Bonds Under Pressure, UK Parliament Rejects Election Again

Market sentiment remains positive as hopes of a US-China trade deal continue to provide a floor under risk sentiment amid hopes that the escalation in tariffs can be reversed.  Weak Chinese trade data over the weekend has largely been ignored and instead markets have focused on further stimulus unleashed by China in the wake of the cut in its banks’ reserve ratios, which freed up around USD 126bn in liquidity to help shore up growth.  Expectations that the European Central Bank (ECB) will this week provide another monetary boost by lowering its deposit rates and embarking on a fresh wave of quantitative easing, are also helping to support risk sentiment though a lot is already in the price in terms of ECB expectations.

One of the casualties of the turn in sentiment has been bonds, with yields rising in G10 bond markets.  For example US 10 year yields have risen by around 18 basis points since their low a week ago.   The US dollar has also come under pressure, losing ground in particular to emerging market currencies over the past week.  Safe haven currencies such as the Japanese yen (JPY) and Swiss franc (CHF) have fared even worse.   As I noted last week I think the bounce in risk appetite will be short-lived, but how long is short?  Clearly markets anticipate positive developments in US-China trade talks, and it seems unlikely that risk appetite will deteriorate ahead of talks, at least until there is some clarity on the discussions.  Of course a tweet here or there could derail markets, but that is hard to predict.

Sterling (GBP) has been another currency that has benefited from USD weakness, but also from growing expectations that the UK will not crash out of the EU without a deal.  Developments overnight have done little to provide much clarity, however.  UK Prime Minister Boris Johnson failed in his bid for an early election on October 15, with MPs voting 293 in favour of an election against 46 opposed;  Johnson required two-thirds or 434 MPs to support the motion.  Johnson is now effectively a hostage in his own government unable to hold an election and legally unable to leave without a deal.  Parliament has been suspended until October 14, with Johnson stating that he will not delay Brexit any further, reiterating that he is prepared to leave the EU without an agreement if necessary.

This would effectively ignore legislation passed into law earlier blocking a no-deal Brexit forcing the PM to seek a delay until 31 Jan 2020. Separately parliament passed a motion by 311 to 302 to compel Downing Street to release various documents related to no-deal Brexit planning, but officials are so far resisting their release.  A lack of progress in talks with Irish PM Varadkar in Dublin on Monday highlights the challenges ahead.  GBP has rallied following firmer than expected Gross Domestic Product data (GDP) yesterday and growing hopes that the UK will be prevented from crashing out of the EU at the end of October, but could the currency could be derailed if there is still no progress towards a deal as the deadline approaches.

 

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Will The Risk Rally Endure?

There has been a definitive turnaround in risk sentiment this week, with equities rallying and bonds falling.  Whether it can be sustained is another question. I think it will be short-lived.

Markets are pinning their hopes on trade talks which have been agreed be US and Chinese officials to take place in October.  These would be the first official talks since July and follow an intensification of tariffs over recent weeks.  However, talks previously broke up due to a lack of progress on various structural issues and there is no guarantee that anything would be different this time around.  Nonetheless, such hopes may be sufficient to keep market sentiment buoyed in the short term.

Data overnight was bullish for risk sentiment, with the US August ADP employment report revealing private sector gains of +195k, which was higher than expected.  The US ISM non-manufacturing index was also stronger than expected, rising to 56.4 in August from 53.7 previously.  This contrasted with the slide in the manufacturing PMI, which slipped in contraction below 50, reported earlier this week.  The data sets up for a positive outcome for the US August jobs report to be released later today, where the consensus (Bloomberg) is for a 160k increase in payrolls and for the unemployment rate to remain at 3.7%.

As risk appetite has improved the US dollar has come under pressure, falling from its recent highs.  Nonetheless, the dollar remains at over two year highs despite speculation that the US authorities are on the verge of embarking on intervention to weaken the currency.  While I think such intervention is still very unlikely given that it would do little to change the factors driving the dollar higher, chatter about potential intervention may still keep dollar bulls wary.  While intervention is a risk, I don’t think this stop the USD from moving even higher in the weeks ahead.

Conversely China’s currency, the renminbi has reversed some of its recent losses, but this looks like a temporary retracement rather than a change in trend.  China’s economy continues to weaken as reflected in a series of weaker data releases and a weaker currency is still an effective way to alleviate some of the pressure on Chinese exporters. As long as the pace of decline is not too rapid and does incite a sharp increase in capital outflows, I expect the renminbi to continue to weaken.

Tariffs Implemented, Talks Awaited

US and China went ahead with their tariffs implementation over the weekend, with the US adding 15% tariffs on around $110bn of Chinese imports, mainly aimed at consumer goods. Another $160bn of goods will be hit by 15% tariffs on December 15, with the implementation delayed to avoid a big impact on holiday spending.

China retaliated by implementing $75bn of tariffs on US goods on Sunday, much of which was aimed at agricultural goods including 10% on various meat, an additional 5% on top of the existing 25% on soybeans and a further 10% on sorghum and cotton and 5% on crude oil.  Chinese tariffs on US autos will resume in December.  China’s currency is likely to continue to weaken further given the tariffs intensification.

Against this background markets will closely monitor comments from both China and the US on the potential for trade talks over coming weeks, with President Trump stating that face to face talks are “still on”.  Meanwhile Chinese economic data continues to worsen, with China’s official August manufacturing PMI released on Saturday dropping to 49.5 in August from 49.7 in July, indicating ongoing contraction in China’s manufacturing sector.

There are plenty of events and data on tap this week including the August US ISM manufacturing survey, August non-farm payrolls and a slew of Fed speakers including Fed Chairman Powell.   The ISM index is forecast to remain steady around 51.2, reflecting the pressure on US manufacturers, although the index is still likely to remain in expansion.  Meanwhile consensus forecasts look for a 158k increase in August payrolls and for the unemployment rate to remain at 3.7%.

Events in the UK will also garner plenty of interest as parliament returns from their summer break, albeit only for a few days as Parliament will be prorogued in the following week.  The opposition Labour Party will aim to present legislation to prevent the country from crashing out of the EU without a deal against the background of protests against the decision to suspend parliament.  The potential for fresh elections is also in prospect.  GBP will remain volatile against this background.

US-China Trade War: The Gloves Are Off

The US-China trade war took another step for the worse over the weekend. China announced tariffs on the US of between 5- 10% on $75bn of US imports from September.  Chinese tariffs target 5,078 products including agriculture and small aircraft as well as crude oil. The US responded by increasing its tariffs on $250bn of Chinese imports from 25% to 30% while increasing duties from 10% to 15% on $300bn of Chinese imports to the US from September 1.   President Trump initially said he had “second thoughts” on additional tariffs, but these were clarified to state that “he regrets not raising the tariffs higher”.

The gloves are off on both sides. As indicated by the editorial in China’s People’s Daily states that China will fight the trade war to the end while influential Chinese journalist Hu Xijin said that “we have nothing more to lose, while the US is starting to lose China”, highlights China’s tougher stance.  Meanwhile President Trump is looking at the “Emergency Economic Powers Act of 1977” in forcing US companies to quit China.

Asia’s markets have responded in pain, with stocks and currencies falling while safe havens such as US Treasuries have been in demand.  Indeed the 10-year US Treasury yield has fallen to a three-year low.  Markets have priced in even further easing by the Fed FOMC, with almost three rate cuts by the PBoC discounted in by the end of this year.  Equity futures point to a weak opening in US equities today.

One casualty is the Chinese yuan, which took another leg lower today, having fallen by close to 7% since mid-April.  Further pressure on the yuan is likely, but China may not be too concerned as long as the pace of weakness does not get out of hand. China may try to control the pace of the decline to prevent a repeat of the FX reserves drain seen in mid-2015 and Jan 2016. At the least yuan depreciation will act as a buffer for Chinese exporters against increased US tariffs.  However, expect further yuan depreciation to be met with increased criticism and perhaps more US action, with the US already having labeled China a currency manipulator.

Combating Recession Risks

Following a volatile last week market attention will remain on trade tensions, measures to combat the risks of recession and will turn to the Jackson Hole central bankers’ symposium at the end of the week. The inversion of the US yield curve has led to growing expectations that the US is heading into recession and has spurred inflows into bonds. As a result US Treasury yields continue to fall and the stockpile of negative yielding debt has risen to well over $16 trillion. While economic data in the US remains relatively firm, the picture in the rest of the world has deteriorated sharply as reflected in weakening German and Chinese trade, against the background of a weak trade backdrop.

There have been some mixed headlines on trade over the weekend – Larry Kudlow, Director of the National Economic Council under President Trump, said yesterday that recent phone calls between US and Chinese trade negotiators had been “positive”, with more teleconference meetings planned over the next 10 days.  Separately US media reported that the US commerce department was preparing to extend a temporary license for companies to do business with Huawei for 90 days. However, Trump poured cold water on this by stating that “Huawei is a company that we may not do business with at all”.  A decision will be made today.

In the wake of growing expectations of recession, attention is turning on what will be done by governments and central banks to combat such risks.  The Jackson Hole meeting on Thursday will be particularly important to gauge what major central bankers are thinking and in particular whether and to what degree Federal Reserve Chairman Powell is planning on cutting US rates further.  We will be able to garner further evidence of Fed deliberations, with the release of the Fed FOMC July meeting minutes on Wednesday.

While central bankers look at potential monetary policy steps governments are likely to look at ways of providing further fiscal stimulus.  Kudlow stated that the US administration was “looking at” the prospects of tax cuts, while pressure on the German government to loosen is purse strings has also grown.  Even in the UK where a hard Brexit looms, the government is reportedly readying itself with a fiscal package to support growth in the aftermath.   Such news will come as a relief to markets, but recession worries are not likely to dissipate quickly, which will likely keep volatility elevated, and maintain the bias towards safe haven assets in the weeks ahead.

Taking Stock

As we get to the end of the week trade headlines are still continuing to capture most attention. However, it has been increasingly difficult for anyone to guess what comes next in the long running trade war between the US and China.  Most investors and analysts think the trade war will persist for a long while but President Trump tweeted that it would “fairly short” and that talks with China were on track to resume next months.

Markets are not convinced and becoming increasingly desensitised to the news flow over trade, which seems to shift from good to bad news on a regular basis.  For example, the decision to delay the imposition of tariffs on around $156bn of Chinese exports until December failed to fuel a bounce in US equities. The decision has also left Chinese officials unperturbed.  China has vowed to retaliate, stating that the US had “deviated from the correct track of consultation and settlement of differences”.

The situation in Hong Kong is adding another dimension to the trade war.   President Trump has said that believed China’s President Xi could “work that out in a humane fashion” while in contrast many in the US Congress are pushing for a stronger stance. The eventual reaction will depend on whether demonstrations persist and how China moves going forward.

Hong Kong’s economy and markets are under pressure too, unsurprisingly. The economy is now facing the prospect of a technical recession, with growth in the third quarter likely to be negative following a -0.3% q/q drop in GDP in the second quarter.   Industry bodies have revealed that tourism has dropped sharply, with double digit declines in hotel occupancy and sharp reductions in purchases by mainland tourists. The number of tour groups from mainland China have declined by close to 30% in June compared to the average this year while hotel occupancy rates are expected to drop 40% y/y in July.

A Host Of Global Risks

Last week was a tumultuous one to say the least.  It’s been a long time since so many risk factors have come together at the same time.  The list is a long one and includes the escalation of the US-China trade war, which last week saw President Trump announce further tariffs on the remaining $300bn of Chinese exports to the US that do not already have tariffs levied on them, a break of USDCNY 7.00 and the US officially naming China as a currency manipulator.

The list of risk factors afflicting sentiment also includes intensifying Japan-Korea trade tensions, growing potential for a no-deal Brexit, demonstrations in Hong Kong, risks of a fresh election in Italy, growing fears of another Argentina default, ongoing tensions with Iran and escalating tensions between India and Pakistan over Kashmir.

All of this is taking place against the background of weakening global growth, with officials globally cutting their growth forecasts and sharply lower yields in G10 bond markets.  The latest country to miss its growth estimates is Singapore, a highly trade driven economy and bellwether of global trade, which today slashed its GDP forecasts.

Central banks are reacting by easing policy.  Last week, the New Zealand’s RBNZ, cut its policy rate by a bigger than expected 50 basis points, India cut its policy rate by a bigger than expected 35 basis points and Thailand surprisingly cutting by 25 basis points.  More rate cuts/policy easing is in the pipeline globally in the weeks and months ahead, with all eyes on the next moves by the Fed.  Moving into focus in this respect will be the Jackson Hole central bankers’ symposium on 22/23 August and Fed FOMC minutes on 21 August.

After the abrupt and sharp depreciation in China’s currency CNY, last week and break of USDCNY 7.00 there is evidence that China wants to control/slow the pace of depreciation to avoid a repeat, even as the overall path of the currency remains a weaker one. Firstly, CNY fixings have been generally stronger than expected over recent days and secondly, the spread between CNY and CNH has widened sharply, with the former stronger than the latter by a wider margin than usual.  Thirdly, comments from Chinese officials suggest that they are no keen on sharp pace of depreciation.

Markets will remain on tenterhooks given all the factors above and it finally seems that equity markets are succumbing to pressure, with stocks broadly lower over the last month, even as gains for the year remain relatively healthy.  The US dollar has remained a beneficiary of higher risk aversion though safe havens including Japanese yen and Swiss Franc are the main gainers in line with the move into safe assets globally.  Unfortunately there is little chance of any turnaround anytime soon given the potential for any one or more of the above risk factors to worsen.

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