…with the US expansion now the second longest ever, energy-price base effects on inflation about to turn less positive, dollar-negative comments from the White House, and front-loaded contributions to benefit plans of mid-September maybe it’s time to back up of the truck and load up (on EM)?
CHART 3: AND US’ ISM SENTIMENT SURVEYS TO WEAKEN
The Fed’s latest missive is not conducive to that view: “information received since the Federal Open Market Committee met in June indicates that the labor market has continued to STRENGTHEN and that economic activity has been rising at a STRONG rate. Job gains have been STRONG, on average, in recent months, and the unemployment rate has stayed low. Household spending and business fixed investment have grown STRONGLY. … The stance of monetary policy remains accommodative, thereby supporting STRONG labor market conditions and a sustained return to 2 percent inflation.”
Sounds like the Fed wants to tell us something. Sure enough, both the ISM manufacturing and the non-manufacturing gauge have been more than just a little resilient this year.
However, both should face downside pressure based on e.g.:
i) the past rise in mortgage rates (denting consumption), and
ii) the recent rise in the dollar (denting the profit-outlook in local currency). In July, ISM non-manufacturing weakened the most in a year, bringing down the ISM non-manufacturing gauge to its weakest level since August 2017.
This is a sign of what’s to come, we believe.
If ISM starts to weaken (as we expect), then the rate market is correct in pricing a flat ED$ curve for 2020 (the ED10 vs ED6 spread is currently showing the Dec20 vs Dec19 ED$ spread). The equity markets’ pricing of cyclical equities is likely to be wrong, in our view.
CHART 4: THE EURODOLLAR CURVE IS MORE LIKELY TO BE RIGHT THAN CYCLICAL EQUITIES
The Fed poses a short-term risk to this view. Despite Fed tightening, US financial conditions are as expansive as a year ago. Maybe some officials could discuss a quicker hiking pace? Or maybe a hike in the R-star could be in the offing? We have earlier argued that the Fed’s signal of a low neutral rate via its dot-plot likely serves as a ceiling for forward rates, helping keep rates and yields lows via depressed term premiums but that “…going forward not only could the dollar’s [2017] depreciation inform the Fed that neutral rates are now higher. A pick-up in core inflation, in productivity growth would also point in this direction…”
CHART 5: HOWEVER, HIGHER US YIELDS COULD FOLLOW IF THE DOT-PLOT IS REVISED
Higher US yields, posing a threat to EM, may follow if the dot-plot is revised. Higher US yields would also follow if the FI market stopped being so negative on the economic outlook for the US. Incidentally, the time is ripe for a turn-around in the US economic surprise index… US data usually improves during the autumn. But this time should be different (see chart 4).
CHART 6: WILL US DATA START TO SURPRISE POSITIVELY(!?)
To sum up this esoteric part, we do think that the flattening of the US curve means that longer-term investors should start to “back up of the truck and load up (on EM)”, though we would stay far away from currencies such as the TRY (Turkey is stuffed) and the ZAR (Zimbabwefication)… For all that, we would consider going long EM assets vs cyclicals, given the likely trajectory of ISM (lower).
ANOTHER SUMO SOMA DAY HAS PASSED
We have earlier concluded that the USD tends to gain on days when the Fed’s balance sheet shrinks due to maturing bonds & notes. We call these days “SOMA days”, since the maturing bonds are held in the Fed’s System Open Market Account. US markets recently experienced the largest SOMA liquidity shrink so far (July 31), when bonds worth 28.5bn came due. The negative impact on US excess liquidity was -24bn, which was the monthly maximum as set by the Fed.
CHART 7: EUR/USD INTRADAY ON SOMA DAYS
While EUR/USD initially rose on July 31 due USD selling for month-end reasons and a disappointing core PCE inflation reading, it eventually came under downside pressure in line with the now-usual pattern. Indeed, of the SOMA days since February 28, it has been a good idea to sell EUR/USD at CET14:30 and close the position a few hours later. The hit ratio of going long DXY at CET09:00 on SOMA days, and closing the position CET17:30 is 100% since February…
While the hit ratio for being long dollars on SOMA day is more than respectable, being short the S&P500 future on SOMA days has not worked out as well. While the SOMA days of February through May corresponded to equity market weakness, this was not the case in June and July.
TABLE 1: BEING LONG DOLLARS ON SOMA DAYS OFTEN A GOOD IDEA
The next large liquidity withdrawal due to a SOMA day takes place on August 15 when USD23.1bn comes due (causing a net liquidity withdrawal of USD12.6bn) followed by a 20.9bn maturity on August 31 (causing a net liquidity withdrawal of USD11.4bn). Mark your calendars.
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