One day after the US-China trade war entered “phase II”, with another $200BN in US tariffs slapped on Chinese imports  sending global stocks lower, markets found their footing, and stocks in Europe traded higher after a mixed session in Asia as investors put trade war and political jitters on the backburner and turned their attention to tomorrow’s FOMC rate hike and 2019 dot plot.

Europe’s Stoxx Europe 600 rebounded from Monday’s drop, rising 0.3% as most European bourses traded in the green, while U.S. index futures pointed to a mixed open, with S&P 500 futures slightly firmer even as the Nasdaq hugged the flatline after Instagram’s founders said they were leaving Facebook .

After a one-day holiday, China and Japan returned to the market with diverging reactions: Japanese stocks climbed to the highest since February as the Nikkei closed at session highs, some 0.3% higher, a function of the ongoing decline in the yen…

… while Chinese shares headed in the opposite direction after a long weekend. Meanwhile, Hong Kong where stocks dropped on Monday due to escalating trade tensions, and South Korea were shut.

Italian bonds rallied as the country crept closer to a budget compromise. According to La Stampa, Italy would propose a 1.9% budget deficit, which while somewhat wider than previously expected, would include budget cuts and 36 billion-euro investment package. Five Star leader Di Maio suggested Italy should copy France with a 2.8% deficit-to-GDP but later backtracked and said the gap should be narrower than that. Even with a budget deal imminent, Goldman strategist George Cole remained skeptical, warning that the extra premium investors demand to hold Italian debt over its German equivalent is unlikely to shrink to levels seen before May anytime soon. That’s even if Italy’s leaders project a deficit below the bank’s forecast of 2% and the European Union limit of 3% in their 2019 budget targets, which must be published by Thursday.

Specifically, Cole predicted a difficult outlook over the medium term, due to the “upcoming fiscal expansion, coupled with the weakening in higher frequency indicators” in Italy, should result in only a limited and temporary fall in Italian yields. If the deficit comes in as Goldman expects or lower, the spread could tighten to 210 basis points, but will be hard to narrow beyond 200 basis points

However, the main driver behind global sentiment remains the trade showdown between the US and China, as the two nations dig in for what BBG called “could be a long and bruising trade war, after China’s decision to call off planned talks after the latest round of tariffs. China’s Vice Commerce Minister said China was willing to promote US-China trade in a fairer fashion and is hoping US takes more positive steps as well, although he added trade talks with the US are hard to proceed as US has  abandoned mutual understanding and the restart of trade talks depends completely on the US.

Separately, China’s NDRC Vice Chairman said China is able to offset trade risks through expanding domestic demand and that China will give more support for Chinese firms to expand into international markets including EU, Japan and Africa, while he reiterated the domestic economy is resilient.

Political fears also emerged overnight, following conflicting reports that U.S. Deputy Attorney General Rod Rosenstein may be poised to leave his post – although it remains unclear if he will quit or be fired – while the nomination of Brett Kavanaugh to the U.S. Supreme Court continues to be mired in controversy.

With just one day until the Fed’s latest decision, in which the FOMC is expected to hike another 25 bps and feature fresh projections for the next few years, traders are gearing for further strength in the dollar and more bond weakness. According to JPM portfolio manager Iain Stealey, “what will be more interesting will be to find out the number of rate hikes anticipated for next year. Inflation is above target, so they can keep going on this sort of slow normalization. I don’t see them stopping unless we see a pickup in trade rhetoric which actually does impact the overall economy.”

Meanwhile, speaking of the dollar, it swung between gains and losses amid choppy price action in most major currencies.

The euro edged higher against the dollar after earlier reversing gains and bunds trimmed losses after ECB Chief Economist Peter Praet said he didn’t believe President Mario Draghi intended Monday to send a new signal when he said the pickup in underlying euro-area inflation is “relatively vigorous.” Elsewhere in FX, the pound swung between losses and gains as the U.K. opposition Labour Party said it will vote against Prime Minister Theresa May’s exit deal with the European Union, and is keeping all options open on Brexit including a second referendum and the choice to stay in the bloc. The yen fell to a two-month low against the dollar as markets note the BOJ’s reluctance – and impossibility – to tighten financial conditions. Sweden’s krona held steady against the euro even as the country’s parliament voted to oust Prime Minister Stefan Lofven.

Treasuries remained in their recent defensive mode, with the 10-year yield rising close to its year-to-date high, pushing above 3.11%.

In commodities, Brent continued its ascent after OPEC+ nations defied Trump’s demands for a production boost, and traded above $81 a barrel, the highest in 4 years, while most metals fell.

In the latest Brexit news, UK PM May said it was always clear there would come a critical point in Brexit negotiations and now is the time to hold nerve, while there were separate reports the UK cabinet is said to give PM May’s Brexit plan 2 weeks for progress. May was also said to meet US President Trump on Wednesday to discuss Brexit and a post-Brexit trade deal, according to a British official.

On today’s calendar, expected data includes FHFA House Price Index and Conference Board Consumer Confidence. Aurora Cannabis, IHS Markit, Nike are among companies reporting earnings.

Market Snapshot

• S&P 500 futures up 0.1% to 2,929.25
• STOXX Europe 600 up 0.3% to 383.08
• MXAP up 0.07% to 165.27
• MXAPJ down 0.2% to 523.04
• Nikkei up 0.3% to 23,940.26
• Topix up 1% to 1,822.44
• Hang Seng Index down 1.6% to 27,499.39
• Shanghai Composite down 0.6% to 2,781.14
• Sensex down 0.4% to 36,175.40
• Australia S&P/ASX 200 down 0.02% to 6,185.88
• Kospi up 0.7% to 2,339.17
• German 10Y yield rose 1.4 bps to 0.524%
• Euro down 0.02% to $1.1746
• Italian 10Y yield rose 11.6 bps to 2.586%
• Spanish 10Y yield fell 0.9 bps to 1.515%
• Brent futures up 1% to $81.99/bbl
• Gold spot down 0.1% to $1,200.24
• U.S. Dollar Index little changed at 94.19

Top Overnight News from Bloomberg

• World’s two biggest economies are digging in for what could be a long and bruising trade war, testing the resilience of the strongest global upswing in years
• President Trump didn’t bring up any new areas of contention in his Monday meeting with French President Emmanuel Macron, and the two found areas of agreement over Iran and Syria, French officials said
• U.K. opposition Labour Party is preparing to vote down any deal with the EU that Theresa May brings to Parliament, adding to pressure on the beleaguered premier
• German Chancellor Angela Merkel says U.K.-EU exit deal “might already be achievable in October,” ahead of EU summit likely in November
• European Union will establish mechanism to protect European companies’ financial dealings with Iran from the effect of U.S. sanctions in a bid to keep Iranian nuclear agreement alive
• Unwinding central bank quantitative easing shouldn’t have a material impact on the economy, according to Bank of England policy maker Gertjan Vlieghe
• Euro bears are holding tight, setting the common currency up for a potential short squeeze that could turbocharge a burgeoning rally
• The extra premium investors demand to hold Italian debt over German peers shrunk as La Stampa reported that the budget deficit would be 1.9 percent, below the European Union limit of 3 percent. The coalition needs to publish its 2019 budget targets by Thursday
• The Federal Reserve will raise interest rates this week and continue its quarterly drumbeat of 25-basis-point increases straight through to June 2019, according to economists surveyed by Bloomberg
• Swedish PM Lofven was voted out in a confidence vote in parliament as the center-right opposition and the nationalists joined forces to end four years of Social Democratic rule
• Oil held a gain above $72 a barrel as banks and trading houses became bullish on prices after OPEC and allies rebuffed President Trump’s call to boost production

Asian stocks traded mixed with the region indecisive following a lacklustre lead from Wall St. where both S&P 500 and Dow slipped from all-time highs on trade related concerns. ASX 200 (flat) losses were initially led by weakness in the financial sector but the index recovered later in the session. The Nikkei 225 (+0.3%) was choppy in lock-step with an indecisive currency. The Shanghai Composite (-0.6%) underperformed on the return from the long weekend and took its first opportunity to react to China’s cancellation of trade discussions, while the PBoC conducted a net liquidity drain and China was also reportedly to create a national system to monitor government spending. Elsewhere, Hang Seng and KOSPI are closed due to public holidays. Finally, 10yr JGBs were marginally lower in which prices tested the 150.00 level to the downside coinciding with weakness in T-notes, while the BoJ’s Rinban announcement was for a relatively reserved JPY 475bln.

Top Asian News from BBG

• Amarin’s 475% Rally Boosts Japanese Supplier of Fish-Oil EPA
• Japan Stocks Erase This Year’s Loss on Seven-Day Winning Streak
• Japan Court Clears Reactor Restart in Win for Nuclear Push
• China Stocks Fall as Trade Spat Deepens; Developers Lead Retreat
• Defaulting Shadow Lender Is Said to Face India Insolvency Filing

European equities have started the day higher with the FTSE MIB the marked outperformer as reports suggest the Italian Government are set to announce a deficit/GDP under 2%. Next are leading the gains in the FTSE and the Stoxx 600 after the UK retailer reported inspiring earnings and upwardly revised FY guidance for profits by GBP 10mln. Evonik shares are languishing close to the foot of the Stoxx 600 after RAG-Stiftung reduced its holding in the co. to 64.3%. The energy sector is extending on the gains seen yesterday and is the outperforming sector off the back of rising oil prices.

Top European News

• Praet Says Draghi’s Inflation Comments Didn’t Reveal Any News
• Telecom Italia Board Is Said to Discuss Nextel Bid
• Goldman Sees Choppy Waters for Italy’s Bonds Even After Budget
• Labour Sees Second Referendum as Tool to Avoid No-Deal Brexit

In FX, the dollar index is clinging to recovery gains just above the 94.000 level as the clock begins to tick down to  Wednesday’s FOMC meeting, but largely due to dovish/bearish impulses from the BoJ and resultant JPY weakness vs the Greenback alongside other major counterparts on a cross basis. Indeed, Usd/Jpy looks poised to probe 113.00 as Governor Kuroda effectively endorsed further upside potential given ongoing easy policy in Japan vs more normalisation in the US. Technically, 113.24 forms the 200 WMA, and the 2018 high so far is 113.40, assuming the big figure is surpassed and that  could be down to the Fed via September’s SEP and/or the tone of the accompanying statement given that another 25 bp hike seems baked in. GBP/EUR – The Pound is in pole position among G10s, partly due to the aforementioned lack of yen for the Jpy and perhaps positive sounding Brexit deal vibes from German Chancellor Merkel amidst all the divergence at home. Cable is retesting offers/resistance around 1.3150 and bids/support circa 0.8950 vs the single currency as ECB’s Praet plays down hawkish inflation comments from President Draghi, or at least perceptions and the rather ‘vigorous’ market reaction. Eur/Usd has eased back towards 1.1750 vs 1.1800+ yesterday, and from a chart perspective has retreated through a key Fib again (1.1780). CAD/AUD/CHF – All extending losses vs the Greenback, or perhaps shouldering the weight of the Dollar’s partial revival, with the Loonie slipping further from recent highs to circa 1.2960 and still mainly contingent on NAFTA instead of still  bid/rising crude prices, the Aud capped below 0.7250 and hampered by the lack of US-China trade talks, and the Franc  underperforming around 0.9650 and down through 1.1350 vs the Eur amidst latest Italian fiscal reports suggesting compliance with EU budget rules.

In commodities, the oil market added to gains seen yesterday, with the fossil fuel hitting over 4 year highs, and Brent breaking USD 82.00 to the upside in European trade as the production-shy rhetoric from OPEC remains fresh in traders minds. In the metals scope, gold is uneventful and trading within an exceedingly thin range of USD 3/oz with the yellow metal consolidating around the USD 1200/oz, as traders look ahead to tomorrows anticipated hike from the FOMC. Copper is seeing further weakness, with the construction material down over a percent, as market participants express demand concerns amid continued US-Sino trade tensions.

Looking at the day ahead, the focus in markets may well be on any headlines which come from the General Debate of the UN General Assembly. President Trump is to due address the Assembly (time 10:15 EST/ 15:15 BST) while Japan PM Shinzo Abe is also due to meet Trump on the sidelines to discuss trade while EU Trade Commissioner Malmstrom is due to meet with US Trade Representative Lighthizer as well as Japan’s Economy Minister Seko on the subject of trade and the WTO. Outside of that the data releases are mostly second tier. In Europe we’ll get September confidence indicators in France while in the US we get the July FHFA house price index and S&P CoreLogic house price index, along with September consumer confidence data and the September Richmond Fed manufacturing index.

US Event Calendar

• 9am: FHFA House Price Index MoM, est. 0.25%, prior 0.2%
• 9am: Case Shiller 20-City MoM SA, est. 0.1%, prior 0.11%; YoY NSA, est. 6.2%, prior 6.31%
• 10am: Richmond Fed Manufact. Index, est. 20, prior 24
• 10am: Conf. Board Consumer Confidence, est. 132.1, prior 133.4; Present Situation, prior 172.2; Conf. Board Expectations, prior 107.6

DB’s Jim Reid concludes the overnight wrap

Draghi’s comments yesterday (see below) led to a rates selloff that pushed 10yr yields up 3-6bps across most of Europe yesterday – BTPs +11.9bps due also to politics – with Bunds in particular closing at 0.507% (+4.9bps) and to the highest since 23 May just before Italy’s politics took a turn for the worse. Yields are now up 32.2bps from the intraday May lows and 20.8bps from the August lows. 10yr Treasuries out-performed but still closed 2.6bps higher at 3.090%.

Draghi spoke in the early afternoon to the European Parliament in Brussels and said that “underlying inflation is expected to increase further over the coming months as the tightening labour market is pushing up wage growth” and also that “domestic price pressures are strengthening and broadening”. There was also plenty of excitement when Draghi said that he sees a “relatively vigorous” pickup in underlying inflation however this language was used in reference to ECB staff projections of a pickup in future underlying inflation offsetting slowing non-core components so it was a little misleading that this got all the initial attention. Draghi also endorsed current market pricing with respect to forward guidance and downplayed any conditionality of an end of asset purchases by year end. DB broadly agrees with Draghi’s comment, and we expect core inflation to hit 1.3% by year-end and to average 1.5% next year, enough to justify our call for a September 2019 rate hike.

The euro also rose sharply post the comments, though it subsequently pared back the move into the close to end the session flat versus the dollar. That initial Euro strength seemed to partly weigh on equity markets in the region although to be fair they were already weak going into the headlines. The STOXX 600 eventually ended -0.56% and the DAX and CAC -0.64% and -0.33% respectively. In the US it was much the same with markets also dealing with the news (per Bloomberg) that Deputy Attorney General Rod Rosenstein will meet with President Trump on Thursday to possibly resign – adding to the political volatility around the Russia investigation. The S&P 500 and the DOW closed -0.35% and -0.68% lower, respectively, while the NASDAQ advanced +0.08%. If you were wondering which assets actually had a good day yesterday then the Oil complex ticks that box with Brent (+3.05%) and WTI (+1.84%) both rallying. The key driver was the weekend news that OPEC and its allies seemingly are in no rush to raise output. Talk of $100/bbl Brent is now becoming more frequent. That would certainly flush out inflation.

This morning in Asia sentiment is a lot more mixed. The Nikkei (+0.17%) is slightly higher – albeit for the seventh session in succession – having reopened from a long weekend however bourses in China (Shanghai Comp -0.76%) are much weaker and clearly impacted by the weekend trade news. Vice Commerce Minister Wang Shouwen has also reiterated overnight that trade talks have stalled and that China won’t talk under when the US is “putting a knife on China’s neck”.

The ASX (+0.02%) is more or less flat while markets in Hong Kong and South Korea are both closed. Futures in the US are slightly in the red while the rate selloff has continued across much of the Asia region – with 10y yields in the likes of Australia 4.6bps higher.

Moving on. With just two days until the 2019 budget deadline in Italy, there’s an unsurprising steady stream of daily headlines for markets to digest. After Messaggero reiterated that Finance Minister Tria was aiming to fix the deficit at 1.6%, Repubblica reported that Five Star were pushing for 2.6%. As seen above BTPs were a bit nervous yesterday in light of the week ahead. Headlines from Italian newswires tend to come out just as we go to print so expect more shortly. In other markets yesterday, it was a relatively soft day for EM FX (-0.24%) and EM equities (-0.86%). Argentina’s assets generally sold off, with 10-year bond yields 21bps higher, the Peso -0.22% weaker, and benchmark equities down -3.39% after the news that the country was in talks for an increase to its $50bn credit line with the IMF. Argentina’s President Mauricio Macri actually said yesterday in an interview with Bloomberg TV that there is “zero chance” of Argentina defaulting again. Given that Argentina has defaulted on its sovereign debt a total of 8 times since independence in 1816, history would suggest slightly more prudence here.

On the economic data front, surveys were relatively strong in Germany and the US. The German IFO business confidence survey printed at 103.7 from 103.8. Both the current assessment and the forward-looking expectations sub-indexes beat expectations. In the US, surveys from the Chicago and Dallas Federal Reserve Banks both printed in expansionary territory. Overall yesterday’s data continued to signal growth near the top of its post-recession range.

Looking at the day ahead, the focus in markets may well be on any headlines which come from the General Debate of the UN General Assembly. President Trump is to due address the Assembly (time 10:15 EST/ 15:15 BST) while Japan PM Shinzo Abe is also due to meet Trump on the sidelines to discuss trade while EU Trade Commissioner Malmstrom is due to meet with US Trade Representative Lighthizer as well as Japan’s Economy Minister Seko on the subject of trade and the WTO. Outside of that the data releases are mostly second tier. In Europe we’ll get September confidence indicators in France while in the US we get the July FHFA house price index and S&P CoreLogic house price index, along with September consumer confidence data and the September Richmond Fed manufacturing index. Outside of that, BoJ Governor Kuroda is due to speak just after we go to print, while the ECB’s Praet and Coeure also speak at various stages today. It will be interesting to hear after Draghi yesterday.

Finally look out for the Brexit debate at the U.K. Labour Party conference today. It may start to shape their policy going forward which will be especially important if a general election is the only way out of the current Brexit impasse. Some kind of second referendum may start to gather momentum in the opposition party after today although not necessarily an in/out one which may disappointment many in the party. Bloomberg reported last night that Labour is also planning to vote down PM May’s Brexit deal.