Global: Risk-off environment persists in this early week on the back of the latest escalation of the global trade war. With China announcing that it will raise tariffs on $60bn of US goods from June 1, price volatility in the equity markets has remained elevated after last week’s sell-off. Chinese equities are now down 12 percent since high reached in the end of April. Figure 1 (left frame) shows an interesting co-movement between Chinese stocks and USDCNY (inverted); in the past 2.5 years, lower equities have been associated with a depreciating currency. The persistence of the global uncertainty has weighed on the Chinese yuan against the US dollar, with the spot rate slowly approaching its critical and psychological resistance of 7. Should investors worry about the weakening yuan?
US: US Treasuries have continued to perform well in the current economic environment, with the 10-year down 20bps in the past month (currently trading at 2.40%). The greenback has also remained strong versus most of the currencies; convictions have remained high as interest-rate differentials against G10 currencies have been favorable to the US Dollar, especially against the euro. Consumer price inflation rose 2% YoY in April, its highest level in 5 months, strongly helped by a rise in prices for petrol and cost of accommodation. The core reading ticked up a notch to 2.1%, confirming that pressure on core inflation remains firm; leading indicators such as the underlying inflation gauge (UIG) in addition to NFIB surveys are both pricing a higher core measure in the next months to come.
Euro: While inflation expectations have strongly recovered in the US following the stock and oil rally in the first quarter of this year, they have continued to decrease in the Euro area. The 5Y5Y inflation swap fell from 1.74% in June 2018 to 1.37% in May; should the ECB be worried? In addition, escalation of trade war and Brexit uncertainty will continue to weigh on the economic growth outlook in the medium term, generating another wave of price volatility in some of the asset classes. The euro also looks vulnerable in this current economic environment, especially after it broke the 1.1185 6-month support against the US dollar last week.
UK: The volatility of Sterling has eased in the past few weeks even though we are approaching the EU elections (will take place on May 23rd). As a reminder, as the Parliament was unable to agree a way forward, Brexit deadline was pushed back to 31 October. We think that there is still a 40% of the UK leaving the European Union this year (15% No Deal and 25% Deal).
US Treasuries Net Specs
After decreasing dramatically from 2.1M contracts at the end of September 2018 to 651K contracts at the beginning of April, net shorts on US Treasuries have started to increase again in aggregate, up almost 200K in the past 5 weeks. However, the trend on US yields looks negative in this current risk-off environment, with the 10Y approaching its December low of 2.34%.
EURUSD: The high interest rate differential combined with the global uncertainty have been weighing on G10 currencies, especially against the euro. EURUSD broke its 6M support at 1.1185 in the end of last month, confirming the vulnerability of the single currency in the short run. The momentum looks bearish, hence any rebound on the euro should be considered as a good opportunity to short it. We will look to short some above 1.13 for a retest of the 1.11 level (with a stop loss at 1.1450).
GBPUSD: Over the past couple of months, Cable has been trading within a narrow range of 250 pips, between 1.29 and 1.3170, which corresponds to the 61.8% and 50% Fibo retracement of the 1.20 – 1.4340 range. We would not play the pair on the short run due to the elevated uncertainty, however, we would start building a long position if GBPUSD goes back below 1.25.
EURGBP: The pair has also been stuck in a tight range for the past few months, oscillating between 0.85 and 0.87. It looks like EURGBP received strong support at around 0.85, hence we would wait for lower levels to take a small long position.
USDJPY: The Japanese yen has appreciated significantly since the end of April on the back of a rise in risk-off sentiment. USDJPY is down 250pips, currently trading at around 109, its 50% Fibo retracement of the 99.60-118.70 range. We are still short in this current environment, as the pair could reach new lows if LT US yields continue to fall. Yen crosses have also been on play in recent weeks, with AUDJPY down 5 figures and trading at its lowest level since early January.
USDCHF: The Swiss franc eventually reacted positively to the recent sell-off, however, the US dollar strength could send the pair back to its LT resistance of 1.0330 (reached last time in January 2017). We would wait for higher levels to start shorting the pair.
Chart of the Week
In this chart, we look at the performance of US equities relative to Treasuries in the past few decades. As you know, different asset classes have different price volatility; hence, in order to compare the relative performance of equities versus bonds, we need to adjust for the volatility. Using monthly times series of total returns in the SP500 index and the Bloomberg Barclays US Aggregate Bond Index, we compute monthly returns and then adjust our US Treasuries position using the 1-year volatility of equities, rebalancing our portfolio every month such that the volatility of both asset classes remain constant.
Since January 1974, the S&P 500 has lost 65% of its value relative to risk-free securities, with a high of 77% reached in the end of 2010. It is interesting to note that in the past two economic downturns, equities have lost 20% of their values between 1999 and 2002 and 12% of their value between 2007 and 2009. Last year, we saw that the 10Y nominal yield struggled to rise above 3.25% despite a nominal annual growth of 6% in the US. Should we expect US Treasuries to outperform equities once again in the next economic recession?
Disclosure: I am/we are short USDJPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.