Action Shifting To Currencies as Rates Volatility Eases

US stocks barely closed higher at the end of last week and flirted with bear market territory. US consumer and retail stocks remain under pressure alongside industrials as recession fears intensify.  Indeed while inflation concern remain elevated, recession fears are increasing. US Treasury yields are finally coming off the boil amid such fears, with May seeing a significant pull back in yields; the biggest decline has been in the 3-10 year part of the yield curve over recent weeks.  This has been met with a decline in interest rate volatility unlike equity and implied currency volatility measures, which have pushed higher.   For instance, major currency implied volatility measures have reached their highest since around March 2020. Emerging markets volatility breached its March 2020 high in March 2022 and after a brief fall is moving back higher.  

Action is shifting to currencies and the drop in the US dollar from its highs, with the currency increasingly undermined by lower US yields.  In Asia, the 3 most sensitive currencies to yield differentials (US 10 year yield minus 10 year local currency bond yields) are the Thai baht, Indonesian rupiah and Korean won.  As such, Korean won is likely to rally the most in Asia should US yields fall further.   The Chinese yuan has strengthened amid US dollar weakness though underperformance of the Chinese currency is likely versus its peers as the authorities likely aim to weaken it on a trade weighted (CFETS) basis. 

In China, the surprisingly large 15 basis point cut in 5-year loan prime rate last week will be seen as a boon for China’s property market.  However, while support for the property market has increased there does not seem to be much more stimulus ready to be unleashed despite various pledges.  China’s April data slate was weak highlighting the risks of a contraction in GDP this quarter and providing evidence that the “around 5.5%” official growth target looks increasingly out of reach.  COVID restrictions across the country are easing gradually pointing to some pick up in activity though consumption and the service sector are likely to remain under pressure for months to come as mass testing, quarantines and border controls continue to restrict mobility.  

There was relief for China’s markets today as President Biden highlighted the potential for a reduction/removal of tariffs implemented by President Trump, stating that he will discuss tariffs with Treasury Secretary Yellen when he returns from his Asia trip.  Removing tariffs is by no means a done deal given there will be plenty of pressure to maintain some level of US tariffs on China. A reduction in tariffs would be beneficial for the US in that it would help reduce imported inflation pressures while it would also help to support Chinese exports at a time when they are slowing down and adding pressure on China’s current account position.  However, some of this impact would likely be mitigated by a relatively stronger yuan, which would undoubtedly benefit as tariffs were cut.  

Key data and events highlight this week include monetary policy decisions in Indonesia (Tue), New Zealand (Wed), South Korea and Turkey (both Thu).  Federal Reserve FOMC meeting minutes will also be released (Wed). Although not expected by the consensus there is a good chance that Indonesia hikes policy rates by 25 basis points. In New Zealand a 50bp hike is likely while a 25bp hike in South Korea is expected.  In contrast despite pressure on the Turkish lira and very elevated inflation no change in monetary policy is expected in Turkey this week.  Meanwhile the Federal Reserve FOMC minutes will provide further detail on how quickly the Fed wants to get to neutral rates and beyond and on its quantitative tightening policy. 

Skittish Markets Amid Higher Yields

The US and to some extent global bond market rout over recent weeks has caused particular pain to crowded growth/momentum stocks.  US 10 year Treasury yields have now risen by around 50 basis points this year, bringing back memories of the 2013 Taper Tantrum and 2016 spike in US yields following the election of Donald Trump as President.  Improving data and falling virus cases have helped fuel the move higher in yields, with the rise in yields hitting equity markets globally and in particular technology stocks as investors focus on the cost of funding amid relatively high valuations in some growth/momentum stocks. 

US rates markets stabilised somewhat at the end of last week after taking a drubbing over much of the week. The rally in interest rate markets on Friday helped to buoy equities, albeit to a limited extent with the Nasdaq managing to eke out gains.  Commodity prices dropped sharply while the US dollar continued to firm up.  Even so market volatility measures such as the VIX (equity volatility) remain elevated.

Currency volatility measures have moved higher too, but not to the same degree as equities or rates.  Emerging markets (EM) FX volatility has reacted even less than developed market FX volatility.  Perhaps this is the next shoe to fall, but so far EM FX have looked relatively well composed despite the rout in rates markets, partly due to a more limited US dollar (USD) reaction than would be expected.  The sharp spike in US yields does not bode well for EM currencies, however.  Higher market volatility, pressure on yield differentials and a slide in growth/momentum stocks could hurt EM assets and it will be very hard for the USD to continue to ignore higher yields. 

While gains in US risk assets may help Asian markets at the beginning of this week any follow through will be dampened by the release of a weaker than expected China manufacturing and services purchasing managers index (PMI) data. The manufacturing PMI dropped to its weakest since May 2020 while the services PMI fell to its lowest since the Feb 2020 COVID related collapse.  I would however, be wary of over interpreting the data given the usual seasonal weakness around Chinese New Year holidays.  Services in particular was impacted by reduced travel over the holidays.  

Other high frequency indicators show that China’s growth momentum remains positive and growth this year is likely to be solid.  More information on the official outlook and forecasts will come from China’s National People’s Congress beginning Friday, which will present the annual work report for 2021 and the release of China’s 14th 5-year plan.  Once again, a growth target for this year will likely be excluded though targets for economic variables are likely while the annual average growth target is likely to be lowered, possibly down to around 5% from “over 6.5%” for the previous 5 years.  

Data on tap this week largely consists of a slew of February PMIs while in the US the February ISM manufacturing survey will be released, with confidence likely boosted optimism about COVID and fiscal stimulus.  Over the rest of the week key releases include US jobs data (Fri), Eurozone February CPI inflation (Tue), Turkey CPI (Wed), UK Spring Budget (Wed), Australia Q4 GDP (Wed) and monetary policy decisions in Australia (Tue), Malaysia (Wed) and Poland (Wed).  None of these central banks are expected to shift policy. 

The Week Ahead

This week the difficulty of trying to pass President Biden’s $1.8tn stimulus package through Congress is likely to become increasingly apparent.  Many Senate republicans are already balking at the price tag and contents, adding more weight to the view of an eventual passage of a sub $1tn package of measures (see my explanation of why Republican support is needed). One of the most contentious issues is likely to be a federally mandated $15 minimum wage. 

At least, the Senate won’t be juggling the impeachment of Donald Trump, at the same time as debating administration nominations and President Biden’s fiscal proposal, with the impeachment trial now scheduled for the week of February 8.

The contrast between US and European data at the end of last week was clear in the release of Markit purchasing managers indices (PMI) data.  US PMI’s registered strong flash readings for January, with both the manufacturing and services indices rising while in contrast the Eurozone composite PMI fell in January, sliding further into contraction.  A disappointing UK retail sales report highlighted the pressure on the UK high street too. 

The reality is that many developed economies are struggling into the new year, with a sharp increase in virus cases including new variants, slower than hoped for rollout of vaccines, and vaccine production shortages, all pointing to a later than expected recovery phase. 

This week, the Federal Reserve FOMC meeting (Wed) will garner most attention in markets. A few Fed officials mentioned tapering recently, clearly rattling markets, as memories of the 2013 “taper tantrum” came back to the surface.  After tamping down on any taper talk Fed Chair Powell is likely remain dovish even as he expresses some optimism on growth.  Growth in Q4 will have looked weak and US Q4 GDP (Thu) will be in focus, with most components likely to have slowed.  A plethora of earnings releases will continue this week including key releases from the likes of Microsoft, AMD, Tesla, Apple and Facebook. 

A dovish FOMC will do no favours for the US dollar (USD), which came under renewed pressure last week.  However, risk assets appear to be struggling a little and should risk appetite worsen it could boost the USD, especially given extreme short positioning in the currency. Emerging Market currencies will be particularly vulnerable if any rally in the USD is associated with higher US real yields. 

Asia In Demand

Equity markets managed to shake off Covid concerns at the end of last week despite virus cases in the US reaching a record high and Europe battling a full-blown second wave; S&P 500 and Russell 2000 hit record highs.  Asian equities started the week building on this positive momentum.  Helping markets was the news that advisors to President-elect Joe Biden have said they oppose a nationwide US lockdown despite the sharp rise in virus cases.  This will help allay fears that the US economy will weaken sharply over the next few months amid severe lockdowns and before a vaccine can be distributed.

Vaccine enthusiasm will likely play against Covid escalation in the days and weeks ahead. In the near-term slim chances of a sizeable US fiscal stimulus taken together with a more rapid increase in global Covid infections highlight clear risks to risk assets, and this may be enough to put roadblocks in place at a time when various equity indices are reaching key technical levels.  Conversely, it is too early to write the US dollar off in the short term even if the medium-term trend is likely to be downwards. 

Asia remains favoured within emerging markets, as the virus has come under control across most of the region.  News of the signing of the Regional Comprehensive Economic Partnership (RCEP) trade deal by 15 countries in the region after 8 years of negotiations, but without the US and India, provides another boost to regional economic and market prospects.  The deal is less extensive than the Trans-Pacific Partnership (TPP) as it removes around 90% of tariffs rather than 100% under TPP.  Nonetheless, it is estimated that the deal could boost the global economy by close to $200bn by 2030.  Although the deal still has to be ratified by a number of countries it is a step closer to a unified trade block like the EU.   

Additionally, Chinese data today ought to be supportive for regional assets even amid the threat of further sanctions by President Trump’s administration in the weeks ahead. China’s October activity data including industrial production fixed assets investment, property investment and the jobless rate were on balance positive, showing that China’s economic recovery is gathering steam.  The data will likely provide further support to China’s markets including China’s currency, though it effectively seals the case for no further easing by China’s central bank, PBoC, while giving the rest of Asia more fuel to rally. 

Over the rest of the week emerging markets central banks will garner most attention, with a plethora of policy rate decisions on tap.  Hungary (Tue), Thailand (Wed), Philippines (Thu), South Africa (Thu), and China (Fri) are set to keep policy rates on hold while Indonesia (Thu) is likely to cut by 25bps and Turkey is expected to hike its policy rate by 475bp hike (Thu).   Turkey in particular will be a focus in this respect given the replacement of central bank governor and the more than 10% rally in the Turkish lira last week.

US Elections – The Proof Is In The Pudding

The week ahead is a huge for data and events.  First and foremost is the US Presidential election on Tuesday.  Polls show Democratic contender Biden well in the lead over President Trump, with around an 8.8% gap in polling between the two contenders.  However, Biden has lost some ground over recent weeks in polls including in key toss-up races though betting odds actually show a late shift back in favour of Biden.  Polls predict that Democrats will also take the Senate from the Republicans and add to their majority in the House. 

While the polls indicate a Blue Wave for the Democrats there is still a healthy degree of cynicism given how badly they predicted the outcome of the 2016 election, when most pollsters predicted a Hillary Clinton victory.  In recognition pollsters say they have changed their methodologies to correct for past errors.  The proof is in the pudding and until elections are over, investors will be holding their breath.  Even after election day itself, it is not clear that we will see an outcome quickly.  A jump in early voting may complicate things as well as the large amount of mail in voting, which could in some states take days to count. 

The problem may be more acute if the election is a close call, which polls are admittedly not suggesting, but nonetheless, the potential for multiple legal challenges and even civil unrest should not be discounted.  Note that States technically have until December 14 to certify election results.  Some states that will be key to either side will be Florida and Pennsylvania as well as Michigan,  North Carolina, Arizona and Wisconsin.  Florida in particular, could be essential, and could be one of the first states to be called on election night.  The winner in Florida has gone on to the win the Presidency in 13 of the 14 last elections. It is also one of the closest races this time around.

All of this is taking place at a time when Covid-19 cases are accelerating, potential a bad omen for Trump given that polls have shown widespread disapproval over his handling of the virus.  Indeed, Covid inflections in the US increased by 97,000 on Friday, the largest one day increase since the outbreak of the virus. The jump in cases were led by Midwestern states, some of which are major battleground states in the elections.  Admittedly, some of the increase in cases can be ascribed to higher testing rates, but hospitalisations have also risen sharply. 

All of this doesn’t bode well for the economy.  While the third quarter registered an above consensus increase in US GDP of 33.1% on annualised basis, the outlook for Q4 looks much softer and without a new fiscal stimulus package, momentum will slow sharply.  The labour market in particular is weak and while this week’s US October employment report will likely show a strong increase in non-farm payrolls (consensus 610,000), there will still likely be around 10 million fewer jobs since February.  The Federal Reserve FOMC meeting this week is unlikely to deliver any further support, with the onus squarely on more fiscal stimulus.

Equity markets have clearly become increasingly nervous heading into the election, with US stocks registering their worst week since March amid election nervousness and spike in Covid infections.   Tech stocks were hit despite mostly beating earnings expectations.  The US dollar in contrast, made some headway, but didn’t really fully capitalise on the sell off in stocks and rise in risk aversion, that would usually be expected to propel the currency higher.   If polls are correct and there is a strong outcome for Democrats in the election, stocks will likely find their feet again, while the US dollar will resume weakness. 

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