All Eyes On Jackson Hole

Following four weeks of gains, US equities lost ground last week while equity volatility (VIX) moved higher.  Equities look likely to struggle in the days ahead.  While investor participation in the rally has been limited amid thin summer liquidity, it has contributed to easing financial conditions, likely to the chagrin of the Fed.  However, nervousness ahead of the Jackson Hole symposium (25-27 Aug) has grown with many thinking Fed Chair Powell will sound hawkish. This has given risk assets pause for thought, helping US yields back up and the US dollar to reverse recent losses.  Indeed, the USD index (DXY) now has the 14 July high around 109.29 in its sights. 

Equities could struggle to push higher in the short term.  The 200-day moving average level around 4320 for the S&P 500 looks like it will provide resistance on the top side, while the relative strength indicator (RSI) suggests that the S&P 500 is close to overbought levels.   The narrative of a bear market rally remains in place and as economic conditions worsen, the outlook for earnings will also be less positive, potentially acting as a further drag on equity market sentiment.  A stronger dollar also acts as a headwind to US stocks. 

A plethora of Federal Reserve speakers has pushed back against more dovish market expectation, yet markets are still pricing in some Fed easing in the second half of 2023. At Jackson Hole, Fed Chair Powell is likely to reinforce the view that the Fed may still have to hike policy rates several more times in the months ahead and cut less quickly than markets expect next year.  As such, last week’s move ie. US dollar rally, US Treasury yields moving higher, and equities weakening, may extend further in the days ahead. 

Emerging market currencies in particular, had a poor week, with soft China data not helping.  Indeed, China’s July activity data were uniformly weak, highlighting that the economy is likely to fall well short of the official “around 5.5%” growth target for this year.  A heatwave in China is not helping.  Today’s small 5 basis points cut in banks 1 year loan prime rates and 15 basis points cut in the 5-year rate will do little to stimulate activity especially in the property market.  CNH has been impacted and is likely to fall further. A hawkish Powell may help to keep the pressure on emerging markets in the short term and limited policy action in China will do little to mitigate such pressures. 

Aside from Jackson Hole, key data and events this week include monetary policy decisions in Indonesia and Korea. Indonesia (Tue) is likely to keep its policy rate on hold while Korea (Thu) is likely to hike its policy rate by 25bp.  On the data front, US core Personal Consumption Expenditures (PCE) will likely reveal a sharper slowing in July compared to core CPI due to shelters weights (Fri) while purchasing managers indices (PMI) data globally will likely soften as growth pressures intensify, reflecting the slide towards or into recession in several economies including the US and Euro area. 

All Bets Are Off!

For anyone thinking that markets had already fully priced aggressive Federal Reserve and European Central Bank (ECB) rate hikes, last week’s message from the US May CPI inflation report as well the ECB meeting was crystal clear.  All bets are off!  The US CPI report destroyed any hopes that US inflation had peaked with headline CPI surging 1% on the month and the annual rate hitting a new post-COVID high of 8.6%.  If there was ever any doubt, the data not only seals the case for at least a 50 basis point (1/2 %) hike at this Wednesday’s Fed FOMC meeting but increases the risk of a 75bp move though the latter still seems unlikely.  More likely, the Fed embarks on a series of 50bps hikes. . 

Separately, the ECB shifted away from its long held dovish stance and announced an expected end to its bond purchase plan (APP) at the beginning of July, effectively pre-announced a 25bp policy rate hike in July and 25-50bp hikes in September, with the central bank expecting to maintain a tightening cycle beyond September.  Many other central banks are scrambling to catch up the curve as inflation pressures end up being much higher than many of them previously anticipated.  There are exceptions of course such as Japan (see below), Russia recently cut its policy rate by 150bp and China which may still cut policy rates in the weeks ahead (watch this week’s 1y Medium Term Lending Facility decision, with a small 5-10bp cut possible), but these exceptions are few and far between.

The jump in US inflation will also further support the US dollar, keeping it on the front in the days ahead against most other currencies.  Already at the start of the week, most currencies were hurt in the face of a resurgent US dollar, especially high beta emerging market currencies. Separately, market volatility measures (e.g. MOVE and VIX) are likely to rise while liquidity is likely to remain poor.  Risk assets overall are likely to struggle against this background. Overall, it’s hard to see sentiment turn around quickly.

This week the main focus will be on the Federal Reserve FOMC meeting (Wed) but there are also several other central bank decisions of interest including the BCB in Brazil (Wed) where consensus expects the pace of hikes to slow to 50bp.  Additionally, 25bp rate hikes from the Bank of England and CBC in Taiwan (both Thu) are expected while the Bank of Japan (Fri) meeting is likely to be uneventful as BoJ governor Kuroda has doubled down on his aggressive stimulus stance while noting that a weaker Japanese yen benefits the economy.  Key data this week includes likely yet more weak Chinese activity data in May (Wed), jobs data the UK (Tue) and Australia (Thu) and a likely stronger than consensus increase in May  US retail sales (Wed).  

Action Shifting To Currencies as Rates Volatility Eases

US stocks barely closed higher at the end of last week and flirted with bear market territory. US consumer and retail stocks remain under pressure alongside industrials as recession fears intensify.  Indeed while inflation concern remain elevated, recession fears are increasing. US Treasury yields are finally coming off the boil amid such fears, with May seeing a significant pull back in yields; the biggest decline has been in the 3-10 year part of the yield curve over recent weeks.  This has been met with a decline in interest rate volatility unlike equity and implied currency volatility measures, which have pushed higher.   For instance, major currency implied volatility measures have reached their highest since around March 2020. Emerging markets volatility breached its March 2020 high in March 2022 and after a brief fall is moving back higher.  

Action is shifting to currencies and the drop in the US dollar from its highs, with the currency increasingly undermined by lower US yields.  In Asia, the 3 most sensitive currencies to yield differentials (US 10 year yield minus 10 year local currency bond yields) are the Thai baht, Indonesian rupiah and Korean won.  As such, Korean won is likely to rally the most in Asia should US yields fall further.   The Chinese yuan has strengthened amid US dollar weakness though underperformance of the Chinese currency is likely versus its peers as the authorities likely aim to weaken it on a trade weighted (CFETS) basis. 

In China, the surprisingly large 15 basis point cut in 5-year loan prime rate last week will be seen as a boon for China’s property market.  However, while support for the property market has increased there does not seem to be much more stimulus ready to be unleashed despite various pledges.  China’s April data slate was weak highlighting the risks of a contraction in GDP this quarter and providing evidence that the “around 5.5%” official growth target looks increasingly out of reach.  COVID restrictions across the country are easing gradually pointing to some pick up in activity though consumption and the service sector are likely to remain under pressure for months to come as mass testing, quarantines and border controls continue to restrict mobility.  

There was relief for China’s markets today as President Biden highlighted the potential for a reduction/removal of tariffs implemented by President Trump, stating that he will discuss tariffs with Treasury Secretary Yellen when he returns from his Asia trip.  Removing tariffs is by no means a done deal given there will be plenty of pressure to maintain some level of US tariffs on China. A reduction in tariffs would be beneficial for the US in that it would help reduce imported inflation pressures while it would also help to support Chinese exports at a time when they are slowing down and adding pressure on China’s current account position.  However, some of this impact would likely be mitigated by a relatively stronger yuan, which would undoubtedly benefit as tariffs were cut.  

Key data and events highlight this week include monetary policy decisions in Indonesia (Tue), New Zealand (Wed), South Korea and Turkey (both Thu).  Federal Reserve FOMC meeting minutes will also be released (Wed). Although not expected by the consensus there is a good chance that Indonesia hikes policy rates by 25 basis points. In New Zealand a 50bp hike is likely while a 25bp hike in South Korea is expected.  In contrast despite pressure on the Turkish lira and very elevated inflation no change in monetary policy is expected in Turkey this week.  Meanwhile the Federal Reserve FOMC minutes will provide further detail on how quickly the Fed wants to get to neutral rates and beyond and on its quantitative tightening policy. 

Testing The Fed’s Resolve, China Data Gives Some Relief

In the aftermath of the surge in US consumer prices in October which reached the highest since 1990 at 6.2% year-on-year, the Fed’s stance is under intense scrutiny.  While tapering is beginning soon, the biggest question mark is on the timing of interest rate hikes, with markets having increasingly brought forward expectations of the first Fed hike to mid next year even as Chair Powell & Co keep telling us that inflation pressures are “transitory”.  Front end rates have reacted sharply and the US dollar is following rates US rates higher.  The flatter yield curve also suggests the market is struggling to believe the Fed.  Meanwhile, liquidity in interest rates market remains thin, and smaller Fed purchases going forward will not help.  In contrast, equities are hardly flinching, with the FOMO rally persisting. US equities closed the week higher despite a drop in the Michigan sentiment index, which fell to a new 10-year low of 66.8 in early November (consensus 72.5), with inflation being largely to blame. 

There was a bit of relief for markets on the China data front today.  The October data slate revealed less sharp softening compared to the previous month, but momentum continues to be downwards. Industrial production increased by 3.5% (consensus 3.0% y/y). A host of regulatory, and environmental pressures are leading to policy led weakness in manufacturing.  While there has been some easing in such pressures, there is unlikely to be much of a let up in the months ahead.  While retail sales also increased by more than expected up 4.9% (consensus 3.7% y/y) sales have been impacted by China’s “zero-tolerance” COVID policy, which has led to lockdowns across many provinces.  Fixed assets and property investment slowed more than expected reflect the growing pressure on the property sector. Also, in focus today will be the virtual summit between President’s Biden and Xi. I don’t expect any easing in tariffs from the US side.  

Over the rest of the week, US retail sales data will be take prominence (Tue). Sales likely rose by a strong 1.3% month on month in October, but the data are nominal and goods prices rose 1.5% in the October CPI, implying real good spending was far more restrained.  Central bank decisions among a number of emerging markets including in Hungary (Tue), South Africa (Thu), Turkey (Thu), Indonesia (Thu) and Philippines (Thu) will also be in focus.  The divergence between most Asian central banks and elsewhere is becoming increasingly apparent, with expectations for policy rate hikes in Hungary and South Africa, and a likely cut in Turkey contrasting with likely no changes from Indonesia and Philippines.   Also watch for any traction on the passage of the $1.75bn “build back better” fiscal package in the US, with a possible House vote this week.  Separately, markets are still awaiting news on whether Fed Chair Powell will remain for another term or whether Brainard takes his seat, with a decision possible this week.

As noted, sharply higher than expected inflation readings in the US and China will play havoc with the narrative that inflation pressures are “transitory” while highlighting the depth of supply side pressures.  Higher US market rates, with the US yield curve shifting higher in the wake of the CPI, bodes badly for emerging market carry trades in the near term as it reduces the relative yield gap.  At the same time a tightening in global liquidity conditions via Fed tapering may also raise some obstacles for EM carry.  That said, there is still plenty of juice left in carry trades in the months ahead.  Markets are already aggressively pricing in Fed rates hikes and there is limited room for a further hawkish shift i.e a lot is already in the price.  Meanwhile FX volatility remains relatively low even as volatility in rate markets is elevated.  Many EM central banks are also hiking rates. As such carry and volatility adjusted expected returns in most EM FX remain positive.

Regulatory Crackdown

How much can global markets withstand the combined US and Chinese regulatory onslaught on Chinese tech stocks and Chinese companies listed in the US? Notably Chinese regulators have called for talks with the US Securities and Exchange Commission over the decision to halt US IPOs of Chinese companies. Given that regulators on both sides do not seem to be letting up, the risks are skewed towards increased contagion though Chinese stocks have already fallen sharply over recent weeks, with the CSI 300 down around 15% since its high in February.

Unfortunately Chinese stocks and investors in these stocks are the casualties of a regulatory crackdown on consumer internet stocks and more recently Chinese private education companies. While the idea is not to provoke market volatility, regulators in China are unlikely to back off quickly even as the tone of the crackdown is likely to be less aggressive in the weeks ahead.

Stocks ended last week and began this week softer amid such concerns while the softer than expected US Q2 GDP print last week didn’t help matters.  More evidence that peak US growth has passed was delivered yesterday, with the US ISM manufacturing index surprising to the downside in July, declining to 59.5 — its lowest level since January but still at a relatively high level. US economic surprises (according to the Citi index) are negative and at their lowest in over a year.

The below consensus outcome for China’s manufacturing purchasing manager’s index which slipped closer towards contraction is unlikely to be helpful for markets either as the data adds to signs of moderating economic growth in China.  China’s softer July PMI releases have left a sour taste for Asian markets given more evidence of moderation in activity while the spread of the Delta variant amid low vaccination rates, still points to underperformance of regional markets. 

US dollar sentiment has continued to improve as reflected in speculative futures data (CFTC IMM data on non-commercial futures) which shows that the market holds the biggest net aggregate USD long position since March 2020.  Nonetheless, it still seems difficult to see dollar upside momentum increase given very low US real yields.  Moreover, the fact that the market is now long USD according to the IMM data, means scope for any short covering rally has dissipated.

Key data and events this week include the Bank of England (Thu) and Reserve Bank of India (Fri) policy decisions and US jobs July report (Fri).  No rate changes are likely from any of these as was the case with today’s decision by the Reserve Bank of Australia. As for US payrolls, the consensus expectation looks for a strong 900,000 increase in July and for the unemployment rate to fall to 5.7%.  

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