Debate Over Fed Tightening Rages On

After receiving a major beating over recent weeks this week has seen a ‘risk on’ tone permeate through markets as dip buyers emerge.  COVID is increasingly taking a back seat though risks from simmering geopolitical tensions over Russia/Ukraine continue to act as a threat to markets.  Nonetheless, equity volatility has fallen, with the VIX ‘fear gauge’ dropping sharply over recent sessions.  In contrast, interest rate volatility remains elevated as debate over a potential 50 basis point hike from the Federal Reserve and/or policy hikes at successive FOMC meetings continues.  Fed speakers this week including St. Louis Fed President Bullard and Philadelphia Fed President Harker in comments yesterday appear to have dampened expectations of a 50 basis point hike, but this has unlikely put an end to such speculation.

Overall market uncertainty is likely to persist in the weeks ahead setting the scene for renewed bouts of volatility.  The debate over Fed rate hikes both in terms of magnitude and timing is far from over, with analysts ramping up expectations of multiple hikes this year.  There is a strong chance that the Fed will announce tightening at each of the next three meetings including beginning quantitative tightening (QT).  Markets are pricing in five quarter point hikes in the next year and there may be scope for even more aggressive tightening.  Given likely persistently high inflation readings in the months ahead it is not likely the time to push back against markets tightening expectations. 

Much of Asia has been closed for part or all of this week though China’s purchasing managers index (PMI) data for January released last weekend highlighted a loss of economic momentum.  Although official stimulus measures will likely help to avoid a sharp slowing in economic growth, sentiment is unlikely to get back to pre-COVID levels anytime soon. China’s zero-tolerance approach to COVID means that even small outbreaks will lead to lockdowns, likely dampening services sentiment and travel. Meanwhile, manufacturing pressure may find some support from fiscal policy measures as policy is front loaded, and likely further monetary easing ahead, with at least another 10 basis point easing in the Loan Prime Rate and 50bp cut in the RRR likely in the weeks ahead. However, the overall trajectory of activity remains downwards.

Monetary policy decisions in the Euro area (Thu) and UK (Thu) will be among the highlights this week in addition to US Jan jobs (Fri).  The Reserve Bank of Australia (RBA) left policy unchanged as expected but revealed a relatively dovish statement even as it formally announced an end to quantitative easing (QE). There is likely to be a contrasting stance between the Bank of England (BoE) and European Central Bank (ECB), with the former likely to hike by 25 basis point on concerns about rising inflation expectations while we the latter is likely in cruise control for H1 2022. In the US there are risks of a worse than consensus outcome for US non-farm payrolls due to a surge in Omicron cases (consensus 175k).  Separately, in emerging markets, focus will be on Brazil, where the central bank, BCB is expected to hike rates by 150bp (Thu).

Setting Up For A More Volatile Q4

After a disappointing September for risk assets, markets at least found some relief at the end of last week, with the S&P 500 ending up over a 1% while US Treasury yields fell and the US dollar also lost ground.  However, sentiment in Asia to kick of the week has been poor, with Evergrande concerns coming back to the forefront.

There was positive news on the US data front, with the Institute of Supply Management (ISM) manufacturing index surprising to the upside in September, rising modestly to 61.1 from an already strong level at 59.9 in August (consensus: 59.5) though the details were less positive.  In particular, the rise in supplier delivery times and prices paid reflects a re-emergence of supply chain issues. 

Separately, the infrastructure can was kicked down the road as infighting within the Democratic party on the passage of the bipartisan $1.2 trillion infrastructure bill and larger $3.5tn package, led to a further delay of up to one more month. It is likely that the eventual size of the proposed $3.5tn spending plan will end up being smaller, but there still seems to be some distance between the progressives in the Democratic party want and what the moderates want. Separately, the debt ceiling issue is likely to go down to the wire too.

China’s Evergrande remains in focus, with the company reportedly suspended from trading in Hong Kong pending “information on a major transaction”. According to China’s Cailian news platform another developer plans to acquire a 51% stake in the property services unit. The sale is likely a further step towards restructuring the entity and preventing a wider contagion to China’s property sector and economy.

Over the rest of the week attention will turn to the US September jobs report, which will as usual likely be closely eyed by Federal Reserve policymakers.   A pickup in hiring relative to the 235,000 rise in August is expected, with the consensus looking for a 470,000 increase. It would likely take a very poor outcome to derail the Federal Reserve’s tapering plans in my view.  

Several central banks including in Australia (Tue), New Zealand (Wed), Poland (Wed) and India (Fri) will deliberate on policy.  Among these the most eventful will likely be the RBNZ, with a 25 basis points rate hike likely while the others are all set to remain on hold.  Other data includes the European Central bank (ECB) meeting accounts of the September meeting (Thu), US ISM Sep services index (Tue) and Turkey September CPI (today). 

Overall, going into the fourth quarter investors will have to contend with host of concerns including weakening global activity especially in the US and China, supply chain pressures, persistent inflation risks, Evergrande contagion and related China property developer woes, China’s regulatory crackdown, raising the debt ceiling, difficulties in passing the US infrastructure bills, Fed tapering, and ongoing COVID concerns.  This may set up for a much rockier and more volatile quarter ahead for markets especially amid a growing wave of more hawkish G10 central banks.

Regulatory Crackdown

How much can global markets withstand the combined US and Chinese regulatory onslaught on Chinese tech stocks and Chinese companies listed in the US? Notably Chinese regulators have called for talks with the US Securities and Exchange Commission over the decision to halt US IPOs of Chinese companies. Given that regulators on both sides do not seem to be letting up, the risks are skewed towards increased contagion though Chinese stocks have already fallen sharply over recent weeks, with the CSI 300 down around 15% since its high in February.

Unfortunately Chinese stocks and investors in these stocks are the casualties of a regulatory crackdown on consumer internet stocks and more recently Chinese private education companies. While the idea is not to provoke market volatility, regulators in China are unlikely to back off quickly even as the tone of the crackdown is likely to be less aggressive in the weeks ahead.

Stocks ended last week and began this week softer amid such concerns while the softer than expected US Q2 GDP print last week didn’t help matters.  More evidence that peak US growth has passed was delivered yesterday, with the US ISM manufacturing index surprising to the downside in July, declining to 59.5 — its lowest level since January but still at a relatively high level. US economic surprises (according to the Citi index) are negative and at their lowest in over a year.

The below consensus outcome for China’s manufacturing purchasing manager’s index which slipped closer towards contraction is unlikely to be helpful for markets either as the data adds to signs of moderating economic growth in China.  China’s softer July PMI releases have left a sour taste for Asian markets given more evidence of moderation in activity while the spread of the Delta variant amid low vaccination rates, still points to underperformance of regional markets. 

US dollar sentiment has continued to improve as reflected in speculative futures data (CFTC IMM data on non-commercial futures) which shows that the market holds the biggest net aggregate USD long position since March 2020.  Nonetheless, it still seems difficult to see dollar upside momentum increase given very low US real yields.  Moreover, the fact that the market is now long USD according to the IMM data, means scope for any short covering rally has dissipated.

Key data and events this week include the Bank of England (Thu) and Reserve Bank of India (Fri) policy decisions and US jobs July report (Fri).  No rate changes are likely from any of these as was the case with today’s decision by the Reserve Bank of Australia. As for US payrolls, the consensus expectation looks for a strong 900,000 increase in July and for the unemployment rate to fall to 5.7%.  

Absorbing The Fed’s Message

Markets absorbed a high inflation reading in the form of US core Personal Consumption Expenditure (PCE) price index without flinching at the end of last week, further acknowledgement that the Fed’s “transitory” inflation message is belatedly sinking in to the market’s psyche.  Core PCE inflation exceeded expectations for April, surging 0.7% m/m after a 0.4% gain in March (consensus: 0.6%). On a y/y basis, core PCE inflation surged to 3.1%—its highest level in almost three decades. High inflation readings are likely to persist over the near-term, if for no other reason than base effect, but price pressures will likely ease by the end of the year. 

The market’s sanguine reaction has helped US Treasury yields to continue to consolidate.  Also helping to restrain yields is the fact that positive US economic surprises (data releases versus consensus expectations) are close to their lowest level since June 2020 and barely positive (according to the Citi index), in contrast to euro area economic surprises, a factor that is helping to support the euro.

Cross-asset volatility measures remain very low, with the glut of liquidity continuing to depress volatility across equities, interest rates and FX.  Given that markets’ inflation fears has eased, it is difficult to see what will provoke any spike in volatility in the near term.  All of this this does not bode well for the USD.  Sentiment as reflected in the latest CFTC IMM speculative data on net non-commercial futures USD positions, remains downbeat.  This is corroborated in FX options risk reversal skews (3m, 25d) of USD crosses. 

In particular, USDCNY will be closely watched after strong gains in the renminbi lately.  Chinese officials are trying to prevent or at least slow USD weakness vs. CNY. The latest measure came from China’s central bank, the PBoC instructing banks to increase their FX reserve requirements by 2% to 7% ie to hold more foreign currency as a means of reducing demand for the Chinese currency.  Expect official resistance to yuan appreciation pressures to grow.      

Data so far this week has been mixed. China’s May NBS manufacturing purchasing managers index released yesterday slipped marginally to 51.0 from 51.1 previously (consensus 51.1) while the non-manufacturing PMI increased to 55.2 from 54.9 previously. Both remained in expansion, however indicative of continued economic expansion. China’s exports are holding up particularly well and this is expected to continue to fuel manufacturing expansion while manufacturing imports are similarly strong. 

Today’s Reserve Bank of Australia decision on monetary policy delivered no surprises, with policy unchanged and attention shifting to the July meeting when the bond purchase program will be reviewed.  On Friday it’s the turn of the the Indian central bank, Reserve Bank of India (RBI), with an unchanged policy outcome likely despite the growth risks emanating from a 2nd wave COVID infections cross the country and attendant lockdowns.  Last but not least, is the May US jobs report for which consensus expectations are for 650,000 gain in non-farm payrolls and the unemployment rate falling to 5.9% from 6.1% previously.

India’s Covid Worsening, Central Banks and US Data

A number of holidays this week points to quieter week for markets.  However, as I note below, there are still a number of risk events on the horizon. 

A growing focus is the divergent trend in the path of Covid in emerging markets and in developed economies, with the former especially in some parts of Asia, Latin America and Africa, seeing a significant worsening, which will likely result in delayed recoveries and lead to some EM asset market underperformance. 

India’s Covid situation worsens dramatically

As all the headlines show, India’s Covid situation has become particularly dire though a lack of large-scale lockdowns has led to only a limited mark down in growth forecasts there even as risks intensify.  Already there has been a political cost, with Indian PM Modi’s BJP party losing a key state election in West Bengal and losing ground in other state elections.  Virus cases are still on the rise and sadly the picture will worsen before there are any signs of improvement.  

Covid cases in India have been trending higher since February and hit record highs this weekend, above 400,000. The number of cases is approaching 20 million, with over 215k deaths, while the country has administered 157.2 million vaccine doses.  However, at the current rate of vaccination of 2.26 million per day, it will take 2.2 years to cover 75% of the population with a two-dose vaccine. 

US dollar consolidating

After losing ground in April (the USD index DXY fell close to 3% over the month) the US dollar (USD) looks likely to consolidate this month.  USD positioning has already improved over recent months, suggesting limited scope for short covering.  Seasonal factors are unlikely to be particularly influential this month.  However, I am cognizant that cross asset market volatility has eased significantly, while risk assets are already priced for a lot of good news.  Nonetheless, risk factors are increasingly rising, especially increasing Covid cases in many emerging markets as noted above.  This leaves the market prone to bouts of risk aversion, which could result in some bouts of USD strength amid an overall backdrop of consolidation.

Key data and events

This week is an important one for both data and events.  There are several central bank decisions including in Australia (Tue), Thailand and Poland (Wed), Malaysia, UK, Turkey, and Brazil (Thu).  None of the central banks are expected to change policy settings except Brazil, with the consensus looking for a 75bp hike there.  In the UK, there is uncertainty over the future path of QE and whether the Bank of England extends asset purchases or takes the first steps to bringing asset purchases to an end echoing the Bank of Canada by announcing tapering. 

On the data front, the main highlights include the US ISM surveys (today and Wed), US April jobs report (Fri) and China trade data.  Both the US ISM surveys and payrolls are likely to reveal robust readings.  Fiscal stimulus and easing Covid likely helped to boost US jobs growth in April while the unemployment rate likely fell.  Meanwhile the ISM surveys will likely remain around historical highs for similar reasons.  Overall, the data will continue to paint a picture of strengthening US economic recovery. Meanwhile China trade data is likely to reveal strong exports and imports growth, though much of this will likely be due to base effects.

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