We close out the week on a fairly optimistic tone in equities, with the S&P 500 (closed +0.6%) breaking out of the recent bear channel, and the ASX 200 now trading above 6400 (+0.6% on the day). A 1.3% gain in crude is helping, and we see small buying in S&P 500 futures, likely assisted by a 0.6% rally in the Nikkei 225.
Moves in European equity indices were less convincing, but that was a function of a stronger EUR and the fact that Mario Draghi lacked the dovish feel the market was excepting. It doesn’t surprise that the flow in our German DAX index (GER30 - see below) was mixed, with a few would-be buyers holding off until we see a more convincing feel and a break of the bear channel and through the 16 May high (12,317). We are expecting a test of 12,000 on the re-open.
In FX markets, we’ve seen increased flow in EUR/GBP, which won’t necessarily surprise, with sellers fading the move into 0.89. There has been limited interest to act on the news Labour are set to take the Peterborough by-election, denying the Brexit Party its first seat in the Commons. EURGBP has to be on in the focus list, and a close through the double-top suggests revisiting EURGBP longs.
Yesterday’s bullish candle low of 0.8829 seems key, although it takes a brave soul to be long GBP for any extended period in the face of what I think will be one of the most interesting political periods for markets to navigate. Where next Thursday we see the first round of voting in the Tory leadership battle, which will move through (potentially) five rounds of votes until we see a new leader announced in the week of 22 July.
Boris Johnson is the big favourite here, and it fits with the view that the Tories will have to move closer to the Brexit party and represent the ‘no deal’ camp. While Labour will be heading towards the Lib Dems firm stance of ‘remain/no Brexit’. It really has to come down to a new general election or a second referendum, and positioned somewhere in the centre of this argument is no longer sustainable. If you thought making a longer-term call on GBP was hard before, it is now nigh on impossible, as politics in the UK means little other than remain or leave, and the showdown that seems inevitable in the months ahead.
ECB waiting for Trump to act
European banks will initially be able to borrow capital from the ECB under its LTRO program (Long-term Refinancing Operation - https://www.ecb.europa.eu/mopo/implement/omo/html/index.en.html ) at 10bp (or 0.1%) initially, although this could end up being as low as -0.3% depending how much is extended into the real economy. That’s correct, the banks could get paid to lend, and perhaps they’ll generate a profit from this if there's the underlying demand for credit in Europe. European bank equity failed to get excited on the news though, and we saw the EU bank sector close -1.4% on the day. Traders went into last night’s meeting expecting Draghi to live up to his name as the king of doves and clearly, this failed to materialise, with Draghi offering a certain confidence in the bank’s growth and inflation forecasts. Leading to EURUSD momentarily trading north of 1.13, but price is currently holding the neckline of the April/May double bottom at 1.1265 and that is of interest.
While central bank sees economics in a glass-half-full mindset, what we did hear, and what feels so important right now is the idea that the ECB “stands ready to adjust all of its instruments” to meet its goals. Draghi focused on ‘trade’ as a potential external shock, not just on what plays out between the US and Mexico and China, but the fate of the auto industry is something that could genuinely impact Europe. The tail risk doesn’t stop there though, and we can add Brexit, and Italian politics to that mix.
ECB, Fed and RBA waiting for clarity on trade
This is a similar stance as the Fed and the RBA (and most likely every central bank), who have detailed that if appropriate they will act to keep the expansion in check. In the case of the Fed, recall we heard (on 30 May) vice-chair Richard Clarida, who has fast become the Fed voice the markets listen to above all else, detailing the Fed need to be “nimble” to ensure the expansion continues. “Nimble” effectively means insurance cuts at this stage. Our own RBA governor, Dr Lowe, held a similar line on Tuesday when he said the bank had prepared its forecast based on a cash rate at 1%, and that “it was not unreasonable to expect a lower cash rate”.
So, central banks are waiting for one man to act; Donald Trump. They hold a wait-and-see attitude and will be “nimble” in accordance with the developments and consider today we are hearing talks with Mexico will roll into tonights US session and Trump has detailed he'll decide on the implementation of 25% tariffs on the $300b of Chinese exports after the G20 later this month - that is our timeline.
July will be a big month of central bank easing
The markets though are far more forward-looking, they have their view on how this all plays out and have positioned for central banks to come and join – and, that time is July to August. Markets tend to have a pretty good pedigree of prophesying economic trends and the sheer conviction held in interest rate markets, and front-end of the bond yield curve is clear. If I look at the implied probability of central bank action, we immediately turn to Australia with the RBA first off the rank, with the market placing a 60% chance of a rate cut on 2 July. Looking out the swaps curve and the market sees the cash rate troughing out at 75bp (or 0.75%) in 12 months. It feels that if we do hit 1%, and start talking about 0.75%, then we will be talking unconventional policy; QE, helicopter money etc.
In the US, the market places a 67% chance the Fed cut at the 31 July meeting, although tonight’s US non-farm payrolls report could influence this pricing, and further fuel the monster rally in Treasuries if we see it come in below 130,000 jobs. We see the market discounting 66bp (or 0.66ppt) of cuts by year-end. The markets see a 57% chance the RBNZ go again in August, and in Europe, we see 6bp of further cuts priced in the coming 12 months, although the reality is the bank will embark of asset purchases (QE) before cutting rates. Therefore, we look ahead at the 25 July ECB meeting for real clarity here on asset purchases, understanding the ECB would have had more time to see how trade dynamics threaten its outlook.
The bottom line is Donald Trump is right at the heart of this dynamic. He is the one man who can effectively compel central banks into a further easing cycle, and Trump knows it. He is likely relishing the power, and he knows he has the capacity to cause a huge positioning shift in rates and bonds. The fact US 5s are trading through the 200-week moving average suggests the market is convinced that in most scenarios central banks come to their pricing It promises to be a huge few weeks that could determine the fate on rates and the investment climate.