(Reuters) – A look at the day ahead in European and global markets from Wayne Cole

China’s inflation data for June surprised on the downside, with consumer prices slipping 0.2% on the month to leave annual CPI dead flat. Producer prices fell 5.4% on the year, the sharpest decline since late 2015.

On the face of it, this implies there is plenty of scope to ease monetary and fiscal policy further. Yet it also underlines the scale of the challenge that Beijing faces in avoiding an outright deflationary spiral. Japan’s experience shows what deflation combined with a shrinking population can mean for an economy.

The soft data saw the yuan lose early gains but Chinese blue chips are still up, in part thanks to hopes that Beijing is relaxing its regulatory grip on the tech sector.

Globally, a deflationary pulse from China could over time help to offset service-driven inflation in developed nations. Disinflation in goods is a major reason analysts expect coming U.S. CPI data to show a slowdown in June.

Headline U.S. inflation is forecast at 3.1%, a remarkable turnaround from 9.1% a year earlier even if core measures are proving stickier. That would be welcome news for the Treasury market after its recent drubbing.

Some funds were clearly long of bonds in anticipation of an “end of the tightening cycle” rally that never materialised, and got badly squeezed when the market moved against them.

The fact that U.S. 10-year yields are still testing 4.09% despite the downside miss on headline payrolls suggests the market is still long and there’s further pain ahead.

One side effect of the surge in bond yields has been a shake-out of carry trades in the forex market. Every investor and their mum has borrowed cheaply in yen to invest in high yielders, with the Mexican peso likely the most crowded of all the trades.

Rising yields in the developed world make emerging markets look relatively less attractive and can pressure those positions. It was notable late last week that Mexican bonds suddenly sold off and the peso slid 2.6% on the yen over two sessions – although that follows months of gains.

Such trades are usually done by selling yen for dollars and dollars for pesos, or whatever the target currency is, so when the positions are reversed it leads to selling of dollars for yen.

This was likely a major reason the dollar dropped 1.3% on the yen on Friday, and why any major unwinding of carry trades would drag the dollar down even if its own fundamentals seemed sound.

Still, a sustained unwinding seems unlikely unless and until the Bank of Japan finally gives up on its yield curve control (YCC) policy. The BOJ’s next meeting is on July 28 and many western banks are tipping some form of tightening, although the BoJ itself has shown scant sign of gratifying them. Were it to happen, it would be a seismic event for markets.

Key developments that could influence markets on Monday:

– Bank of England Governor Andrew Bailey and Finance Minister Jeremy Hunt speak at the annual Mansion House dinner

– Fed speakers at Monday events include San Francisco President Mary Daly, Cleveland President Loretta Mester and Atlanta President Raphael Bostic

(By Wayne Cole; Editing by Edmund Klamann)

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