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. 

Strong US Jobs Data And Hawkish Fed Speak Keeps Tightening Expectations Elevated

US bond yields rose sharply on Friday, particularly on the front end of the curve in the wake of the above consensus US July jobs report, which showed a strong 528,000 (consensus 250,000) increase in non-farm payrolls and the unemployment rate dropping to 3.5% (consensus 3.6%).  The three-month moving average of US jobs gains now total 437,000. However, the drop in the unemployment rate was due in part to a drop in the participation rate so it wasn’t all good news.  Wage growth was firm, with average hourly earnings up 5.2% y/y. Overall the data highlighted a still strong jobs market and markets are now pricing in a greater probability of 75 basis points hike by the Federal Reserve at its September meeting. 

The firm US jobs data accompanied hawkish Fed speak over the past week, with various Fed officials pushing back against more dovish rate expectations that had been built into markets over recent weeks. The Fed’s Evans, Kashkari and Daly are scheduled to speak this week and are likely to maintain the run of hawkish Fed comments, pushing back against residual expectation of an early peak in the Fed Funds rate. Despite weaker closes for equities on Friday, stocks still ended higher over the week, but may struggle given the renewed hawkish shift in rate expectations.  That said, with the bulk of second quarter earnings out of the way equities have held up well. 

The data and Fed speakers also give further reason to be cautious on extrapolating the recent pull back in the US dollar, with the currency bouncing at the end of the week and starting this week on a firm note.  The USD index has bounced off trend line support and has bounced off its 50-day moving average level, which has been a good support over recent months.  In the near term some consolidation in the USD is likely though this week’s US CPI inflation report is likely to provide more direction.  Conversely, while the euro appears to have found a short-term bottom, it’s hard to see a significant bounce in the currency. 

Data over the weekend revealed a stronger than expected increase in Chinese exports in July at 18% y/y (cons. 14.1%) and lower imports at 2.3% y/y (cons. 4.0%), resulting in a surge in the trade surplus to $101.26bn (cons. $89.04bn).  The weak imports data highlights ongoing pressure on domestic demand while exports will likely struggle to maintain firm momentum amid a likely slowing in external demand.  China’s July inflation data this will be in focus (Wed) this week while more reaction by China to last week’s visit by Speaker to Pelosi to Taiwan will also be expected. 

In the US, the key data will be the July CPI report (Wed); the consensus expects elevated readings of 8.7%/6.1% y/y for total/core prices.  Headline CPI will have moderated from June, but core CPI is likely to have ticked higher.  Long term inflation expectations as measured in the University of Michigan August confidence survey (Fri) will also be in focus.  On the policy rate front, a 25bp hike from the Bank of Thailand kicks of its tightening cycle (Wed) and a 75bp hike from Mexico’s central bank, Banxico.  However, unlike Thailand Banxico is likely nearing the end of its tightening cycle.   

Fed Tapering Concerns/Rising COVID Cases In Europe

Equities struggled at the end of last week amid news of rising COVID cases and hints by Federal Reserve officials of a preference for faster tapering though tech stocks benefitted from a rally in US Treasuries.  Oil prices fell further as markets pondered the potential for releases from China, Japan and US strategic oil reserves. Meanwhile, various countries are registering record daily COVID cases in Europe, resulting in partial lockdowns in a few countries. The outlook doesn’t look good heading into the winter flu season, while protests against mobility restrictions are on the rise. 

The US dollar extended gains at the start of this week helped by hawkish comments from Federal Reserve officials.  Conversely, rising COVID cases across Europe and resultant mobility restrictions, have hurt the euro, with the EURUSD exchange rate falling through 1.13 and showing little sign of any reversal.  Worsening sentiment towards the euro has fuelled a collapse in speculative euro positioning, with the market being net short for 6 out of the last 7 weeks (according to the CFTC IMM net non-commercial futures data).  In contrast, China’s authorities are becoming more concerned with the strength of the Chinese renminbi, which is currently around five year highs in trade weighted terms.  Measures to cap renmimbi strength are likely to be forthcoming.

Risk assets could struggle in the wake of speculation/pressure for more aggressive Fed tapering.  Fed Vice Chair Clarida and Governor Waller sounded relatively hawkish on Friday. Clarida said that the FOMC could discuss the pace of tapering at the December FOMC meeting and separately Waller stated that recent data had pushed him toward “favoring a faster pace of tapering and a more rapid removal of accommodation in 2022.”  This implies that the December Fed FOMC meeting will be a live one and could potentially see the announcement of more rapid tapering than the $15bn per month rate that was announced at the last Fed meeting. 

As such, the Fed FOMC minutes (Wed) will be under scrutiny to provide clues to any hint of support for more aggressive tapering though they will likely reveal that most officials see no rush for rate hikes.  On the same day the US core Personal Consumption Expenditure (PCE) report is likely to have registered a strong increase in October keeping inflation concerns at the fore.  Fed nominations are also likely this week, and markets will be especially focused on whether Fed Chair Powell will be reaffirmed for another term.  The overall composition of the FOMC is likely to become a more dovish one next year. 

Several central bank policy decisions are scheduled this week including in China where the Peoples Bank of China (PBoC) unsurprisingly kept its Loan Prime Rate on hold today.  However, in its latest quarterly monetary policy report released on Friday, the PBoC removed some key phrases cited in its previous reports, implying a softer tone to policy ahead. Any such easing would be targeted such as recent support for lenders via a new special relending facility to support the clean use of coal, via loans at special rates.  Additionally, a cut in the reserve ratio (RRR) cannot be ruled out.

Next up will be the Reserve Bank of New Zealand (RBNZ) (Wed), with a 25bp hike likely and risks of an even bigger 50bp hike. The Bank of Korea is also likely to hike, with a 25bp increase in policy rates likely (Thu) given rising inflation pressures and concerns about financial imbalances. The Riksbank in Sweden (Thu) is likely to keep policy unchanged though an upgrade in their forecasts is expected. 

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.

Reflation Trade Is Back

A much softer than expected US January jobs report didn’t prevent US equities from closing higher at the end of last week as the reflation trade kicked back in.  One of the biggest driving forces for markets was the growing prospects that much of President Biden’s $1.9 trillion fiscal stimulus plan will be passed, albeit via a process of reconciliation, which allows Democrats to circumvent the need to gain the support of at least 10 republicans. This contrasts with prior expectations that the final stimulus was going to be less than $1 trillion. 

Pushing stimulus through this way highlights Biden’s urgency to inject more spending into the economy but could come at the cost of hurting bipartisan policy efforts. The impact of expectations of increased fiscal stimulus is particularly apparent in the US rates market, with US Treasuries selling off and bear steepening of the curve.  Although higher US Treasury yields failed to give support to the US dollar (USD) there is still scope for a short covering rally, which could still help give the USD relief.     

At the beginning of the year the US jobs market took a hit from renewed lockdowns and surge in COVID cases; US January non-farm payrolls increased 49k, and December was revised to -227k from -140k while more positively the unemployment rate fell to 6.3% from 6.7% though this was flattered by a drop in the participation rate as less people were looking for work.  According to the payrolls report there are still 9.9 million more unemployed compared to pre-COVID levels.  As such, the weak jobs data added more support to Biden’s fiscal stimulus proposals.   

This week focus will likely turn more to President Trump’s impeachment trial in the Senate than economic data.  Key data/events this week include China’s credit and monetary aggregates (9-15 Feb), central bank decisions in Sweden (Wed), Philippines, Mexico (Thu) and Russia (Fri).  Among these the consensus is for only Mexico to cut its policy rate. Also in focus are inflation readings in China (Wed), US (Wed) and India (Fri).  UK GDP (Fri) and US Michigan sentiment (Fri) will also garner attention. 

The return of the reflation trade, rally in risk assets and decline in cross-asset volatility bodes well for emerging markets (EM) assets.  However, there are definitely various cross currents impacting asset markets at present especially with US Treasury yields rising, which could potentially support the USD and pressure EM local bond rates markets.  EM assets were clearly favoured towards the end of last year, and while the positive story has not dissipated, EM assets may take a pause for breath before pushing higher again.  

In Asia, the Chinese-new-year holidays this week may dampen activity while China’s PBoC also appears to be limiting liquidity injections around the holidays, which could limit some of the gains in Chinese and impact China linked assets.  Chinese authorities have re-focussed attention on preventing an excessive build-up of leverage and credit metrics have peaked as a result.  As such, they may be less keen to inject a lot of liquidity into markets at present. 

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