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.

Turkey, Emerging Market Central Banks, Eurozone Divergence

Attention today is on developments in Turkey. Despite consensus expectations of a 100bp (1%) hike in rates, Turkey’s central bank delivered a bigger than expected 200bp increase last week, with a hawkish statement.  This appears not have been welcomed by Turkish President Erdogan who promptly removed central bank (CBRT) Governor Aqbal on Saturday.  Despite some reassurance from Aqbal’s replacement that policy would deliver price stability the result has been substantial pressure on Turkey’s currency the lira (TRY) at the start of trading in Asia today, with the lira down as much as 15% initially, erasing more than four months of gains.  Turkish authorities are likely to intervene to limit the damage, but the damage has been done.  There has also been some, albeit more limited fall out on other emerging market currencies.

The end of the week saw a bit of a reversal in recent trends, with tech stocks gaining most, at the expense of bank stocks, which were weighed down by the news that the US Federal Reserve would not extend the Supplementary Leverage Ratio (SLR) exemption but rather to look at a more permanent solution. This could lower banks demand for Treasuries while constraining dealer balance sheets. Both S&P 500 and Nasdaq recorded declines over the week amid a further rise in US Treasury yields.  Quadruple witching saw an increase in volumes and oil prices recorded a sharp close to 8% decline over the week while Chinese stocks continued to suffer. 

Aside from Turkey there was some interesting central bank action last week in the emerging markets.  The BCB in Brazil hiked by 75bps, more expected, and indicated the high likelihood of another 75bps at the May meeting.  The CBR in Russia also joined in on the hawkish emerging markets (EM) action surprising markets by hiking rates by 25bps, with a likely acceleration in tightening likely over coming meetings.  EM central bank decisions this week include China (today), Philippines (Thu), Thailand (Wed), Hungary (Tue), South Africa (Thu), Mexico (Fri) and Colombia (Fri).   Separately, the SNB in Switzerland also decides on policy (Thu). China’s loan prime rates were left unchanged as expected and no changes are likely from any of the other central banks this week. 

Other data and events this week include the US PCE report (Fri), President Biden’s press conference (Thu) which could offer clues to the “Rescue” package that could amount to $3-4trn. A host of Fed speakers are also on tap, including Fed Chair Powell, as well as Eurozone flash purchasing managers indices (PMIs) (Wed), and UK retail sales (Fri).  The data will reveal stark differences in the recovery picture in the UK and Eurozone while the difference between the US and Europe looks even more stark.  Europe is struggling with a third wave of Covid case, vaccination delays and tighter restrictions, leading to a reduction in growth forecasts, while US growth forecasts are being revised higher in the wake of the $1.9tn stimulus package. This will likely result in some underperformance of Eurozone markets relative to the US.  

Watching US Yields

Risk assets struggled to make headway last week, with technology stocks stumbling in particular.  Nonetheless, inflows into equities remain strong as more and more retail money is drawn in (perhaps signs of a near term peak).  Asian stocks started the week in positive mood despite last week’s nervousness, but equity investors will continue to keep one eye on the move in US yields.

US Treasuries continued to remain under pressure and the curve continued to bear steepen.  A combination of US fiscal stimulus hopes/expectations, vaccine progress and reduction in COVID cases, appear to be pressuring bonds. President Biden is likely to pass his $1.9 tn stimulus package in the weeks ahead, with a House vote likely this week, while the Fed continues to dampen down of any tapering talk, helping to push inflation expectations as reflected in break-evens, higher.  Indeed, this will likely be the message from a number of Fed speeches this week including Chair Powell testifying before Congress (Tue and Wed). 

Despite higher US nominal and real yields and visibly more nervous equities, the US dollar (USD) continues to struggle, failing to find a trigger to much covering of the massive short USD position still present.  We note that non-commercial FX futures positioning data (CFTC IMM) revealed only a limited reduction in aggregate USD short positions (as a % of open interest) in the latest week. Antipodean currencies led the way at the end of last week, but pound sterling (GBP) speculative positions have seen the biggest bounce over the last couple of weeks. 

Despite the USDs reluctance to rally lately, the short-term bias could shift to a firmer USD sooner rather than later, including against Asian emerging market currencies.  Indeed, several Asian currencies lost ground last week, with the Philippines peso (PHP) and Indonesian rupiah (IDR) leading the way lower.  The Asia USD index (ADXY) appears to have peaked and looks vulnerable to more short-term downside.

US economic data at the end of last week revealed that the flash estimates for the February purchasing managers indices (PMIs) stayed at fairly strong levels for both the manufacturing and services sectors.  Separately, US existing home sales posted stronger-than-expected numbers for January.

Attention this week will be on progress of passage on US fiscal stimulus as well as a number of central bank decisions beginning with China (today), New Zealand (Wed,) Hungary (Wed), and South Korea (Fri).  No policy changes from these central banks are likely.  Also of interest will be the UK’s announcement on exit plans from the current lockdown (today) and Germany’s Feb IFO survey, which is forecast to edge higher. 

Reflation Trade Is Back

A much softer than expected US January jobs report didn’t prevent US equities from closing higher at the end of last week as the reflation trade kicked back in.  One of the biggest driving forces for markets was the growing prospects that much of President Biden’s $1.9 trillion fiscal stimulus plan will be passed, albeit via a process of reconciliation, which allows Democrats to circumvent the need to gain the support of at least 10 republicans. This contrasts with prior expectations that the final stimulus was going to be less than $1 trillion. 

Pushing stimulus through this way highlights Biden’s urgency to inject more spending into the economy but could come at the cost of hurting bipartisan policy efforts. The impact of expectations of increased fiscal stimulus is particularly apparent in the US rates market, with US Treasuries selling off and bear steepening of the curve.  Although higher US Treasury yields failed to give support to the US dollar (USD) there is still scope for a short covering rally, which could still help give the USD relief.     

At the beginning of the year the US jobs market took a hit from renewed lockdowns and surge in COVID cases; US January non-farm payrolls increased 49k, and December was revised to -227k from -140k while more positively the unemployment rate fell to 6.3% from 6.7% though this was flattered by a drop in the participation rate as less people were looking for work.  According to the payrolls report there are still 9.9 million more unemployed compared to pre-COVID levels.  As such, the weak jobs data added more support to Biden’s fiscal stimulus proposals.   

This week focus will likely turn more to President Trump’s impeachment trial in the Senate than economic data.  Key data/events this week include China’s credit and monetary aggregates (9-15 Feb), central bank decisions in Sweden (Wed), Philippines, Mexico (Thu) and Russia (Fri).  Among these the consensus is for only Mexico to cut its policy rate. Also in focus are inflation readings in China (Wed), US (Wed) and India (Fri).  UK GDP (Fri) and US Michigan sentiment (Fri) will also garner attention. 

The return of the reflation trade, rally in risk assets and decline in cross-asset volatility bodes well for emerging markets (EM) assets.  However, there are definitely various cross currents impacting asset markets at present especially with US Treasury yields rising, which could potentially support the USD and pressure EM local bond rates markets.  EM assets were clearly favoured towards the end of last year, and while the positive story has not dissipated, EM assets may take a pause for breath before pushing higher again.  

In Asia, the Chinese-new-year holidays this week may dampen activity while China’s PBoC also appears to be limiting liquidity injections around the holidays, which could limit some of the gains in Chinese and impact China linked assets.  Chinese authorities have re-focussed attention on preventing an excessive build-up of leverage and credit metrics have peaked as a result.  As such, they may be less keen to inject a lot of liquidity into markets at present. 

Chinese Data Softens

It was a tough week for risk assets last week as stocks dropped, volatility increased and the battle between retail investors and hedge funds intensified, with the latter on the losing side. The end of the week saw US and European stocks drop.  Whether the decline in stocks is due to over extended valuations, vaccine variants, vaccine supply pressures, weak activity data or more likely a combination of all of these, asset markets go into this week on a more unstable footing, with risks skewed towards pull back extending further.  It’s hard to blame day traders for the drop given that most of activity from retail traders is buying of stocks, and now silver, with heavy short position, but they are likely contributing to the rise in volatility.  The US dollar (USD) could be a key beneficiary given the massive extent of short positioning in the currency.

Data in China is showing some softening in momentum.  China’s Jan official purchasing managers index (PMI) kicked off this week’s data and event schedule yesterday, with both the manufacturing and service sector PMIs disappointing expectations; the manufacturing PMI fell to 51.3 in Jan (consensus 51.6, last month 51.9) and services to 52.4 in Jan from 55.7 previously.  China’s softer PMI once again contrasted with a series of Asia manufacturing PMIs, released this morning. Later today the US Jan ISM manufacturing index is likely to register a modest decline (consensus: 60.0 from 60.7 previously). Also in focus today is India’s budget announcement, with the Fiscal Year 2021 budget deficit likely to be around 6-7% of GDP, much higher than the original 3.5% estimate.  

Over the rest of the week there are interest rate decisions in Australia (Tuesday), Thailand, Poland (both on Wednesday), UK (Thursday) and India (Friday).  Among these the Reserve Bank of India has the most potential for a surprise relative to market expectations, with a rate cut likely.  The highlight of the week is likely to be the US January jobs report at the end of this week (consensus 55k).  Deliberations on US fiscal stimulus will also be in focus, with a group of 10 Republican Senators writing to President Biden with a $600 billion stimulus proposal, well below the $1.9 trillion put forward by the administration.  Democrats have hinted that they may push through stimulus via reconciliation, which not require Republican support in the Senate, but such a move would likely sour any mood of cooperation in the Senate. 

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