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. 

Brexit Developments Sharply In Focus

Two major market risks have been sidelined, though admittedly not taken off the table.  Firstly the prospects of an intensification of the US-China trade war appears to have diminished and secondly the risks of the UK crashing out of the EU without a deal have lessened.  This presents a calmer and less volatile backdrop for markets even as global growth continues to remain under pressure.  Separately markets are hoping and expecting for some icing on the cake in the form of Fed easing later this month. As long as US Q3 earnings are not too bad, this suggests a period of calm ahead.

US-China trade developments are likely to take a back seat in the run up to the APEC meeting on 16-17 November in Chile where a ‘Phase 1’ trade deal may be signed by both US and Chinese leaders.  Talks rumbling in the background appear to progressing well, with US Treasury Secretary Mnuchin and Trade Representative Lighthizer scheduled to speak to China’s Vice Premier Liu He this week by phone.  Markets will carefully eye what the prospects are for a delay of the $156bn of US tariffs on China that are due to take effect on December 15.

Brexit developments will move sharply back into focus today, with UK Prime Minister Boris Johnson set to make a fresh attempt at passing a ‘meaningful vote’ today or gaining a majority in a vote on legislation implementing the deal tomorrow.  This follows having to jettison a vote on Saturday and being forced to write to the EU requesting a three-month delay to the Article 50 exit process.  The government thinks it has the number of votes necessary to pass the vote and the fact that GBP has only lost a little ground today (at the time of writing) suggests that markets think the chances are high.

Other than this, the European Central Bank meeting on Thursday will garner attention although President Draghi is unlikely to offer any further changes in policy, having come under criticism from hawks in the ECB governing council who opposed the renewed bond buying from the ECB.  Expect Draghi to maintain a dovish stance at this meeting.  Other central banks in focus this week include Norway, Sweden, Turkey and Indonesia.  The former two are likely to leave policy unchanged while both Turkey and Indonesia are likely to ease policy.

 

Sweden Riksbank preview

There is almost no disagreement about expectations for today’s Riksbank policy decision. The central bank last lowered the repo rate in December and is unlikely to alter policy settings again so soon, with the policy rate likely to be maintained at 0.75%

The SEK is unlikely to be impacted by today’s rate decision, with the currency benefitting from the recent improvement in risk appetite. However, a relatively dovish statement from the Riksbank may undermine the SEK especially as it approaches EUR/SEK support around 8.75.

Further out, we expect SEK to continue to appreciate gradually but its worth noting that gains in the currency are not comfortable for the Swedish authorities, who have called for stricter capital rules on its banks to help weaken the currency (via keeping policy rates low).

GBP resilience, SEK vulnerable

Signs of some further flexibility on both sides reveal that negotiations over the US fiscal cliff are progressing, albeit very slowly. Discussions between President Obama and House speaker Boehner yesterday appeared to go relatively well but the chances of a deal by year end remain slim. Against this background US equities posted gains while risk measures improved ignoring the weaker than expected reading for the December Empire manufacturing survey.

There is little else in terms of directional influence today, with highlights including RBA December board minutes, a vote on the Italian 2013 budget, UK inflation data and an interest rate decision in Sweden. The overall tone is likely to continue to be constructive for risk assets.

While I expect GBP to show some resilience over the coming year especially against the EUR, I look for the currency to eventually end the year weaker against the USD. The principal risk to GBP revolves around the UK economy. It seems very likely that the UK economy has contracted in the final quarter of the year. Worryingly, a weaker external environment taken together with the relative resilience of GBP has resulted in a deteriorating trade deficit, which could ultimately inflict pressure on GBP to weaken.

The fact that the UK basic balance (direct investment + portfolio flows + current account) position remains in negative territory also suggests that the underlying support for GBP is weak. Given these soft economic fundamentals it is difficult to see GBP breaking significantly higher over the coming months. Although the relationship is not perfect, my expectation that EUR/USD will drift lower over the course of 2013 will act to drag EUR/GBP lower too, with my forecast at 0.79 by end year.

EUR/SEK has probed higher over recent weeks and look to register further upside. Today’s Riksbank policy meeting will be the next focal point for SEK but with a rate cut largely priced in following recent deterioration in employment data and other signs of slowing growth, the SEK is unlikely to find any support in the near term. Sweden’s industry body and the OECD have highlighted the policy room to lower interest rates, with the OECD also noted the fiscal leeway that Sweden has should economic conditions worsen.

Officials are also targeting the exchange rate given recent comments by Sweden’s finance minister Borg about increasing foreign exchange reserves over the longer term. The implication is that the SEK will suffer as other currencies are bought against it. The weakness in the SEK is consistent with my quantitative models and a break of EUR/SEK 8.80 is looming over the short term.

SEK weaker, Asian FX still following CNY

Despite a series of better than expected data releases in the US including October durable goods orders, Case Shiller house prices and consumer confidence the lack of progress towards resolving the fiscal cliff is weighing on risk appetite. Comments by Senate Majority leader Reid of little progress in budget talks hit equity markets and will cast a shadow over risk appetite today.

News that the US did not label China a currency manipulator did little to help as such an outcome was expected in the US Treasury’s semi-annual currency report, especially given the recent appreciation of the CNY. Any positive boost from the Greek aid deal also proved short lived. The lack of major data releases or events today will likely most asset classes within recent ranges.

The EUR has failed to hold onto Greek debt deal inspired gains but looks well supported above 1.2900. The realisation that any aid to Greece will still be subject to several parliamentary approvals, ongoing reforms and a successful debt buy back may have dampened sentiment or more likely the deal was already priced in.

Looking ahead there is little on the economic front to provide any directional impetus for EUR/USD aside from M3 money supply data where a modest increase is expected in October. In contrast the run of better US economic data is set to continue, with October new home sales and the Beige Book likely to provide encouraging reading. The difficulty in reaching agreement on the fiscal cliff may perversely play negatively for the EUR as risk aversion pushes higher.

My quantitative models have continued to point to EUR/SEK upside. Economic data yesterday provided more negative news for the currency, with business and consumer confidence for November recording bigger than expected declines. Q3 GDP data tomorrow will confirm the slowing in the economy, while retail sales are set to record a decline.

However, while the SEK remains vulnerable it is already pricing in some bad news. I suspect that the 26 October high around EUR/SEK 8.7194 will be difficult to break through. I prefer to play SEK weakness versus NOK at current levels.

Asian currencies remain relatively well supported and continue to track movements in the CNY rather than the USD although slightly higher risk aversion will weigh limit the ability of Asian FX to strengthen. USD/KRW looks likely to continue to struggle to break below the 1080 level as markets remain wary of official action to weaken the currency. A likely unchanged rate decision from the Bank of Thailand ought to leave the THB to trade within its tight range.

%d bloggers like this: