Contrasting messages from bonds, gold and equities

September 8, 2009 — Mitul Kotecha

There is an interesting divergence developing between bond yields, gold prices and the trend in equity markets.  Whilst equities continue to go up, bond yields are falling and gold prices are rising.  Indeed the usually strong relationship between the S&P 500 and US 10 year yields has collapsed to an insignificant correlation around -0.09 over the past month compared to a high correlation of 0.84 in the month to 8 August.  

Rising equities appear to signify an improvement in risk appetite whilst bonds (US 10-year yield around 3.4%) and gold (around $1000 per troy ounce) are giving the opposite message.  So which indicator is correct and why the breakdown in the usually solid relationship?  

Growing optimism about economic recovery and the run of better than forecast data releases suggest that equities are correct but there is growing risk that so much good news is now priced in that we should pay attention to what bond yields and gold prices are telling us.  

Some of the move lower in bond yields can probably be attributed to the wall of liquidity sloshing around due to central banks’ unconventional policy measures.  However, it is still remarkable that despite the plethora of better than expected data releases, bond yields have actually declined.  This may reflect the success of quantitative easing but could also be associated with sustained economic and market fears.    

The commitment by G20 officials last weekend not to reverse stimulus policies prematurely may also have given more confidence in the view that interest rates will not be raised quickly.  Reflecting this 2 year German bund yields dropped to a record low level at the beginning of the week although longer term bond yield have pushed higher in the 30 year area.  The G20 commitment could turn out to be a double edged sword, however.  If there is no commitment to reduce burgeoning deficits, bonds could ultimately take fright.  

If bonds and gold prices are really reflecting safe haven demand then it will pose a risk to the sustainability of any equity rally over coming months.  As equity valuations begin to look increasingly stretched – the P/E ratio on the S&P 500 has reached 18.76 (according to Bloomberg calculations) compared to a low of around 10.00 at the beginning of March 2009 – it will need more to keep the rally going and high amongst the factors needed is some clarity about the pace and shape of growth once stimulus is reversed. 

For currency markets I think it will be difficult to see a trend until there is more clarity about the economic outlook and in the meantime currency markets will continue to stock watch for direction even if the influence of risk appetite is declining.  Even so, the dollar appears to be reacting more to equities than bond movements and is coming under growing pressure as equities rise.  

Many currencies are poised to break out of recent ranges to the topside versus the dollar led by risk currencies such as the AUD, NZD and CAD.  If it turns out that the equity story rather than the bond message is the correct one then the real message is a bullish one for risk appetite and given the dollar’s usually negative reaction to improved risk appetite, it could face further pressure over coming weeks.

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What goes up…

September 1, 2009 — Mitul Kotecha

…must come down. It was a soft end to August overall. Despite a 6.7% fall in Chinese stocks on the last day of the month, global equity markets for the most part registered gains over August. For example the S&P 500 registered a healthy 3.4% increase in August compared to close to a 15% drop in Chinese (Shanghai B) equities. The phrase, “the higher it goes, the harder it falls” looks appropriate in the case of Chinese stocks; at the time of writing, year-to-date the S&P 500 is up around 13% compared to a 68% gain for the Chinese stocks.

Looked at from another angle the S&P 500 is up an impressive 51% from its low in March 2009, whilst the Shanghai index is up a whopping 113% from its low in October 2008. Much of the selling in Chinese stocks as usual appears to be rumour based with talk of more lending curbs in China and a report that China’s state owned enterprises may terminate commodity contracts with foreign banks spurring the initial selling. The law of gravity suggests that Chinese stock may have further to fall.

The fact that the sharp sell off in Chinese stocks is having only a limited impact on other markets is an interesting development in itself. It suggests that investors in other markets and products are not getting too carried away with China stock watching. In particular, currencies appear calm despite the volatility in Chinese stocks and generally correlations between equity markets and currencies remain low according to my calculations (happy to provide correlation coefficients to anyone who is interested).

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Saturated by good news

August 27, 2009 — Mitul Kotecha

We are currently moving into an environment where economic data is becoming less and less influential in moving markets and this could continue for some weeks.  The bottom line is that so much recovery news is in the price that the continuing run of better than forecast data are having only a limited impact.  Over recent days this run has included firmer than forecast readings on US manufacturing sentiment, consumer sentiment, housing activity and durable goods orders.  The market has become saturated with good news and is showing signs of fatigue.  

Just take a look at the reaction to the latest numbers. Equity markets barely flinched in reaction to positive data including a surge in new home sales and a jump in durable goods orders.  In Europe, the German IFO recorded its biggest increase since 1996.  Perhaps the subdued market reaction was due to the details of some of the reports which could have been considered as not as upbeat as the headlines suggested.  However, this explain is tenuous at best.  

News that China’s state council is studying restrictions on overcapacity in industries including steel and cement will not have helped market sentiment as concerns about Chinese growth are likely to resurface. Nonetheless, the most likely explanation for the lack of momentum in markets is fatigue.  There have been plenty of positive data surprises over recent weeks and markets have become increasingly desensitised to such news. 

Another explanation of the failure of positive data to boost sentiment is that risk appetite is almost back to pre-crisis levels according to many indicators I follow.  Indeed, further impetus for risk currencies will be more limited in the months ahead as the room for a further decline in risk aversion is becoming more limited.

This combined with growing fatigue will have interesting consequences. Firstly it suggests a degree of dollar and yen resilience over coming weeks and growing pressure on risk trades, especially commodity currencies which will suffer disproportionately to fears about Chinese growth and lower commodities demand. 

Nonetheless, consolidation in the weeks ahead rather than any sharp moves is the most likely path.  Although the overall trend of improving risk appetite will continue it is already becoming evident that it will take a lot more to drive risk appetite higher than a steady stream of data showing that the global economy is turning around. In any case, currencies have become less sensitive to the gyrations in risk suggesting that other influences will be sought in the months ahead.  In the meantime range trading will continue. 

The reduced swings in currencies have taken FX largely off the radar as far as policy makers are concerned and it is difficult to see the topic being a major issue at upcoming policy meetings. Lower currency volatility is clearly a boon for policy makers and reflects some “normalisaiton” in currency markets. It perhaps also reflects the fact that FX valuations are less of out synch than they were a few months back, with the USD far less overvalued against many currencies.

Posted in Asia, China, Commodities, Currencies, Economics, Economy, equity markets, Europe, Germany, US. Tags: , , , , , , , , , , , , , , , , . 1 Comment »

Chinese stocks enter bear market

August 19, 2009 — Mitul Kotecha

Markets can only be described as fickle as they gyrate back and forth depending on the latest news or earnings report and as a result direction is changing not just daily but also intra-day.  Investors in most asset classes will continue to focus on stocks especially the recently underperforming Chinese equity market (Shanghai A share index) which officially moved into bearish territory after falling by over 20% from its early August high. 

Various reasons for the drop can be cited including regulator’s curbs on the stock market, high valuations, absence of new fund launches, limits on institutional buying,  high level of new accounts adding to volatility, tighter regulations on real estate, etc, but whatever the reason the direction has been clearly downwards and the impact is being felt across markets.

The turnaround in equity markets during Wednesday’s sessions was dramatic and was led by the turnaround in Chinese stocks which dragged other Asian bourses down with it.   This outweighed any positive sentiment from Market positives so far this week including a strong reading for the German August ZEW survey which surpassed forecasts by a large margin.  This followed the extension of the TALF by the Fed, and a jump in the US Empire manufacturing survey at the beginning of the week.  

Aside from weaker equities the usual FX beneficiaries including the dollar and yen strengthened on the back of the Chinese stock rout.   S&P’s affirmation of China’s credit ratings and positive comments from China’s stats office about the economic outlook in the months ahead  failed to support sentiment.  This would have been expected to provide a positive backdrop for Asian markets but Chinese stock market jitters provided a strong headwind to local markets. 

Overall most measures of risk have seen a substantial improvement over the past few months but there is no doubt that nerves are creeping back into the market.   This time the nervousness is coming from China and worryingly it is swamping the effect of any good news on the global economy and earnings.   This may prove to be a blip on the long road to recovery in risk appetite but it is difficult to ignore such a sharp fall in Chinese stocks without looking at the potential contagion to other equity markets.  

On the FX front those currencies that are most correlated with risk aversion such as the Australian dollar, New Zealand dollar, South African rand, Indonesian rupiah, Brazilian real and Mexican peso will gyrate in relation to the moves in risk appetite.   These currencies have had the highest correlations with risk aversion over the past month and in the current environment will come under some pressure at least until risk sentiment changes again, which in this market could happen at any moment and without warning.

Posted in Asia, Bond markets, central banks, China, Currencies, Economics, Economy, equity markets, India, US. Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , . 2 Comments »

All eyes on Chinese stocks

August 18, 2009 — Mitul Kotecha

Equity markets extended their declines overnight as European and US stocks were smacked across the board.  One of the biggest pull backs has occurred in the Chinese stock market where stocks are down by around 17% since early (3rd) August although stocks are still up close to 73% on the year.  Some of this could be on fears of monetary tightening in China as well as missed profit estimates. 

Risk trades were sold and the dollar and yen strengthened whilst bond markets continued to rally.  News that contributed to the move could have included a sharp 35.7% YoY decline in FDI flows to China in July as well as a broad tightening of lending standards in Q2 according to the latest Senior Loan Officer survey by the Fed.  In contrast there was some positive news on the manufacturing front as the US Empire manufacturing survey jumped 13 points to its highest reading since November 2007. 

The Fed announced that the TALF with a capacity of as much as $1 trillion will expire on June 30 rather than December 31 but for other asset backed securities and CMBS sold before January the plan was extended by three months.   This extension failed to prevent a drop in financial shares overnight with the S&P financials index down 4.2%. 

Commodity prices also extended their drop, with the CRB index now down by around 5.6% since 5 August.   This will continue to play negatively for commodity currencies including the Australian, NZ and Canadian dollars, with the currencies looking vulnerable to more downside today.   Expectations of rising oil inventories and a firmer dollar tone are also playing negatively for commodities. 

Some relief may come today from firmer economic data expected in the US and Eurozone.   US housing starts and building permits are set to reveal further signs of stabilisation in the US housing market whilst the German ZEW survey will rise in August on the back of better economic data and past stronger equity market performance.  It is debatable how much economic data can help counter the worsening in equity sentiment but it may at least provide a semblance of relief.  

The dollar index is trading around the top of its recent range and sentiment for the currency has clearly become less negative as reflected in the latest CFTC Commitments of Traders Report which showed a sharp pull back in net aggregate dollar short positions in the latest week.  

Nonetheless, the dollar is likely to show little inclination to break out of its recent ranges against most currencies.  Overall FX market attention will focus on the Shanghai composite to lead the way in terms of risk appetite and overall direction. Thin holiday trading will leave the markets prone to exaggerated moves over the near term.

Posted in Asia, China, Commodities, Currencies, Economics, Economy, equity markets, US. Tags: , , , , , , , , , , , , , , , , , , , , . Leave a Comment »
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