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.

Two Speed Recovery

The spread of the COVID Delta variant globally holds key risks for markets in the weeks ahead.  However, as long as hospitalisation rates remain relatively low, it should be less detrimental to the path of re-opening in countries with higher vaccination rates.  As a stark example, the UK will shed almost all of its COVID restrictions today despite spiking COVID cases amid relatively low hospitalisation rates.  

This is particularly difficult for many emerging markets including much of Asia given low vaccination rates.  As such, a two-speed recovery between developed and emerging economies is occurring, with the former registering much higher vaccination rates compared to the latter.  Unlike the move to re-open in developed markets, re-opening in many emerging markets is far more difficult given sharply increasing hospitalisation rates among unvaccinated people as the Delta variant runs rampant. 

As such, the risks of renewed restrictions in many countries could put the global recovery process in jeopardy at a time when we are already past peak growth.  Maybe this is helping to dampen US bond yields or yields are being supressed by the fact that the market has a lot of faith in the Fed even as inflation has surprised on the upside in many countries.  Whatever the cause, US 10y bond yields have slipped below 1.3% back to levels not seen since mid-February and continue to edge lower.    

Event highlights this week include several central bank policy decisions including in China (Tue), Eurozone, Indonesia, South Africa (all Wed) and Russia (Fri).  No changes are expected for China’s Loan Prime Rate (LPR) though the risk of easing has increased marginally following the People’s Bank of China (PBoC) reserve requirements (RRR) cut last week. The Central Bank of Russia (CBR) is expected to hike by 75bp, with risks of a bigger move.  Bank Indonesia is likely to remain on hold despite growing economic pressure.  South Africa’s Reserve Bank (SARB) is expected to remain on hold and remain dovish while a change in forward guidance from the European Central Bank (ECB) is expected this week. 

Oil will be in focus today after OPEC+ agreed on a deal to expand output, with the UAE and Saudi Arabia putting away differences to agree upon a 400k barrels a day increase in output from August.  The US dollar (USD) is trading firmer, but overall looks like it is close to topping out.  For example, EURUSD looks oversold relative to real rate differentials.  Interest rates markets will eye US fiscal developments, with Democrats crafting the budget resolution needed for a reconciliation bill, which may see additional progress this week.

Lingering Disappointment

Another soft close to US stock markets at the end of last week sets up for a nervous start to the week ahead.  The S&P 500 has now declined for a third straight week, with tech stocks leading the way lower as more froth is blown way from the multi-month run up in these stocks.  Lingering disappointment in the wake of the Federal Reserve FOMC meeting is one factor that has weighed on risk assets.  More details on how the Fed plans to implement its new policy on average inflation targeting will be sought. Markets will also look to see whether the Fed is pondering any changes to its Quantitative Easing program. This week Fed officials will get the opportunity to elaborate on their views, with several Fed speeches in the pipeline including three appearances by Fed Chair Powell. 

Disappointment on monetary policy can be matched with a lack of progress on the fiscal front, with hopes of an agreement on Phase 4 fiscal stimulus ahead of US elections fading rapidly.  A loss of momentum in US economic activity as reflected in the NY Fed’s weekly economic index and declining positive data surprises as reflected in the Citi Economic Surprise Index, are beginning to show that the need for fresh stimulus is growing.  On the political front, the situation has become even more tense ahead of elections; following the death of Supreme Court justice Ruth Bader Ginsburg attention this week will focus on President Trump’s pick to replace her, adding another twist to the battle between Democrats and Republicans ahead of the election.    

Another major focal point ahead of elections is US-China tensions, which continue to simmer away. China’s economy and currency continue to outperform even as tensions mount.  August’s slate of Chinese data were upbeat and China’s currency (CNY) is increasingly reflecting positive economic momentum, with the CNY CFETS trade weighted index rising to multi week highs.  There is every chance that tensions will only get worse ahead of US elections, likely as the US maintains a tough approach in the weeks ahead but so far Chinese and Asian markets in general are not reacting too much.  This may change if as is likely, tensions worsen further. 

After last week’s heavy slate of central bank meetings, this week is also going to see many central banks deliberate on monetary policy.  The week kicks off with China’s Loan Prime Rate announcement (Mon), followed by policy decisions in Hungary and Sweden (both Tue), New Zealand, Thailand, Norway (all on Wed), and Turkey (Thu).  Markets expect all of the central banks above to keep policy unchanged as was the case with the many central banks announcing policy decisions last week.  The lack of central bank action adds further evidence that 1) growth is starting to improve in many countries and 2) the limits of conventional policy are being reached.  While renewed rounds of virus infections threaten the recovery process much of the onus on policy action is now on the fiscal front. 

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