Capital Ideas: The midterms, the Fed, Brexit, and the Sino-US trade war

Where are we?

US exceptionalism on the trade war front has met with ugly reality since the beginning of October as the quarterly earnings of US corporations started showing the impact of trade tariffs and rising labour costs on profit margins. Last fortnight, despite a brief equity rally on post-US midterms relief, US stocks remained unable to sustain rallies on a confluence of rising rates, a tightening labour market, trade tariffs, and peaking tax stimulus impact.

While the outlook on Chinese assets remains hazy in the wake of the unknown Sino-US trade path, there are some early signs of consolidation in Chinese markets thanks to coordinated efforts from different arms of the government. There is a tax stimulus on the horizon, credit taps are open with an earlier RRR cut likely to be followed by a lowering of the policy rate at some stage, and we still see a relative lack of intervention in persistent CNY weakness. Can we call a bottom on Chinese indices already? Perhaps not, but that we are closer to bottom is a compelling idea.

The USD index is correcting from a high of 97.70 to a low 96 handle on optimism for the Trump-Xi meeting at the G20 summit and Federal Reserve officials walking back some surprisingly hawkish comments from Chair Powell last month and thus paring the Fed futures rate for late 2019. EUR dipped to a low of 1.1216 on slowdown fears and Italy budget risks but has since been propped up by the softer USD. Sterling gave up all its accumulated optimism as the cabinet approval of the Brexit draft proved irrelevant in the face of a Tory split leading to key resignations. USDJPY continues to be caught between volatile risk appetite and dipping USD. Commodity currencies are relatively firmer on hopes of a US-China truce and China’s measures to prop up domestic demand. USDCNH remains firm but the big threat of the 7 handle is on pause until the G20. Emerging currencies enjoyed a mini recovery on the back of softer USD, lower yields and the fall in crude oil.

Bond yields in developed economies have seen a pullback as markets reprice the odds of central banks continuing to tighten as fear of a global slowdown over the course of 2019 gain traction. The US 10-year yield has fallen from 3.20 to around 3 as Fed officials moderate some earlier hawkish hints. UK yields continue to dance to the tune of Brexit negotiations and the recent setback has seen the yields plunge from 1.71 to 1.36. With crude falling and early signs of a German economic slowdown from the recent PMI print, the German 10-year yield has fallen from above 0.50% to below 0.35%.

Last fortnight also saw some action-packed price moves in crude oil and natural gas. Crude collapsed more than 7% on the day Opec’s research arm released gloomy demand projections for 2019. Natural gas has lit up this week, bouncing more than 21% in the last five trading days on a combination of low inventory and a spike in demand. Spare a thought for the hedge fund pair-trading long oil and short natural gas!

Possible implications of the divided US Congress

• There could be greater noise around a potential Trump impeachment, but practically the odds are rather low
• Some analysts are talking up the possibility of Trump going hard on China to please his voter base, but that is a stretch too far as Trump hasn’t really turned around on China decisively yet; the baseline scenario is still anchored to further escalation in the trade tussle.
• For a president who measures his success on the stock market returns, the trade tiff with China is his last big trump card left to prop up markets as Fed put is unlikely to show up for at least three more quarters – so an eventual truce remains the likely Nash equilibrium in the trade war.
• Democrats in the House will likely add to the legislative gridlock and keep regulatory pressure on banks which could unwind some of the optimism in the sector
• Another round of tax cuts is unlikely (odds were low even with Republicans controlling the House and Senate), but a boost to infrastructure spending is likely, which also means the possibility of a government shutdown
• In short, the midterm results matter in myriad little ways to US markets in particular, but considering the macro factors of monetary tightening, US-China trade war, Brexit, Italy, China pledged shares, and leveraged EM countries, the results are unlikely to influence the markets much once the initial noise dissipates

US-China: who has the correct song sheet?

Seemingly out of nowhere, President Trump opened the possibility of a US-China trade deal at the beginning of the month just when the market was getting prepared for a prolonged tussle between the two… and the market duly hopped on the risk-on train. What prompted his turnaround is anyone’s guess – market correction or the midterm election?

At the same time, the rest of Trump’s administration is pointing towards escalation with VP Mike Pence particularly offering stern comments at the recent APEC summit on China’s loans to vulnerable economies and its ‘Belt and Road’ initiative. US commerce secretary Wilbur Ross reiterated the week before that the US plans to raise tariffs on China by January and downplayed the significance of Trump-Xi meeting at the upcoming G20 – this is likely to be a discussion on the framework of engagement than specific actions. Kudlow has been trying to downplay the G20 meeting ever since it was announced, but Trump continues to sell the idea of an eventual trade deal with China.

If the history of Mnuchin negotiating a Chinese import deal earlier this year only to be being rebuffed by Trump is anything to go by, the market should not bet against the man whose voice weighs most heavily in the eventual decision.

Brexit plot twist

The circular game of optimism/reality check/grandstanding that has been going on for the last three months on Brexit has had an ugly few weeks; the nadir was perhaps Brexit Secretary Dominic Raab’s departure on moral grounds one day after the deal was announced.

The resignations of Raab and McVey (and by the looks of it, more to follow) have clearly disrupted the residual odds of a November EU summit as the odds of eventual parliamentary approval for the negotiated deal fell from unfavourable to insignificant, sterling drowned, and the market’s pricing of a Bank of England rate hike in 2019 fell to pieces.

What are the range of possibilities from here?

• Theresa May could lose her leadership, paving the way for another election
• Theresa May can hold on to her post during the chaos and eventually manage to get a negotiated deal up for Parliamentary approval early next year
• A disorderly Brexit if Parliament votes against it
• Even if Parliament votes in favour of the deal, given some of the current deal terms the contentious issues of an Irish border backstop is merely being pushed down the road to 2020 and that could still come back to haunt the markets in case we see no further progress.
• There is also a not-so-negligible probability of another referendum (betting market odds at 40% now) if May loses power leading to an election

EM recovery

After being pounded by the double whammy of rising crude and spiking Treasury yields for nearly a month in September and early October, the stars appear to be realigning a wee bit for emerging economies with Treasury yields tapering off, US CPI softer, and crude lower since. These currencies were also helped to a good extent by some signs of a possible US-China trade dialogue from Trump.

USDINR fell from a high of 74.48 to below 71.50; USDIDR also followed suit with a dip to the 14,500 base from the high of 15,284; USDBRL on the contrary went nowhere and if anything inched up higher as the Bolsanaro rally on BRL ran out of stream; TRY had seen the most remarkable reversal as the central bank grew a spine and hiked rates substantially to tame spiralling inflation. The country’s current account saw a decisive turnaround from deficit to surplus on the back of the weaker currency, and the toning down of verbal volleys with Trump helped too – USDTRY, which traded above the 7 handle in the peak of the crisis in August, is back below the key support level of 5.50.

But now with crude having corrected deep enough for OPEC to consider production cuts, USD’s status as the reserve currency bolstered by CNY on the loose, EUR and sterling combating substantial domestic concerns, and US-China dynamics still suspect despite some signs of turnaround from Trump, it is prudent to exit the emerging recovery theme.

The Fed’s see-saw communication

Fed chair Jerome Powell’s surprising comments in early October on the central bank’s willingness to go beyond the neutral rate triggered some sharp moves in the Fed funds futures market and consequently in USD. Powell, unlike some of his predecessors, didn’t backtrack on the comment for more than a month. When he did speak for the first time, he was cautious enough to not repeat the initial comment, but he didn’t explicitly walk it back either. But what we have seen as a pattern in the last few days is that other Fed members are attempting to soften the impact of the “well past neutral” phrasing. We need to read Kashkari with a bucket of salt for he is a perma-dove – let’s leave him aside. The curious twists came from Bostic (who was tilting from dovish to hawkish in the recent months) and Clarida (who was echoing Powell since joining the Board) as they both indicated that Fed is closer to the neutral rate and that they would like to stay around the neutral rate.

While this episode hasn’t led to dramatic price jumps or breakdowns, it highlights the risk of making all eight Fed meetings live with press conferences next year given a Fed chair unafraid to speak his mind.

The dollar has retraced back in line with the fall in implied yields in the Fed futures market for Dec 2019 (down from 2.91 two weeks ago to 2.75 now) in the last two weeks just as it did with their rise.

The correction in Fed funds futures is par as Fed officials tried to downplay Powell’s rate comment, but USD is still driven much more by the US-China powerplay than by Fed trajectory dynamics.