Donald Trump detailing through Asian trade today that he still feels “that China talks will be successful”, and that we’ll likely know in how successful in “3 or 4 weeks” is seemingly supporting risk sentiment to an extent. However, at this juncture, there is still such limited clarity, and broad financial conditions continue to tighten.
We were waiting for the response and now have confirmation that the Chinese have retaliated with tariffs of their own on US goods, where the only surprise here would have been if they hadn’t taken these measures. With nationalistic narrative in local Chinese press increasing markedly over the past 24 hours, amid speculation that China may dump US Treasury’s and potentially refrain from honouring purchases of incoming cargoes (source: Bloomberg), it feels this backdrop is fast approaching what could be coined a ‘trade war’, as tit-for-tat measures are playing out more frequently. The counter response from Trump (on tariffs) has been to disclose that there will be a public hearing on the placement of 25% tariffs on the remaining $300b of China trade on 17 June, which could go into effect seven days later.
Do we really have to wait until June to get the answers we seek?
That’s enough time and water yet to flow under a murky bridge to concern the market, especially as the next scheduled face-to-face meeting between the two leaders is as far out as the G20 meeting in Japan on 28-29 June.
So, with order book dynamics in mind, where there are few buyers and plenty of sellers, and with uncertainty elevated, why would you buy risk assets? Not very likely it seems, because when we get these significant macro thematic concerns, we need a circuit breaker, a date, a point of reference, by which we can cling hope to. That gives us the belief of clarity and a positive resolution – a fate most feel macro strategists feel is the likely outcome, even if they have had to push out there timeline.
So, in this case, potential clarity might not come until late June, and that keeps me cautious. Ok, granted, we see calm conditions in Chinese equity markets today, and S&P500 futures are 0.5% higher., likely as a result of Trump’s comments. However, these markets are coming off extended moves, and it gives us a chance to reload. We are even seeing selling in USDCNH today, driven by Chinese authorities lifting 3-month hibor rates by 521bp and to the highest levels since 14 December, in turn, making it more costly to short the CNH.
Question of the day
One question I fielded today which I felt had real merit, was why, considering a breakdown in US-China trade talks came up consistently, as the biggest tail risk to financial markets in the BoA/ML fund manager survey, is why implied volatility in the S&P 500 is still only at 20.5%, and FX vols are still subdued? Further, consider the net short VIX futures position is at extremes. Where one could then argue this recent spike higher could have easily set off a cascade of short volatility position, as traders bought back to cover, which, in turn, feeds back into a more extreme move lower in the S&P 500, resonating negatively in FX and bond markets.
On reflection, we’re seeing trending conditions in the JPY crosses, with an unwind of carry underway and a renewed bid in bonds – with the total pool of negative yielding bonds now well above $10.37t. We are also seeing equity markets now trending lower and likely to continue to head lower as CTA’s (trend following funds) flip to short positions. However, it still feels measured, and the flows exude no real signs of panic.
Now consider how things looked in Q418, where most central banks were looking to tighten policy, and market participants saw a future of further economic deterioration, yet interest rates and real yields were going up. All the while, the message from the Fed was highly confusing and where markets sniffed out a policy mistake. It’s not hard to see why equity volatility spiked to 36% and equities were taken to the proverbial woodshed. The key difference this time around is that central banks have made a point to lay out the diverse range of policy tools at their disposal, should they need them. The key price maker central banks have all moved to a fully flexible, and certainly more realistic stance, that should financial conditions tighten and inflation expectations fall sufficiently that it threatens their economic outlooks, then a policy response will be rolled out.
It’s no surprise that US interest rates markets are pricing in a full cut by December, while the prospect of a cut from the RBA has moved up to 40% for the June meeting. Central banks have our backs and will ease policy should it be required, yet importantly, they are all moving in alignment, with limited divergence in policy settings. This is undoubtedly keeping broad FX vols contained, even if we see implied volatility in USDCNH, the epicentre of global FX markets, at year-to-date highs.
I guess it’s lucky for both the US and China, that we are not at the point where markets are seeing real evidence that US core PCE inflation has bottomed out and headed back to 2% – along with the recent calls from Powell that it is transitory. An environment where inflation is at or near target, married with trade tensions, would have been an interesting dynamic and would have no doubt seen implied volatility in markets far higher.
Published by Chris Weston, Head of Research, Pepperstone