By Vishnu Varathan, Head, Economics & Strategy, Asia & Oceania Treasury Department, Mizuho Bank, Ltd.,
Anyone pondering exceptionally, if not absurdly, low UST yields juxtaposed against record high US inflation must arrive at the conclusion that the tail is wagging the dog.
Specifically that the usual thought-process of the “inflation dog” that may cause the Fed to wag the normalisation tail, is now twisted to the Fed’s policy response tail wagging the inflation dog (lower); thereby reeling in 10Y yields to test (sub-1.2%) lows not see since Feb 2020.
But it gets better. Somewhere along the way, this dog-wagging tail loop is short-circuited by markets piling into safe-haven trades as falling yields feedback into a loop of “risk off”.
Admittedly, “risk off” appears to have faded in US equity markets. But imaginably, it is only because of a slew of solid earnings on Wall St short-circuiting the background worries about delta variant outbreaks globally.
Whereas fears of delta outbreaks overtaking or defying vaccine rollout all over while not always at the fore, doesn’t seem to be too far off the minds of markets; with US’ Dr Fauci just warning of the US headed the wrong way in terms of fresh outbreaks.
So for all purposes, markets may not be able to completely “shake it off” Taylor Swift style.
But this week, markets have something else to obsess over. The July FOMC (Wed). We expect that this will be a non-event as the absence of fresh ‘Dot Plot’/updated economic forecasts means that there will be nothing “hard” to renew US bond market bets with.
What’s more, well-telegraphed FOMC view means the bar for a “surprise” may be slightly higher.
In Asia, Korea’s Q2 GDP (Tue) will probably thrill in the headlines, not unlike base effects boosted US and EZ Q2 GDP prints, it may reveal soft spots around fading sequential/stimulus effects.
Above all, the uneven nature of the recovery.
Australia’s Q2 CPI (Wed) is another focus as inflation is expected to surge to the ballpark of 3.5% YoY from a far more muted 1.1% in Q1. But this should not stir the RBA at all. An unflustered RBA is not about nonchalance, but rightly recognizing the transitory nature of the majority of cost-push; and critically the spare capacity amid fading stimulus and re-emergent COVID outbreak which will conspire to subdue demand-pull pressures.
Speaking of delta outbreak, Indonesia has extended its lockdown by another week to 2 Aug as new COVID cases remain stubbornly sticky in the 40-50K range despite easing off record highs.
As delta continues to challenge global policy-makers, containment ought to be the dog that wags economic activity resumption. Whereas letting the economic tail wag healthcare policy dog may prove ultimately costly.
FX Theme: Don’t Bet on FOMC Doves to Dent USD
USD recoil last week from the highs is arguably a calibration of the bullish USD wave; but don’t bet on that being the decisive catalyst for an abrupt reversal in USD strength.
Certainly not on account of the upcoming FOMC this week.
A rehash of well-telegraphed points on the economic recovery being on a good footing but short of “substantial” progress is not the stuff that USD bears feed off on a sustained basis.
Fact is, despite the EBC falling short of “average” to settle on “symmetric”, the details of a more dovish execution of this symmetric target hollowed the instinctive post-ECB EUR rebound; and by extension, the emphatic USD pullback has fizzled to reveal a broader consolidation.
What’s odd about this market though is that USD strength/resilience is taking place not only in the absence of rising yields, but rather in an environment of falling yields.
And so that raises two factors that may be at work. The first is a “risk off” mentality that is reinforced further by falling yields, which in turn reinforces a strong USD.
The other is strong US economic data/earnings, which accentuates the sense of relative US economic strength; also a cause for USD to retain its tone.
Crucially, the delta variant retarding economic recovery in Asia, thereby amplifying US-Asia divergence suggests that the case for EM Asia FX to extend strength against the USD may be limited; unless unbridled “risk on” trades flip currency bets into yield-hunting mode.
All said, pre-FOMC caution could stifle trades in a narrower range, while post-FOMC reflections may not provide much grounds for USD to pullback (to the benefit of AXJ); especially considering that fragile recovery amid delta risks may frame any Fed dovishness as reason for extending safe-haven bets.
US Treasuries: Pre-FOMC Consolidation
While 10Y yields bounced off intra-week lows below the 1.2%-handle, the retracement was incomplete and 10Y yields ended below 1.28%. Meanwhile, 2Y yields slipping to sub-0.2% meant that the UST yield curve was left a tad steeper.
The wider question remains. How low can 10Y yields go? Presumably just on confidence about the Fed’s normalization helping to rein in inflation further out.
Temptation to test the 1% psychological level appears to be embedded in some part of the markets while pain trades for bond bears (betting on yields rising and getting caught wrong-footed as a result) is now compounding yield slide.
And the FOMC this week may have little by way of quantitative signals (no ‘Dot Plot” or economic forecast revisions) or by way of qualitative guidance.
On the latter, it is widely understood/accepted that despite strong data from the US, it is premature (at least until “Fall”) to assess “substantial progress” at this juncture.
And so, without a call on the pre-condition for policy normalization, UST markets may have very little to go on; although sustained drop in yields appears to be out of synch with crude oil prices rebounding back (Brent at $74).
In particular, even if the current inflation print is transitory, 10Y UST yields are well below levels consistent with 2% inflation expectations. So for now we expect 10Y UST yield to consolidate 1.12%-1.38%; rather than plunging perilously.
FOMC: Pre-“Substantial” Lull
At the risk of sounding dismissive, we are going to venture that next week’s FOMC meet will by and large be a non-event.
Not because there isn’t anything going on. But rather, despite the shifting sands – with respect to growth and inflation.
With June CPI claiming a 13-year high (of 5.4%) inflation hawks are not unflappable, and so guidance on normalization (“taper” and/or rate hike) timelines remain closely watched.
Moreover, UST yields declining after a slight hawkish shift in June FOMC ‘Dot Plot’ may assuage Fed concerns (of tightening financial conditions) about removing accommodation too soon.
Meanwhile, the doves might point to a resurgence in cases led by the more transmissible delta variant and slowing “delta” of US recovery as appeal for hawks not to be hasty.
These are real and on-going tussles. Yet, July FOMC may not move the needle very much.
First, this meeting will lack fresh ‘Dot Plot’ and economic forecast revisions. Which is to say, there will be no express/standardized quantitative guidance shifts to react to.
Second, despite a widening dispersion of FOMC views, Fed Chair Powell has continued to assert confidence about “transitory” inflation pressures buying the Fed time and space. With no changes to this view, FOMC sensitivity to recent price data ought to be diminished; providing little policy impetus.
Finally, the can has been kicked down the road until “Fall” (likely the Sep FOMC); with widely conceded Fed views that at least until “Fall” it is too soon to assess the “substantial progress” pre-condition for normalization.
Even those convinced that strong data are reasons enough to jump the gun may defer to Jackson Hole in August.
Which leads us to conclude on the opening remark that this July FOMC will be a non event as “substantial” improvement is awaited – a pre-“substantial” lull.
Australia Q2 CPI: Of a Steep Climb & A Flat (Phillips) Curve
A spasm of cost-push inflation is fully expected to push Q2 CPI ~3.5% (from 1.1% in Q1), but this upswing will be wholly (and justifiably) discounted
Admittedly, higher energy/commodity costs conspiring with capacity constraints (e.g. semiconductors, shipping) will inevitably exert upstream cost pressures.
Hence, inflation will not merely an artefact of base effects, but instead, reflect broader sequential price pressures – lifting CPI to 3.0-4.5% through Q2-Q3.
Nevertheless, build-up of cost-push pressures are likely to be transitory as lingering slack in the domestic services economy keep wage pressures in check; which in turn suggests demand-pull pressures are will not be unleashed despite the sharp drop in the jobless rate.
Especially as “delta risks” re-imposing extended/expanded lockdowns across Australia translates in to a bumpier and more uneven recovery beset with pockets of capacity slack.
Upshot being, the RBA will look right through inflation upswing unflinchingly on grounds of a flatter Phillips Curve and faster inflation fade. We concur.
What this means for the AUD is that dovish inclinations will dampen commodity buoyancy; keeping AUD upside in check.
South Korea Q2 GDP: Headline Rebound Mask Unevenness
Q2 GDP, set for a stellar rebound to 6.1% YoY from 1.9% in Q1, is flattered by a low base and uneven drivers; whereas sequential (QoQ) momentum is set to slow. Admittedly, relative resilience of Q2 GDP growth reflects sustained continued strength in exports recovery, which picked up to 42.1% YoY in Q2 from 12.5% in Q1.
Indeed, exports momentum appears to have endured into Q3 with first 20 days exports for July up 32.8% YoY.
The solid export recovery and with it, the manufacturing sector recovery, however, masks the unevenness of the growth recovery in South Korea.
For one, even within manufacturing, production recovery in the SMEs continues to trail large enterprises; despite more flattering base effects endowed by a larger slump in Q2 2020.
What’s more, the service sector led by tourism, restaurants, hotels, wholesale and retail trade outlets continues to feel the pain from the pandemic; despite supplementary fiscal packages worth KRW14.9trn (0.8% of GDP) were dispensed to mitigate the worst of the fallout.
This gaping disparity within the economy has prompted , the government to announced yet another supplementary budget worth KRW33trn (1.6% of GDP); to support small businesses, provide cash handouts to households, support job seekers and bolster the immunization drive.
But a subsequent latest wave of Covid infections surging to record highs has forced re-introduction of tighter social restrictions in Seoul and other parts of the country; dashing hopes of summer holiday travel boost to the travel/hospitality sectors.
Moreover, with Korea’s vaccine rollout lagging (just a third of the population with at least one shot and only 12% vaccinated), delta outbreak risks remain high.
All of which point to fiscal policy remaining the key “catch up” game in town to alleviate uneven and interrupted recovery amid vaccination efforts.
Meanwhile, BoK complements with adequate credit and liquidity provision even as rate cuts have long been exhausted.
Indonesia Cannot Afford Lapse in Covid VigilanceThe single biggest risk to Indonesia’s Covid-19 containment efforts is a hasty and premature relaxation of movement and social restriction measures.
Admittedly, the daily case counts receding from recent peaks of over 56K is a relief. But what’s worrying is that declines are neither emphatic nor final. Cases on Friday and Saturday continued to average 40-50K, which is far from comforting; especially as hospital capacity, ventilator availability and vaccine progress continue to strained.
Mixed signals are also unhelpful, if not confusing. After a week’s extension of the lock down to July 25, the government has extended by another week to 2 Aug.
The underlying urge to re-open is understandable, but may backfire as a case of “more haste, less speed”. Trouble is, the decline in cases remains shallow and unconvincing and a reversal of social restrictions risks a fresh outbreak from still elevated levels of cases.
For one, intra-country spread is yet to be stymied. What’s more, a relaxation at this point could undo the work done so far in reducing cases; ultimately requiring more prolonged lock downs later (as has been the experience elsewhere in the region).
Crucially, lagging vaccination rates mean that vulnerabilities to a relapse remain high.
Inevitably, downside risks to growth will persist, perhaps amplify. Bank Indonesia cut 2021 growth outlook from to 3.5-4.3% from 4.1%-5.1%; stressing “pro-growth” policies into next year.
But concerns around rupiah stability impose a binding policy constrain. As such, fiscal policy will remain the main for counter-cyclical support; even as it brings with it credit ratings risks.
What’s Troubling the Thai Baht?*
Uncharacteristic under-performance in the Thai Baht, rendering it the worst performer to date in 2021, begs the question of the drivers behind exceptional pressures. In fact, at face value, THB as the unequivocal and significant laggard does not square with Thailand’s solid (albeit diminished) C/A surplus or relatively low inflation (assuring real return).
Closer scrutiny reveals Thailand’s structural “tourism multiplier”, which amplifies (cyclical?) COVID devastation on the economy; and ties back to THB woes.
This “tourism multiplier” should not be under-estimated given potential for far more pervasive, compounding adverse effects in excess of Thailand’s exceptionally large reliance on tourism; as initial shock waves rippling via revenue channels are amplified on B/S and jobs impact.
* For a more detailed discussion please see Mizuho Chart Speak – What’s Troubling the Thai Baht, 23rd July 2021
Credit: Mizuho Bank Ltd