Cautious long-end USTs; out of sync FX; India credit
Conditions for a selloff in the long-end (10Y and beyond) of the US Treasuries curve are aligning. Notable bond market selloffs over the past decade include the taper tantrums of 2013 and Trump’s election victory in 2016. In both instances, a period of sliding implied UST volatility, signalling complacency that US yields will be stable for an extended period preceded the subsequent bond market bear steepening. Speculative positioning also tends to be more neutral or slightly long on USTs before a sizable bond market selloff. We argue that both conditions are in place currently. While the Fed will keep rates at zero for an extended period and extend dovish guidance out (possibly via yield curve control), support for the longer tenors will probably be less obvious.
In 2013, a subtle tweak in Fed forward guidance was sufficient for a sell off. In 2016, a change in expectations for Trump’s Presidency was the trigger. At this point, market participants are aware of the issuance deluge and waning Fed support for duration. However, it would probably require a material re-assessment that the global economy is on much firmer footing for a true lift off in long-end rates to take place. This view also assumes that even if the Fed deploys yield curve control (YCC) in 2H, the tenors would be limited to the short end (3Y or less).
FX: Are DXY, CNY and EUR out of synch?
The outlook for the USD has turned bearish but a milestone has been reached for DXY. The USD Index (DXY) has been on the retreat after it broke below its 99-101 range of the past two months. One thing has changed though. Last week, the DXY needed higher stock markets to fall. This week, equities have been betting on a weaker USD to sustain the rally. It’s all good until US-China tensions return. For now, President Trump is preoccupied with domestic protests triggered by the George Floyd’s death. That said, an important milestone has been reached. DXY has fallen to 97.3, the level when the Phase 1 trade deal was signed in mid-January. Will recovery hopes be enough to overcome the fear of more China bashing? They are bound to return at the next G7 Summit now delayed to September, and into the US presidential election in November. As a reminder, the Trump administration has just banned, with effect from 16 June, Chinese passenger airlines from flying to the US.
Will CNY decouple from the rest of the world? Contrary to the DXY, the CNY is nowhere close to the level of the Phase 1 trade deal. Given the reopening-fuelled currency appreciation in the rest of the world, it is curious why the CNY is near the weakest levels of the trade war. After all, China wants growth to return to positive territory its 6.8% contraction in 1Q. President Trump also needs a better US economy for his re-election bid. Yet, both the USD and the CNY have depreciated against the rest of the world. Markets don’t appear as fearful as thought about renewed China-US tensions. Some countries have started to see the landscape reshaped by geopolitics and the pandemic as opportunities in repositioning themselves. It is doubtful that they will feel the same way if the CNY starts posting new trade war lows. We’re not saying the CNY would. We’re just mindful that the recovery needs a stable CNY as much as markets have welcomed a weaker USD. Until proven wrong, we continue to see USDCNY moving below 7.10 for the global recovery.
Is the EUR truly ready to start appreciating for the rest of the year? EUR has returned to 1.12 on Wednesday, its end-2019 level. The feat was achieved mostly on a weaker USD driven by ebullient markets; EUR is the largest component in the DXY. To start posting year-to-date gains, EUR would need an outlook that is more optimistic than the US. The European Central Bank has, however, categorised this year’s Eurozone recession as mild at -5% yoy, medium at -8.0% and extreme at -12%. Our forecasts are around medium. On the governing council meeting today, our economist expects the ECB to expand the Pandemic Emergency Purchase Program (PEPP), currently at EUR750bn, by a third to EUR1trn, along with an extension in the duration of the LTROs. If so, this may disappoint EUR bulls who have discounted a larger EUR500bn. Lastly, Germany’s EUR130bn stimulus package sealed yesterday is likely to be the last before next year’s Bundestag election (August to October 2021).
Credit: Implications of India’s rating downgrade
Moody’s downgraded its rating for India to Baa3 this week, with its India rating now equivalent to the ratings of the other rating firms. Its downgrade was not unexpected—India’s growth has fallen sharply, while its fiscal margin has also been eroded due to stimulus. But what are the implications for the Indian USD credit market?
Credit ratings of government-related issuers do hinge on the strength of implicit sovereign support. Thus, following its sovereign downgrade, Moody’s has also lowered ratings of many Indian state-owned firms to Baa3. The net impact on USD credit was muted though. While spreads did widen for some state-owned firms, private firms continue to see compression spreads amidst the recovery in global risk appetite. Importantly, Moody’s decision is not swaying markets to anticipate a loss of India’s coveted investment-grade rating. Indeed, considering the sharp fall in US rates and extreme monetary accommodation in advanced economies, we think fiscal worries for India need not dominate. Fiscal credibility matters more when global rates rise, with attendant risks of capital outflows. For now, markets could look past India’s rating downgrade, with spreads likely to ease as the economy gradually reopens.
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