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.

Busy Week Ahead For Central Banks

US equities came under more pressure at the end of last week, with the S&P 500 falling to its lowest in four weeks, down around 2% month to data.  The drop will test the buy on dips mentality as the S&P is once again resting just above its pivotal 55-day moving average, a level that has seen strong buying interest in the past. 

Economic data gave little help to market sentiment, with the University of Michigan confidence index improving a little to 71.0 in early September but falling slightly below consensus expectations at 72.0.  Separately, the inflation expectations measures were broadly unchanged, with the most relevant series for Fed officials (the 5-10y) remaining steady at 2.9%, which is still consistent with the Fed’s 2% goal.

This week is all about central bank meetings, with an array of policy meetings including in Indonesia (Tue), Sweden (Tue), Hungary (Tue), China (Wed), Japan (Wed), US (Wed), Brazil (Thu), Philippines (Thu), UK (Thu), Norway (Thu), Switzerland (Thu), South Africa (Thu), and Taiwan (Fri), all on tap. 

Most focus will obviously be on the Federal Reserve FOMC meeting, during which officials will likely signal that they are almost ready to taper. A formal announcement is likely in December or possibly November.  Most other central banks are likely to stay on hold except a likely 25bp hike in Norway, 25bp in Hungary, and 100bp in Brazil.

Politics will also be in focus, with Canada’s Federal election and the results of Russia’s parliamentary elections today.  Polls suggest the incumbent Liberals ahead though the most likely outcome is a minority government in Canada while in Russia the ruling pro Kremlin United Russia party is likely to renew its supermajority. 

Other issues in focus this week are frictions over the US debt ceiling, with the House voting soon on raising the ceiling.  US Treasury Secretary Yellen renewed her calls for Congress to raise of suspend the debt ceiling stating in a Wall Street Journal op-ed that failing to do so “would produce widespread economic catastrophe”. 

In China, Evergrande’s travails will be in the spotlight on Thursday when interest payments on two of its notes come due amid growing default risks.  Indeed, China related stocks slid on Monday morning as Evergrande concerns spread through the market.  Property developer stocks are under most pressure and whether there is wider contagion will depend on events on Thursday.

The US dollar has continued to strengthen, edging towards its 20 Aug high around 92.729 (DXY) and looks likely to remain firm heading into the Fed FOMC meeting especially as it will hard for Fed Chair Powell to sound too dovish and given risks of a hawkish shift in the dot plot.  Positioning data is showing increasingly positive sentiment towards the dollar, with speculative positioning (CFTC IMM net non-commercial futures) data showing the highest net long DXY position since May 2020. 

Conversely, speculative positioning in Australian dollar has hit a record low likely undermined by weaker iron ore prices.  Similarly, positioning in Canadian dollar is at its lowest since Dec 2020 while Swiss franc positioning is at its lowest since Dec 2019. Asian currencies have been hit, with the ADXY sliding over recent days.  The Chinese currency, CNY has been undermined by weaker data and concerns over Evergrande while high virus cases in some countries are hurting the likes of Thai baht. 

Powell Keeps The Risk Rally Going

It felt as though markets spent all of last week waiting for the Jackson Hole symposium but in the event Federal Reserve Chair Powell didn’t really tell us anything new.  This was good enough for risk assets, with equities ending the week higher and bonds also rallying, with the US Treasury curve bull steepening, setting up a positive start for equity markets this week.  The US dollar came under pressure as Powell did not repeat the hawkish messages of some recent Fed speakers over recent days.

Overall Powell noted that one of the key criteria for tapering has been met, namely “substantial further progress” for inflation while “clear progress” has been met on the second goal of maximum employment. Powell also disassociated the criteria for rate hikes and tapering, with markets continuing to price in the first hike around March 2023. A tapering announcement is likely this year, but September looks too soon. 

The US dollar is likely to remain under pressure this week in the wake of Powell’s comments which ought to bode well for many emerging market currencies.  The potential for a softer than consensus US August jobs report (non-farm payrolls consensus 750k) at the end of the week also suggests that the USD could struggle to make a short term rebound though US interest rate markets, will likely remain supported. 

All of this bodes well for some consolidation in Asian markets though tomorrow’s Chinese August purchasing managers index (PMI) data will provide further direction.  Further moderation in both manufacturing and services PMIs will likely keep up the pressure on the authorities there to avoid renminbi appreciation as well as loosen liquidity likely via another reserve requirement ratio (RRR) cut. 

Other key data this week includes Q2 GDP releases in Australia (Wed), India (Tue), and Canada (Tue), US ISM surveys (Wed) and (Fri), Eurozone inflation data (Tue), and Polish inflation (Tue).  Also keep an eye on German political developments; the election is less than one month away and recent polling has shown that the SPD has pulled ahead of Merkel’s CDU for the first time in 15 years, raising the possibility of a left wing coalition. 

Geopolitical issues, specifically to do with Afghanistan remain a threat to risk appetite as the US deadline for evacuation approaches.  Separately, oil prices could be impacted by Hurricane Ida, which hit the US Gulf Coast yesterday.   

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