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. 

The Devil is in the details

The “partial solution” delivered by European Union (EU) leaders last week has failed to match the high hopes ahead of the EU Summit. Nonetheless, the deliverance of a “fiscal compact”, acceleration of the European Stability Mechanism (ESM) to July 2012 , no forced private sector participation in debt restructuring (outside Greece), and possible boost to the International Monetary Fund (IMF) of up to EUR 200 billion, are steps in the right direction. The fact that UK Prime Minister Cameron threw a spanner in the works to veto a joint proposal to revise the EU Treaty should not detract from the progress made.

Nonetheless, the measures may not be sufficient to allay market concerns, with disappointment at the lack of European Central Bank (ECB) action in terms of stepping up to the plate as lender of the last resort still weighing on sentiment. Data will add to the disappointment this week as “flash” Eurozone purchasing managers indices (PMI) drop further in December.

This week events in the US will garner more attention, including the Federal Reserve FOMC meeting, November inflation and retail sales data plus manufacturing confidence gauges as well as November industrial production on tap. The Fed will not shift its policy stance at this meeting but may sound a little more upbeat on the economy following recent firmer data. Inflation will likely remain subdued while the other data will continue to show gradual recovery.

Overall, the market is likely to thin further as the week progresses and holidays approach, with ranges likely to dominate against the background of little directional impetus. Our call to sell risk assets on rallies remains in place, however. The EUR will likely struggle to make much headway in the current environment, especially given that many details of the EU agreement still need to be ironed out and once again the risk to market confidence lies in implementation or lack of it. A range of EUR/USD 1.3260-1.3550 is likely to hold over the short term.

Euphoria fades, risk currencies weaker

The euphoria emanating from last week’s eurozone agreement will likely fade into this week as renewed doubts creep in. Details of how the EFSF bailout fund will be leveraged or how the special purpose vehicle will be utilised have yet to emerge while the firewall to protect countries such as Italy and Spain may still be insufficient given that the use of the European Central Bank (ECB) to provide unlimited support has been ruled out.

With more questions than answers markets will be hungry for further details over coming weeks and until then it is difficult to see risk appetite stretching too far. One indication of such concern was the fact that Italy’s borrowing costs climbed to euro-era highs the day after the European Union (EU) plan was agreed. The G20 meeting on 3-4 November will be eyed for further developments as well as further reaction to the EU agreement.

There are plenty of events to digest this week that could add to any market nervousness. In terms of central banks we do not expect to see any change in policy stance from the ECB, Federal Reserve or Reserve Bank of Australia (RBA) this week but the decisions may be close calls. The ECB under the helm of new President Draghi will be under pressure to ease policy as growth momentum has clearly weakened but the Bank will likely hold off for the December meeting when new growth and inflation forecasts will be released.

The RBA may also take some solace from a better global economic and market climate but the market disagrees having priced in a cut this week. The Fed will look to see how ‘Operation Twist” is faring before moving again but recent indications from some Fed officials suggest growing support for purchases of mortgage backed securities.

On the data front eurozone inflation today will be the key number in Europe while the US jobs report at the end of the week will be the main release in the US. Ahead of the payrolls data, clues will be garnered from the ISM manufacturing data and ADP jobs report. The consensus is for a 95k increase in non-farm payrolls and the unemployment to remain at 9.1% maintaining the trend of only gradual improvement in the US jobs market.

Recent data releases have turned less negative, however, and at the least have helped to alleviate renewed recessionary concerns. Overall, I suspect that markets will come back down to the reality of slow growth and unanswered questions this week, with risk assets likely to lose steam over coming days.

Plenty of event risk

This week is heavy with event risk, with a lot expected from EU leaders. So far the risk on tone to markets has held up, with for example the VIX fear gauge resting below the key 30.0. The G20 meeting over the weekend set the deadline for action for concrete solutions to the eurozone debt crisis for the October 23 EU Summit.

However, there will be little detail on issues such as banking sector recapitalisation, private sector involvement in any debt restructuring or ‘leveraging’ the EFSF bailout fund until the report on Wednesday night by the Troika on Greece. The reward to EU leaders would be the potential for more aid from the IMF but even now it seems that a German government official has poured cold water of a plan being announced at the EU Summit which will disappoint markets.

There are also plenty of data releases for markets to digest over coming days including inflation releases, manufacturing surveys and industrial production data in the US while in Europe the German IFO and ZEW surveys are scheduled for release. The data will follow on from the better than expected September US retail sales releases at the end of last week continuing to dampen expectations that the global economy is falling in recession though there will be a marked deceleration in European data.

Meanwhile the US Q3 earnings season rolls. The risk on tone will likely continue to weigh on the USD and weigh on bonds but unlike a few weeks ago when a lot of bad news was priced in, the scope for disappointment is becoming increasingly high.

Many currencies remain highly correlated with gyrations in risk and in this respect the improvement in risk appetite is good news for high beta / commodity. AUD, NZD, CAD and JPY are amongst the most sensitive currencies and therefore prone to a bigger reaction as risk improves, with the former three strengthening and the JPY weakening. Asian currencies poised to benefit from firmer risk appetite include INR and KRW, both with relatively high correlations with risk.

EUR/USD has made a solid recovery over recent days from its lows around 1.3146 spurred by hopes of action by European officials. Such hopes may yet be dashed but the EUR looks supported over coming days ahead of the EU summit Speculative positioning also reflects a slight improvement in EUR sentiment as IMM short positions have declined in the last week but its worth noting that this week’s European data are unlikely to be supportive for the EUR.

Euro slides as Greek worries intensify

The USD ended last week on high a note having overcome speeches by Fed Chairman Bernanke and President Obama. Bernanke’s lack of detail on potential further Fed stimulus offered the USD a lifeline as there was no mention of QE3 but nervousness may mount ahead of the September 21 FOMC meeting.

This week’s data releases (including retail sales, inflation, industrial production and regional manufacturing surveys may offer some direction to the USD and it is likely that the data over coming days will look less negative than in past weeks, giving the USD some support. Having broken above its 200 day moving average around 76.1986 for the first time in a year the USD index is set to begin the week in positive mode and will likely extend its gains over coming days.

In sharp contrast, EUR/USD crumbled at the end of last week dropping through its 200 day moving average despite positive news from Germany (rejection of bills in the constitutional court) and Italy (passage of austerity measures). The European Central Bank (ECB) did not help the EUR’s cause however, with the change in its stance to a more balanced assessment of risks from its more hawkish stance previously.

However, the real damage occurred as speculation of a Greek default intensified and ECB hawk Stark resigned from the ECB council, highlighting the divisions within the governing board. This week attention will remain on Greece as negotiations between the Troika (ECB, EU and IMF) and Greek officials resume.

Ahead of the talks Greece approved a further EUR 2 billion in austerity measures over the weekend but nonetheless, despite denials by Greek officials speculation of a debt default will continue to hammer the EUR lower. Near term technical support is seen around 1.3525 for EUR/USD.

GBP found some relief last week following the decision by the Bank of England to leave policy unchanged though it is unlikely to be able to make much if any headway against the USD over coming sessions as expectations of further UK quantitative easing may simply have been pushed back to the November meeting.

Inflation data this week will give further clues to policy but once again there is likely to be no sign of any easing in inflation pressure, limiting the room for maneuver for the BoE. Moreover, a weak outcome for UK retail sales in August will maintain the trend of soft UK data keeping up the pressure for more BoE action. As a result GBP will struggle against the USD but given that problems in Europe look even worse, GBP will likely extend gains against the EUR this week.

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