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. 

Will Stability Return?

After a very nervous end to last week, with US tech stocks leading the sell-off in US equity markets amid lofty valuations, heavy positioning and stretched technical indicators, markets will look for signs that stability will return in the days ahead.  However, the November US election is increasing in prominence as a market driver, something that is beginning to manifest itself in equity volatility and will likely play more of a role for FX and rates markets volatility going forward. 

The fact that there has been little progress between Democrats and the US administration on further fiscal stimulus adds to the uncertainty for markets ahead of US elections.  Also after Fed Chair Powell’s Jackson Hole speech in which he unveiled a new average inflation strategy, markets will look for this to be reflected in forward guidance. This could happen as early as this month’s FOMC meeting on September 16 but will more likely take place later.

After a torrid several weeks the US dollar made some recovery last week amid short covering, but underlying sentiment remains weak (latest CFTC IMM data shows speculative USD positioning languishing around multi-year lows).  Whether the USD can make a more sustainable recovery remains doubtful in the weeks ahead of US elections and is more difficult given the Fed’s more dovish shift.  However, in the near term there may be more scope for short covering.

Key highlights this week are China Aug trade data today, US Aug CPI (Fri), Bank of Canada meeting (Wed), European Central Bank (ECB) and Bank Negara Malaysia (Thu).  Among these the ECB meeting will be interesting; while a policy change is unlikely the ECB will probably highlight its readiness to act further to address downside inflation risks.  The ECB may also be more vocal about the recent strengthening of the euro to a two-year high, but aside from jawboning, there is little the ECB is likely to do about it. 

Emerging markets assets have benefitted from a weaker USD and but with growth remaining under pressure as likely to be revealed in weak Russian and South African GDP data this week while Covid cases in many EM countries continue to rise rapidly, risks remain high.  China’s trade data will give some early direction this week, but with US-China trade tensions only likely to escalate further, the outlook for emerging markets assets is clouded in uncertainty. 

Data, Earnings, Central Banks and Virus Cases In Focus

Risk appetite took a turn for the better at the end of last week despite an array of the usual suspect risk factors (accelerating Covid-19 cases, US-China tensions, rich valuations). This kept the US dollar under pressure given the inverse relationship between equities and the USD over recent weeks.  Market positioning continues to show sentiment for the USD remaining negative (CFTC IMM data revealed that aggregate USD speculative positions have been net short for 15 out of the last 17 weeks, including the last 5).  Increasingly risks of a US fiscal cliff as stimulus programs run out, with Republicans and Democrats wrangling over more stimulus and US Presidential elections will be added to the list of factors testing market resilience in the days and weeks ahead.

This week there are several key data and events including China June trade data (Tue), China Q2 GDP (Thu), US June  CPI (Tue), US June retail sales (Thu), Australia June employment data and several central bank decisions including Bank of Japan (Wed), European Central Bank (Thu), Bank of Canada (Wed), Bank Indonesia (Thu), Bank of Korea (Thu), and National Bank of Poland (Tue).  Aside from economic data and events the path of virus infections will be closely watched, especially in the US given risks of a reversal of opening up measures.  Last but not least the Q2 earnings season kicks off this week, with financials in particular in focus this week.  Low real yields continue to prove supportive for equities and gold, but very weak earnings could prove to be a major test for equity markets.

On the data front, Chinese exports and imports likely fell in June, but at a slower pace than in the previous month, China’s Q2 GDP is likely to bounce, while US CPI likely got a boost from gasoline prices, and US retail sales likely recorded a sharp jump in June. Almost all of the central bank decisions this week are likely to be dull affairs, with unchanged policy decisions amid subdued inflation, although there is a high risk that Bank Indonesia eases.  The EU Leaders Summit at the end of the week will garner attention too, with any progress on thrashing out agreement on the recovery package in focus.  Watch tech stocks this week too; FANGS look overbought on technical including Relative Strength Index (RSIs) and more significantly breaching 100% Fibonacci retracement levels as does the Nasdaq index, but arguably they have looked rich in absolute terms for a while.

There has been plenty of focus on the rally in Chinese equities over recent weeks and that will continue this week.  Last week Chinese stocks had their best week in 5 years and the CSI 300 is up close to 19% year to date.  Stocks have been helped by state media stories highlighting a “healthy” bull market, but the rally is being compared to the bubble in Chinese stocks in 2014/15, with turnover and margin debt rising.  At that time stock prices rallied sharply only to collapse.   However, Chinese equity valuations are cheaper this time and many analysts still look for equities to continue to rally in the weeks ahead.  China’s authorities are also likely to be more careful about any potential bubble developing.

Italy downgrade adds to EUR woes

The USD index remains firm but it remains unlikely that the USD is being bought on its own merits but rather on disappointments in the eurozone. Nonetheless, speculative USD sentiment has turned positive for the first time since June 2010 according to the CFTC IMM data, reflecting a major shift in appetite for the currency. Clearly there are risks to the USD including the potential for more QE3 being announced at this week’s FOMC meeting but this risk is likely to be small.

In contrast, the reversal in speculative sentiment for the EUR has been just as dramatic but in the opposite direction as the net short EUR position has increased over recent weeks, with positioning now at its lowest since June 2010. Sentiment is likely to have soured further overnight following news that Italy’s credit rating was cut by S&P to A from A+ despite the recent passage of an austerity package.

This outweighed any boost to sentiment from what was noted by the Greek Finance Minister as “productive” talks yesterday. Another conference call today is scheduled but the longer markets wait for approval of the next loan tranche the bigger the risk to the EUR. In addition Greek and Spanish T-bill auctions and European Central Bank (ECB) cash operations will be in focus. The EUR remains vulnerable to a test of support around 1.3500.

GBP has continued to slide over recent weeks, having fallen by around 5% since its high just above 1.66 a month ago. However, it has managed to hold its own against the EUR which looks in even more of a sorry state than the pound. The fact that GBP has been unable to capitalise on the EUR’s woes is largely attributable to growing expectations of further UK quantitative easing.

The minutes of the last Bank of England meeting on September 8 to be released on Wednesday will give more clues as to the support within the Monetary Policy Committee for further QE but its likely that the MPC will want to see the next Quarterly Inflation Report in November before committing itself to any further easing. In the meantime, GBP will find it difficult to sustain any recovery, with its drop against the USD likely to extend to around 1.5583 in the short term.

Japan returns from its Respect for the Aged holiday today but local market participants will have missed little action on the JPY, with the currency remaining confined to a very tight range. The inability of USD/JPY to move higher despite the general bounce in the USD index reflects 1) the fact that USD/JPY is very highly correlated with 2 year bond yield differentials and 2) the fact that US yields continue to be compressed relative to Japan. Additionally, risk aversion continues to favour the JPY and combined, these factors suggest little prospect of any drop in the JPY versus USD soon.

Greek Decision Delayed

European Union Finance Ministers have agreed that additional funding for Greece will come from both official and private investors, with the later likely through a voluntary rollover of existing Greek debt as per the ‘Vienna Initiative’ of 2009 applied at the time to Emerging Europe. Agreement was reached following the decision by Germany to ease its demands for private sector participation in a debt restructuring. The news brought some relief to markets on Friday.

However, the announcement today that a final decision on a further tranche of aid and a second bailout package will not take place until early July will come as a blow to markets and likely lead to a more cautious start to this week. The onus is now on Greek Prime Minister Papandreou to gain approval for further austerity measures following the recent government cabinet reshuffle and in the face of a no confidence vote tomorrow. Failure to pass the confidence motion could provoke a political crisis, leading to likely contagion across Europe.

Europe has given the Greek government until the end of this month to implement measures including budget cuts and asset sales, with failure to pass further austerity measures likely to lead to a delay of any further aid. There will be plenty of noise surrounding Greece over coming days, with the issue likely to dominate the EU summit in Brussels on June 23-24. In the meantime the EUR/USD looks like it will settle into a range over the short-term, with support around the 100 day moving average of 1.4165.

EUR speculative positioning is currently around its 3-month average, with the market continuing to hold a sizeable long position in EUR/USD according to the CFTC IMM data. The risks remain skewed to the downside as nervousness about a Greek deal grows. Should the Greek Prime Minister pass a no confidence motion there will be some short term relief but tensions are likely to persist for a long while yet. Moreover, other eurozone countries are not in the clear yet as reflected by Moody’s announcement that Italy’s AA2 government bond rating is on review for possible downgrade.

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