For several days markets have quaked
As muck about trade has been raked
But Wednesday’s retracement
And China’s emplacement
Of yuan means some fears have been slaked
Yesterday was a session for those with strong stomachs. Equities plummeted (DJIA -589) early as did bond yields (10-year Treasury yields fell to 1.59%) with both markets pointing to an imminent recession. But then, as sometimes happens, things turned around inexplicably. There was no data to drive the change, as there was really no data yesterday. The only Fed comments were from Chicago’s Evans, a known dove, who said that the recent escalation in trade tensions could well warrant further rate cuts. But we already knew that and had heard it on Tuesday from two other Fed speakers.
However, the fear that was rampant at the opening (gold exploded through $1500/oz, USDJPY traded below 105.50) just as quickly dissipated and through the rest of the session, equities rallied back to flat, Treasury prices fell such that yields actually closed the day higher than the day before, and both the dollar and yen reversed early gains and settled slightly lower on the day. Gold, however, maintained most of its gains.
Price action like that, which can be quite unsettling, tends to be indicative of a great deal of uncertainty in markets. In fact, that is what markets do best, with bulls and bears fighting it out for supremacy. But the ultimate conclusion has to be that recent market trends are being questioned. As I wrote yesterday, and has been widely mentioned elsewhere as well, there is a fundamental difference of opinion between the stock and bond markets, where bonds investors see a much gloomier economic future than stock investors. In fact, it is fair to say, that stock investors are so fixated on the potential benefits of lower interest rates that they seem to be forgetting why those lower rates are being contemplated, slowing growth. At some point, this conundrum will be resolved, either as Treasury yields rebound amid stronger growth indications, or with lower stock prices as the economic data defines a worse economic situation than currently expected. While my view, alas, remains the latter is more likely, it is still an open question as to how things play out.
The end result, however, is that as I have written frequently in the past, volatility in markets is going to be with us for some time to come. Today, though, it is not as evident as it was yesterday. Equity markets around the world have shown modest gains, generally on the order of 0.5%, while bond prices have been fairly stable along with the dollar. In fact, the dollar has done very little overall.
There has been much made of the fact that the PBOC fixed USDCNY at 7.0039, above the 7.00 level and its weakest fix since 2008. However, market expectations were for a fix at an even higher level, ~7.0130, so despite the optics on the surface, this was seen as an attempt to mitigate the recent anxiety. Ultimately, the PBOC is likely to allow a very gradual depreciation of the yuan going forward as they find themselves caught between competing problems. On the one hand, slowing growth indicates the need for a weaker yuan to help support exporters. However, the flip side is that the huge increase in USD borrowings by Chinese companies, especially in the local property sector, means that a weaker yuan will crimp their ability to service and repay that debt, potentially leading to larger systemic issues. Clearly the PBOC wants to avoid anything like that, so slow and steady seems the most likely outcome.
And in fact, that is probably what we are going to see in a number of currencies as the impacts of the growing trade conflict widens around the world. The dollar will continue to be a key destination for investment as long as the US economy, even if it is slowing somewhat, remains stronger than economies elsewhere. Yesterday we saw the aggressive actions of three Asian central banks, and last night the Philippines cut rates by 25bps as well. Markets are pricing in cuts pretty much everywhere in the world so the fact that the Fed is likely to produce at least two more cuts is hardly a reason to avoid the dollar. In fact, US rates continue to trade above every other developed market rate and, as such, remain attractive to foreign investors. There is no evidence that situation will change in the near-term, and so support for the dollar is likely to remain firm.
A quick look at today’s price action shows what I would describe as consolidation of recent moves. Looking across the board, the dollar has had a strong week against most currencies. The two exceptions have been the yen, which has rallied 1.25% on increased market fears, and the euro, which surprisingly has rallied about 1.0% this week. But otherwise, the dollar has been ascendant vs. virtually everything else. As long as economic uncertainty remains the driving force in markets, and that seems like a pretty good bet, the dollar should continue to perform well.
On the data front, the only thing to be released is Initial Claims (exp 215K) and there are no Fed speakers on the calendar. That implies that the FX market will take its cues from elsewhere, with equities the leading candidate. In the current framework, stronger equities means less risk and less reason to hold dollars, so given Europe’s modest rebound and US futures pointing higher, that seems like a reasonable expectation for today, a modestly softer buck.