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.

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ECB meeting, Brexit, Fed minutes, China trade, India elections in focus

This week there a number of key events to focus attention on including European Central Bank (ECB) policy meeting, Federal Reserve FOMC March minutes, the commencement of India’s general elections, China data, and further Brexit developments as UK Prime Minister May tries to gain a further short extension to the Brexit deadline, until June 30.

The better than expected US March jobs report, revealing a bigger than expected 196k increase in jobs, with a softer than expected 0.1% monthly increase in hourly earnings, which effectively revealed a firm jobs market, without major wage pressures, helped US markets close off the week on a positive note. The data adds to further evidence that the Fed may not need to hike policy rates further.

The European Central Bank decision is likely to prove uneventful though recent comments by ECB President Draghi have fuelled speculation that the central bank will introduce a tiered deposit system to alleviate the impact of negative rates on banks.   EUR is unlikely to benefit from this.  Separately Fed FOMC minutes will be scrutinised to ascertain how dovish the Fed has become as the markets shift towards pricing in rate cuts, but it is unlikely that the minutes provide further fuel to interest rate doves.

Friday is the deadline to agree on an extension with the EU to prevent a hard Brexit.  Meanwhile PM May is set to restart talks with opposition Labour Party leader Corbyn to thrash out a cross party agreement on Brexit terms ahead of an EU summit on Wednesday that will look at her request for a Brexit extension until June 30.  GBP has lost momentum lately and investors appear to be fatigued with the daily Brexit news gyrations.

Meanwhile, US-China trade talks appear to be edging towards some sort of a deal while Chinese data this week is also likely to be supportive for risk assets.   As China eases financing conditions, evidence of a pick up in the credit impulse will be evident in March aggregate financing, new loans and money supply data this week.   Meanwhile China’s March trade data is likely to look better or at least less negative than over recent months. This suggests that risk assets will likely fare well this week.

India will be in the spotlight as India’s multi stage elections kick off on Thursday.  Prime Minister Modi is in good stead to ahead of elections, boosted by his government’s reaction to recent terrorist attacks on Indian paramilitary in Kashmir.   Concerns that Modi’s ruling BJP would lose a significant amount of seats in the wake of state election losses towards the end of last year have receded.  Nonetheless, election uncertainties may keep the INR on the backfoot this week.

Turkey hikes, ECB and BoE don’t. Trump dampens trade hopes

Despite comments from Turkish President Erdogan railing against prospects for a rate hike, Turkey’s central bank, CBRT hiked the repo rate to 24%, a much bigger than expected 625bp increase.  This may not be sufficient to turn things round sustainably but will at least prevent a return of the extreme volatility seen over past weeks.  The decision saw USDTRY drop by about 6% before reversing some of the move.  Undoubtedly the decision will provide support to EM assets globally including in Asia today.

Elsewhere the European Central Bank (ECB) delivered few punches by leaving policy unchanged and reaffirming that its quantitative easing will reduce to EUR 15bn per month (from EUR 30bn) from October while anticipating an end after December 2018.   The ECB also downgraded its growth outlook but kept the risks broadly balanced.  The outcome will likely to help put a floor under the EUR.  Unsurprisingly the Bank of England (BoE) left its policy on hold voting unanimously to do so, leaving little inspiration to GBP.

President Trump poured cold water on US-China trade talks by denying a Wall Street Journal article that he faces rising political pressure to agree a deal with China.  Trump tweeted, “They are under pressure to make a deal with us. If we meet, we meet?” . Meanwhile US CPI missed expectations at 0.2% m/m, 2.7% y/y in August, an outcome consistent with gradual rate hikes ahead.   The data will also help to undermine the USD in the short term.

China Trade talks, ECB, BoE and CBRT

Today marks the most interesting day of the data calendar this week.  Central banks in the Eurozone (ECB), UK (BoE) and Turkey (CBRT) all announce policy decisions while US CPI (Aug) is released.  The ECB and BoE meetings should be non events.  The ECB is likely to confirm its €15 billion per month taper over Q4 18.  The BoE monetary policy committee is likely have a unanimous vote for a hold.

The big move ought to come from Turkey.  They will need to tighten to convince markets that the central bank it is free from political pressure and that it is ready to react to intensifying inflation pressures.  A hike in the region of 300 basis points will be needed to convince markets.   This would also provide some relief to other emerging markets.

The big news today is the offer of high level trade talks from US Treasury Secretary Mnuchin to meet with Liu He (China’s top economic official), ahead of the imposition of $200bn tariffs (that were supposedly going to be implemented at end Aug).  This shows that the US administration is finally showing signs of cracking under pressure from businesses ahead of mid-term elections but I would take this with a heavy pinch of salt.

Mnuchin appears to be increasingly isolated in terms of trade policy within the US administration. Other members of the administration including Navarro, Lighthizer, and Bolton all hold a hard line against China.  Last time Mnuchin was involved in such talks with China in May they were derailed by the hawks in the administration.  So the talks could mark a turning point, but more likely they are a false dawn.  That said it will provide some relief for markets today.

Catching a falling knife

After a very long absence and much to the neglect to Econometer.org I am pleased to write a new post and apologise to those that subscribed to my blog, for the very long delay since my last post.   There is so much to say about the market turmoil at present, it is almost hard not to write something.

For those of you with eyes only on the continued strength in US stocks, which have hit record high after record high in recent weeks, it may be shocking news to your ears that the rest of the world, especially the emerging markets (EM) world, is in decidedly worse shape.

Compounding the impact of Federal Reserve rate hikes and strengthening US dollar, EM assets took another blow as President Trump’s long threatened tariffs on China began to be implemented.  Investors in countries with major external vulnerabilities in the form of large USD debts and current account deficits took fright and panic ensued.

Argentina and Turkey have been at the forefront of pressure due the factors above and also to policy inaction though Argentina has at least bit the bullet. Even in Asia, it is no coincidence that markets in current account deficit countries in the region, namely India, Indonesia, underperformed especially FX.  Even China’s currency, the renminbi, went through a rapid period of weakness, before showing some relative stability over recent weeks though I suspect the weakness was largely engineered.

What next? The plethora of factors impacting market sentiment will not just go away.  The Fed is set to keep on hiking, with several more rate increases likely over the next year or so.  Meanwhile the ECB is on track to ending its quantitative easing program by year end; the ECB meeting this Thursday will likely spell out more detail on its plans.  The other major central bank that has not yet revealed plans to step back from its easing policy is the Bank of Japan, but even the BoJ has been reducing its bond buying over past months.

The trade war is also set to escalate further.  Following the $50bn of tariffs already imposed on China $200 billion more could go into effect “very soon” according to Mr Trump. Worryingly he also added that tariffs on a further $267bn of Chinese goods could are “ready to go on short notice”, effectively encompassing all of China’s imports to the US.  China has so far responded in kind. Meanwhile though a deal has been agreed between the US and Mexico, a deal encompassing Canada in the form a new NAFTA remains elusive.

Idiosyncratic issues in Argentina and Turkey remain a threat to other emerging markets, not because of economic or banking sector risks, but due increased contagion as investors shaken from losses in a particular country, pull capital out of other EM assets.  The weakness in many emerging market currencies, local currency bonds and equities, has however, exposed value.  Whether investors want to catch a falling knife, only to lose their fingers is another question. which I will explore in my next post.

Euro treads water ahead of ECB decision

EUR/USD has been treading water in a relatively tight range ahead of the European Central Bank meeting later today but the currency looks vulnerable to further slippage in the days ahead. Having dropped from its high around 1.3898 on 27 December the EUR has failed to sustain any bounce.

The ECB is unlikely to offer any support to the currency especially given that there is a small chance that they may even trim policy rates at today’s meeting. If the Bank does not cut rates today, the ECB is set to open the door to a cut in March, something that would undermine the EUR further.

Either way, the EUR is losing support and our quantitative models highlight the potential for further downside moves in the currency. Other measures such as short term interest rate differentials also highlight risks to EUR.

EUR/USD is set to edge lower to technical support around 1.3477 in the near term.

Risk and carry attraction increasing

The outcome of the EU Summit together with hopes of monetary stimulus has definitely helped to put a floor under risk appetite. Indeed, such monetary stimulus expectations are reflected in the price of gold which continued to rise overnight. Risk assets in general have maintained a positive tone recently and even forward looking indicators of global activity such as the Baltic Dry Index have been trending higher.

Although it is difficult to become too positive given the still very significant downdraft to global growth officials in Europe have bought some time to get their collective house back in order. Whether they will use it wisely is another question entirely. It is difficult to see much of a market move ahead of the ECB Council meeting and US June jobs report this week. Moreover, the US Independence Day holiday will keep trading subdued today.

My Risk Barometer has moved back into ‘risk neutral’ territory following several weeks of remaining in ‘risk hating’ territory. Consequently the backdrop for risk currencies has turned positive. Although FX trading has become more subdued amid summer conditions and a US holiday today as reflected in the drop in implied volatilities, there is a clear sense that investors are increasingly moving into carry trades.

My Yield Appetite Index {YAI) has surged over recent weeks, now at its highest in several months. I remain concerned that markets are addicted to stimulus while underlying economic conditions remain weak as likely revealed in today’s releases of June service sector purchasing managers’ indices in Europe.

Nonetheless, it seems likely according to my risk measures that the current tone of risk / carry attraction will persist for some weeks to come. The currencies that will benefit in an environment of improving risk appetite / yield attraction are the ZAR, MXN, PLN, CAD & NOK by order of magnitude of correlation with our risk barometer.

However, the beneficiaries are by no means limited to these currencies. Almost every currency except the ARS and PHP has a statistically significant correlation with the risk barometer. The only currencies that come under pressure as risk appetite improves are the USD and JPY given their negative correlations.

Currencies with healthy carry such as the AUD, which broke above its 200 day moving average versus USD overnight, will be even bigger beneficiaries as investors pile into carry trades over coming weeks as indicated by the jump in our YAI.

Notably there is plenty of scope to build carry positions as our speculative measure of yield attraction (based on CFTC IMM data) remains relatively low, suggesting that leveraged investors have still not jumped on the carry bandwagon.

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