Markets Firm Despite Weak Data and Political Mayhem

Following an eventful (to put it mildly) week in US politics, the main thrust for markets is that the prospects of another sizeable US fiscal stimulus package has increased as Democrats will now take the Senate following the Georgia run-off elections as well as the House and Presidency.  The Blue sweep effectively gives Democrats more potential to pass policies without the constraints of requiring Republican support in the Senate.  That said, the Senate may not be willing to pass significantly more progressive measures given that the seats will be 50/50 for Republicans and Democrats, with the deciding vote coming from VP-elect Harris.

The data/markets dichotomy was once again clear from the weakness in the US December payrolls data on Friday, which revealed a 140,000 drop (consensus +50, 000) as Covid restrictions severely impacted leisure and hospitality jobs.  If anything, this will just add to pressure for more fiscal stimulus. US markets don’t care about soft data or are at least looking past it, with key indices reaching record highs last week led by tech stocks. Stocks and risk assets overall registered a stellar first trading week of the year amid a glut of liquidity even as US Treasury yields pushed higher.  

The US dollar also finally strengthened, gaining some respite amid a market positioned short and despite very negative sentiment.  More gains are likely if the USDs positive relationship with US yields continues to re-establish itself, assuming US Treasury 10 year yields push higher amid further bear steepening as expectations of more fiscal stimulus grow. The same cannot be said for gold prices, which tanked 4% at the end of last week as gold’s negative correlation with US Treasury yields took effect.  Asian currencies and local currency bonds will likely also face headwinds in the near term as the USD consolidates further. 

Aside from steps in the US House towards impeaching President Trump for a second time and any measures announced by the US administration in its final days, markets will focus on US (Wed) and Chinese inflation (tomorrow) data this week.  Both releases are unlikely to provoke any concern about inflation pressures even as market inflation expectations push higher.  Australia (Nov) and US retail sales data (Dec) (both tomorrow) will give some colour on how the consumer is faring.  In this respect US data will likely disappoint.  Other key data and events this week include China trade data (Thu) and rate decisions in Poland (Wed) and Korea (Fri). Chinese trade data is likely to reveal another strong reading for both exports and imports while Poland and Korea policy rates are likely to remain unchanged.

Calm after the storm

After yesterday’s carnage, global equity markets have recovered some of their poise. Whether this is a pause before another wave of pressure or something more sustainable is debatable. It appears that US equities are finally succumbing to a plethora of bad news.  Higher US yields have driven the equity risk premium lower.  Also there’s probably a degree of profit taking ahead of the onset of the Q3 US earnings season.

At the same time valuations have become increasingly stretched.  For example, the S&P 500 price/earnings ratio is around 6% higher than its 5 year average while almost all emerging market price/earnings ratios are well below their 5 year averages.  While strong US growth prospects may justify some or even all of this differential, the gap with emerging markets has widened significantly.

While US President Trump blames an “out of control” US Federal Reserve, it would have been hard for the Fed to do anything else but raise policy rates at its last meeting.  If the Fed didn’t hike at the end of September, bond yields would like have moved even higher than the 3.26% reached on the 10 year US Treasury yield earlier this week as markets would have believed the Fed is falling behind the curve.   However, as US yields rise and the equity risk premium reacts, the opportunity cost of investing in equities rises too.

In the FX world the US dollar could succumb to more pressure if US equities fall further but as we saw yesterday, USD weakness may mainly be expressed versus other major currencies (EUR etc).  Emerging market currencies continue to face too many headwinds including higher US rates and tightening USD liquidity, as well as trade tariffs.  The fact that emerging market growth indicators are slowing, led by China, also does not bode well for EM assets.  Unfortunately that means that emerging market assets will not benefit for the time being from any rout in US assets despite their valuation differences.

Risk rally losing steam

The rally in risk assets is losing its momentum, with US stock markets failing to extend gains following a four day rally while US Treasury yields continued their ascent in the wake of Fed Chairman Yellen’s testimony highlighting no deviation from tapering. Her testimony to the Senate will be delayed today while US data in the form of retail sales is likely to register a soft outcome. Sentiment was boosted overnight by strong Chinese trade data in January and the approval by the US Congress allowing a suspension of the debt limit, a far cry from the major saga that took place last time the debt ceiling was about to be breached.

Additionally Eurozone markets will find some support from comments by European Central Bank board member Coeure who noted that the central banks is “very seriously” considering negative deposit rates. His view may be supported by the release of the ECB monthly bulletin today and Survey of Professional Forecasters (SPF). Coeure’s comments undermined the EUR however, while in contrast sharp upward revisions to growth forecasts by the Bank of England in its Quarterly Inflation Report boosted GBP. Suffice to say, EUR/GBP dropped like a stone and looks set to remain under downward pressure.

“Feral hogs” beware

Bond and equity selling has been sustained as worries both about Federal Reserve tapering and liquidity in China’s banking sector continues to roil markets. Fed comments overnight did little to soothe market angst, with the Fed’s Fisher and Kocherlakota both revealing little concern about the market reaction to prospects of Fed tapering. However, both Fed officials were keen to point out that policy will remain accommodative even after the end of quantitative easing which helped to allay some of the pain on markets in overnight trading.

Reinforcing market volatility is the approach of month and quarter end. Several other Fed speakers will be on tap over coming days while 2, 5 and 7 year Treasury auctions will also be under scrutiny but ahead of the speeches and auctions markets will look to today’s US data releases including May durable goods orders, June consumer confidence and May new home sales for further direction.

EUR/USD failed to get much of lift from the rise in the German IFO business confidence survey in June and looks set to extend declines over coming sessions. Despite its drop from its high around 1.3420 EUR/USD has not been particularly sensitive to higher US yields over recent weeks but this may be changing. As revealed in the latest CFTC IMM report net speculative positioning in EUR/USD became positive for the first time in four months.

Now that the room for EUR short covering has disappeared EUR’s sensitivity to yield is likely to grow. The fact that the 10 year US Treasury yield differential with bunds has widened sharply will be difficult for EUR/USD to ignore, with attendant negative consequences for the currency. The lack of key Eurozone data releases over coming days will leave the EUR/USD increasingly at the mercy of US yield movements.

Another currency having to deal with a relatively thin data slate is GBP. Only the government’s Spending Review, Bank of England Financial Stability Report and second estimate of Q1 GDP are scheduled for release this week but none of these are likely to prove to be market movers. Having been hit by a firmer USD, GBP/USD has fallen well off its recent highs around 1.5752. On the crosses GBP looks a little healthier but is notably failing to make any headway against the EUR.

While the USD has rallied on higher US yields markets are not looking for a similar policy moves in the UK, especially given that some BoE MPC members are still inclined to increase asset purchases. Indeed, the recent rise in UK gilt yields may embolden the doves on the MPC. Although net speculative short GBP positions have not fully evaporated, the room for GBP upside is now very limited, with a firm USD in general set to continue to push GBP lower.

US dollar helped by higher yields

The dichotomy between hard economic data and asset market performance continues but unlike over past weeks at least there was some justification for the rally in equity markets following the stronger than expected US April jobs report. US non farm payrolls rose by 165k while revisions added 114k to previous months and the unemployment rate dropped further to 7.5%.

The data will offer the Fed some comfort perhaps reducing the need to expand further asset purchases in the months ahead. Nonetheless, the jury is still out and following the shift in Fed language at the FOMC meeting last week, in which they opened the door to increasing quantitative easing, it may take more than one, albeit important data release to completely erase expectations of more QE.

Further Fed thoughts on the jobs data as well as the plethora of disappointing data releases over previous weeks could emerge from the Chicago Fed conference this week, with several Fed speakers including Chairman Bernanke scheduled to speak. Given that there is little else on the data front market direction will take it cue from Fed comments.

Aside from central bank meetings in the UK and Australia the data slate is similarly thin elsewhere. No change is expected from both the Band of England and Reserve Bank of Australia but the latter is a much closer call given weaker data both domestically and in China. If the RBA does not move AUD will find some further support after rallying on the back of the jump in copper prices last week although gains will be limited as markets may just push back Australian easing expectations to the next meeting.

In the Eurozone, the final services confidence indices and German industrial data will be on tap and will add more evidence of the weaker economic trajectory and likely restrain the EUR and keep Eurozone core bonds supported. EUR/USD will find little else to give it direction, with higher US yields also likely to help keep any gains in EUR/USD capped, with resistance seen around 1.3220.

Japan has little on the data front too with trade and current account data in focus. The jump in the USD/JPY following the US jobs report will mean that attention will be on whether the 100 level can finally be cracked, with the spike in US 10 year Treasury yields likely keeping the USD supported versus JPY. I suspect that this level will not be breached unless US yields rise further.

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