Waiting For The Fed To Come To The Rescue

COVID-2019 has in the mind of the market shifted from being a localized China and by extension Asia virus to a global phenomenon.  Asia went through fear and panic are few weeks ago while the world watched but did not react greatly as equities continued to rally to new highs outside Asia.  All this has changed dramatically over the last week or so, with markets initially spooked by the sharp rise in cases in Italy and Korea, and as the days have progressed, a sharp increase in the number of countries recording cases of infection.

The sell off in markets has been dramatic, even compared to previous routs in global equity markets.  It is unclear whether fading the declines is a good move given that the headline news flow continues to worsen, but investors are likely to try to look for opportunity in the malaise.   The fact that investors had become increasingly leveraged, positioning had increased significantly and valuations had become stretched, probably added more weight to the sell-off in equity markets and risk assets globally.  Conversely, G10 government bonds have rallied hard, especially US Treasuries as investors jump into safe havens.

Markets are attempting a tentative rally in risk assets today in the hope that major central banks and governments can come to the rescue.  The US Federal Reserve on Friday gave a strong signal that it is prepared to loosen policy if needed and markets have increasingly priced in easing , beginning with at least a 25bps rate cut this month (19 March).  The question is now not whether the Fed cuts, but will the cut be 25bp or 50bp.  Similarly, the Bank of Japan today indicated its readiness to support the economy if needed as have other central banks.

As the number of new infections outside of China is now increasing compared to new infections in China, and Chinese officials are promising both fiscal and monetary stimulus, China is no longer the main point of concern.  That said, there is no doubt that China’s economy is likely to tank this quarter; an early indication came from the sharp decline in China’s official manufacturing purchasing managers’ index, which fell to a record low of 35.7 in February, deep into contraction territory.  The imponderable is how quickly the Chinese economy will get back on its feet.  The potential for “V” shape recovery is looking increasingly slim.

Volatility has also risen across markets, though it is notable that FX volatility has risen by far less than equity or interest rate volatility, suggesting scope for catch up.  Heightened expectations of Fed rate cuts, and sharp decline in yields, alongside fears that the number of virus cases in the US will accelerate, have combined to weigh on the US dollar, helping many currencies including the euro and emerging market currencies to make up some lost ground.  This is likely to continue in the short term, especially if overall market risk appetite shows some improvement.

Markets will likely struggle this week to find their feet.  As we’re seeing today there are attempts to buy into the fall at least in Asia.  Buyers will continue to run into bad news in terms of headlines, suggesting that it will not be an easy rise. Aside from watching coronavirus headlines there will be plenty of attention on the race to be the Democrat Party presidential candidate in the US, with the Super Tuesday primaries in focus.  UK/Europe trade talks will also garner attention as both sides try to hammer out a deal, while OPEC will meet to deliberate whether to implement output cuts to arrest the slide in oil prices.  On the data front, US ISM manufacturing and jobs data will be in focus.

Will The Risk Rally Endure?

There has been a definitive turnaround in risk sentiment this week, with equities rallying and bonds falling.  Whether it can be sustained is another question. I think it will be short-lived.

Markets are pinning their hopes on trade talks which have been agreed be US and Chinese officials to take place in October.  These would be the first official talks since July and follow an intensification of tariffs over recent weeks.  However, talks previously broke up due to a lack of progress on various structural issues and there is no guarantee that anything would be different this time around.  Nonetheless, such hopes may be sufficient to keep market sentiment buoyed in the short term.

Data overnight was bullish for risk sentiment, with the US August ADP employment report revealing private sector gains of +195k, which was higher than expected.  The US ISM non-manufacturing index was also stronger than expected, rising to 56.4 in August from 53.7 previously.  This contrasted with the slide in the manufacturing PMI, which slipped in contraction below 50, reported earlier this week.  The data sets up for a positive outcome for the US August jobs report to be released later today, where the consensus (Bloomberg) is for a 160k increase in payrolls and for the unemployment rate to remain at 3.7%.

As risk appetite has improved the US dollar has come under pressure, falling from its recent highs.  Nonetheless, the dollar remains at over two year highs despite speculation that the US authorities are on the verge of embarking on intervention to weaken the currency.  While I think such intervention is still very unlikely given that it would do little to change the factors driving the dollar higher, chatter about potential intervention may still keep dollar bulls wary.  While intervention is a risk, I don’t think this stop the USD from moving even higher in the weeks ahead.

Conversely China’s currency, the renminbi has reversed some of its recent losses, but this looks like a temporary retracement rather than a change in trend.  China’s economy continues to weaken as reflected in a series of weaker data releases and a weaker currency is still an effective way to alleviate some of the pressure on Chinese exporters. As long as the pace of decline is not too rapid and does incite a sharp increase in capital outflows, I expect the renminbi to continue to weaken.

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 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.

 

Market tensions set to return

Having returned from my summer break it appears that markets are in reasonable shape. Volatility is low, while equities have registered solid gains over recent weeks and markets in general appear to be more settled. In part this is due to hopes and expectations of further stimulus measures in the US and Europe. The coming weeks may be much less calm than experienced over the summer.

Having lost steam over recent weeks the USD may benefit from renewed market nervousness over coming weeks. On the one hand there are hopes of more Fed stimulus in September following comments by Fed Chairman Bernanke that there is “scope for further action”. More information will likely come from the Jackson Hole Fed symposium on Friday and expectations of more quantitative easing could restrain the USD.

On the other hand, it increasingly appears that the summer rally in risk assets is beginning to fade, a factor that will help the USD. The latter effect is likely to be more dominant on the USD especially as it is far from clear that another round of Fed quantitative easing will be USD negative. My analysis suggests that the impact on the USD from QE is ambiguous.

There is plenty of event risk over coming weeks which could feed potential nervousness in the market and help the USD. Markets have to contend with the IMF / EU review of Portugal’s aid program tomorrow which takes place against the background of reports that deficit targets have slipped amid weakening growth. In addition, the 6 September European Central Bank (ECB) meeting will be a major focus given expectations of a further cut in policy rates and other policy steps to purchase Eurozone peripheral debt

Aside from these events, Dutch general elections on 12 September could provoke more uncertainty given that polls currently show a split outcome while the decision by the German constitutional court on the ESM permanent bailout fund on the same date will add to tensions especially as the outcome remains unclear.

Meanwhile, discussions and speculation on Greece’s future within the Eurozone or at least some easing in its bailout terms and a potential formal request for Spanish bailout from the EFSF temporary bailout fund will run alongside these other uncertainties.

To cap it all off, these events combined with the the Eurogroup / Ecofin meeting on 14-15 September will leave markets with plenty to fret about over coming weeks. EUR/USD will struggle to extend upon its gains against this background, with moves above 1.2600 likely to provide better levels to sell EUR.

Caution ahead of EU Summit

Risk appetite has continued to firm over the last few weeks although notably risk is still elevated compared to the the levels seen in May, suggesting that there is some way to go before risk appetite normalises. Improving risk appetite perhaps reflects rising expectations of a credible set of solutions to the Eurozone crisis but various summits and official meetings including the G20 meeting have failed to deliver anything of this nature.

Attention will turn to the EU Summit on 28-29 June where various issues ranging from debt mutualisation to fiscal and banking union as well as a potential renegotiation of Greece’s bailout terms, will be discussed. Markets are likely to remain relatively range bound ahead of the Summit.

There are also plenty of data releases to contend with over coming days including new home sales, consumer confidence and durable goods orders in the US as well as flash CPI inflation estimates, economic confidence gauges and Italian debt auctions in the Eurozone. Japan will release inflation data too and industrial production data.

On balance US data will continue to outperform although consumer confidence is likely to slip in June. In Europe, confidence indices will reveal some further deterioration in June, while in Japan weak industrial production and a drop in monthly inflation will maintain the pressure on policymakers to act in the country.

The USD will continue to find support from the fact that the Fed did not implement more quantitative easing but firmer risk appetite will cap the ability of the USD to strengthen much from current levels. It is notable that the USD long positions dropped sharply according to IMM data ahead of the Fed meeting but it is likely that Fed QE inaction will result in some rebuilding of USD longs.

In any case, given the uncertainty ahead of the EU Summit it is unlikely that the EUR will break out of its current ranges. Notably there was a major bout of EUR short covering last week, with EUR/USD shorts dropping sharply according to the IMM data. Hopes ahead of the EU Summit may encourage more short covering but as usual scope for disagreement and disappointment on many fronts, suggests that investors should not become overly bullish. EUR/USD will find some initial resistance around 1.2583 to any upside.

Risk assets rally, AUD jumps on strong jobs data

Risk assets rallied hard overnight overcoming, albeit temporarily, fears of a Eurozone calamity. The boost to markets appeared to come from hopes of stimulus on many fronts. Although the European Central Bank (ECB) did not cut policy interest rates President Draghi did note that he ‘stands ready to act’ if needed. This implies that rates cuts are in the pipeline very soon but any more action will require European politicians to act first. Following the G7 conference call there is also speculation that EU officials are coordinating some form of support for Spain, especially for its banking sector but details of what this will entail is lacking.

Meanwhile, speculation that the Fed will at least extend ‘Operation Twist” if not opt for a further round of quantitative easing has helped to support the uplift to sentiment. Further clues will come from Fed Chairman Bernanke’s testimony to Congress today although we don’t expect him to signal a policy shift. Markets are clearly grasping for any potential positives in the form of potential policy support but the risk of disappointment remains high, especially in Europe where policy makers have yet to reveal any fresh plans.

The USD dropped further overnight as risk currencies rallied. Market positioning had become very long USDs and some correction of long positioning / profit taking is obviously taking place Data releases did not provide any support to the currency although the Beige Book did note that the economy was continuing to grow ‘moderately’ which was perhaps less negative than it could have been. The USD may find some support from the Bernanke’s testimony today. Although the Fed chief is set to be cautious in his outlook he is unlikely to point to further stimulus at this stage.

It’s worth highlighting the Australian data this morning. Employment rose by surprisingly strong 38.9k. The details of the jobs report are even better than the headline. Full time employment was up 46.1k, while part time jobs were down 7.2k. The only slight negative is the rise in the unemployment rate to 5.1% but this was largely due to a rise in the participation rate to 65.5% from 65.2%. This is the second solid Australian reading in a row following on from the Q1 GDP data yesterday. Given today’s jump in risk assets the data will help compound AUD gains in the short term. AUD/USD will face strong resistance around 1.0021.

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