The Day Ahead: Flight to Safety in Motion

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Risk aversion is the trend in early trading after China unexpectedly raised interest rates to combat inflation and Moody's dropped Portugal's credit rating to junk and warned of the potential need for a second bailout.

"Investors are still smarting from yesterday's downgrade of Portugal's credit rating to junk status by Moody's, with the euro, European equities, U.S. stock index futures and Treasury yields all modestly lower," said economists at BMO Capital Markets. "Peripheral Europe's credit spreads, including Italy and Spain, continue to widen against Germany."

S&P 500 futures are down 6.25 points at 1,330.50 while Dow futures are 44 points lower at 12,493. The Euro is 0.75% weaker vs. the U.S. dollar at 1.4312.  The DAX is down 0.40%, the CAC is 0.60% worse, and the FTSE is off by 0.75%. Commodity prices are trading down too: light crude oil fell 0.82% overnight to $96.12, while gold prices dropped 0.11% to $1,511.10.

U.S. Treasuries are rallying as a result and the yield curve is flattening. The  benchmark 10-year note is +8/32 at 100-09+ yielding 3.089% (back inside the 2.90 to 3.10 range). The 2s/10s curve is 3bps flatter at 267bps wide. And the Fannie Mae 4.0 MBS coupon is +5/32 at 100-11.

China's central bank hiked one-year lending and deposit rates by 25 basis points to 6.56% and 3.50%, respectively. This is the fifth such hike since October and unexpected move after
Chinese premier Wen Jiabao declared victory over domestic inflation on June 23rd, saying that the government has successfully reined in price pressures.

Just released, MBA said new mortgage applications rose 4.8% last week, marking the first increase in three weeks. The weekly advance did little to the overall trend, as the index remains near a 14-year low. Meantime, refinancings plummeted 9.2% in the week, leaving them 40.1% down from last year.

Key Events Today:

10:00 - The ISM Non-Manufacturing Index is anticipated to report growth for the 19th consecutive month in June. The consensus forecast expects the index to come in four points above the break-even level, at 54, representing some modest slowdown from May's 54 level, but a better pace than April's 52.8. 

New orders, the key forward-looking component, increased four points to 56.8 in May, and employment ticked up to 54, so the fundamentals of this report are looking good. In addition, last week's ISM manufacturing report climbed unexpectedly by two points to 55.3, adding some hope that this report - which looks at the services, construction, and financial sectors - will also post an upside surprise.

"One source of support for the ISM non-manufacturing for June is some degree of optimism over the commodities price situation," said forecasters at Janney Capital Markets. "Last month, survey respondents noted that not a single of the two or so dozen commodities which serve as common inputs declined in price, a trend which should change in June. Even though economic conditions are clearly pointing towards a patch of weaker aggregate demand, strong levels of corporate investment suggest that the services sector could avoid an out-right contraction, though slower expansion is a near certainty."

Economists at Nomura Global Economics are more pessimistic, anticipating a 51.2 score.

"We expect weakness to emerge in this report as there have been hints of demand destruction because of the softening in weekly retail sales and lower consumer confidence," they said. "As always, we will pay close attention to the employment index, which could be a timely indicator of service sector hiring in June.

Economists at Citigroup say the important employment component "probably slipped a bit, after the surprising pickup in May."

In other news Reuters reports:

It’s Sheila Bair’s last hurrah, as she attends her final Federal Deposit Insurance Corp meeting as chairman before stepping down on Friday at the end of her five-year term. This meeting of the FDIC board is to consider rules for putting into place the agency's new powers to liquidate large, failing financial firms. Also on the agenda are "living wills," which are intended to provide a roadmap for how large financial firms can be broken up if they fail. The goal is to unwind big firms without disrupting markets.

Christine Lagarde, who took the helm of the International Monetary Fund on Tuesday, holds her first press conference in Washington (0930/1330) as managing director. Her attention will almost immediately have to turn to discussions of a second IMF-EU bailout to keep Greece going until 2014. The former French finance minister is likely to avoid putting her stamp on any major decisions until she is fully comfortable in her new job. Her experience as finance minister should allow for an easy transition on several issues the IMF faces, including the monitoring of systemically important countries, such as the United States and China. In her first month on the job, she will also likely help select a new No. 2, who is likely to remain an American.