Market Cross-Currents

There are many cross currents afflicting markets at present.  Equity valuations look high but US earnings have been strong so far, with close to 90% of S&P 500 earnings coming in above expectations. This has helped to buoy equity markets despite concerns over the spreading of the Delta COVID variant and its negative impact on recovery.  Yet the market doesn’t appear entirely convinced on the recovery trade, with small caps continuing to lag mega caps. 

The USD index (DXY) remained supported at the end of last week even as US yields remain capped, but the USD does appear to be losing momentum. Positioning has now turned long according to the CFTC IMM data indicating that the short covering rally is largely exhausted; aggregate net USD positioning vs. major currencies (EUR, JPY, GBP, AUD, NZD, CAD & CHF as a percent of open interest) turned positive for the first time in over a year. 

Inflation fears have not dissipated especially after recent above consensus consumer price index (CPI) readings, for example in the US and UK.  Reflecting such uncertainty, interest rate market volatility remains high as seen in the ICE BofA MOVE index while inflation gauges such as 5y5y swaps have pushed higher in July.  There was some better news on the inflationary front at the end of last week, with the Markit US July purchasing managers indices (PMIs) revealing an easing in both input and selling prices for a second straight month, albeit remaining at an elevated level. 

This week we will get more information on inflation trends, with the June Personal Consumption Expenditures (PCE) report in the US (Fri), Eurozone July CPI (Fri), Australia Q2 CPI (Wed) and Canada June CPI (Wed), on tap this week.  We will also get to see whether the Fed is more concerned about inflation risks at the Federal Open Markets Committee (FOMC) meeting (Wed).  The Fed is likely to continue to downplay the surge in inflation, arguing that it is transitory, while the standard of “substantial further progress” remains a “ways off”.   Nonetheless, it may not be long before the Fed is more explicit in announcing that is formally moving towards tapering. 

An emerging markets central bank policy decision in focus this week is the National Bank of Hungary (NBH) where a 15bp hike in the base rate is expected.  Central banks in emerging markets are taking differing stances, with for example Russia hiking interest rates by 100 basis points at the end of the week while China left its Loan Prime Rate unchanged.  The July German IFO business climate survey later today will be in focus too (consensus 102.5).  Overall, amid thinner summer trading conditions market activity is likely to be light this week.

India’s Covid Worsening, Central Banks and US Data

A number of holidays this week points to quieter week for markets.  However, as I note below, there are still a number of risk events on the horizon. 

A growing focus is the divergent trend in the path of Covid in emerging markets and in developed economies, with the former especially in some parts of Asia, Latin America and Africa, seeing a significant worsening, which will likely result in delayed recoveries and lead to some EM asset market underperformance. 

India’s Covid situation worsens dramatically

As all the headlines show, India’s Covid situation has become particularly dire though a lack of large-scale lockdowns has led to only a limited mark down in growth forecasts there even as risks intensify.  Already there has been a political cost, with Indian PM Modi’s BJP party losing a key state election in West Bengal and losing ground in other state elections.  Virus cases are still on the rise and sadly the picture will worsen before there are any signs of improvement.  

Covid cases in India have been trending higher since February and hit record highs this weekend, above 400,000. The number of cases is approaching 20 million, with over 215k deaths, while the country has administered 157.2 million vaccine doses.  However, at the current rate of vaccination of 2.26 million per day, it will take 2.2 years to cover 75% of the population with a two-dose vaccine. 

US dollar consolidating

After losing ground in April (the USD index DXY fell close to 3% over the month) the US dollar (USD) looks likely to consolidate this month.  USD positioning has already improved over recent months, suggesting limited scope for short covering.  Seasonal factors are unlikely to be particularly influential this month.  However, I am cognizant that cross asset market volatility has eased significantly, while risk assets are already priced for a lot of good news.  Nonetheless, risk factors are increasingly rising, especially increasing Covid cases in many emerging markets as noted above.  This leaves the market prone to bouts of risk aversion, which could result in some bouts of USD strength amid an overall backdrop of consolidation.

Key data and events

This week is an important one for both data and events.  There are several central bank decisions including in Australia (Tue), Thailand and Poland (Wed), Malaysia, UK, Turkey, and Brazil (Thu).  None of the central banks are expected to change policy settings except Brazil, with the consensus looking for a 75bp hike there.  In the UK, there is uncertainty over the future path of QE and whether the Bank of England extends asset purchases or takes the first steps to bringing asset purchases to an end echoing the Bank of Canada by announcing tapering. 

On the data front, the main highlights include the US ISM surveys (today and Wed), US April jobs report (Fri) and China trade data.  Both the US ISM surveys and payrolls are likely to reveal robust readings.  Fiscal stimulus and easing Covid likely helped to boost US jobs growth in April while the unemployment rate likely fell.  Meanwhile the ISM surveys will likely remain around historical highs for similar reasons.  Overall, the data will continue to paint a picture of strengthening US economic recovery. Meanwhile China trade data is likely to reveal strong exports and imports growth, though much of this will likely be due to base effects.

Will the Fed Calm US Treasury Market Volatility?

The main market action on Friday was once again in US Treasuries, with another sharp sell off as the 10y yield spiked 8.8 basis points despite three large US debt auctions over the week that were received relatively well by the market.  The sell-off helped the US dollar (USD) to strengthen while oil prices slipped. USD sentiment is clearly becoming less negative as reflected in the latest CFTC IMM data (non-commercial speculative market positioning), which shows that USD (DXY) positions (as a % of open interest) are still short, but at their highest since the week of 8 Dec 2020. Tech stocks didn’t take well to higher yields, but the Dow and S&P 500 closed higher. The move in yields may pressure Asian currencies and bond markets after some consolidation/retracement towards the end of last week though equity markets look better placed. 

At the end of last week US University of Michigan consumer sentiment rose to 83.0 in the preliminary release for March from 76.8 in February and exceeded expectations at 78.5 (consensus). This week attention will turn to a plethora of central banks spearheaded by the Federal Reserve FOMC (Wed). Markets will be watching for any revisions to US growth forecasts amid a dovish tone, albeit with little sign of any push back on higher yields. US rates markets will also focus on the US 20y auction, which could keep the curve pressured steeper.  Nervousness over the Statutory Liquidity Ratio (SLR) exemption, which is set to expire at the end of the month, will also likely intensify.  A less dovish than hoped for Fed, will likely keep the USD on the front foot. 

Other central bank decisions this week will take place in the UK, Norway, Turkey, Russia, Indonesia, Taiwan, Brazil and Japan. None of these are likely change policy settings except Brazil, where the market is looking for a 1/2% hike. Developments to look out for include some push back from the Bank of England on higher yields, a move to bring forward the rate hike path in Norway, a potentially controversial no change decision in Turkey and the Bank of Japan’s announcement of the results of its policy tools and in particular clarification on the tolerated trading range for 10-year JGBs.

Data this week kicks off with Chinese activity data today including February industrial production and retail sales. Seasonal distortions and base effects will make this month’s data look particularly strong.  Other data this week includes US Feb retail sales (tomorrow) where a weak outcome is likely depressed by harsher-than-usual winter weather as well as a fading of the boost from stimulus payments. Australia February employment is also likely to be soft (Thursday).  

Overall, equity volatility has eased, especially in the equity market, suggesting some return of normal trading conditions there, but interest rate volatility remains high driven by the move in US Treasury yields.  The USD gave back some gains towards the end of last week, but will likely benefit from higher US yields and is set to start this week in firm form.  US interest rate gyrations will likely provide further direction for the USD over the rest of the week.   Much of course will depend on the Fed FOMC meeting, which will be the main event this week. 

Going “The Extra Mile”

Risk assets ended last week on a soft note as Brexit uncertainties intensified amid a lack of progress towards a transition deal.  However, news overnight was a little more promising, as PM Johnson and EC President von der Leyen agreed to “go the extra mile” to try to agree up on a deal.  “Incremental” progress has reportedly been made and talks could now continue up to Christmas.  Sterling (GBP) rallied on the news and further gains are likely on any deal.  However, gains may prove short lived, with markets likely to focus on the economic difficulties ahead of the UK economy.  A no deal outcome is likely to result in a much sharper decline in GBP, however.

Progress towards fresh US fiscal stimulus progress faltered leaving US equity markets on shaky ground.  As it is, US stocks have struggled to extend gains over December after a stellar month in November and in recent days momentum has faded further.  Last week 9 out of 11 S&P sectors fell, suggesting broad based pressure.  Whether it is just a case of exhaustion/profit taking after solid year-to-date gains – for example, Nasdaq is up almost 38% and S&P up 13.4%, ytd – or something more alarming is debatable.  The massive amount of liquidity sloshing around and likely more dovishness from the Fed this week, would suggest the former.  

At the same time the US dollar (DXY) and broader BDXY are down almost 6% and 5% respectively, this year and most forecasts including our own look for more USD weakness next year.  Some of this is likely priced in as reflected in 27 straight weeks of negative aggregate USD (vs major currencies) positioning as a % of open interest (CFTC). The USD looks a little firmer this month, but gains are tentative and like equities this could simply reflect profit taking.  For example, in Asian currencies that have performed well this year such as the offshore Chinese yuan (CNH) and Korean won (KRW), fell most last week, partly due to increased central bank resistance. 

This week is a heavy one for events and data.  The main event on the calendar is the Federal Reserve FOMC meeting (Wed).  The Fed could include new forward guidance stating that quantitative easing (QE) will continue until there is clear-cut progress toward the employment and inflation goals.  The Fed may also lengthen the average maturity of asset purchases. Central bank decisions in Hungary (Tue), UK, Norway, Indonesia, Taiwan, Philippines (all on Thu), Russia, Japan and Mexico (all on Fri) will also be in focus though no changes in policy are likely from any of them.   On the data front China activity data (Tue), Canada CPI (Wed), US retail sales (Wed), and Australian employment (Thu) will be main highlights.

Host Of Central Banks In Focus

Well, last week, tech stocks had their worst week since March, with stability far from returning.  While the jury is still out, most still view the pull back in tech stocks as a healthy correction following a prolonged period of gains, blaming increased options activity over recent months for the magnitude of the decline. The buy on dip mentality is likely to continue to prevail, though tech stocks have not yet show any sign of wanting to make a convincing pull back.   

Signs of nervousness are clear; equity volatility remains elevated, but many investors are still sitting on healthy gains over recent months.  Given the low cost of funding, low returns in government bonds, alongside continued strong demand for stay at home electronics and a vaccine that could still take months to arrive, it is hard to see the tech sector falling too far.   

The fall in the pound sterling has been quite dramatic over recent weeks, both against the US dollar and euro.  Fears over a collapse in trade talks with the European Union have intensified.  The sudden waking up of the market to these risks has been provoked by the prospects that the withdrawal agreement with the EU will be torn up, prompting threats of legal action by the EU.

Time is running out to get a deal on the table before the end of the Brexit transition period at the end of the year, but UK Prime Minister Johnson has said that the internal market bill is necessary to prevent “a foreign of international body from having the power to break up our country.” The new legislation is already facing a rebellion in parliament. Against this background its hard to see GBP rally, with the currency likely to be particularly volatile over the coming weeks.

Attention this week will turn to several central bank decisions, with monetary policy makers in Poland (Tue), US (Wed), Brazil (Wed), Japan (Thu), Indonesia (Thu), Taiwan (Thu), South Africa, (Thu), UK (Thu) and Russia (Fri) all scheduled to announce their decisions.  After months of policy easing globally, this week will look rather boring, with none of the above likely to ease further.   

The Fed FOMC meeting will likely capture most attention, but there is potential for disappointment if the Fed does not provide further details on its shift to average inflation targeting in its forward guidance, even as the accompanying statement and Chair Powell’s press conference are likely to sound dovish. The US dollar has continued to stabilize, aided by the drop in GBP, but a dovish Fed could limit further upside in the short term. 

Aside from central bank decisions attention will be on US election polls, which take on more importance as the election creeps closer.  US fiscal stimulus talks have hit a wall, with little chance of progress this week, while US pressure on China and Chinese companies is likely to continue to be unrelenting as elections approach.  On the political front the race to take over Japan’s prime minister following the resignation of Shinzo Abe will conclude this week (Wed).   

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