Mizuho week ahead – Divergent Spring

By Vishnu Varathan, Head, Economics & Strategy, Asia & Oceania Treasury Department, Mizuho Bank, Ltd.,

Week-in-brief:  Divergent Spring

“Spring is the time of year when it is summer in the sun and winter in the shade” – Charles Dickens

Dickens nailed our current condition “summer in the sun .. .and winter in the shade“.

US/US markets are basking in the glorious sun of fiscal/monetary stimulus and vaccination advantages, whereas India is knocked back into the “winter” of Covid in the shadows of the latest outbreaks. China’s data too had both sunny parts and patches of shade, and that is the general divergence experienced in EM Asia as it navigates a meandering path out of Covid.

And the divergence in and of itself could spring a negative surprise on economic/markets outcomes.

China’s Q1 GDP was a stellar 18.5% YoY. Although flattered by a soft base from Q1 2020, which was China’s worst quarter from its brutal lockdown, the pick-up in and of itself revealed encouraging improvement in industrial output with some catch up in consumption and investments.

And so, the worry should not be anywhere in the vicinity of fretting specific data misses. Rather the far greater risk has to do with steering the economy through this phase of still divergent recovery, such  that consumption and investment recover more broadly/durably so as to feed into the strategy of “dual circulation” economic model.

Above all, navigating the policy dilemma – between the need to spur a shift to (consumption- and investment-driven) “dual circulation” economy on one hand and keeping asset bubble/financial risks in check on the other – remains critical. On that note, PBoC will keep policy (LPR) rates on hold (Tue).

The ECB (Thu) is also expected to maintain status quo, though EUR strength may be a bit of a thorn despite the abatement of upward pressures in long-end yields being a relief.

In the region,  Bank Indonesia is set to keep policy on hold (Tue); especially given that signs of stress on the IDR raise the stakes (and costs) of putting through more easing at this juncture.

Moreover, President Jokowi backing of the Bank Indonesia Bill, which is deemed to dilute the central bank’s independence in favour of leaning into the Finance Ministry’s fiscal stimulus efforts despite the stretched fiscal position, has already taken a toll on rupiah dynamics; setting it on its back foot.

And Bank Indonesia will not risk another leg of wobbles in the IDR as rupiah stability policy objectives cannot be abandoned, even if the government’s growth and employment targets are co-opted by the central bank.

It is one thing to supplement objectives, quite another to supplant.

On the other side of the spectrum, neither the MAS nor the BNM are expected to respond (hawkishly/less dovishly) to a fairly steep step-up anticipated in headline inflation (Wed). Not just because headline inflation will remain below the respective central banks’ target levels and/or a good part of the cost-push coming through is expected to be transitory.

Crucially, negative output gaps buy time and space to look through inflation step-up; and focus on the greater danger of an incomplete and uneven recovery. This merely reflects a much larger theme of divergent inflation upturn and lingering downside risks to economic recovery, which is likely to remain a bug bear for policy-makers.

Meanwhile, US market exuberance building on exceptional reflation triggers (both monetary and fiscal) not only underscore the divergence between markets and economic risks; but also highlight the mounting correction risks that could spring from policy inflection further down the road.

FX Theme: Soft USD; but Divergent AXJ

A soft USD theme could continue to assert itself, carrying over from last week; given that UST yields have fallen substantially in fairly bullish bond markets in the US. What’s more, the concoction of low yields and extended rallies on Wall St could also forge some “risk on” FX dynamics that could accentuate a softer USD and favour higher-yielding “risk” currencies.

This could explain and validate rupee regaining traction (after dropping post-RBI on QE) and rupiah enjoying some degree of stability ahead of Bank Indonesia’s decision this week. But it would be a mistake to paint the EM Asia FX landscape with just one share of (bearish) Green(back).

For one, underlying risk sentiments are far from being homogeneously optimistic.

A case in point being India’s resurgence of Covid; which suggests that once some ground is made back (from post-RBI losses) thanks softer USD and UST yields, rupee will be liable to a pullback as worries of binding economic setback from this second wave takes over.

Equally, for rupiah, the allure from lower UST yields will be subject to confidence about Bank Indonesia’s policy credibility and independence as the Bank Indonesia Bill accentuates policy dilemma within the framework.

Last week, Antipodeans led gains on the back of a softer USD; and there could be more legs to that trade if infrastructure positives and Covid differentials kick-in at the right time. But the bigger point here is that a bearish USD trend is far from cemented at this juncture as markets grapple with US divergence being entrenched as a durable advantage; which may very well be the trigger for ‘USD Smile’ dynamics to shift to the “right-half”. In particular if 2022 “taper” views begin to become more pervasive.

So for now, AXJ bulls, emboldened by USD bears, must tread with caution for bears may turn tables.

US Treasuries

Speaking of divergence, sustained pullback in UST yields despite exceptionally strong US data from jobs, to sentiments to retails/output data a puzzle without the context of policy assurance about lower of longer rates.

To be sure, it is still not deemed to be a sustainable reversal in long-end UST yield trend (to the downside) given that Fed speak has thrown up the possibility of “taper” in 2022; if one were to extrapolate “well before” reference to “taper” vis-a-vis rate hikes.

What’s more, once the uncertainty about US infrastructure fiscal plan with regards to tax funding is assuaged, a leg up in long-end UST yields may be on the cards.

For this week, the ECB set to retain a dovish tone and welcoming a dampening in upside pressures in long-end bond yields should help subdue upside in 10Y UST yields; particularly if bond market technicals continue to support short-covering.

We expect some consolidation around current renege of 1.50-1.72% for now; with dips below 1.5% and rallies above 1.72% likely to see offsetting interest.

India’s COVID Resurgence Threatens to Derail Recovery

Three things about India’s Covid second wave that are extremely worrying, and threaten to set back India’s recovery disproportionately.

First, the resurgence suggests that the outbreak is back with a vengeance. Catalysed by more transmissible strains, and a population caught with containment fatigue (and resultant complacency), new daily cases are surging alarmingly to unprecedented rates.

Daily cases have surged past 250K over the weekend, and India has overtaken Brazil as the worst-hit country, in terms of total cumulative cases, apart from the US. Crucially, at the current pace of outbreak, India’s path is diametrically opposed to the US, where Covid is under control, suggesting a more negative divergence from the recovery narrative.

Second, vaccination pace as things stand will not be able to neuter this outbreak. And so, without robust complementary containment discipline, the strategy to ramp up vaccination is not absolved of prolonged period of healthcare and economic distress.

In particular, the realities and tragedy, of severe strains on hospitalization capacity in the interim (before vaccinations finally catch up with, and rein in, the outbreak), will inadvertently result in unnecessarily larger than expected human tragedy and economic scarring.

Moreover, shades of vaccine nationalism means that strains on domestic vaccine manufacturing capacity will lamentably impede progress in tackling Covid in a timely manner. And time is of the essence given path dependence of economic outcomes on the trajectory of Covid infections/hospitalisations. This not only affects India’s vaccination trajectory, but has a global impact insofar that India is one of the global manufacturers of the Covid vaccine.

Finally, even if the near-term setback to growth is not likely to be as severe as last year’s brutal lockdown, lingering effects of scarring, and on confidence, is an unwelcome blow to a fragile recovery; which in any case is overstated by base effects.

The upshot is that flattening the curve is as, if not more, critical now as it was during the surge last year; and ramping up vaccines alone is neither feasible nor adequate. And the impact on recovery is not merely a delay, but a very real threat of diminution given scarring and path dependence.

Bank Indonesia: Constrained Status Quo

Bank Indonesia is set to keep policy on hold. To be sure, this is not a comfortable extension of the policy pause to assess the recovery, and as a lead up to timing normalization further out.

Instead, this is a an uncomfortable compromise at the current constrained status quo; albeit with a distinct dovish bias that underscores desire for more policy support in favour of boosting economic recovery and jobs as adverse impact from COVID lingers.

But risks to rupiah stability necessitate the inconvenient restraint.  Especially as signs of stress on the IDR in recent weeks raise the stakes of putting through more easing at this juncture .

In particular, the Parliamentary/President Jokowi’s backing of the Bank Indonesia Bill, which is deemed to dilute the central bank’s independence in favour of leaning into the Finance Ministry’s fiscal stimulus efforts despite the stretched fiscal position, compromises BI’s rupiah stability mandate.

And not merely because the BI Bill requires adding an employment and growth mandate to BI’s policy objectives. Critically, it fails to consider the negative perceptions on central bank independence and the tension, if not outright clash, between the various policy objective.

Mainly because;

1) there is no clear-cut Taylor rule equivalent that Bank  Indonesia has a precedent   of being able to adhere to, which is imperative to establish policy credibility, and;

2) pre-existing debt monetisation risks being compounded by growing dangers of   the BI bill being seen as a subordination of BI to the MoF.

And Bank Indonesia cannot afford another leg of wobbles in the IDR as rupiah stability policy objectives cannot be perceived to abandoned; even if the government’s growth and pro jobs targets are co-opted by the central bank.

After all, it is one thing to supplement policy targets (although this will require adequate policy framework strengthening), but quite another to supplant existing (rupiah) objective.

With rupiah remaining vulnerable, despite a weaker USD trend last week, it is our observation that Bank Indonesia cannot pull off RBI-type QE for now.

A far more constrained status quo will have to be accepted as the trade-off for wider policy (and rupiah) stability.

China’s 3-D Challenge: Divergence, “Dual Circulation” & Dilemmas

China’s Q1 GDP growth at a mind-blowing 18.3% YoY is admittedly flattered/distorted by exceptional Covid base effects. Nevertheless, it is an unequivocally encouraging sign that the world’s second largest economy is emerging from Covid emphatically.

Detractors will nit-pick at GDP print missing even loftier expectations of 18.5% and/or industrial output rebound starting to decelerate at the margin as well (March: 14.1% YoY shy of the 18.0%). Admittedly, China’s recovery losing momentum is a justifiable concern for anyone casting their glance further out; beyond low base effects and pent-up demand to get a sense of where the post-Covid growth momentum encumbered by structural and geo-political headwinds.

But fretting soft patches in data details misses the forest for the trees.

Which is that China’s biggest risk is not data misses per se, but a mismanaged transition from a vulnerable intersection of ravaged demand and looming geo-political and structural headwinds.

This transition entails the “3-D Challenge” of;

i) reining in the divergence (across sectors/income groups), which is a pre-condition   to as to;

ii) set the wheels in motion to attain “dual circulation” economy whilst;

iii) navigating binding policy dilemma between (growth) boost and asset/financial bubbles

Source: Mizuho Bank Ltd