 guidance on
higher PC unit volume, perhaps indicating an IT refresh is taking hold.
Meanwhile, Tesla made the bold move of opening its electric motor patents to
other firms in an effort to springboard wider adoption of its clean energy
vehicle standards.

– Allergan rejected Valeant’s latest offer and provided a comprehensive
rebuttal of not just the logic behind Valeant’s offer but also the company’s
entire business model. Valeant raised the cash component by $13.70 to $72 and
left the stock component at 0.83 shares of Valeant stock. The revised offer
valued the deal around $180/share or about $54B in total. Allergan responded
with a scathing presentation that questioned the sustainability of Valeant’s
entire business model. According to Allergan, Valeant’s unsustainable model
relies on serial acquisitions and R&D cost reductions, as opposed to
top-line revenue growth and operational excellence.

– In other deal news, Tyson Foods won the contest for Hillshire Brands with its
$63/share cash offer, making a total deal valued at $8.55B, including Hillshire’s
outstanding debt. Pilgrim’s Pride refrained from raising its $55/share offer
over the weekend, and the company later said it was still on the hunt for a big
processed food acquisition. Merck has a deal in hand to buy biotech name Idenix
Pharmaceuticals for $24.50/share, in a total deal valued at $3.9 billion. The
deal gives Merck a good position in the hepatitis C area, where Idenix has
promising portfolio of drug candidates. CNBC reported that Merck paid a huge
premium for the company, following a bidding war with Johnson & Johnson and
AbbVie. Priceline agreed to buy dining reservation site OpenTable for $2.6
billion in cash. Priceline has been looking to extend its business beyond
travel, and OpenTable has 15 million customers who book reservations across 31K
restaurants a month.

– In FX trading, major pairs were in consolidation mode after last week’s ECB
rate cut and US May payrolls. The greenback tried to hold onto its slight gains
with dealers noting that yield spread between two-year yields on USTs and
German bunds were at their widest since 2007 at one point, EUR/USD saw strong
resistance ahead of big option barriers at 1.3500 which could prove tough to
break. The level corresponded to last week’s post-ECB decision low. EUR/JPY
closed out the week below its 200-day moving average around 138.70. The key
level was tested in late May but sustained moves below the level on a closing
basis have not held since just before Japan PM Abe’s electoral victory in
summer 2012. This time the break could be for real. GBP/USD was approaching the
1.70 handle following Carney hawkish message. With rate hikes coming even
sooner, sterling should strengthen further. Note that the 1.7050 level has been
a pivotal trading point over the past eight years.

– Japan put out final Q1 GDP figures that were stronger than expected. The
capital investment component stood out with a 7.6% q/q rise, above the 4.9%
prelim and 4.6% estimate, bringing the overall figure to 1.6% and 6.7%
annualized. Later in the week, the BOJ policy statement maintained its economic
assessment for the 11th consecutive meeting but raised its view on overseas
economies. BOJ Governor Kuroda’s press conference reflected the recent upbeat
GDP and CPI data, noting the impact of the sales tax hike has been within
expectations and forecasting a summer recovery following the Q2 contraction.
The Nikkei225 ended the week flat after an early selloff.

– China released the bulk of its economic data for May to little fanfare
despite the generally robust set of numbers. Retail sales growth hit a
four-month high of 12.5%, new loans of CNY870B beat estimates by a large
margin, M2 money supply reached a 5-month high, while the CPI recovered from
multi-month lows amid a large increase in food prices. Markets also overlooked
the surprising drop in imports component of the trade figures out early in the
week, with the overall trade balance hitting a 5-year high of $35.9B. Much of
the focus fell on the details of the 50bp RRR cut by the PBoC on Monday as part
of a “targeted stimulus” aimed at reviving credit for smaller
enterprises and the rural segment of the economy.

– Down under, Australia saw its first negative net employment change in four
months with all of the losses coming in the part-time sector. In fact, total
hours worked in May saw the biggest monthly increase in over a year, which
largely made up for participation rate falling to an eight-year low of 64.6%.
The New Zealand central bank raised its benchmark rates by another 25bps to
3.25%, and the accompanying statement was much more hawkish than expected.
Governor Wheeler did not see the recent strength in NZD and dairy price
declines as sufficiently detrimental, generally maintaining the bank’s outlook
for 90-day bill rates through 2016. Fixed income markets repriced the
probability for a July decision in favor of another rate hike, while NZD/USD
hit a 4-week high near the $0.87 handle.