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.

Two Speed Recovery

The spread of the COVID Delta variant globally holds key risks for markets in the weeks ahead.  However, as long as hospitalisation rates remain relatively low, it should be less detrimental to the path of re-opening in countries with higher vaccination rates.  As a stark example, the UK will shed almost all of its COVID restrictions today despite spiking COVID cases amid relatively low hospitalisation rates.  

This is particularly difficult for many emerging markets including much of Asia given low vaccination rates.  As such, a two-speed recovery between developed and emerging economies is occurring, with the former registering much higher vaccination rates compared to the latter.  Unlike the move to re-open in developed markets, re-opening in many emerging markets is far more difficult given sharply increasing hospitalisation rates among unvaccinated people as the Delta variant runs rampant. 

As such, the risks of renewed restrictions in many countries could put the global recovery process in jeopardy at a time when we are already past peak growth.  Maybe this is helping to dampen US bond yields or yields are being supressed by the fact that the market has a lot of faith in the Fed even as inflation has surprised on the upside in many countries.  Whatever the cause, US 10y bond yields have slipped below 1.3% back to levels not seen since mid-February and continue to edge lower.    

Event highlights this week include several central bank policy decisions including in China (Tue), Eurozone, Indonesia, South Africa (all Wed) and Russia (Fri).  No changes are expected for China’s Loan Prime Rate (LPR) though the risk of easing has increased marginally following the People’s Bank of China (PBoC) reserve requirements (RRR) cut last week. The Central Bank of Russia (CBR) is expected to hike by 75bp, with risks of a bigger move.  Bank Indonesia is likely to remain on hold despite growing economic pressure.  South Africa’s Reserve Bank (SARB) is expected to remain on hold and remain dovish while a change in forward guidance from the European Central Bank (ECB) is expected this week. 

Oil will be in focus today after OPEC+ agreed on a deal to expand output, with the UAE and Saudi Arabia putting away differences to agree upon a 400k barrels a day increase in output from August.  The US dollar (USD) is trading firmer, but overall looks like it is close to topping out.  For example, EURUSD looks oversold relative to real rate differentials.  Interest rates markets will eye US fiscal developments, with Democrats crafting the budget resolution needed for a reconciliation bill, which may see additional progress this week.

What Could Prompt Higher Volatility?

Equities were buoyed last week in the wake of US President Biden’s infrastructure deal and renewed reflation trade optimism amid mixed post Federal Reserve FOMC messages from Fed officials. This resulted in US stocks recording their biggest weekly gain since February.  The prospects of passing the infrastructure deal has improved in the wake of Biden’s decision not to tie it to a much larger spending package that is being pushed through by Democrats but is not supported by Republicans. 

Given heightened sensitivity over inflation, the slightly weaker than expected US Personal Consumption Expenditures (PCE) data on Friday, which increased 0.5% m/m in May, slightly below the 0.6% consensus, added further support to the reflation trade, helping the US Treasury curve to steepen.  Moreover, the University of Michigan 5-10y inflation expectations series came in lower in June compared to the previous month. Fed officials likely put much more emphasis on this long-term series and will view the 2.8% reading as consistent with their “largely transitory” take on the pickup in inflation.

Cross-asset volatility has continued to decline, which bodes well for carry trades and risk assets.  For example, the VIX “fear gauge” index has dropped to pre-COVID level, something that has been echoed in other market volatility measures.  However, it’s hard to ignore the shift in tone from many central banks globally to a more hawkish one while risk asset momentum will likely wane as the strength of recovery slows, suggesting that low volatility may not persist.  It is notable that changes in global excess liquidity and China’s credit impulse have both weakened, implying a downdraft for risk assets and commodity prices and higher volatility. 

If there is anything that could prompt any increase in volatility this week, its the US June jobs report on Friday.  June likely saw another strong (consensus 700k) increase in nonfarm payrolls while the unemployment rate likely dropped to 5.7% from 5.8% previously.  Despite the likely strong gain in hiring, payrolls would still be close to 7 million lower compared to pre-COVID levels, suggesting a long way to go before the US jobs market normalises. The June US Institute for Supply Management (ISM) manufacturing index will also come under scrutiny though little change is expected from the May reading, with a 61.0 outcome likely from 61.2 in May. 

Other data and events of importance this week include the 100th year anniversary of China’s Communist Party (Thu), the release of purchasing managers indices (PMI) data globally including China’s official NBS PMI (Wed) for which a slight moderation is expected.  Eurozone June CPI inflation (Wed) which is likely to edge lower, Sweden’s Riksbank policy decision (Thu) where an unchanged outcome is likely and Bank of England (BoE) Governor Bailey’s Mansion House Speech (Thu), will be among the other key events in focus this week. 

Absorbing The Fed’s Message

Markets absorbed a high inflation reading in the form of US core Personal Consumption Expenditure (PCE) price index without flinching at the end of last week, further acknowledgement that the Fed’s “transitory” inflation message is belatedly sinking in to the market’s psyche.  Core PCE inflation exceeded expectations for April, surging 0.7% m/m after a 0.4% gain in March (consensus: 0.6%). On a y/y basis, core PCE inflation surged to 3.1%—its highest level in almost three decades. High inflation readings are likely to persist over the near-term, if for no other reason than base effect, but price pressures will likely ease by the end of the year. 

The market’s sanguine reaction has helped US Treasury yields to continue to consolidate.  Also helping to restrain yields is the fact that positive US economic surprises (data releases versus consensus expectations) are close to their lowest level since June 2020 and barely positive (according to the Citi index), in contrast to euro area economic surprises, a factor that is helping to support the euro.

Cross-asset volatility measures remain very low, with the glut of liquidity continuing to depress volatility across equities, interest rates and FX.  Given that markets’ inflation fears has eased, it is difficult to see what will provoke any spike in volatility in the near term.  All of this this does not bode well for the USD.  Sentiment as reflected in the latest CFTC IMM speculative data on net non-commercial futures USD positions, remains downbeat.  This is corroborated in FX options risk reversal skews (3m, 25d) of USD crosses. 

In particular, USDCNY will be closely watched after strong gains in the renminbi lately.  Chinese officials are trying to prevent or at least slow USD weakness vs. CNY. The latest measure came from China’s central bank, the PBoC instructing banks to increase their FX reserve requirements by 2% to 7% ie to hold more foreign currency as a means of reducing demand for the Chinese currency.  Expect official resistance to yuan appreciation pressures to grow.      

Data so far this week has been mixed. China’s May NBS manufacturing purchasing managers index released yesterday slipped marginally to 51.0 from 51.1 previously (consensus 51.1) while the non-manufacturing PMI increased to 55.2 from 54.9 previously. Both remained in expansion, however indicative of continued economic expansion. China’s exports are holding up particularly well and this is expected to continue to fuel manufacturing expansion while manufacturing imports are similarly strong. 

Today’s Reserve Bank of Australia decision on monetary policy delivered no surprises, with policy unchanged and attention shifting to the July meeting when the bond purchase program will be reviewed.  On Friday it’s the turn of the the Indian central bank, Reserve Bank of India (RBI), with an unchanged policy outcome likely despite the growth risks emanating from a 2nd wave COVID infections cross the country and attendant lockdowns.  Last but not least, is the May US jobs report for which consensus expectations are for 650,000 gain in non-farm payrolls and the unemployment rate falling to 5.9% from 6.1% previously.

When Bad Means Good

Bad meant good on Friday as weaker than expected US April jobs data helped to dampen concerns over inflation risks and higher rates. At a time when markets were becoming increasingly fearful of rising inflation risks the softer US jobs data will act as a balm on such fears. It also complicates matters ahead of bipartisan talks between President Biden and congressional leaders this week. Democrats will likely use the data to outline their case for more stimulus to boost growth, while Republicans will highlight that excessive unemployment benefits are holding back hiring.  

US Payrolls increased by 266,000 in April, well below the 1 million consensus and the unemployment rate rose to 6.1% from 6.0%, above the 5.8% consensus.  The data supports the view of most Fed officials that progress has not been “substantial” enough for them to start signaling tapering.  Unsurprisingly Markets pushed back the pricing of the first rate hike from early-2023 to May 2023 in the wake of the weaker US jobs data. The US dollar (USD) took a hit and looks likely to kick off the week on the back foot.  High yielding currencies will likely benefit the most.  

This week inflation releases will come under scrutiny, with CPI data in the US (Wed), China (Tue) and India (Wed) in focus, albeit for different reasons.  In the US, base effects will likely push inflation higher, with a sharp pick up in core CPI in particular likely.  A similar story is expected in China, but base effects will likely act in the opposite direction in India.  Other highlights this week include a likely modest decline in US retail sales (Fri), further easing in China’s credit aggregates (9-15 May) and a material improvement expected to be revealed in Australia’s Federal Budget (Tue).  Last but not least, central banks in Mexico and Philippines (both Thu) are expected to leave policy unchanged.

Separately, markets will digest the outcome of UK local elections, especially those in Scotland, which revealed that pro-independence parties (SNP and Scottish Greens) gained a majority in the Scottish parliament. A constitutional battle with the Conservative UK government looms though UK Prime Minister Boris Johnson is showing no signs of acceding to demands for a new Scottish referendum.  There will also be focus on the aftermath of the ransomware attack on the Colonial Pipeline in the US, which has already pushed energy prices higher.  And finally, the much anticipated (among Krypto traders) appearance of Elon Musk on SNL hit Dodgecoin, after he called it “a hustle”. 

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