Feeling the Heat

As tensions continue to flare
Twixt China and Uncle Sam’s heir
The positive feelings
In equity dealings
Could easily turn to a bear

Meanwhile down on Threadneedle Street
The Old Lady’s fairly downbeat
Thus negative rates
Are now on their plates
With bank stocks there feeling the heat

A yoyo may be the best metaphor for market price action thus far in May as we have seen a nearly equal number of up and down days with the pattern nearly perfect of gains followed by losses and vice versa. Today is no different as equity markets are on their back foot, after yesterday’s gains, in response to increasing tensions between Presidents Trump and Xi. Realistically, this is all political, and largely for each President’s domestic audience, but it has taken the form of a blame game, with each nation blaming the other for the instance and severity of the Covid-19 outbreak. What is a bit different this time is that President Trump, who had been quick to condemn China in the past, had also been scrupulous in maintaining that he and President Xi had an excellent working relationship. However, last night’s Twitter tirade included direct attacks on Mr Xi, a new tactic and one over which markets have now shown concern.

Thus, equity markets around the world are lower this morning with modest losses seen in Asia (Nikkei -0.2%, Hang Seng and Shanghai -0.5%) and slightly larger losses throughout the Continent (DAX -1.6%, CAC -1.1%, FTSE 100 -1.0%). US futures are pointing in the same direction with all three indices currently down about 0.7%. Has anything really changed? Arguably not. After all, both broad economic data and corporate earnings numbers remain awful, yet equity market prices, despite today’s dour mood, remain within sight of all-time highs. And of course, the bond market continues to point to a very different future as 10-year Treasury yields (-1bp today) continue to trade near historically low levels. To reiterate, the conundrum between a bond market that is implying extremely slow economic activity for the next decade, with no concomitant inflation seems an odd companion to an equity market where the median P/E ratio has once again moved above 20, well above its long-term average. This dichotomy continues to be a key topic of conversation in the market, and one which history has shown cannot last forever. The trillion-dollar question is, which market adjusts most?

With the increasing dissent between the US and China as a background, we also learned of the specter of the next country to move toward a negative interest rate stance, the UK. When Mark Carney was governor there, he categorically ruled out negative interest rates as an effective tool to help support the economy. He got to closely observe the experiment throughout Europe and concluded the detriments to the banking community outweighed any potential economic positives. (This is something that is gaining more credence within the Eurozone as well although the ECB continues to insist NIRP has been good for the Eurozone.) However, Carney is no longer governor, Andrew Bailey now holds the chair. And he has just informed Parliament, “I have changed my position a bit,” on the subject, and is now willing to consider negative rates after all. This is in concert with other members of the MPC, which implies that NIRP is likely soon to be reality in the UK. It should be no surprise that UK banking stocks are suffering after these comments as banks are the second victims of the process. (Individual savers are the first victims as their savings no longer offer any income, and in extreme cases decline.)

The other natural victim of NIRP is the currency. As discussed earlier this week, there is a pretty solid correlation between negative real rates and a currency’s relative value. Now granted, if real rates are negative everywhere, then we are simply back to the relative amount of negativity that exists, but regardless, this potential policy shift is clearly new, and one would expect the pound to suffer accordingly. Surprisingly, it is little changed this morning, down less than 0.1% amid a modest trading range overnight. However, it certainly raises the question of the future path of the pound.

When the Eurozone first mooted negative interest rates, in 2014, the dollar was already in the midst of a strong rally based on the view that the Fed was getting set to start to raise interest rates at that time. Thus, separating the impact of NIRP from that of expected higher US rates on the EUR/USD exchange rate is no easy task. However, there is no question that the euro’s value has suffered from NIRP as there is limited incentive for fixed income investment by foreigners. It should therefore be expected that the pound will be weaker going forward as foreign investment interest will diminish in the UK. Whether negative rates will help encourage foreign direct investment is another story entirely, and one which we will not understand fully for many years to come. With all this in mind, though, the damage to the pound is not likely to be too great. After all, given the fact that negative real rates are widespread, and already the situation in the UK, a base-rate cut from 0.1% to -0.1% doesn’t seem like that big a deal overall. We shall see how the market behaves.

As to the session today, FX markets have been as quiet as we have seen in several months. In the G10 space, Aussie and Kiwi are the underperformers, but both are lower by a mere 0.35%, quite a small move relative to recent activity, and simply a modest unwind of yesterday’s much more powerful rally in both. But away from those two, the rest of the bloc is less than 0.2% different from the close with both gainers (EUR, DKK) and losers (GBP, JPY) equidistant from those levels.

On the EMG side, there is a bit more constructive performance with oil’s continued rally (+2%) helping RUB (+0.4%) while the CE4 are also modestly firmer simply following the euro higher. APAC currencies seem a bit worse for wear after the Twitter spat between Trump and China, but the losses are miniscule.

Data this morning showed the preliminary PMI data from Europe is still dire, but not quite as bad as last month’s showing. In the US today we see Initial Claims (exp 2.4M), Continuing Claims (24.25M) and Existing Home Sales (4.22M). But as I have been writing all month, at this point data is assumed to be dreadful and only policy decisions seem to have an impact on the market. Yesterday we saw the Minutes of the Fed’s April 29 meeting, where there was a great deal of discussion about the economy’s problems and how they can continue to support it. Ideas floated were firmer forward guidance, attaching rate moves to numeric economic targets, and yield curve control, where the Fed determines to keep the interest rate on a particular tenor of Treasury bonds at a specific level. Both Japan and Australia are currently executing this, and the Fed has done so in its history, keeping long-term yields at 2.50% during WWII. My money is on the 10-year being pegged at 0.25% for as long as necessary. But that is a discussion for another day. For today, the dollar seems more likely to rebound a bit rather than decline, but that, too, is one man’s view.

Good luck and stay safe
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