Macro: Sandcastle economics
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Summary: Equity markets tried to rally again, even as tensions mounted on US House Speaker Nancy Pelosi’s visit to Taiwan yesterday and the announcement of strong measures from China against Taiwan, with more likely to come in the hours and days ahead. But risk sentiment rolled over by later in the day, chiefly due to a huge sell-off in US Treasuries all along the curve as a number of Fed speakers clear disagree with the market’s assessment of Fed guidance. This took the JPY back down several notches after its recent sharp rally and tamed the gold rally as well.
USDJPY lurched from lows below 131.00 to well above 133.00 yesterday on the tremendous reversal in US treasury yields on the day, a reversal seen, if with lower beta, in other JPY crosses. The hunky move that reminds traders of the extreme sensitivity of the JPY to US treasury yields, with a sustainable JPY rally either requiring that global bond yields push back to new lows for the cycle – now a dimmer prospect – or that the BoJ changes its policy mix away from capping yields out to 10 years, something Governor Kuroda has shown no signs of doing.
The recovery in US yields on Tuesday meant that Gold turned back lower from the $1780 resistance it had been toying with. The yellow metal was seen reversing back down to sub-1760 levels overnight after the USD was boosted by the Fed speakers guiding for a steady path of interest rate increases to come. Gold also likely gave back the gains it had been accumulating ahead of Pelosi’s visit to Taiwan and the upsurge in geopolitical tensions due to that, but there is further room for geopolitical rivalry as China announced military drills and missile tests, suggesting we can still have more bouts of gold strength. The 1780-1800 area will remain key to watch.
With the demand destruction fears somewhat at ease, the focus is shifting back on supply constraints in commodities. OPEC and its allies meet today to decide on the group’s output levels for September. With the group having under-impressed on the production roadmap for now, any increases in targets may remain underwhelming. A decision not to raise production would also disappoint, especially after President Joe Biden visited Saudi Arabia this month hoping to strike a deal on oil production.
Besides Mester’s comments noted above, Chicago Fed President Charles Evans (voter next year) said a 50bps rate hike is a reasonable assessment for the September meeting, and 75bps is a possibility too if inflation does not improve. He expects 25bps from there on until Q2 2023 and said that 3.75%-4.00% would be a “sufficiently high level” for rates by end 2023. St. Louis Fed president and 2022 voter James Bullard echoed these specific levels for the rate next year and said that “a recession is not going to happen”. The Fed’s median forecast for the Fed Funds rate by the end of 2023 is 3.8%, well above the 2.9% that the market is currently pricing in. Mary Daly (2024 voter) of the San Francisco Fed stated that work on inflation is nowhere near almost done.
China has already reacted strongly to Pelosi’s visit: launching live military drills in areas all around the island, and some very close to land, banning imports of citrus fruits and the exports of sand to the island. China is Taiwan’s largest trading partner, with a bilateral trade relationship worth more than $300 billion annually. Other measures could escalate after Pelosi’s departure and could include measures directed at the US as well as “gray-zone” tactics that raise the risk of intensifying confrontation. It remains to be seen how transportation and supply chain from and to Taiwan will be affected. Logistics may not be affected much as wide gaps open outside the drill areas in the sea and airspaces, but risks are real for some disruptions. China’s rhetoric so far has been carefully worded to focus on House speaker Pelosi and less reference to criticizing the US global strategy or the Biden administration. How the situation will develop is still fluid as of writing. It is however almost for sure that there will be more frictions between the U.S. and China on many fronts. Both sides will be testing the reaction functions of each other and fine-tune their grand scheme of strategies accordingly. Chinese equities are likely to be volatile in the weeks to come.
After the decline in US ISM manufacturing index earlier in the week, the focus is now on the services index set for release today, arguably far more important as 70% of the US economy is in services. The market may be leaning for a downside surprise to Bloomberg consensus expectations of 53.5 (vs. 55.3 in June) as the flash S&P Global Services PMI plunged to 47.0, suggesting a services sector in outright contraction. A reading below 50 might administer a strong shock to markets – challenging yesterday’s jump in US Treasury yields and sharp fall in the Japanese yen.
1) US Fed speakers have affirmed that more rate hikes are coming. The RBA also affirmed it too will continue to raise rates over the coming months. 2) Job cuts have been observed across countries and global companies. From New Zealand’s jobless rate unexpectedly rising today, to a trading company, Robinhood, overnight announcing cut its workforce by 23%. These new themes are likely to for the rest of 2022. Australia’s RBA thinks unemployment will rise from 3.5% to 4%. 3) US-China tensions are increasing after the US house speaker visited Taiwan when China asked her not to, and this could be a positive for defence stocks going forward. The USD will also likely gain traction as the safe-haven currency.
Today’s key focus in Europe is German earnings and Societe Generale in France as the continent is facing significant macro headwinds. In the US, earnings from Booking comes with downside risks due to Airbnb’s disappointing outlook yesterday and Fortinet is important for the cyber security theme.
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