Fed’s Powell, China trade, Japan-Korea tensions

Markets cheered Fed Chair Powell’s testimony to the US Congress this week, with Powell all but confirming that the Fed will cut interest rates in the US by 25bps later this month.  Powell’s comments yesterday and Wednesday highlighted the risks to the US economy including the threats from persistently low inflation, worsening global trade outlook, weak global growth, and possibility that Congress does not raise the debt ceiling, even as he saw “the economy as being in a good place”.  His comments highlight that any easing this month, would be an insurance cut, but markets are expecting the Fed to ease further in the months ahead, with at least one more priced in by the market this year.

Meanwhile attention remains focused on trade tensions. On this front, president Trump complained overnight that China hasn’t increased its purchases of US farm products, something that he said China had pledged to do at the G20 meeting when he met with China’s President Xi.  Data released yesterday showed that Chinese purchases of US agricultural good have actually slowed.  According to the US department of Agriculture China bought 127,800 metric tons of US soybeans last week and 76 tons of US pork, both sharp reductions compared to previous weeks.  Chinese media for its part says that the country had not committed to increasing purchases, but rather that Trump had hoped China would buy more goods.  Clearly, there is has left plenty of confusion about what was actually agreed upon.

Trade tensions have also risen in Asia, with tensions between South Korea and Japan intensifying.  Japan is implementing restrictions on exports to Korea of chemicals essential for chip making in retaliation over a ruling by Korea’s Supreme court awarding damages against Japanese companies for forced labour during the second world war. Japan says that such claims were settled under a 1965 treaty and is seeking arbitration. Korea evidently disagrees. The trade spat could also have widespread implications given the wide range of products that South Korean chips are used in, impacting supply chains globally.  Meetings between Japanese and Korean officials today will be watched for any rapprochement but any near term solution looks unlikely.

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US-China Trade Truce Boosts Sentiment

Weekend developments will help set up the markets for a risk on day.  However, any improvement in sentiment will likely be capped. The good news was that the US and China agreed to a trade truce at the G20 summit, President Trump and North Korean leader Kim Jong Un met at the demilitarised zone while separately the EU and Mercosur agreed upon a trade deal in a strong retort against the rising trend of protectionism.

Presidents Trump and Xi agreed to delay the implementation of new tariffs (on the remaining $300bn of Chinese exports to the US) while agreeing to restart trade talks, albeit with no time table scheduled as yet.  The delay in tariffs escalation and restart of trade talks was in line with expectations but concessions on Huawei were not.   Trump stated that US companies can sell equipment to Huawei without giving details on what can be sold while China also agreed to buy more US agricultural goods.

The chances of a US-China trade deal have risen, but it could still take several months before various remaining structural issues (forced technology transfers, state subsidies, discrimination against foreign companies, regulations on intellectual property etc)
are ironed out. The lack of time frame on US-China trade talks, ongoing structural issues, lack of details on what equipment US suppliers can sell to Huawei and a host of data releases, will limit the improvement in sentiment and reduce the likelihood of any near term deal.

Looking ahead, sentiment may be clouded somewhat by the disappointing China purchasing managers’ index (PMI) yesterday, with the manufacturing PMI coming in at 49.4 in June, the same as in May, with manufacturing continuing to contract.  However, markets may be willing to overlook this as trade tensions were likely a prime reason for the continued weakness in manufacturing confidence.   As such, China’s currency CNY and asset markets will likely react positively overall.

The events over the weekend will likely reduce the chances of a 50bps rate by the Fed at their next meeting, but much will depend on upcoming data.   This includes the June US ISM survey today and employment report on Friday.  Markets expect a 160k bounce back in payrolls in June after the surprisingly weak 75k increase in the previous month.  Assuming the data is line with expectations it seems unlikely that the Fed will feel the need to ease policy by more than 25bp when they meet at the end of the month.

G20, Fed and Iran

Market attention this week will focus on Fed speakers, the G20 meeting and tensions between the US and Iran.  Here are my thoughts on all three:

Federal Reserve Chairman Powell and Vice Chair Williams are both scheduled to speak tomorrow.  Investors will be looking for any further clues on the path, timing and magnitude of Fed interest rates in the months ahead and whether they validate market expectations of easing at the July FOMC meeting.   Markets are already pricing in several cuts and a result the USD has weakened sharply over recent months, suggesting that the bar to an even more dovish stance is high.  Nonetheless, the Fed is at least likely to deliver a 25bp rate cut at the July meeting followed by at least one or two further hikes this year.

The main event this week (Fri-Sat) is the G20 meeting in Japan and in particular the potential meeting between Presidents Trump and Xi on the sidelines.  Expectations/optimism towards some form of progress on trade talks appears high.  Markets are set to remain upbeat heading into the G20, suggesting that risk assets will maintain their rally this week, which will bode well for equities. However, the reality is that the gap between both sides remain wide and there may be some positive noises emanating from the G20 on trade, concrete progress is likely to be limited.

Trump and Xi are likely to discuss a range of issues, with trade teams from both sides preparing the topics for discussion, after talks broke down last month.  It is likely that both Trump and Xi will agree to continue more formal talks, with both leaders sounding positive in the run up to the G20.  However, the threat of additional 25% US tariffs on the remaining $300bn of Chinese exports to the US, remains in place and it is unlikely that this will be taken off the table without some major concessions from China.  As I’ve previously stated it could take months before a concrete deal is agreed upon.  In the meantime global trade will continue to deteriorate.

Elsewhere geopolitical tensions remain in focus as President Trump threatens Iran with additional sanctions in an effort to force Iran to renegotiate the 2015 nuclear accord, as early as today. This follows Trump’s decision to call off planned air strikes in response to Iran’s shooting down of an unmanned drone.  Iranian oil exports have plunged as a result of sanctions and oil prices continue to react, rallying by around 8.7% in just under a week.  Markets will remain nervous over the risks of any further escalation, leaving oil prices susceptible to a further push higher.

 

Dovish Fed Hits The US Dollar

The US Federal Reserve shifted towards a dovish stance yesterday and asset markets applauded.   Against the background of signs of slowing growth, intensifying trade tensions and growing “uncertainties” about the economic outlook, the Fed removed the previous “patient” stance and instead noted that “act as appropriate to sustain the expansion”.   The bottom line is that the Fed is priming the market for easing as early as July, though the market had already primed itself by moving sharply in terms of pricing in rate cuts over recent weeks.   The market is now pricing in three rate cuts this year and at least one next year, which seems reasonable.

Clearly there are a huge number of uncertainties ahead, making the Fed’s job particularly difficult and the picture could look quite different should the upcoming G20 meeting in Japan (28-29 June) deliver some form of trade agreement between the US and China.  This would likely result in less need for Fed easing.  As I have noted previously there are still a huge number of challenges and obstacles to any such agreement, suggesting that market hopes of an agreement stand a good risk of being dashed.   Until then, risk assets will remain upbeat, with equity markets rallying in the wake of the Fed decision even as bond yields moved lower and gold prices reached a 5-year high.

The USD remains under pressure and took another blow in the wake of the FOMC meeting.  The USD has now lost ground against almost all G10 currencies except GBP amid Brexit concerns over the last month.  This has extended today and the currency looks set to remain under pressure in the short term as markets continue to price in Fed rate cuts.  The tension between President Trump and Fed Chairman Powell is not doing the USD any good either.  The USD index (DXY) is now threatening to break below its 200-day moving average (96.710) though this has proven to provide strong support in the past.  A sustained break below this level could see the USD extend losses against major and many emerging market currencies.

Are Recession Risks Rising?

It is incredible that just a few months ago most analysts were expecting at least two if not three interest rate hikes by the Federal Reserve.  How quickly things change.  Markets are pricing in at least a couple of rate cuts by the FOMC while US Treasury yields have fallen sharply as growth concerns have intensified, even as the hard economic has not yet turned that bad.  Recession risks are once again being actively talked about as trade fears intensify, with President Trump threatening increased tariffs on both Mexico and China.  As I noted earlier this week, trade tensions have escalated.

Reflecting this, core bond markets have rallied sharply, with 10 year US Treasury yields dropping by around 60bps so far this year, while bund yields are negative out to 10 years.  Historically such a plunge would be associated with a sharp weakening in growth expectations and onset of recession.  However, equity markets are holding up better; the US S&P 500 has dropped around 6.8% from its highs but is still up close to 10% for the year.  Even Chinese equities are up close to 20% this year despite falling close to 13% from their highs.  Equities could be the last shoe to fall.

In currency markets the US dollar has come under pressure recently but is still stronger versus most currencies this year except notably Japanese and Canadian dollar among major currencies and the likes of Russian rouble and Thai baht among emerging market currencies.  On the other end of the spectrum Turkish lira and Argentine peso have fallen most, but their weakness has largely been idiosyncratic.  In a weaker growth environment, and one in which global trade is hit hard, it would be particularly negative for trade orientated EM economies and currencies.

The US dollar has a natural advantage compared to most major currencies at present in that it has a relatively higher yield. Anyone wishing to sell or go short would need to pay away this yield.  However, if the market is increasingly pricing in rate cuts, the USD looks like a much less attractive proposition and this is what appears to be happening now as investors offload long USD positions build up over past months.  Further USD weakness is likely at least in the short term, but it always hard to write the USDs resilience off.

Going forward much will of course depend on tariffs.  If President Trump implements tariffs on an additional $300 billion of Chinese exports to the US as he has threatened this would hurt global growth as would tariffs on Mexico.  Neither is guaranteed and could still be averted.  Even if these tariffs are implemented fears of recession still appear to be overdone.  Growth will certainly slow in the months ahead as indicated by forward looking indicators such manufacturing purchasing managers’ indices, but there is little in terms of data yet to suggest that recession is on the cards.

 

US/China Tensions Escalate

Risk appetite starts the week in poor form. The shock announcement of 5% tariffs on all Mexican exports (from June 10) to the US and an intensification of tensions with China, have fuelled growing expectations of a worsening in the global growth outlook. Safe haven assets such as JPY and CHF are likely to remain in demand while core bond yields are likely to continue to move lower, with markets continuing to raise bets on Fed rate cuts this year.  Indeed the 10y US Treasury yield has dropped by 1.1% since 8 November last year, with the fall in yields accelerating over recent weeks.

US/China tensions escalated over the weekend, with the deputy head of China’s negotiating team, Wang Shouwen, accusing the US of “resorting to intimidation and coercion”.  This coincides with the increase in US tariffs on $200bn of Chinese goods coming into effect over the weekend as Chinese shipments reached US shores, while earlier on Saturday Chinese tariffs on $60bn of US exports came into effect.  There is also growing speculation that China may curb exports of rare earth exports to the US.

Wang accused the US of abusing export controls and persisting with “exorbitant” demands and insisting on “mandatory requirements that infringe on China’s sovereign affairs”.   Meanwhile China’s defence minister Wei Fenghe, said that China will “fight to the end” on trade if needed.  China is also starting to investigate foreign companies who have violated Chinese law.  Soon after Chinese state media reported that the government was investigating FedEx for allegedly “undermining the legitimate rights and interest” of its Chinese clients.

Attention this week will be on several central bank decisions including the ECB (6th June), RBA (4th June) and RBI (6th June).  The market is fully priced in for an RBA rate cut to 1.25% this week.  The ECB is unlikely to surprise, with no change in policy likely.  Attention will be on terms of the TLTRO III while ECB President Draghi is likely to sound dovish in his press conference.  RBI is set to cut policy rates again, with Friday’s release of weaker than expected Q1 GDP adding to pressure on the Reserve Bank to boost growth amid low inflation.

Awaiting More US Tariffs And China Retaliation

Weekend developments in the trade war included China’s denial that they had reneged on any prior agreements, contrary to what the US administration has said as a rationale for ratcheting up tariffs on China.  In fact, China’s vice-minister Liu He said that such changes (to the draft) were “natural”.  He also said the remaining differences were “matters of principle”,  which implies that China will not make concessions on such some key structural issues.  This does not bode well for a quick agreement.

Meanwhile Trump’s economic advisor Larry Kudlow suggested that Trump and China’s President Xi could meet at the G20 meeting at the end of June. This offers a glimmer of hope but in reality such a meeting would achieve little without any agreement on substantive issues, which appears a long way off.  Markets now await details from the US administration on tariffs on a further $325bn of Chinese exports to the US effectively covering all Chinese exports to the US.

China has promised retaliation and we could see them outline further tariffs on US exports in the next couple of days as well as the possible introduction of non-tariff barriers, making life harder for US companies in China.  The bottom line is that any deal now seems far off while the risk of further escalation on both sides has risen.  Global markets are increasingly taking fright as a result, especially emerging market assets.

There are no further negotiations scheduled between the US and China though Kudlow has said that China has invited Treasury Secretary Mnuchin and trade representative Lighthizer to Beijing for further talks.  Given that Trump now appears to have a unified administration as well as many Republicans and Democrats behind him while China is digging its heels in this, don’t expect a resolution anytime soon.

China’s currency CNY is facing growing pressure as the US-China trade war escalates.   The CNY CFETS index has weakened by around 1% in just over a week (ie CNY has depreciated relative to its trading partners) and is now at its weakest since 20 Feb 19.  While not weaponising the currency, there’s every chance that China will manage CNY depreciation to help compensate Chinese exporters for the pressure faced from higher tariffs (as appeared to take place last summer). Expect more pain ahead.

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