Crypto Volatility

It was a calmer end for stock markets in a volatile week but crypto was not so fortunate after China’s State Council repeated its warning about Bitcoin mining and trading as central banks appear to be increasing their scrutiny of crypto at a time when many of them are introducing their own digital currencies.  Concerns over increased regulations, especially in China where the bulk of Crypto mining takes place, taken together with ESG issues as focus turns to the environmental costs of mining crypto, threaten to do more damage.  Volatility continued over the weekend, with Bitcoin and other crypto undergoing sharp moves.  Crypto volatility threatens to find its way into other markets, with for example, US equities positively correlated to moves in crypto while the US dollar (USD) could benefit.

There was at least a little relief for markets in terms of inflation angst, with market inflation measures (breakevens) falling while commodities, another factor fueling inflation fears, continued to come off the boil. It seems that the Federal Reserve’s dovish message may finally be sinking in even as the Fed FOMC minutes noted that they are planning on discussing tapering at some point, rather than previously not even thinking about thinking of tapering. US Treasury yields have been capped amid the cooling in inflation fears while rate sensitive equities, especially Tech are likely to find some solace.  The USD has struggled over recent weeks but the recent rise in real yields will likely offer some support. 

There was yet more evidence that the US economy is powering ahead, with measures of manufacturing and services sentiment as reflected in Markit purchasing managers indices (PMIs), rising to record highs as fiscal support and an improving COVID-19 outlook continue to boost optimism. While US economic data has been strengthening, markets have become accustomed to positive US releases and therefore any reaction is likely to be more muted.  Indeed, the Citi Economic Surprise Index, a measure of US data relative to expectations, is near its lowest since June 2020. 

This week is relatively light on the data front.  The key US data release is the Personal Consumption Expenditures (PCE) report, something that the Federal Reserve looks at closely, on Friday; consensus expectations are for a 2.3% quarter on quarter (q/q) increase in core PCE in Q1.  A number of Fed speakers will also be on the wires and their comments will be scrutinized on any further elaboration on “discussing a plan” on tapering.  There will also be a few central bank decisions including in Hungary (Tue), Indonesia (Tue), New Zealand (Wed), and Korea (Thu).  No changes are likely from any of these central banks.

Geopolitical Risks Rise

Last week ended on a positive note for risk assets, with equities rallying to record highs. In particular tech stocks are back in lead this quarter. The biggest surprise was the ability of US Treasuries to rally at the same time, particularly in the wake of a strong slate of economic data. The rally may be attributable to strong foreign and pension buying amid short market positioning.  Indeed, CFTC data show that Treasury bearish positions had increased as of April 13th.  The pull back in US Treasury yields points to some relief for emerging market assets. Similarly, commodity positions had also been cut, with gold, copper and oil positioning liquidation taking place. The risk rally and lower US yields have put the US dollar on the back foot, extending its decline over the week.  As such, the USD “exceptionalism” story appears to be fading somewhat.

Last week finished off with another set of firm US data; Housing starts surged 19.4% m/m to 1,739k, well-above the 1,613k consensus, from 1,457k (revised from 1,421k) in February. Similarly, consumer sentiment continued to improve in April, according to the preliminary release of the University of Michigan survey, with the index rising to a new post-COVID high of 86.5.  This week’s highlights include central bank decisions in China (Tue), Indonesia (Tue), Canada (Wed), Euro area (Thu) and Russia (Fri).  Russia’s central bank CBR is expected to hike by 25bp while no changes are expected from the other central banks.  Canada’s Federal Budget today and CPI (Wed) will also be in focus.  Data wise, Australia March retail sales (Wed), New Zealand Q1 CPI and Euro area flash purchasing managers indices PMIs (Fri) will garner attention.  

On Friday, the US Treasury released its semi-annual FX report and found that once again Vietnam and Switzerland met all three criteria under the 2015 Act. over 2020.  Taiwan was also found to breach the Treasury criteria.  The outcome means that there will be ‘enhanced analysis’ of these countries.  However, the {US} US Treasury declined to name any of these countries as currency manipulators, citing insufficient evidence under the 1988 Act.  The other interesting development is that the Treasury questioned the foreign exchange activities of Chinese state banks given that it appears that China’s official FX intervention was very limited.  Separately, Ireland and Mexico were added to the US Treasury Monitoring List.

Geopolitical risks are rising once again and could act as a threat to markets in the day and weeks ahead. Last week the US levied sanctions on Russia including targeting Russian government debt. Russia responded with counter sanctions. However, the US administration did hold out an olive branch in the form of a potential joint summit. Focus is also on growing tensions between Ukraine and Russia Similarly, US and Japanese leaders voiced concerns over Chinese policies, which were subsequently rejected by China’s foreign ministry. Despite the US criticism of China the US and China appear to be moving ahead with cooperate on climate change. US-China over Taiwan remain elevated however.

US Fiscal And UK/EU Brexit Discussions

The worse than expected US jobs report on Friday failed to stop the S&P 500 from registering another record high, but it does put even more pressure on US legislators to agree on a fiscal stimulus deal.  US November non-farm payrolls came in at 245,000, below the 460,000 consensus expectations and while the unemployment rate dropped to 6.7% from 6.9% previously this was all due a drop in the participation rate.  In other words the fact there are less people registering as actively looking for jobs has flattered the unemployment rate. Payrolls growth has slowed sharply and there are still 9.8 million more unemployed compared to February while further COVID restrictions point to more weakness in jobs ahead.  The good news is that some form of compromise is emerging on Capitol Hill, with a bipartisan proposal of $908 billion gaining traction, though frictions remain over aid to states and local governments and liability protections for businesses.

This week is crucial for Brexit transition deal discussions. The weekend phone call between UK PM Johnson and European Commission president von del Leyen made little progress on outstanding issues including fishing rights and level playing field.  Irish PM Martin noted that talks were on “a knife-edge”. European Union leaders are looking for a deal to be agreed upon before the European Council meeting on Thursday though time is running out.  The lack of progress is weighing on the pound (GBP), which took an initial dive this morning before recovering somewhat.  As it stands, the UK will leave the EU on December 31 with or without a deal.   Further complicating matters the UK’s Internal Market Bill, which gives ministers power to rewrite parts of the original Brexit divorce deal, will return to parliament today.

This week’s data and event slate is likely to kick off with upbeat Chinese November trade data; both exports and imports are likely to record healthy increases (Bloomberg consensus: exports 12.0% y/y, imports 7.3% y/y). The data is likely to bode well for risk sentiment, and for Chinese and Asian markets today.  Policy rates decisions in Canada and Europe will be of interest, especially with the European Central Bank (ECB) (Thu) likely to deliver a further easing.  Bank of Canada (Wed) is unlikely to reveal any major changes to policy.  Inflation data in China (Wed) and the US (Thu) are likely to reflect the disinflationary impact of COVID. Finally, the EU Leaders’ Summit may sign off on any Brexit agreement assuming there is one by then while an agreement on the EU Recovery Fund is unlikely to be reached.  

EU Deal Boosts Euro But Momentum To Fade

The European Union deal for Greece was clearly on the positive side of expectations and from that perspective helped to buoy sentiment for European assets. The fact that EU leaders managed to work over differences and emerge with a solid deal will help remove some of the uncertainty about Greece’s future and lower the risks of contagion.

To recap EU leaders announced a EUR 109 billion second aid package for Greece. Private bondholders will contribute a target of a further EUR 37 billion via bond swaps or rolling over existing debt for new bonds maturing in 30 years. Investors will have the option to exchange existing debt into four instruments. The aim is to obtain 90% participation from Greek bondholders.

Moreover, it appears that governments will guarantee any defaulted Greek debt offered as collateral until the country can return to the market. Effectively this means that even if ratings agencies declare a default rating on Greek debt, Greek banks may still be able to obtain funding from the European Central Bank (ECB) as the debt is guaranteed by national governments.

Greece, Portugal and Ireland will benefit from lower interest rates on loans and longer maturities. Moreover, the European Financial Stability Facility (EFSF) bailout fund will have a wider scope for bond buying directly from investors. This lets the ECB off the hook to avoid further use of its own bond purchase programme and removes any further impairing of its balance sheet. The idea of a tax on banks was removed, as criticism of the workability of such a plan increased.

The downside of the deal includes the fact that:
1) European tax payers are on the line for a potentially unlimited amount to guarantee defaulted Greek debt,
2) The bondholder programme is only limited to Greece, so there is no contingency should something similar be needed in other countries
3) The participation rate for private bondholders is yet to be known (but will most likely be high).
3) The deal will lead to a default on Greek debt given the programme amounts to a 21% drop in value but a credit event is unlikely to be triggered.
4) Greece still has a highly ambitious privatisation and austerity plan to implement which even some Greek officials have admitted is overly optimistic and at worst could turn into a fire sale of Greek assets.
5) EFSF bond purchases will need the “mutual agreement” of member states which is by no means guaranteed.
6) The fund size is not large enough should Italy and Spain need similar bailouts especially as leaders have stressed that the Greek package will not be replicated for other countries.

The EUR rallied on the outcome of the European talks. However, the EUR has plenty of other worries to deal with including divergence in growth across the eurozone, overly long EUR market positioning, EUR overvaluation, likely growth underperformance versus the US and a likely rebound in general for the USD over coming months especially if the Fed does not embark on QE3 and agrees a deal to raise the debt ceiling. EUR/USD is likely to remain supported in the near term, with near term resistance around 1.4467. I still suspect that the momentum will not last, with EUR/USD looking particularly rich at current levels.

Risk Aversion to remain elevated

It remains a tumultuous time for markets, gripped by a cacophony of concerns ranging from the lack of resolution to the Eurozone debt crisis to the failure to reach agreement on raising the US debt ceiling and associated deficit reduction plans. Mingled among these is the growing evidence that economic growth is turning out weaker than expected. Meanwhile Europe’s crisis appears to be shifting from bad to worse, as reflected in a shift in attention towards the hitherto untouched Italy although Italian concerns have eased lately.

The release of the EU bank stress test results at the end of last week have not helped, with plenty of criticism about their severity and rigour following the failure of only 8 banks out of the 90 tested. Expectations centred on several more banks failing, with much more capital required than the EUR 2.5 billion shortfall revealed in the tests. Answering to this criticism officials note that there has already been a significant amount of capital raised over recent months by banks, but this will be insufficient to stem the growing disbelief over the results.

Attention is still very much focussed on Greece and reaching agreement on a second bailout for the country, with further discussions at the special EU summit on July 21. The contentious issue remains the extent of private sector participation in any debt restructuring. The decision to enhance the flexibility of the EFSF bailout fund to embark on debt buybacks has not helped. Consequently contagion risks to other countries in the Eurozone periphery are at a heightened state. Despite all of this the EUR has shown a degree of resilience, having failed to sustain its recent drop below 1.40 versus USD.

One explanation for the EUR’s ability to avoid a steeper decline is that the situation on the other side of the pond does not look much better. Hints of QE3 in the US and the impasse between Republicans and Democrats on budget deficit cutting measures tied to any increase in the debt ceiling are limiting the USD’s ability to benefit from Europe’s woes. Moreover, more weak data including a drop in the Empire manufacturing survey and a drop in the Michigan consumer sentiment index to a two-year low, have added to the worries about US recovery prospects.

Against this background risk aversion will remain elevated, supporting the likes of the CHF and JPY while the EUR and USD will continue to fight it out for the winner of the ugliest currency contest. Assuming that a deal will eventually be cobbled together to raise the US debt ceiling (albeit with less ambitious deficit cutting measures than initially hoped for) and that the Fed does not embark on QE3, the EUR will emerge as the most ugly currency, but there will be plenty of volatility in the meantime.

Data and events this week include more US Q2 earnings, June housing starts and existing home sales. While housing data are set to increase, the overall shape of the housing market remains very weak. In Europe, July business and investor surveys will be in focus, with a sharp fall in the German ZEW investor confidence survey likely and a further softening in July purchasing managers indices across the eurozone. The German IFO business confidence survey is also likely to decline in July but will still point to healthy growth in the country. In the UK Bank of England MPC minutes will confirm no bias for policy rate changes with a 7-2 vote likely, while June retail sales are likely to bounce back.

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