Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Euro rallies on Italy's budget hopes
John J. Hardy
Chief Macro Strategist
Summary: The steepest equity rally in years in China has seen muted positive contagion around the world, at least in part as the CNY remains locked in a tight range near a perceived floor. Elsewhere, a brightening mood on Italy’s budget has boosted the euro again despite Moody’s downgrade of Italian debt on Friday. The week sees a blitz of central bank decisions.
China moved over the weekend to reassure the domestic market, as Xi Jinping offered “unwavering” rhetorical support for the private sector and the presentation of a draft of proposed tax deductions for private individuals for costs including interest on mortgages, education and health care. While Chinese equities surged strongly on the news – the largest rally in years – there was no transmission into the CNY, which remains glued to the floor in both basket and USDCNY terms. That floor is a key reason behind extremely low realised FX volatility, in our view.
Italy’s BTP yields dropped further after late Friday developments. Most importantly, the euro surged on the change of tone from the key EU Commission figure Pierre Moscovici, who expressed a desire to reduce tension with Italy. This change of tone is short on specifics, but the shift was seized on as a critical development showing that the EU has finally “blinked”.
One might argue that it is in the EU’s interest to avoid a populist surge at the EU parliamentary elections next May and wait until next year to take up the budget and deficit issue again if and when the Italian government’s deficit maths prove to have been overoptimistic. Regardless, the hopeful surge looks a bit tenuous until we see further progress, and the Italian side still says that it expects the EU to take the unprecedented step of rejecting Italy’s budget on Tuesday. Finally on the issue, Italy’s sovereign debt was downgraded to one step above junk by Moody’s very late Friday, though the headline is not necessarily a negative catalyst given that many feared a deeper ratings cut.
This week’s economic calendar is populated with a rash of central bank meetings. Tomorrow’s Riksbank looks pivotal for SEK due to the technical situation for EURSEK (more below) and the Riksbank’s latest guidance, though existential EU headline risks are also an important driver for the pair. Elsewhere, the Bank of Canada decision looks important as governor Poloz and company are expected to hike rates again. Two big EM central bank meetings this week are Turkey on Thursday and Russia on Friday. In Turkey, the central bank there will need to gauge whether sentiment and confidence have improved enough to signal an eventual move to cut rates. Too early to expect anything this week.
The two things we focus on most these days for next steps are the USDCNY rate and which side of the 200-day moving average the US S&P 500 Index is trading on. That index closed precisely on that level once again on Friday.
Chart: EURCHF
EURCHF poised near the pivotal 1.1500 level on hopes that we are about to see a significant thaw in the showdown over Italy’s proposed budget. To engineer a solid surge and close above this pivotal level, we may need further concrete signs that Italy and the EU can agree on budget terms.
The G-10 rundown
USD – the US dollar is easing lower to kick off trading this week on the EUR surge linked to Italy. We’ll have a hard time getting a bearing on the US dollar until we have a better sense of what China wants to do with the renminbi.
EUR – the rally came just in time to avoid a local break lower in EURUSD on Friday, but we’ll need to see a further improvement in Italian yield spreads and more concrete evidence that this round of budget negotiations will reach an amicable conclusion for a more convincing lift-off. As well, watching the October flash PMIs this Wednesday as the persistence of the declines in recent months is a concern. Not seeing the European Central Bank meeting this Thursday as a major catalyst.
JPY – with China rallying and the EU looking up this morning, global bond yields are rising and this all points to a weak JPY, with EURJPY back above 130.00 suddenly after last week’s poke well below a tactically pivotal 129.00 level last week.
GBP – sterling is not thriving as Brexit uncertainty weighs again and the general feeling is that the two sides will take negotiations to the wire, with the special “Brexit summit” in Mid-November now feeling uncomfortably close. Technical test already here in EURGBP as it pokes at the 200-day moving average again from below (currently 0.8825).
CHF – EU existential risks the critical focus, as made obvious by the EURCHF surge on Friday linked to a rally in Italy’s BTP’s. 1.1500 is the key level there as we discuss above.
AUD – surprising lack of positive contagion into the AUD from the rally in Chinese equities today – perhaps as the USDCNY is keeping the USD somewhat anchored.
CAD – A technical break above tactically important 1.3050 area last week, but the market will want a look at the Bank of Canada decision this week and the forward guidance that comes with the likely 25-basis point rate hike. USDCAD vulnerable to the upside on rate spreads at present.
NZD – the kiwi rallying after last week’s strong Q3 CPI print and as AUDNZD has poked more firmly below the 1.0850 area. On a valuation basis, we see little reason for a large extension of the move lower unless the RBNZ’s Orr changes his tune (far too early for this). AUDNZD yield spreads at the front end of the yield curve still pegged near the highs for the cycle as well.
SEK – EURSEK not far from the key pivot lower just below 10.29 ahead of the Riksbank decision on Wednesday, which may need to confirm the market’s impression that we are set for a December rate hike to progress lower. Reasonably stable risk appetite and avoidance of fresh EU existential pain are additional likely prerequisites for a solid move lower in EURSEK.
NOK – Norges Bank this week may not bring much after the drop in oil prices supports their more cautious stance the last time around. Still potential for NOK upside on valuation if the general mood is not too negative.
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