A sea of red, but AAA shock will fade

Aug 3 (Reuters) – No doubt about it, Wednesday was one of the gloomiest days in a long time for stock markets around the world, as Fitch’s surprise move to strip the US of its AAA credit rating gave investors the ideal cover to take profit and cut risk exposure.

But will the downgrade have any lasting market impact? It is questionable, to say the least, and Asia could recover ground on Thursday if key purchasing managers index reports show service sector activity across the region held up well in July.

Services PMI data from Australia, Japan, India, and China are due on Thursday, with China’s unofficial Caixin report coming under the closest scrutiny. It is expected to show the seventh straight month of growth, but at a slower pace from June.

China’s economic indicators have undershot consensus for months, and by a significant margin too. Could that be about to turn?

Investors will be hoping for a positive surprise after Wednesday’s heavy selling. The MSCI Asia ex-Japan index had its worst day since June last year and the MSCI World index had its biggest fall since December, while the Nasdaq and S&P 500 posted their biggest declines since February and April, respectively.

Fitch’s decision late on Tuesday came as a surprise and certainly contributed to the slump in stocks. But its effect on the dollar and US bonds – two areas where souring US creditworthiness should hit the hardest – was negligible.

Two- and 10-year Treasury yields moved a few basis points and the dollar rose. The dollar has now appreciated 10 of the last 12 trading days – bad news for hedge funds holding the largest short dollar position in two-and-a-half years.

G10 FX volatility crept to a two-month high on Wednesday but it’s worth remembering that in early June, vol slumped to its lowest since March last year.

The US yield curve has been steepening for more than a week, led by selling at the long end. That trend accelerated on Wednesday after the Treasury laid out plans to increase the size of debt auctions in the coming quarters.

Japanese stocks on Wednesday suffered their worst day of the year, knocked down by the triple whammy of the BOJ’s step last week toward policy normalization, rising long US bond yields, and a stronger dollar.

But again, the bigger picture is less alarming. The yen ended the day little changed, and dollar/yen volatility is comfortably lower than it was before Friday’s BOJ move.

Here are key developments that could provide more direction to markets on Thursday:

– China, Japan, India, and Australia services PMI(July)

– Australia trade balance (June)

– Bank of England rate decision

(By Jamie McGeever; Editing by Marguerita Choy)