Where are we?
The US-China trade war has halted for the time being as a period of a ceasefire kicks in following the G20 meeting last weekend. The two superpowers agreed on a 90-day truce for further dialogue on critical matters concerning intellectual property and theft during which time there won’t be any tariff escalation – although the prevailing tariffs stay in place. China has agreed to boost purchases of farm and industrial goods as well. President Xi also indicated that a new attempt by Qualcomm to buy NXP would find a more receptive Chinese response. Although subsequent reports question the veracity of some of these claims, at least things are moving forward, if only in baby steps.
Fed chair Jerome Powell backtracked from his hawkish comments in early October where he made a case that Fed rates are well below the neutral rate. The backtracking was initially started by his fellow Fed officials, but the decisive move came from the man himself when he mentioned during a speech which otherwise painted a rosy picture of US economy that “that Fed rates are closer to normal”.
If the fear of further escalation in US-China trade war and the monetary tightening from the Fed marching along to a point of pain were holding the markets on the back foot for the past fortnight with even the iconic FAANG stocks entering the bear territory, the latest trade war and Fed developments have brought some optimism back to equities. The SPX is up 7.50% from its October low and the NASDAQ is up more than 9.50% from its November low.
Chinese equities are enjoying a relief rally after being pressured pretty much all year by government attempts to invigorate the economy as well as the ever-escalating trade tensions with US. The SHCOMP and CSI 300 are up nearly 9% from their October lows.
The USD index shot up to 97.50 in the lead-up to the G20 summit but has since steadily slid lower to 96.50 and looking set for a deeper pullback. EUR is caught between broad-based signs of economic slowdown, hopes of Italy falling in line with the EU on budget and US-China truce. Sterling is volatile and facing serious downside pressure as the Brexit saga reaches its climactic stages – but two-way risk remains wide open. USDJPY remains rangebound, caught between rising risk appetite and a falling USD. Commodity currencies have rallied across the board on trade truce optimism. Emerging currencies extend their impressive recovery further across the board as the Fed tilts dovish and Trump leaves the door open for a possible trade deal with China.
As the Fed bias turned towards dovish the first signs of yield curve inversion emerged among US treasuries this week with 3-year and 5-year yield spread turning negative first, followed by 2-year and 5-year spread. The big indicator remains 10-year vs 2-year and that is converging in tandem too at 15 basis points. The US 10-year is back below the big 3% mark and the 30-year is at 3.25%. German yields and those in the rest of the Eurozone continue to head lower as the signs of an economic slowdown are getting more pronounced.
Italian yields have seen the sharpest slide in the past fortnight as more signs emerge that Italy may agree to the EU’s budget deficit targets. UK 10Y-year yields are back lower, filling the post August rate hike gap up as the baseline Brexit scenario remains a no-deal exit. Japanese yields’ spike to test the Bank of Japan’s widened tolerance band is history as the Q3 GDP contraction paints a gloomy outlook for the economy.
Crude oil has recovered 10% since the low of November 29 but only after it found new bottoms through the early part of the fortnight. It has now finally shown signs of bottoming out as the trade war risk seems to be receding and also because the Saudis and the Russians met on the sidelines of the G20 meeting and discussed the idea of cutting output to support the falling price. Coffee’s wait for a rebound continues. Gold and silver are surprisingly firmer post the G20 summit but largely within their recent ranges.
Is the truce a game-changer?
Yes and no. Yes, only to the extent that Trump is following his now familiar model of adopting an extremely militant stance, followed by some signs of turnaround on the pretext of renegotiation, and eventually we get a rebranded version of status quo plus. But beyond establishing that pattern, the answer is a clear no for these are small and largely predictable steps which were inevitable once US exceptionalism proved to be a bunkum theory and US equities joined the correction wave.
To begin with, 90 days appears to be too short a time frame for an issue of the magnitude of intellectual property to be resolved when the parties are starting at the absolute extreme ends of the spectrum. Factor in Christmas, New Year and Chinese New Year in that window and we are talking of an effectively even shorter window for negotiations. It’ll eventually come down to the odds of a trade deal despite the ongoing IP frictions rather than because of a clinching resolution through negotiation.
China will take the all the easy steps forward, but it is unlikely that they will surrender their vision of becoming a tech superpower to the tariff blackmails. So essentially it boils down to how much is the US willing to walk forward for a potential trade deal. The answer to that may rest on Trump’s vulnerability to political developments and to a large extent where the SPX trades around the close of the 90-day window, given that the global slowdown is gaining traction and the US cyclical slowdown is an ugly reality facing the still healthy economy down the road.
My baseline scenario remains in favor of an eventual trade deal, but it’ll be quite a volatile trajectory to get to that end point.
Powell tweak or Powell put?
With the immediate reactions in equities and currencies to Powell’s backtracking from his October comment that policy rates are well below neutral rates to just below neutral rates last week, it is tempting to believe that the Fed has finally accepted the reality of the harm its policy normalisation is doing/likely to do to asset prices. But it is a generous reading fraught with extreme risks.
The difference between his comment in October and the recent backtracking is likely to be a case of one rate hike lesser. While the dot plot projects three hikes for 2019, the market had never bought into it. For instance, the Fed futures implied yield for the end of 2019 was 2.89% after Powell’s comment in October and it has steadily slipped to 2.70%. So effectively, the market has come down considerably on its pricing of the second hike in 2019 and frankly, it is not dramatic.
On the point of neutral rates itself – Powell has used every occasion possible to highlight his rather sceptical views on the idea of a definitive neutral rate. Someone like Raphael Bostic has hinted at a range of 2.50% to 3.50%. With Fed funds rate at 2.25% it is possible to make a case for both – being near the neutral rate and well below the neutral rate simultaneously without sounding contradictory or idiotic. Sure, yesterday’s comment from Powell is a dovish tilt (though the speech largely painted a relatively rosy picture of the economy), but it should be seen as part of the tightrope of Fed communication rather than an open admission of panic.
I am inclined to believe that the latest tweak from Powell is a correction of his earlier mistake of coming across as too hawkish in October. Will it lead to a substantial shift in Fed policy guidance in December? To the extent that a rate hike less in dot plots means substantial, it is. Is this the Fed put that the market has been talking up all along? No. I am still backing a case for two more hikes in 2019 after the December one. Although the rate move from there is a tricky call and that is when the Fed put could become a reality.
Brexit saga enters the project fear phase
The UK Treasury’s report on the impact of Brexit came out on the firmer side of earlier leaks with a projection of 10.7% plunge in GDP over 15 years in the case of a disorderly departure. As if that wasn’t alarming enough, the Bank of England came out with even direr projections (or as Carney called it, not forecasts, but worst-case scenario projections for policy preparation) – of more than 8% shrinkage of GDP within a year (would be the worst since WWII and more acute than the financial crisis), sterling falling by 25% and real estate prices correcting by a third.
Against the backdrop of those alarm bells, sterling started inching higher initially as the market started repricing the odds of prime minister Theresa May’s bill getting parliamentary approval as the fears of a disorderly Brexit are drummed up for the next 10 days. But at the same time there are widespread credibility questions on the BoE’s projections with even Paul Krugman (who would do whatever it takes to sound the alarm bells on the impact of a disorderly Brexit) wondering if the BoE went too far there. Here is his Twitter outburst.
We are at a point in the Brexit drama where the baseline scenario is a possible disorderly Brexit but if the situation gets any worse, counterintuitively it increases the odds of May’s deal getting approved or even the outside possibility of another referendum. In short, two-way risks on sterling are as alive as ever.
The debate around the parliamentary vote on the draft deal will involve plenty of speeches for five days of eight-hour debates. Final voting is scheduled for December 11 at 7 PM but with the complexity of voting on the deal plus suggested amendments, we may not have a clear idea of where Brexit is headed even after voting ends.