Market Cross-Currents

There are many cross currents afflicting markets at present.  Equity valuations look high but US earnings have been strong so far, with close to 90% of S&P 500 earnings coming in above expectations. This has helped to buoy equity markets despite concerns over the spreading of the Delta COVID variant and its negative impact on recovery.  Yet the market doesn’t appear entirely convinced on the recovery trade, with small caps continuing to lag mega caps. 

The USD index (DXY) remained supported at the end of last week even as US yields remain capped, but the USD does appear to be losing momentum. Positioning has now turned long according to the CFTC IMM data indicating that the short covering rally is largely exhausted; aggregate net USD positioning vs. major currencies (EUR, JPY, GBP, AUD, NZD, CAD & CHF as a percent of open interest) turned positive for the first time in over a year. 

Inflation fears have not dissipated especially after recent above consensus consumer price index (CPI) readings, for example in the US and UK.  Reflecting such uncertainty, interest rate market volatility remains high as seen in the ICE BofA MOVE index while inflation gauges such as 5y5y swaps have pushed higher in July.  There was some better news on the inflationary front at the end of last week, with the Markit US July purchasing managers indices (PMIs) revealing an easing in both input and selling prices for a second straight month, albeit remaining at an elevated level. 

This week we will get more information on inflation trends, with the June Personal Consumption Expenditures (PCE) report in the US (Fri), Eurozone July CPI (Fri), Australia Q2 CPI (Wed) and Canada June CPI (Wed), on tap this week.  We will also get to see whether the Fed is more concerned about inflation risks at the Federal Open Markets Committee (FOMC) meeting (Wed).  The Fed is likely to continue to downplay the surge in inflation, arguing that it is transitory, while the standard of “substantial further progress” remains a “ways off”.   Nonetheless, it may not be long before the Fed is more explicit in announcing that is formally moving towards tapering. 

An emerging markets central bank policy decision in focus this week is the National Bank of Hungary (NBH) where a 15bp hike in the base rate is expected.  Central banks in emerging markets are taking differing stances, with for example Russia hiking interest rates by 100 basis points at the end of the week while China left its Loan Prime Rate unchanged.  The July German IFO business climate survey later today will be in focus too (consensus 102.5).  Overall, amid thinner summer trading conditions market activity is likely to be light this week.

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.

Crypto Volatility

It was a calmer end for stock markets in a volatile week but crypto was not so fortunate after China’s State Council repeated its warning about Bitcoin mining and trading as central banks appear to be increasing their scrutiny of crypto at a time when many of them are introducing their own digital currencies.  Concerns over increased regulations, especially in China where the bulk of Crypto mining takes place, taken together with ESG issues as focus turns to the environmental costs of mining crypto, threaten to do more damage.  Volatility continued over the weekend, with Bitcoin and other crypto undergoing sharp moves.  Crypto volatility threatens to find its way into other markets, with for example, US equities positively correlated to moves in crypto while the US dollar (USD) could benefit.

There was at least a little relief for markets in terms of inflation angst, with market inflation measures (breakevens) falling while commodities, another factor fueling inflation fears, continued to come off the boil. It seems that the Federal Reserve’s dovish message may finally be sinking in even as the Fed FOMC minutes noted that they are planning on discussing tapering at some point, rather than previously not even thinking about thinking of tapering. US Treasury yields have been capped amid the cooling in inflation fears while rate sensitive equities, especially Tech are likely to find some solace.  The USD has struggled over recent weeks but the recent rise in real yields will likely offer some support. 

There was yet more evidence that the US economy is powering ahead, with measures of manufacturing and services sentiment as reflected in Markit purchasing managers indices (PMIs), rising to record highs as fiscal support and an improving COVID-19 outlook continue to boost optimism. While US economic data has been strengthening, markets have become accustomed to positive US releases and therefore any reaction is likely to be more muted.  Indeed, the Citi Economic Surprise Index, a measure of US data relative to expectations, is near its lowest since June 2020. 

This week is relatively light on the data front.  The key US data release is the Personal Consumption Expenditures (PCE) report, something that the Federal Reserve looks at closely, on Friday; consensus expectations are for a 2.3% quarter on quarter (q/q) increase in core PCE in Q1.  A number of Fed speakers will also be on the wires and their comments will be scrutinized on any further elaboration on “discussing a plan” on tapering.  There will also be a few central bank decisions including in Hungary (Tue), Indonesia (Tue), New Zealand (Wed), and Korea (Thu).  No changes are likely from any of these central banks.

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