Challenging Week Ahead
• The spread of the Delta mutation, which is thought to be more contagious than chickenpox, is spurring the re-introduction of mild social restrictions in several countries, while Sydney’s lockdown has been extended to almost the and of August. With a record number of cases, Japan’s state of emergency has been extended as well. Several US states are also experiencing a sharp rise in the contagion. The vaccines still appear effective in preventing severe cases.
• Beijing’s domestic offensive to rein in domestic businesses may have a significant cooling-off effect on the integration of China into the capital markets, and has given US regulators a new opening to pressure Chinese companies that want to be listed on American exchanges to be more transparent.
• The high-frequency data highlight of the week is the US jobs report. Once again, there is talk of a million positions that were filled last month. A strong employment report will keep the window open for another hint of tapering at the Fed’s Jackson Hole symposium at the end of August.
• The Bank of England is expected to standpat, although there is the risk of a dissent. The pathogen and the social restrictions in Australia are threatening the economic recovery and the Reserve Bank of Australia may increase its support by boosting its bond purchases.
• The Czech central bank is expected to continue its monetary adjustment by delivering the second 25 bp hike in the cycle, which began in June. Brazil’s central bank hiked the Selic rate three times this year by 75 bp each time and it may step up next week with a 100 bp move.
Three macro considerations are shaping the investment climate: the evolution of the virus and the response, the timeframe of the Fed’s tapering, and China’s broad regulatory crackdown.
Beijing’s new policy initiatives are broader and quicker than generally anticipated. Officials seem to be opening up several different fronts, including anti-trust, data protection, discouraging foreign capital raising, and private education reform. The common element is reining in what officials may see as excesses. It dovetails with other efforts seeking to strengthen the Communist Party’s command and control functions.
Beijing seemed unaware or uninterested in the broader implications. The inclusion of the yuan into the IMF’s Special Drawing Rights (SDR) and Chinese stocks and bonds into global benchmarks represents a new integration phase. Recent estimates suggest foreign investors have doubled since 2015 to around $550 bln and around the same amount of Chinese bonds. However, foreign investors have been adversely impacted by the sharp drop in Chinese and Hong Kong equities, and, given the driver, may have a cooling effect on future allocations. It wasn’t until the sell-off in Chinese stocks accelerated to new lows for the year, interest rates jumped, and the yuan sold to new three-month lows that Beijing moved to stabilize the markets.
China is doing what some of its critics were struggling to accomplish, namely, discourage further integration of China into the global capital markets. A year ago, the Trump administration prohibited federal pension fund investment in China. Ahead of the weekend, the SEC announced it would freeze the application process for Chinese IPOs and the sale of other securities on concerns about the risk disclosure. In addition, Chinese companies face being delisted from US exchanges if they continue to refuse to share audits with regulators.
There has been a pushback against claims of decoupling by focusing on the trade of goods and services. But trade is a small part of the integration and is stickier than capital flows. Moreover, trade can be a shallow kind of integration. Direct investment, listing on exchanges, patent registrations, incorporation of industry standards seem to be a deeper commitment.
If there are more sustained outflows from China, the natural question is where they may go. However, in the first instance, it seemed to weigh on global equities. Interest rates fell, and curves tended to flatten, which is also consistent with delayed or weaker recoveries, making price pressures less likely to be sustained.
In the foreign exchange market, the spread of the Delta variant and Chinese developments weighed on those currencies that are perceived to be levered to world growth, with relatively high volatility, and frequently seen as an expression of risk appetites: the dollar-bloc and Scandis, and all but Sweden were seen to be ahead of the Federal Reserve in adjusting monetary policy. As a result, they have underperformed over the past few weeks. At the same time, the strongest two currencies, the yen and Swiss franc tend to be used as funding currencies to purchase higher returning or more volatile assets. As the risk assets are liquidated, the funding currency is typically bought back. However, as July drew to a close, the funding currencies are lagging behind the dollar bloc and Scandis.
The high-frequency data highlight of the week ahead is the US employment report. Once again, some economists are forecasting an increase of more than a million jobs in July. After the nearly 20.7 mln loss of employment in April 2020, the US did add more than a million jobs in May-August last year. June’s 850k estimate is the largest so far this year. The median forecast in Bloomberg’s survey anticipates July’s nonfarm payrolls rising by about 900k, which has drifted a little lower in recent data. Job growth, largely people returning to their jobs, averaged 567k in Q2 after 518k in Q1.
The unemployment rate is projected to fall to 5.7% from 5.9%. At the end of 2019, the average unemployment rate for the past decade (120 months) was 6.2% and 5.9% for 20-years (240 months). The underemployment rate (U-6) has fallen from nearly 23% in April 2020 to 9.8% in June. Not to include the impact of the pandemic and recovery, we looked at the same long-term averages as of the end of 2019, and they stood at 11.7% and 10.7%, respectively.
A robust employment report would mean the earliest window for the Fed to signal its intention on the pace and composition of its bond-buying would be the Jackson Hole conference at the end of August. By the time the Fed meets in September, there will be another employment report, and there may be more clarity about the impact of the growing virus. Fed Chair Powell has pledged an advanced warning to the market about its decision about tapering.
The hawk camp wants to taper, and some want to focus on the MBS purchases, and the sooner, the better. The dove camp is in no hurry and seems somewhat less convinced that those purchases drive up house prices, which have continued to soar at a record pace according to the S&P CoreLogic Case-Shiller 20-city 17% year-over-year in May. The FHFA house price index has risen by more than 1% a month since June 2020. It is more than twice the pace that it had averaged in 2016-2019.
In practical terms, the hawks seem to prefer tapering later this year, which if this window is going to remain open, some clearer guidance needs to be provided soon (September). The doves may be more inclined to start the actual tapering next year, clear of the debt ceiling issue, and have a better understanding of the sustainability of price pressures and after income support programs expire. Tactically, with note and bond yields at several month lows, and record-low real rates, some officials see these conditions as ideal to announce its intention to taper in the coming months. The market has provided a cushion for an exaggerated reaction that cannot be ruled out.
For long-term investors and corporate Treasurers, it might not be a big difference between tapering late 2021 or early 2022. However, many will extrapolate from slowly taking a foot off the accelerator to tapping on the brake. The December 2022 Eurodollar futures contract implies a three-month yield in 16 months of about 40 bp. The current three-month rate is about 13 bp. That implies a 25 bp hike is anticipated. Recall that a significant minority of Fed officials (7/18) anticipated in June that a hike by the end of next year would be appropriate.
Other central banks meet next week. The Reserve Bank of Australia (August 3) meets with rising cases in Sydney, despite the lockdown and the economic fallout being picked up in some recent data, including June’s preliminary retail sales (-1.8% month-over-month, more than twice the decline expected) and a flash composite PMI crashed to 45.2 from 56.7. It looks likely to provide more support through stepped-up bond buying. The RBA is currently buying A$5 bln a week and may increase by A$1-2 bln.
The Bank of England also meets (August 5). Rising inflation and an economy clearly on the mend have seen a few MPC officials turn more hawkish. The risk of a dissent in favor of a reduction in bond purchases may have increased, but until the furlough program concludes at the end of September, the health of the labor market is not clear. Nevertheless, the market appears to be pricing in a hike in the second half of next year. Early signs that the wave of infections may be slowing may have lent support to sterling. Meanwhile, the 10-year Gilt yield hovers around the 200-day moving average (0.55%) after peaking slightly above 0.92% in mid-May.
Four central banks from emerging markets meet next week. Thailand is the least likely to alter policy. India is unlikely to change rates but will announce its August bond purchases. The RBI may have to recognize and tolerate slightly higher inflation. The Czech central bank began a tightening cycle in June and most likely follow-up with another 25 bp rate at the August 5 meeting. Another 50 bp of increases appears to be discounted before the end of the year. Brazil’s central bank has hiked the Selic rate by 225 bp this year (to 4.25%) with three 75 bp rate hikes. Inflation is still accelerating (the IPCA measure stood at 8.35% year-over-year, a five-year high. With the economy seemingly on the course for a strong recovery and the currency off around 2.4% in July, the central bank may be emboldened to deliver a 100 bp hike.
Bannockburn Global Forex