Macro Strategy: USD rates moving up; China credit risks; FX momentum

US bonds’ election bet, China credit and FX volatility.
Eugene Leow, Chang Wei Liang, Philip Wee23 Oct 2020
    Photo credit: Unsplash Photo

    Rates: USD rates signalling optimism

    10Y US yields touched 0.86% overnight, levels not seen since June as the prospect of a Blue sweep is being priced into the marketWhile this does not guarantee that a sizable fiscal stimulus bill will be passed ahead of the elections, the odds of one being delivered under a Blue sweep (albeit delayed) is high. In short, markets are frontloading election and fiscal stimulus expectations.

    Bear steepening of the UST curve also reflects optimism on the economy. Notably, initial jobless claims fell to 787k from 898k in the preceding week. More importantly, continuing claims dropped to 8373k, against consensus expectations of 9625k, suggesting that the labour market recovery is still intact. Technically, we note that 10Y yields have cleanly breached resistance at 0.80%, setting up upside towards 1%. We reiterate our 0.95% target (consensus: 0.75%) for end-2020 that we have kept since the start of July. A further selloff towards our estimate of neutral (1.3%) would probably require vaccine approvals and a clearer path towards a full global economic recovery.

    Credit: Sanction risks for Chinese USD credit

    US-China tensions have manifested in various ways, and one pertinent risk to watch is that of restrictions or sanctions targeted at Chinese military companies. In AugustUS Department of Defense (DoD) published a list of Chinese military companies operating in the US. Even though it is not a formal sanctions list, the US administration may demand exclusion of these companies from US supply chains, impose export restrictions, or even sanctions, with the President’s authority.  Interestingly, some of these companies and their subsidiaries have sizeable outstanding USD bonds, and one might question how, and to what extent, have credit markets priced in these political risks?

    We address this with an event study using a customised USD credit index comprising of DoD-listed companies, constructed with our DACS methodology (see Mapping the credit landscape with DACS, 2 Oct 2020) that is easily applied to any arbitrary group of bonds. In the past, the aggregate spread of the DoD-listed companies and our China DACS index have displayed extremely tight correlations, indicating the outsized influence of common factors. However, following the DoD announcement at the end of August, the aggregate spread of DoD-listed companies has widened in September, in contrast to further spread compression for our China DACS index.   Based on the expected spread derived from DACS, we estimate the cumulative abnormal spread change to be a highly significant 30bps for the DoD-listed firms. Due to the transitive nature of DACS indices, we can map the abnormal spread to a 1.3% loss in market value (or around $750mn) for investors holding the relevant Chinese USD bonds.  Our analysis shows that even if credit markets are demanding higher risk premiums for the bonds in question, the response has been a measured one with little consequence to the flow of credit.Indeed, one of the DoD-listed firms has even successfully issued bonds in September. Markets seem confident that the Chinese government will provide financing support for these firms in the face of another step-up in US political pressures.

    FX Daily: Momentum vs fundamentals

    This week has been more about the “on again, off again” US stimulus hopes than it has been about what the US elections mean for markets. With the US elections less than a fortnight away, investors have not forgotten how US President Donald Trump came from behind the polls in the last couple of weeks before the election. While few expect President Trump to be re-elected, investors still worry about a contested outcome and a market sell-off. The polls will be closely watched after the final presidential debate between President Trump and Democratic candidate Joe Biden this morning. More importantly, the inverse relationship between the USD and US stock markets have weakened after the US 10Y treasury yield started its steady ascent from mid-October.

    The outlook for the DXY and its largest component, the EUR, remains mixed. Speculators looking at charts have turned bullish on EUR again. Then again, they were bearish only a week ago. Sentiment appears to be pivoted around the 50-day moving average around 1.18. On the other hand, the relative strength of the EUR against the USD has weakened in the past couple of months, best reflected by its negative yield differential against the US. Today’s PMIs are expected to diverge again across both sides of the Atlantic. Consensus expects composite PMI in October to hold above 54.0 for a third month in America and to slip below 50.0 (contractionary territory) in the Eurozone. The services sector appears more resilient in the US and more vulnerable in the EU to the second round of coronavirus infections.

    Divergences were also apparent on monetary policies. The Fed has been on hold after it adopted a new average inflation targeting framework. The Fed has taken the stance that a large fiscal stimulus was key to averting a slower and weaker US recovery. Conversely, the European Central Bank governing council meeting on 29 October is expected to pave the way for more monetary stimulus in December. The ECB has turned less optimistic on the Eurozone recovery despite expectations for advance GDP (out on 30 October) to rebound to +9.4% qoq sa in 3Q from -11.8% in 2Q. The outlook for the EU recovery, which also happens to be jobless, has been weighed not only by the coronavirus resurgence and new restrictions and lockdowns, but also by the threat of a no-deal Brexit.

    Eugene Leow

    Rates Strategist - G3 & Asia

    Chang Wei Liang

    Credit & FX Strategist

    Philip Wee

    FX Strategist - G3 & Asia

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