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. 

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-China Phase 1, Now What?

Now that the long awaited Phase 1 deal has been signed between the US and China (significantly taking place in the White House) and details finally released (in a 94 page document) it’s worth asking whether much has actually changed.  After all, China still faces (high) tariffs on around two-thirds of its exports to the US while the deal does little to end Chinese state subsidies.  In return the US offers little aside from removing tariff increases.  Intellectual property transfer commitments agreed in the deal are mostly not new as China had already addressed most of these. 

Ironically the magnitude of Chinese purchases, ($77.7bn in manufactured goods, $32bn in agricultural goods, $52.4bn in energy and $37.9bn in services to Dec 2021) means that the Chinese State will have to be even more active in influencing its economy.  The reality is that to achieve this is going to be extremely difficult if not highly unlikely though this may ultimately not matter if China is seen to significantly increase its US purchases.

Looking ahead don’t expect China to be as agreeable on a Phase 2 deal; any such deal would touch on far more sensitive issues.  The likelihood of this being agreed and signed ahead of US elections or maybe at all, is low.  However, in the near term, the deal keeps the risk taps open and avoids any near-term escalation while President Trump walks away with another notch on his belt.  What it doesn’t do is stop any of the US non-tariff barriers, export controls etc, that will still hurt Chinese companies and push China to develop its own technology. Chinese growth will not get much of an uplift from the deal while markets have already largely priced it in.

The commitment from China on the Chinese yuan (CNY) looks vague (achieve market determined FX rate, strengthen underlying fundamentals, refrain from competitive devaluations, avoid large scale, persistent, one-sided intervention), but China will at least avoid any sharp devaluations (of the type experienced in mid-2015, Jan 16), not that they would want to do that again given the negative consequences on its markets/economy.  And as it is China has not been intervening significantly in FX markets for a long while so this should not be difficult either.

US-China Trade War: The Gloves Are Off

The US-China trade war took another step for the worse over the weekend. China announced tariffs on the US of between 5- 10% on $75bn of US imports from September.  Chinese tariffs target 5,078 products including agriculture and small aircraft as well as crude oil. The US responded by increasing its tariffs on $250bn of Chinese imports from 25% to 30% while increasing duties from 10% to 15% on $300bn of Chinese imports to the US from September 1.   President Trump initially said he had “second thoughts” on additional tariffs, but these were clarified to state that “he regrets not raising the tariffs higher”.

The gloves are off on both sides. As indicated by the editorial in China’s People’s Daily states that China will fight the trade war to the end while influential Chinese journalist Hu Xijin said that “we have nothing more to lose, while the US is starting to lose China”, highlights China’s tougher stance.  Meanwhile President Trump is looking at the “Emergency Economic Powers Act of 1977” in forcing US companies to quit China.

Asia’s markets have responded in pain, with stocks and currencies falling while safe havens such as US Treasuries have been in demand.  Indeed the 10-year US Treasury yield has fallen to a three-year low.  Markets have priced in even further easing by the Fed FOMC, with almost three rate cuts by the PBoC discounted in by the end of this year.  Equity futures point to a weak opening in US equities today.

One casualty is the Chinese yuan, which took another leg lower today, having fallen by close to 7% since mid-April.  Further pressure on the yuan is likely, but China may not be too concerned as long as the pace of weakness does not get out of hand. China may try to control the pace of the decline to prevent a repeat of the FX reserves drain seen in mid-2015 and Jan 2016. At the least yuan depreciation will act as a buffer for Chinese exporters against increased US tariffs.  However, expect further yuan depreciation to be met with increased criticism and perhaps more US action, with the US already having labeled China a currency manipulator.

Firm China data boosts sentiment

It is turning into a solid start to the week for global equity markets and risk assets in general.  Growth concerns are easing and central banks globally have shelved plans to tighten policy.  Comments over the weekend that finance chiefs and central bank stand ready to “act promptly” to support growth, may also reassure markets. Meanwhile, it appears that the US and China are closing in on a trade deal, with US Treasury Secretary Mnuchin stating that enforcement mechanisms could work “in both directions”, potentially easing disagreement on of the contentious issues between the two countries.

In terms of data and events, US Q1 earnings, US March retail sales and industrial production, will be in focus this week alongside more Chinese growth data, elections in Indonesia and the second phase of elections in India.  In Europe, flash purchasing managers’ indices (PMI) for April will give some indication of whether there is any turnaround in growth prospects.  The news will not be particularly good on this front, but the surveys may at least show signs of stabilisation, albeit at weak levels.

China data at the end of last week was particularly supportive, with March aggregate financing, money supply and new yuan loans all beating expectations.  The data add to other evidence of a bounce back in activity in March, with the official manufacturing purchasing managers index (PMI) moving back into expansion territory.   The data comes off a low base after weakness in January and February, but suggests that Chinese monetary and fiscal stimulus is taking effect, with the economy steering towards a soft landing.

Chinese markets clearly like what they see, with equities maintain their strong year to date rally (The CSI Index is up over 34% year to date) and CNY remaining firm (CNY has been the strongest performing Asian currency versus USD so far this year) though China’s bond market will react less well to signs of growth stabilisation.  Chinese data this week including Q1 GDP, March retail sales and industrial production are set to add further evidence of growth stabilisation, helping to keep the positive market momentum alive.

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