The Fed appears to soften its stance – good for bonds
The Fed must be worried about the path of oil prices given the disinflation it is creating around the world. Canada was another country last week to report headline inflation below expectations and meaningfully below the previous month’s number. Total consumer price inflation fell to 1.3% year-on-year compared to 1.6% in April. Even aside from the drop in headline inflation, core inflation is on the slide. The Bank of Canada’s three favored measures of core inflation fell to a cycle low of 1.33%. A June rate rise by the Bank of Canada looks unlikely, and hence the loonie (CAD/USD) continues with an upward bias.
The concerted efforts of some Fed governors’ to talk up the need for further Fed rate rises looking increasingly foolish. At least in the past week’s schedule of speeches Chicago Fed President Charles Evans, the Minneapolis Fed President Neel Kashkari and Dallas Fed President Robert Kaplan added a bit of balance into the dialogue with the market by suggesting that at the very least there needs to be a pause in Fed rate rises.
U.S. 10 year yields ended the week at 2.15%, hardly changed on the week. One and three-month yields fell though reflecting the Fed speeches and the weakness of oil prices. One-month money at 76bps was the lowest since May 26th. Also, consider that two-year government bond yields at 1.34% are not much changed from where they started the year (1.22%) despite 50bps of Fed rate rises.
The U.S. 10 year government bond still looks like a rock solid investment for longer-term investors hoping for the prospect of a positive real yield. The Fed still looks unlikely to consistently hit its 2% inflation target given the structural headwinds in the economy. I still see a greater risk of the U.S. 10 year yielding 1.80% in the next 12 months rather than the 2.5%.
Cryptocurrency – the struggle for recognition
With the markets still deeply skeptical about central bankers and their policies and whether conventional asset prices are sustainable, investor attention has increasingly strayed to cryptocurrencies. Year to date many cryptocurrencies have given some extraordinary returns. Cryptocurrencies have achieved some massive gains since the start of the year. MaidSafeCoin, for example, is up 478% year to date and Ripple is up an extraordinary 4500%, yes four thousand five hundred percent. However as many investors realize, exceptional gains in asset prices cannot be achieved over the longer-term without seeing significant volatility (risk). Cryptocurrencies saw a further wave of volatility last week with many correcting sharply until a recovery on Friday. Bitcoin, for example, saw a drawdown of 7% through to Thursday to follow up from a 25% correction from 12th -15th of June. Ethereum corrected 12%. Coinmarketcap.com lists 100 cryptocurrencies that are actively traded of which around 60% are no longer mineable so in fixed supply.
It is easy to write off the cryptocurrency as a ‘freak show’ however if that were the case why are the Russian and Chinese central banks considering their own digital currencies? Also recently the President of the Bundesbank Dr Jens Weidman was addressing the issue of cryptocurrencies at a Bundesbank policy symposium. At this stage, it is difficult to come to any strong conclusions on the future role of cryptocurrency, however from my economics textbook I recognize cryptocurrency as a (volatile) store of value and a unit of exchange. A small meaningful start has been made for global acceptance.
The eurozone is still rocking and rolling.
Eurozone confidence is on the rise, and there is a real air of reform and change, even if remains mostly a political aspiration. To be sure, the French President is increasingly seen in the EU as the ‘real deal’ in contrast to the stumbling efforts of the U.S. President. Euro-area consumer confidence in May moved to a 16 year high and is very close to an all-time high. The pick up in confidence is leading economists to think about raising their eurozone second-half GDP forecasts.
Eurozone industrial confidence has moderated in June slipping to 55.7 from 56.8. However, we wouldn’t read too much into this slip back. The level of eurozone confidence is still consistent with a healthy GDP growth of 2.5% to 2.7%. In the detail of the survey, the manufacturing sector showed further improvement while the service sector slipped back. The robust manufacturing sector confidence is a positive considering the 6% rise in the value of the euro versus the dollar in the past two months, which must have eaten into the competitiveness of some firms.
China A shares finally make it onto ‘Main Street’ and into the MSCI indices.
MSCI’s decision to add 222 A shares to its benchmark came as no great surprise but still helped the China A index to rise 3% on the week. The decision came after four years of consultation and is the final acknowledgement that China deserves a position on ‘Main Street’. The first move is to add just 5% by value of the China A shares into the MSCI indices. Goldman Sachs estimates that potential buying from emerging market fund managers that follow the indices could be $12bn which amounts to about a day’s traded volume. It’s a start by MSCI to including China on a much greater scale in the future. Goldman’s estimate (sign-in required) that on full inclusion foreigners could end up owning around $430bn by value of China A shares. MSCI will add the shares in two tranches in May and August 2018.
India all signs point to lower interest rates – if only the Indian monetary authorities would believe them.
The Indian monetary authorities continue to acknowledge the lower than expected inflation but are still hesitant to fully believe it. They prefer to wait for further evidence that the fall in inflation will persist. The lower oil price will provide some ongoing support to lower inflation, however, the path of food prices is far more important to the inflation basket with a 57% weighting compared to 6.3% for fuel and light. The Indian Metrological Department continues to forecast a ‘normal’ monsoon. One of the committee’s members Dr Dholakia argued for 50 bps cut in rates. The bond market for certain wants to believe Dr Dholakia’s vision of where official interest rates will move. The Indian government 10-year government bond yield has rallied from around 7% in May to just below 6.5%.
In my view, Indian local bonds continue to offer value for those that have access to the market. The currency is pretty solid against the dollar and this is one of the few parts of the world still offering such as high nominal yield against the backdrop of a country truly making significant progress in its reform program.
GCC markets - waiting for the good news
The GCC financial markets remain challenged by the ongoing geopolitical issues and the weakness in the oil price. The publication of the demands of the Saudi Arabia, the UAE, Egypt and Bahrain on Qatar only served to heighten worries that the current impasse could continue for an extended period.
There is some stress in the Qatar riyal although this is mainly in the offshore market. To-date no one would question the commitment of the Qatar Central Bank to supporting the dollar peg. Qatar’s credit rating remains at risk given the S&P downgrade on June 7th and the negative watch. However, a precipitous fall in the rating looks very unlikely in these initial stages of the dispute. The upward pressure on Qatar bond yields is likely to continue on the back of some foreign selling and even just a passive absence of foreigners from the market.It seems the oil market wants to see some a supply side shock through a cut in OPEC production before the current bout of oil price weakness is reversed. Oil moved into a technical bear market last week. U.S. light sweet crude fell to $43.00, twenty-two percent down on the price at the start of the year. The downward pressure on prices has been exacerbated by the unwinding of long positions held by speculators. These long positions still pose a threat to the oil price with the unwind possibly only partly complete.
Saudi Arabia’s MSCI reward for reform
There was some good news in the GCC with the long-awaited inclusion of Saudi Arabia in the MSCI emerging market indices. The main equity index responded by rising 5.5%. The inclusion of Saudi Arabia is a reflection of the ongoing reforms in the capital markets, including added regulations and improved technology. HSBC calculates that the market will see upward of $9bn of flows into the market as a consequence of its inclusion in the indices. MSCI’s inclusion sets the scene for the Aramco IPO at some stage next year.
Saudi Arabia equities continue to be primed for some further upside. The level of the equity indices more than discount the current level of oil prices. As local investors return from their Eid holidays we suspect that local institutional investors will be back buying.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.