Two Speed Recovery

The spread of the COVID Delta variant globally holds key risks for markets in the weeks ahead.  However, as long as hospitalisation rates remain relatively low, it should be less detrimental to the path of re-opening in countries with higher vaccination rates.  As a stark example, the UK will shed almost all of its COVID restrictions today despite spiking COVID cases amid relatively low hospitalisation rates.  

This is particularly difficult for many emerging markets including much of Asia given low vaccination rates.  As such, a two-speed recovery between developed and emerging economies is occurring, with the former registering much higher vaccination rates compared to the latter.  Unlike the move to re-open in developed markets, re-opening in many emerging markets is far more difficult given sharply increasing hospitalisation rates among unvaccinated people as the Delta variant runs rampant. 

As such, the risks of renewed restrictions in many countries could put the global recovery process in jeopardy at a time when we are already past peak growth.  Maybe this is helping to dampen US bond yields or yields are being supressed by the fact that the market has a lot of faith in the Fed even as inflation has surprised on the upside in many countries.  Whatever the cause, US 10y bond yields have slipped below 1.3% back to levels not seen since mid-February and continue to edge lower.    

Event highlights this week include several central bank policy decisions including in China (Tue), Eurozone, Indonesia, South Africa (all Wed) and Russia (Fri).  No changes are expected for China’s Loan Prime Rate (LPR) though the risk of easing has increased marginally following the People’s Bank of China (PBoC) reserve requirements (RRR) cut last week. The Central Bank of Russia (CBR) is expected to hike by 75bp, with risks of a bigger move.  Bank Indonesia is likely to remain on hold despite growing economic pressure.  South Africa’s Reserve Bank (SARB) is expected to remain on hold and remain dovish while a change in forward guidance from the European Central Bank (ECB) is expected this week. 

Oil will be in focus today after OPEC+ agreed on a deal to expand output, with the UAE and Saudi Arabia putting away differences to agree upon a 400k barrels a day increase in output from August.  The US dollar (USD) is trading firmer, but overall looks like it is close to topping out.  For example, EURUSD looks oversold relative to real rate differentials.  Interest rates markets will eye US fiscal developments, with Democrats crafting the budget resolution needed for a reconciliation bill, which may see additional progress this week.

Lots Of Buyers On Dips

Last week’s bout of risk-aversion proved short-lived though more volatility likes lies ahead. The reflation trade looked like it was falling apart last week as reflected in the sharp decline in US Treasury bond yields and the shift out of value into big tech/growth stocks.  The markets appeared to have increasingly absorbed the Fed’s message that inflation increases will be transitory while a reversal of crowded market positioning in reflation trades exacerbated the moves.  The malaise in markets coincided with several indicators revealing peak growth has passed and the rapid spread of the Delta variant globally.

However, clearly that didn’t appear to be the case by the end of last week as equities rallied strongly and the US Treasury curve shifted higher.  The US dollar gave up some of its gains while oil and gold rallied.  While there are still concerns about peak growth passing and the rapid spread of the Delta variant, there are obviously still plenty of buyers willing to jump in on dips. 

China’s central bank, PBoC went ahead with a much anticipated reserve requirement ratio cut sooner than expected on Friday though this targeted liquidity easing is unlikely to change the fact that growth is losing momentum amid a weakening credit impulse.  This week, key events include China’s June trade data (Tue) for which outsized gains in exports and imports is likely.  China’s monetary and credit aggregates will also be out sometime over the week as well as Q2 GDP and the June data dump, with some further moderation likely to be revealed. 

Top US data includes June CPI inflation (Tue) and retail sales (Fri).  CPI is likely to record another sizeable 4.9% y/y increase though the Fed’s repeated message of transitory inflation, will limit any market concerns over inflation pressures.  Also given the gyrations in markets last week, there will be even more focus on Federal Reserve Chair Powell’s semi-annual testimony to Congress (Wed & Thu).  The start of the Q2 earnings season will also come under scrutiny, with expectations of a 63% surge forecast according to FactSet data.   

Monetary policy rate decisions in New Zealand, Canada, Turkey (all on Wed), Korea (Thu) and Japan (Fri) are on tap, with the former two likely to reveal upbeat views while the CBRT in Turkey will have limited room to ease given the recent spike in inflation.  BoK in Korea may dial back a little of its hawkish rhetoric giving increasing virus cases in the country, while BoJ in Japan is likely to revise higher its inflation forecasts but leave its economic outlook unchanged.  Australian and UK jobs data (Thu) will also garner attention. 

US Jobs Report Provides Comfort For Markets

The US June jobs report released on Friday provided plenty of comfort for US equity markets. Non-farm payrolls rose by an above consensus 850,000 while the unemployment rate ticked higher to 5.9% from 5.8%.  The strong increase in payrolls helped US equities close out another week in positive mood; S&P 500 rose 0.75% and the Nasdaq gained 0.81% as investors continued to pile back into growth stocks. US Treasury bonds were supported, helped by an increase in the unemployment rate, while the US dollar fell.

Despite the jobs gain, payrolls are still around 6.8 million lower than pre-Covid levels, suggesting a long way to go for a full recovery. Federal Reserve officials will likely need to see several more months of jobs market improvement to achieve their “substantial further progress” tapering criterion.  Overall, the data played into the Fed’s narrative that tapering is still some way off and higher US interest rates even further away, leaving little for markets to fret about.

OPEC+ tensions between Saudi Arabia and UAE have increased, delaying OPEC+ talks to today against the background of oil prices pushing higher above $75 per barrel.  Riyadh along with other OPEC+ members appear keen to increase production over coming months while the UAE supports a short term increase, rather than the end of 2022 which other OPEC members are looking for.

Markets activity is likely to be subdued at the start of the due to the US holiday and there seems to be little to break out of the low volatility environment that we are currently in the midst off, though the US dollar will look to extend recent gains against the background of persistent short market positioning as reflected in the CFTC IMM data.  

This week attention will turn to the Federal Reserve FOMC Minutes of its last meeting (Wed), ISM non-manufacturing survey (Tue), and central bank policy meetings in Australia (Tue) and Poland (Thu) alongside Chinese June inflation (Fri) and credit aggregates data (from Fri). 

Given the sharp market reaction following the less dovish Fed FOMC meeting, markets will look for any further elaboration on the potential timeline for tapering in the Fed Minutes.  While both the RBA in Australia and NBP in Poland are likely to stay on hold, the RBA is likely to strike a dovish tone in its statement and Q&A while the NBP is likely to announce a new set of economic projections.  No shocks are expected from China’s June CPI inflation reading, though producer price inflation, PPI is likely to remain elevated.

What Could Prompt Higher Volatility?

Equities were buoyed last week in the wake of US President Biden’s infrastructure deal and renewed reflation trade optimism amid mixed post Federal Reserve FOMC messages from Fed officials. This resulted in US stocks recording their biggest weekly gain since February.  The prospects of passing the infrastructure deal has improved in the wake of Biden’s decision not to tie it to a much larger spending package that is being pushed through by Democrats but is not supported by Republicans. 

Given heightened sensitivity over inflation, the slightly weaker than expected US Personal Consumption Expenditures (PCE) data on Friday, which increased 0.5% m/m in May, slightly below the 0.6% consensus, added further support to the reflation trade, helping the US Treasury curve to steepen.  Moreover, the University of Michigan 5-10y inflation expectations series came in lower in June compared to the previous month. Fed officials likely put much more emphasis on this long-term series and will view the 2.8% reading as consistent with their “largely transitory” take on the pickup in inflation.

Cross-asset volatility has continued to decline, which bodes well for carry trades and risk assets.  For example, the VIX “fear gauge” index has dropped to pre-COVID level, something that has been echoed in other market volatility measures.  However, it’s hard to ignore the shift in tone from many central banks globally to a more hawkish one while risk asset momentum will likely wane as the strength of recovery slows, suggesting that low volatility may not persist.  It is notable that changes in global excess liquidity and China’s credit impulse have both weakened, implying a downdraft for risk assets and commodity prices and higher volatility. 

If there is anything that could prompt any increase in volatility this week, its the US June jobs report on Friday.  June likely saw another strong (consensus 700k) increase in nonfarm payrolls while the unemployment rate likely dropped to 5.7% from 5.8% previously.  Despite the likely strong gain in hiring, payrolls would still be close to 7 million lower compared to pre-COVID levels, suggesting a long way to go before the US jobs market normalises. The June US Institute for Supply Management (ISM) manufacturing index will also come under scrutiny though little change is expected from the May reading, with a 61.0 outcome likely from 61.2 in May. 

Other data and events of importance this week include the 100th year anniversary of China’s Communist Party (Thu), the release of purchasing managers indices (PMI) data globally including China’s official NBS PMI (Wed) for which a slight moderation is expected.  Eurozone June CPI inflation (Wed) which is likely to edge lower, Sweden’s Riksbank policy decision (Thu) where an unchanged outcome is likely and Bank of England (BoE) Governor Bailey’s Mansion House Speech (Thu), will be among the other key events in focus this week. 

Federal Reserve Speakers In Focus

After a major flattening of the US Treasury curve last week in the wake of the Federal Reserve Federal Open Market Committee (FOMC) meeting, this week will be important to determine how comfortable the Fed is with the market reaction to its shift in stance, with a number of speakers on tap including Fed Chairman Powell who testifies to Congress today.

In summary, the Fed FOMC was much less dovish than expected and acknowledged that they are formally thinking about thinking about tapering. The most obvious shift was in the Fed FOMC dot plot, with the median Fed official now expecting 50bp of tightening by the end of 2023.  

Notably, St. Louis Fed President Bullard was even more hawkish on Friday, highlighting the prospects of a “late 2022” hike in US policy rates.  Moreover, Fed speakers overnight did not walk back from the FOMC statement, with Presidents Bullard, Kaplan and Williams delivering views.  Kaplan favours tapering “sooner rather than later”, while Bullard highlighted upside risks to inflation. 

Nonetheless despite hawkish comments, markets have calmed somewhat following the sharp post FOMC reaction last week, which reeked of a major positioning squeeze.  Longer end US Treasury yields move higher overnight while equities recouped losses and the USD weakened. Today most attention will fall on Fed Chairman Powell’s testimony before the House Select Subcommittee on the Coronavirus Crisis on “The Federal Reserve’s Response to the Coronavirus Pandemic.” 

This week there are also several central bank decisions on hand.  Yesterday, China’s central bank PBoC, left policy on hold for a 14th straight month. China is in no rush to raise its policy rate and will likely focus on liquidity adjustments to fine tune policy. Other central bank policy decisions this week will come from Hungary (today), Thailand (Wed), Czech Republic (Wed), Philippines, UK, and Mexico (all on Thu).  

The NBH in Hungary is expected to hike policy rates, with both the 1 week depo rate and base rate likely to be hiked by 30bps. The Czech National bank is also expected to hike, with a 25bp increase in policy rates expected by consensus.  All the rest are forecast to leave policy on hold.  The key data releases this week will be the US May PCE report on Friday, which will likely reveal another sharp rise in prices.  

Although the USD weakened overnight it still looks positive technically, with the dollar index (DXY) remaining above its 200-day moving and MACD differential remaining positive. The Asian dollar index (ADXY) marks an interesting level for Asian FX as its is verging on a break below its 200-day moving average around 108.2861.  As such, the USD bounce may have a little more to run in the short term.

The euro (EUR) will be in focus to see if it breaks below 1.19, with the currency looking vulnerable on a technical basis to further downside. Similarly, the Australian dollar (AUD) is trading just below its 200 day moving average any may struggle to appreciate in the short term.

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