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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FX ‘Flash Crash’

Happy New Year! What a start its been so far.  Weak Chinese data kicked off the year yesterday, with a manufacturing sentiment gauge, the Caixin purchasing manager’s index (PMI), falling into contraction territory for the first time in 19 months, another sign of slowing growth in China’s economy.  This was echoed by other manufacturing PMIs, especially those of trade orientated countries in Asia.   Taking a look at global emerging market PMIs reveals a picture of broadly slowing growth.

Lack of progress on the trade front despite positive noises from both the US and China, and no sign of an ending of the US government shut down are similarly weighing on sentiment as are concerns about slowing US economic growth and of course Fed rate hikes.  The latest contributor to market angst is the lowering of Apple’s revenue outlook, with the company now expecting sales of around $84bn in the quarter ending Dec 29 from earlier estimates of $89bn to $93bn.

All of this and thin liquidity, with a Japanese holiday today and many market participants not back from holidays, contributed to very sharp moves in FX markets.  The biggest mover was the JPY, which surged, leading to an appreciation of around 7.7% versus the AUD at one point and strong gains against other currencies.  Some have attributed algorithmic platform pricing to the sharp FX moves today, but whatever the reason, it shows that markets are on edge.

Although US equity markets closed in positive territory yesterday (barely), the above factors suggest another day in the red for equity markets and risk assets today.  While the JPY has retraced some its sharp gains, it and other safe haven assets such as CHF and US Treasuries are likely to find firm demand in the current environment.   Although I would not suggest extrapolating early year trading too far into the future, the volatility in the first two trading days of the year will be concerning for investors after a painful 2018. More pain in the weeks ahead should not be ruled out.

 

US dollar weakness providing relief

The US dollar index has weakened since mid-August 2018 although weakness in the broad trade weighted USD has become more apparent since the beginning of this month.  Despite a further increase in US yields, 10 year treasury yields have risen in recent weeks to close to 3.1%, the USD has surprisingly not benefited.  It is not clear what is driving USD weakness but improving risk appetite is likely to be a factor. Markets have been increasingly long USDs and this positioning overhang has also acted as a restraint on the USD.

Most G10 currencies have benefitted in September, with The Swedish krona (SEK), Norwegian Krone (NOK) and British pound (GBP) gaining most.  The Japanese yen (JPY) on the other hand has been the only G10 currency to weaken this month as an improvement in risk appetite has led to reduced safe haven demand for the currency.

In Asia most currencies are still weaker versus the dollar over September, with the Indian rupee leading the declines.  Once again Asia’s current account deficit countries (India, Indonesia, and Philippines) have underperformed most others though the authorities in all three countries have become more aggressive in terms of trying to defend their currencies.  Indeed, The Philippines and Indonesia are likely to raise policy interest rates tomorrow while the chance of a rate hike from India’s central bank next week has risen.

As the USD weakens it will increasingly help many emerging market currencies.   The likes of the Argentinian peso, Turkish lira and Brazilian real have been particularly badly beaten up, dropping 51.3%, 38.5% and 18.8%, respectively this year.  Although much of the reason for their declines have been idiosyncratic in nature, USD weakness would provide a major source of relief.  It’s too early to suggest that this drop in the USD is anything more than a correction especially given the proximity to the Fed FOMC decision later, but early signs are positive.

 

Why the JPY will weaken

While I continue to forecast JPY weakness over the coming months the JPY is currently being buffeted by various forces. Elevated risk aversion has limited the downside for JPY as the currency has once again found a safe haven bid although it has weakened as risk appetite improved slightly overnight.

Going forward, I expect US Treasury yields to move sharply higher as the US economy gains momentum and loses the shackles of bad weather, pressurising USD/JPY higher. Additionally likely further easing by the BoJ in April / May will contribute to downward pressure on the JPY.

Separately Japan has shifted from possessing a relatively strong broad basic balance surplus (current account + direct investment + portfolio flows) to a deficit, a factor that will undermine the JPY over the coming months.

EUR and GBP losing ground

Safe haven currencies including JPY and CHF will be the main FX beneficiaries of the current bout of risk aversion although the USD has also edged higher in part due to some slippage in the EUR and GBP. I had noted at the beggining of this week that EUR/USD will remain a buy on dips on any decline to 1.3775. However, after hitting a high around EUR/USD 1.3916 following the European Central Bank’s inaction at its policy meeting last week the currency pair distinctly looks like it has topped out this week. Technical and positioning indicators are also looking less positive for the currency, with the RSI (Relative Strength Index) at a stretched level and speculative positioning above its three month average.

Comments by ECB Vice President Constancio that the markets had not fully taken on the message from the ECB last week that policy will remain accommodative also helped to dampen sentiment for the EUR. Further slippage to technical support around 1.3778 looks likely in the near term.

GBP has lost ground overnight too. Softer data including yesterday’s January industrial production data as well as comments from the Bank of England have weighed on the currency. As noted last week GBP/USD was looking vulnerable above 1.6700 and will face some further short term pressure, with a test of support around 1.6538 looming.

Safe havens in demand

Risk aversion increased further overnight, as reflected in the VIX “fear gauge and my Risk Aversion Barometer, both of which moved higher. Risk assets in general slipped, with US equities closing lower, while safe havens including JPY and gold were in demand.

Ukraine tensions have intensified, with diplomatic efforts yielding no success and Russia stating that it would recognise the results of the referendum in Crimea. Wheat prices are feeling the direct impact of these tensions, with prices rising to a 13 week high while in contrast copper prices continue to be hit by China growth worries.

The outlook today is not a positive one, with a negative follow through expected in the trading session. There is little on the data front of note, aside from Eurozone industrial production which is unlikely to be a market mover.

JPY capped

USD/JPY is being buffeted by the conflicting forces of relatively elevated risk aversion and higher US yields, leaving the currency pair in difficult position to sustain gains. Today’s BoJ outcome has the potential to give some direction but its unlikely that the central bank will deliver any surprises after boosting its funding for lending scheme at the last meeting. Nonetheless, additional easing is likely to take place around as early as April. The emergence of US Treasury buyers as 10 year yields approach 2.8% suggests that US yields may be capped for now and it may take the emergence of more positive / less weather impacted data to push yields higher. Consequently USD/JPY will struggle to make much headway over the short term, with resistance seen around 103.77.

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