Are Recession Risks Rising?

It is incredible that just a few months ago most analysts were expecting at least two if not three interest rate hikes by the Federal Reserve.  How quickly things change.  Markets are pricing in at least a couple of rate cuts by the FOMC while US Treasury yields have fallen sharply as growth concerns have intensified, even as the hard economic has not yet turned that bad.  Recession risks are once again being actively talked about as trade fears intensify, with President Trump threatening increased tariffs on both Mexico and China.  As I noted earlier this week, trade tensions have escalated.

Reflecting this, core bond markets have rallied sharply, with 10 year US Treasury yields dropping by around 60bps so far this year, while bund yields are negative out to 10 years.  Historically such a plunge would be associated with a sharp weakening in growth expectations and onset of recession.  However, equity markets are holding up better; the US S&P 500 has dropped around 6.8% from its highs but is still up close to 10% for the year.  Even Chinese equities are up close to 20% this year despite falling close to 13% from their highs.  Equities could be the last shoe to fall.

In currency markets the US dollar has come under pressure recently but is still stronger versus most currencies this year except notably Japanese and Canadian dollar among major currencies and the likes of Russian rouble and Thai baht among emerging market currencies.  On the other end of the spectrum Turkish lira and Argentine peso have fallen most, but their weakness has largely been idiosyncratic.  In a weaker growth environment, and one in which global trade is hit hard, it would be particularly negative for trade orientated EM economies and currencies.

The US dollar has a natural advantage compared to most major currencies at present in that it has a relatively higher yield. Anyone wishing to sell or go short would need to pay away this yield.  However, if the market is increasingly pricing in rate cuts, the USD looks like a much less attractive proposition and this is what appears to be happening now as investors offload long USD positions build up over past months.  Further USD weakness is likely at least in the short term, but it always hard to write the USDs resilience off.

Going forward much will of course depend on tariffs.  If President Trump implements tariffs on an additional $300 billion of Chinese exports to the US as he has threatened this would hurt global growth as would tariffs on Mexico.  Neither is guaranteed and could still be averted.  Even if these tariffs are implemented fears of recession still appear to be overdone.  Growth will certainly slow in the months ahead as indicated by forward looking indicators such manufacturing purchasing managers’ indices, but there is little in terms of data yet to suggest that recession is on the cards.



US data this week

Despite a softer tone to US equity markets at the end of last week market tensions appear to be easing, with news over the weekend of the ousting of Ukraine’s President helping in this respect. Although US equities ended the week slightly lower the overall tone to risk appetite was firm.

The G20 meeting proved to be a non event in terms of immediate market impact although the aim to lift GDP by more than $2 trillion over the next five years appears to be ambitious to say the least. However, at least focus has shifted from austerity to growth in terms of G20 thinking.

Last week’s release of the February Markit US PMI manufacturing survey which revealed a stronger than expected reading helped to allay some concerns afflicting markets over the pace of US growth giving markets reason for optimism. Indeed, in general markets have attributed recent weakness in US economic data to adverse weather conditions rather than a shift in growth trajectory.

Unfortunately this week’s US data releases are unlikely to be particularly helpful in shaking off growth worries. Although February consumer confidence is likely to be unchanged at a relatively high reading (tomorrow) declines in new homes sales (Wednesday) and durable goods orders (Thursday) in January will not bode well while a revision lower to US Q4 GDP (Friday) will highlight a slower pace of growth momentum at the end of last year than previously recorded.

The US data is likely to be bond friendly helping to cap gains in Treasury yields as well as restraining the USD. Nonetheless, the message from a plethora of Fed speakers on tap this week will likely be one of continued willingness to maintain the current pace of tapering, with recent and current weakness in economic data being shaken off as bad weather related.

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Fed does the Twist, markets do the Shake

Although it was widely expected the Federal Reserve’s decision to implement a fresh version of Operation Twist together with a downbeat assessment of the economy came as a disappointment to equities and risk assets in general. The only surprise was the larger size of the operation at $400 billion.

Moody’s downgrade of three US banks added to the malaise as US equities dropped sharply, commodities slid, longer term Treasuries rallied whilst shorter term bonds dropped. The USD registered broad gains both on the back of the fact that no more quantitative easing was announced and due to a shift away from risk assets. At least there was no more negative news out of the eurozone as talks between the Troika (ECB, IMF, EC) and Greek officials continue on the next tranche of the bailout.

Markets will continue to digest the Fed’s outcome today and the negative tone will likely filter through markets today. There is little on the data front to result in a shift in this tone. In the US data includes weekly jobless claims while in Europe attention will be on manufacturing and service sector confidence measures.

While the potential for a positive outcome to talks in Greece may provide a short term boost to sentiment the overwhelming tone is likely to remain negative especially as Operation Twist is unlikely to change the dynamic of a weak growth trajectory for the US and developed economies over the coming months. Against this background, selling risk assets on rallies remains the preferred option.

The USD will continue to look firmest against high beta emerging market currencies in the current environment. Currencies in this group are those that have the highest correlations with risk (as m measured by my in house risk barometer) over the past 3 months including CAD, ZAR, TRY, INR, MXN, ARS & RUB. In contrast currencies that also have high correlations but actually strengthen as risk aversion increases are CNY and JPY.

US Dollar Under Broad Based Pressure

ThE USD has registered broad based losses over recent days and the longer the stalemate with regard to extending the US debt ceiling the bigger the problem for the currency. Indeed, it appears that the USD is taking the brunt of the pressure compared to other assets. For example, although US treasury yields have edged higher there is still no sense of panic in US bond markets.

Failure to raise the debt ceiling does not automatically imply a debt default but it will raise the prospect should an agreement not be reached in the weeks after. However, the impact on US bonds maybe countered by the increased potential for QE3 or safe haven flows in the event that no agreement is reached.

The worst case scenario for the USD remains no agreement on the debt ceiling ahead of the August 2 deadline but a short term solution that appears to be favored by some in the US Congress may not be that much better as it would effectively be seen as ‘kicking the can down the road’.

The better than hoped for agreement to help resolve Greece’s debt problems at the end of last week came as a blow to the USD given the almost perfect negative correlation between the USD and EUR over recent months. Moreover, the debt ceiling stalemeate is pouring salt into the wound. However, the situation is highly fluid and should officials pull a rabbit out of the hat and find agreement the USD could rally sharply.

All is not rosy for the EUR either and its gains have largely come by courtesy of a weaker USD rather than positive EUR sentiment. Economic news hardly bodes well for the EUR, with data in the eurozone looking somewhat downbeat. For instance, the Belgian July business confidence indicator dropped to a 9-month low in line with the weaker than expected outcome of the July German IFO survey last week.

Moreover, there are still several questions about last week’s second Greek bailout agreement and contagion containment measures including parliamentary approvals and lack of enlargement of the EFSF which could keep markets nervous until there are clear signs that implementation is taking place successfully.

A clear sign that the EU agreement has failed to inspire as much confidence as officials had hoped for is the lack of traction in terms of narrowing peripheral bond spreads, with the exception of Greece. This partly reflects a renewed ‘risk off’ tone to markets but this is not the sole reason.

EUR/USD has extended gains benefiting from USD weakness rather than any positive sentiment towards EUR, breaking above 1.4446, the strong multi-month corrective channel resistance, signalling a bullish move. The next level of technical resistance is around 1.4568 but direction will continue to come from the debt ceiling talks.

The Week Ahead

As markets make the last strides towards year end it appears that currencies at least are becoming increasingly resigned to trading in ranges. Even the beleaguered EUR has not traded far from the 1.3200 level despite significant bond market gyrations. Even news that inflation in China came in well above expectations in November (5.1% YoY) and increased prospects of a rate hike is likely to prompt a limited reaction from a lethargic market.

At the tail end of last week US data provided further support to the growing pool of evidence indicating strengthening US economic conditions, with the trade deficit surprisingly narrowing in October, a fact that will add to Q4 GDP growth, whilst the Michigan measure of consumer confidence registered a bigger than expected increase in November to its highest level since June.

The jump in consumer confidence bodes well for retail spending and highlights the prospects that US November retail sales tomorrow are set to reveal solid gains both headline and ex-autos sales driven by sales and promotions over the holiday season. Other data too, will paint an encouraging picture, with November industrial production (Wed) set to reveal a healthy gain helped by a bounce in utility output. Manufacturing surveys will be mixed with a rebound in the Empire manufacturing survey in December likely but in contrast a drop in the Philly Fed expected.

The main event this week is the FOMC decision tomorrow the Fed is expected to deliver few surprises. The Fed funds rate is expected to remain “exceptionally low for an extended period”. Despite some recent encouraging data recovery remains slow and the fact that core inflation continues to decelerate (CPI inflation data on Wednesday is set to reveal a benign outcome with core CPI at 0.6%) whilst the unemployment rate has moved higher means that the Fed is no rush to alter policy including its commitment to buy $600 billion in Treasuries including $105 billion between now and January 11.

In Europe there are also some key releases that will garner plenty of attention including the December German ZEW and IFO investor and manufacturing confidence surveys and flash purchasing managers indices (PMI) readings. The data are set to remain reasonably healthy and may keep market attention from straying to ongoing problems in the eurozone periphery but this will prove temporary at least until the markets are convinced that European Union leaders are shifting away from “piecemeal” solutions to ending the crisis. The EU leaders’ summit at the end of the week will be important in this respect. A Spanish debt auction on Thursday will also be in focus.

Assuming the forecasts for US data prove correct it is likely that US bond markets will remain under pressure unless the Fed says something that fuels a further decline in yield such as highlighting prospects for more quantitative easing (QE). However, following the tax compromise agreement last week this seems unlikely. Higher relative US bond yields will keep the USD supported, and as I have previously noted, the most sensitive currencies will be the AUD, EUR and JPY, all of which are likely to remain under varying degrees of downward pressure in the short term. The AUD will also be particularly sensitive to prospects of further Chinese monetary tightening.

US bonds sell off, USD rallies

US Treasuries didn’t like it but the compromise agreement to extend Bush era tax cuts, as well as a 13-month unfunded extension of long term unemployment benefits and a $120 billion payroll tax holiday will provide the US economy with further support and likely to lead to some upgrading of US growth forecasts. The agreement changes the dynamic of fiscal support for the US economy and means that the US is the only major country not tightening fiscal policy. It also implies less heavy lifting needed from the Federal Reserve.

Whilst some US taxpayers will not now face tax increases following the end of the year, the longer term question of fiscal adjustment and reform appears to have been postponed. US bond yields jumped on the news as the agreement effectively adds $1 trillion to US debt over the next couple of years. The contrasting fiscal stance with Europe could eventually haunt US markets as focus eventually return to US fiscal issues, with negative implications for the country’s credit ratings. However, at present, attention remains firmly fixed on European sovereign risk rather than US deficit fears.

There has been some relief to European debt markets, albeit temporarily, with debt markets ignoring the news that European Finance Ministers have not agreed to extend the size of the support fund (EFSF) and have also failed to agree on the introduction of recently touted “E-bonds”. ECB buying of peripheral bonds has given some support whilst the passage of the first votes of the Irish budget has eased tensions in its bond markets. Nonetheless as highlighted by the IMF, Europe’s ”piecemeal” response to the debt crisis in the region is insufficient to stem the crisis, suggesting that the current easing in pressure could prove short-lived.

The jump in US bond yields has given the USD some support but I wouldn’t overplay the impact on the USD of bond yields at present. Correlations reflecting the sensitivity of bond yields to various currencies remain relatively low suggesting that the influence of yield on FX is still limited. That said, the correlation is likely to increase over coming months as US yields move higher. The impact on USD/JPY is likely to be particularly sharp, with the currency pair likely to move higher over coming months. The USD has likely rallied due to the likelihood that the tax cut extensions will mean prospects of less quantitative easing by the Fed and prospects of relatively firmer US growth.

An ongoing concern for markets is the prospects of higher interest rates in China. As regular readers of Econometer many note, my blog posts have been a bit sporadic lately. This is not down to laziness but the fact that I have been on the road quite a bit travelling in Asia (and UK) visiting clients. One of the clear concerns that I have heard often repeated is the potential for China’s measures to curb real estate speculation, rising inflation, and lending, to slow China’s growth sharply and cause problems for the rest of the world. This is the topic of another post for another day, but against the background of such concerns the AUD and other high beta currencies are likely to fail to make much headway.

Double-dip fears pressure USD

Markets have found it hard to decide whether to sell the USD due to weaker economic data or buy it on higher risk aversion, but the moves overnight were clear; the USD sold off sharply in the wake of a run of soft data releases. Four separate US releases came in below consensus yesterday, with the June ISM, jobless claims, pending home sales and domestic vehicle sales, all disappointed to varying degrees, especially pending home sales, which dropped an astonishing 30% in June.

The news could have been much worse today, with the release of the US June jobs report. Following the 13k increase in the June ADP employment count the consensus forecast for nonfarm payrolls looked way too optimistic; consensus expectations were for a 130k drop in payrolls according to Bloomberg, with estimates ranging from 0 to -250k. In the event payrolls dropped by 125k and the unemployment dropped to 9.5%, an outcome that was not as bad as feared.

It was not just the US ISM that slipped, but a host of global purchasing managers indices (PMIs) weakened in June including China and India, supporting the view that economic activity will lose momentum in H2 2010. Before we all get too carried away it is worth noting that most manufacturing surveys are coming off a high level.

Nonetheless, for once it wasn’t European concerns that sparked an increase in risk aversion as eurozone banks borrowed less than feared from the ECB, and the Spanish bond tender passed off relatively well, factors that helped EUR/USD jump above 1.25000. Although I remain bearish on the prospects for the EUR over coming months, there may be some further near term upside, with EUR/USD 1.2675, the next resistance level in focus.

As a consequence of US double-dip fears, risk aversion remains at a high level, with US bond yields and commodity prices dropping sharply, leaving commodity currencies sharply lower. In the current environment the USD is likely to be sold on rallies.

On the commodity currency front, AUD/USD may find some relief from the news of a compromise on a proposed mining tax, but the weight of risk aversion will limit any rebound, with my preference to play AUD upside versus NZD. The main concession from Australian Prime Minister Gillard reduce was to reduce the tax to 30% for iron and coal, whilst retaining the 40% tax for oil and gas projects. The agreement likely increases the chance of an election in Australia in the next couple of months as Gillard capitalises on a popularity bounce. Fresh elections could be another factor that limits AUD upside over coming weeks.

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