Relief For Risk Assets, But How Long Will It Last?

Last week was one of considerable relief for risk assets; US equities recorded solid gains, with the S&P and Nasdaq up 6.2% and 8.2% respectively.  Conversely, oil (Brent) dropped by over 4% and the US dollar index dropped by around 1%.  Reflecting the improvement in sentiment, the VIX “fear gauge” has now dropped by around a third over the last couple of weeks to settle below 25.0.  The MOVE index of interest rates volatility has also fallen sharply.  All of this in a week when the Federal Reserve hiked policy rates by a quarter percent and promised more to come in a hawkish meeting. 

A lot of the bad news was clearly in the price including the pricing of several Fed rate hikes, but with the war in Ukraine ongoing, peace talks appearing to make little progress, stagflation fears intensifying and a renewed rise in COVID cases in many countries due to a new variant (BA.2), we’re still very far from an all clear signal for risk assets.  Separately, the US administration appears no closer to persuading China into supporting a stronger stance against Russia; no statement was issued after the call between Presidents Biden and Xi at the end of last week.

China’s neutral stance on the war in Ukraine still poses risks to its markets as indicated by the sharp outflows of foreign portfolio capital over recent weeks.  After pledges made by the authorities to provide much needed stability to China’s economy and markets, the coming weeks will be scrutinised for follow up action.  On this note, China’s Loan Prime Rates (LPR) outcome today was in focus.  There was a small chance that China’s Banks would lower their fixings but after the unchanged Medium Term Lending Facility (MLF) outcome last week, the prospects of a cut had lessened. Nonetheless despite no change in policy today, recent official pledges of support suggest its only a matter of time before there is a cut in the policy rate.

Over the rest of the week there will be several other central bank decisions in focus, mostly in emerging markets, including in Hungary (Tue), Philippines, Norway, South Africa and Mexico (all on Thu).  Most are expected to hike rates. A 25bp hike in Norway is likely, 50bp hike in Mexico, 25bp hike in South Africa and 150bp hike in Hungary.  There will also be several Federal Reserve speakers on tap this week including Chair Powell (Tue), as well as Williams, Bostic, Daly, Mester and Evans.  They are likely to provide more colour following last week’s Fed rate hike, with focus on comments on balance sheet reduction and the pace of further tightening ahead.  

The Week Ahead

Of course the main focus for markets will continue to be the war in Ukraine. The risk of Nato being dragged into the war has risen after Russian warnings that military conveys to Ukraine will be considered legitimate targets and a military training facility near Poland’s border was attacked.  Russia has reportedly intensified its attacks on key Ukrainian cities while peace talks are reportedly making some progress though nothing concrete has yet been achieved.  The US and China will also gold high-level talks in Rome today while there has been no traction towards a no-fly zone over Ukraine. 

Illiquidity and volatility are likely to continue to characterise market activity in the days ahead while risks of a Russian default grow. Stagflation risks will likely continue to sound louder in the weeks ahead too, leaving central banks in a bind.  As it was, economic growth was slowing and inflation was highly elevated ahead of the crisis in Ukraine.  Now it’s going to look a whole lot worse, implying a still tense environment for risk assets.  The US dollar looks firm going into this week against this background. 

This week’s key central bank events include Bank Indonesia (Tue), Federal Reserve FOMC decision (Wed), Bank of England (Thu), European Central Bank (ECB) Watchers Conference (Thu), CBC in Taiwan, CBRT in Turkey (Thu), BCB in Brazil, Bank of Japan (Fri), and CBR (Fri) in Russia.  Most focus will of course be on the Fed where a 25 basis points hike in interest rates is highly likely.  Any clues to the pace of tightening and details of quantitative tightening will also be in focus.  Similarly, the BoE is likely to hike by 25bp.  The ECB Conference will be watched for discussion on the speed of policy withdrawal. 

Meanwhile, the BoJ is likely to downgrade its growth outlook while no change in policy is expected in Indonesia, Turkey and Russia.  In contrast, Brazil is expected to hike rates by 100bp.  There will also be attention on China’s 1 year medium term lending facility where a cut amid slowing activity, would presage a potential easing in the policy Loan Prime Rate (LPR) next week.  Data in focus will be China activity data (Tue) where a further slowing in both industrial production and retail sales is likely while US February retail sales (Wed) are likely to gain momentum.  Last but not least, Australian jobs data (Thu) are likely to reveal a strong print for February.   

Debate Over Fed Tightening Rages On

After receiving a major beating over recent weeks this week has seen a ‘risk on’ tone permeate through markets as dip buyers emerge.  COVID is increasingly taking a back seat though risks from simmering geopolitical tensions over Russia/Ukraine continue to act as a threat to markets.  Nonetheless, equity volatility has fallen, with the VIX ‘fear gauge’ dropping sharply over recent sessions.  In contrast, interest rate volatility remains elevated as debate over a potential 50 basis point hike from the Federal Reserve and/or policy hikes at successive FOMC meetings continues.  Fed speakers this week including St. Louis Fed President Bullard and Philadelphia Fed President Harker in comments yesterday appear to have dampened expectations of a 50 basis point hike, but this has unlikely put an end to such speculation.

Overall market uncertainty is likely to persist in the weeks ahead setting the scene for renewed bouts of volatility.  The debate over Fed rate hikes both in terms of magnitude and timing is far from over, with analysts ramping up expectations of multiple hikes this year.  There is a strong chance that the Fed will announce tightening at each of the next three meetings including beginning quantitative tightening (QT).  Markets are pricing in five quarter point hikes in the next year and there may be scope for even more aggressive tightening.  Given likely persistently high inflation readings in the months ahead it is not likely the time to push back against markets tightening expectations. 

Much of Asia has been closed for part or all of this week though China’s purchasing managers index (PMI) data for January released last weekend highlighted a loss of economic momentum.  Although official stimulus measures will likely help to avoid a sharp slowing in economic growth, sentiment is unlikely to get back to pre-COVID levels anytime soon. China’s zero-tolerance approach to COVID means that even small outbreaks will lead to lockdowns, likely dampening services sentiment and travel. Meanwhile, manufacturing pressure may find some support from fiscal policy measures as policy is front loaded, and likely further monetary easing ahead, with at least another 10 basis point easing in the Loan Prime Rate and 50bp cut in the RRR likely in the weeks ahead. However, the overall trajectory of activity remains downwards.

Monetary policy decisions in the Euro area (Thu) and UK (Thu) will be among the highlights this week in addition to US Jan jobs (Fri).  The Reserve Bank of Australia (RBA) left policy unchanged as expected but revealed a relatively dovish statement even as it formally announced an end to quantitative easing (QE). There is likely to be a contrasting stance between the Bank of England (BoE) and European Central Bank (ECB), with the former likely to hike by 25 basis point on concerns about rising inflation expectations while we the latter is likely in cruise control for H1 2022. In the US there are risks of a worse than consensus outcome for US non-farm payrolls due to a surge in Omicron cases (consensus 175k).  Separately, in emerging markets, focus will be on Brazil, where the central bank, BCB is expected to hike rates by 150bp (Thu).

Fed Tapering Concerns/Rising COVID Cases In Europe

Equities struggled at the end of last week amid news of rising COVID cases and hints by Federal Reserve officials of a preference for faster tapering though tech stocks benefitted from a rally in US Treasuries.  Oil prices fell further as markets pondered the potential for releases from China, Japan and US strategic oil reserves. Meanwhile, various countries are registering record daily COVID cases in Europe, resulting in partial lockdowns in a few countries. The outlook doesn’t look good heading into the winter flu season, while protests against mobility restrictions are on the rise. 

The US dollar extended gains at the start of this week helped by hawkish comments from Federal Reserve officials.  Conversely, rising COVID cases across Europe and resultant mobility restrictions, have hurt the euro, with the EURUSD exchange rate falling through 1.13 and showing little sign of any reversal.  Worsening sentiment towards the euro has fuelled a collapse in speculative euro positioning, with the market being net short for 6 out of the last 7 weeks (according to the CFTC IMM net non-commercial futures data).  In contrast, China’s authorities are becoming more concerned with the strength of the Chinese renminbi, which is currently around five year highs in trade weighted terms.  Measures to cap renmimbi strength are likely to be forthcoming.

Risk assets could struggle in the wake of speculation/pressure for more aggressive Fed tapering.  Fed Vice Chair Clarida and Governor Waller sounded relatively hawkish on Friday. Clarida said that the FOMC could discuss the pace of tapering at the December FOMC meeting and separately Waller stated that recent data had pushed him toward “favoring a faster pace of tapering and a more rapid removal of accommodation in 2022.”  This implies that the December Fed FOMC meeting will be a live one and could potentially see the announcement of more rapid tapering than the $15bn per month rate that was announced at the last Fed meeting. 

As such, the Fed FOMC minutes (Wed) will be under scrutiny to provide clues to any hint of support for more aggressive tapering though they will likely reveal that most officials see no rush for rate hikes.  On the same day the US core Personal Consumption Expenditure (PCE) report is likely to have registered a strong increase in October keeping inflation concerns at the fore.  Fed nominations are also likely this week, and markets will be especially focused on whether Fed Chair Powell will be reaffirmed for another term.  The overall composition of the FOMC is likely to become a more dovish one next year. 

Several central bank policy decisions are scheduled this week including in China where the Peoples Bank of China (PBoC) unsurprisingly kept its Loan Prime Rate on hold today.  However, in its latest quarterly monetary policy report released on Friday, the PBoC removed some key phrases cited in its previous reports, implying a softer tone to policy ahead. Any such easing would be targeted such as recent support for lenders via a new special relending facility to support the clean use of coal, via loans at special rates.  Additionally, a cut in the reserve ratio (RRR) cannot be ruled out.

Next up will be the Reserve Bank of New Zealand (RBNZ) (Wed), with a 25bp hike likely and risks of an even bigger 50bp hike. The Bank of Korea is also likely to hike, with a 25bp increase in policy rates likely (Thu) given rising inflation pressures and concerns about financial imbalances. The Riksbank in Sweden (Thu) is likely to keep policy unchanged though an upgrade in their forecasts is expected. 

Testing The Fed’s Resolve, China Data Gives Some Relief

In the aftermath of the surge in US consumer prices in October which reached the highest since 1990 at 6.2% year-on-year, the Fed’s stance is under intense scrutiny.  While tapering is beginning soon, the biggest question mark is on the timing of interest rate hikes, with markets having increasingly brought forward expectations of the first Fed hike to mid next year even as Chair Powell & Co keep telling us that inflation pressures are “transitory”.  Front end rates have reacted sharply and the US dollar is following rates US rates higher.  The flatter yield curve also suggests the market is struggling to believe the Fed.  Meanwhile, liquidity in interest rates market remains thin, and smaller Fed purchases going forward will not help.  In contrast, equities are hardly flinching, with the FOMO rally persisting. US equities closed the week higher despite a drop in the Michigan sentiment index, which fell to a new 10-year low of 66.8 in early November (consensus 72.5), with inflation being largely to blame. 

There was a bit of relief for markets on the China data front today.  The October data slate revealed less sharp softening compared to the previous month, but momentum continues to be downwards. Industrial production increased by 3.5% (consensus 3.0% y/y). A host of regulatory, and environmental pressures are leading to policy led weakness in manufacturing.  While there has been some easing in such pressures, there is unlikely to be much of a let up in the months ahead.  While retail sales also increased by more than expected up 4.9% (consensus 3.7% y/y) sales have been impacted by China’s “zero-tolerance” COVID policy, which has led to lockdowns across many provinces.  Fixed assets and property investment slowed more than expected reflect the growing pressure on the property sector. Also, in focus today will be the virtual summit between President’s Biden and Xi. I don’t expect any easing in tariffs from the US side.  

Over the rest of the week, US retail sales data will be take prominence (Tue). Sales likely rose by a strong 1.3% month on month in October, but the data are nominal and goods prices rose 1.5% in the October CPI, implying real good spending was far more restrained.  Central bank decisions among a number of emerging markets including in Hungary (Tue), South Africa (Thu), Turkey (Thu), Indonesia (Thu) and Philippines (Thu) will also be in focus.  The divergence between most Asian central banks and elsewhere is becoming increasingly apparent, with expectations for policy rate hikes in Hungary and South Africa, and a likely cut in Turkey contrasting with likely no changes from Indonesia and Philippines.   Also watch for any traction on the passage of the $1.75bn “build back better” fiscal package in the US, with a possible House vote this week.  Separately, markets are still awaiting news on whether Fed Chair Powell will remain for another term or whether Brainard takes his seat, with a decision possible this week.

As noted, sharply higher than expected inflation readings in the US and China will play havoc with the narrative that inflation pressures are “transitory” while highlighting the depth of supply side pressures.  Higher US market rates, with the US yield curve shifting higher in the wake of the CPI, bodes badly for emerging market carry trades in the near term as it reduces the relative yield gap.  At the same time a tightening in global liquidity conditions via Fed tapering may also raise some obstacles for EM carry.  That said, there is still plenty of juice left in carry trades in the months ahead.  Markets are already aggressively pricing in Fed rates hikes and there is limited room for a further hawkish shift i.e a lot is already in the price.  Meanwhile FX volatility remains relatively low even as volatility in rate markets is elevated.  Many EM central banks are also hiking rates. As such carry and volatility adjusted expected returns in most EM FX remain positive.

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