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Big Challenges for Equities, Bonds and FX Markets

Moreover, the actual question on any new referendum ballot will be the subject of intense debate. If there is a new referendum, the question on the ballot is unlikely to be as simple as “Leave” or “Remain”. The question may be worded to involve a specific choice, such as “Remain” or “Exit with Prime Minister May’s Deal” or something like that. Risks for the British pound remain quite high.

The main recent trade war news has been that U.S. President Trump has decided not to impose another round of penalty tariffs, but to delay for now and see if there is progress on a deal. There is no doubt that both the US and China are feeling more pain than either initially anticipated, and so they would like to find enough items on which to agree to have some kind of a deal. Even if a deal is cut, getting it ratified is not that simple. Any deal structured as a binding contract, as opposed to a Memorandum of Understanding (MOU) which would not be binding, will need Congressional approval. It is highly unlikely that the US House of Representatives will approve any China deal, and while they are at it, the House is also likely to reject the new USMCA (the renamed NAFTA) deal.

Another key item for markets will be whether the US rescinds the steel and aluminum tariffs. Canada has told the US that if these tariffs remain in place, then they may reject the new USMCA deal. China is quite likely to feel the same way – why agree to a deal without the US showing the willingness to rescind some of the tariffs already imposed. Getting rid of the tariffs would be a big lift for equities globally, even without Congressional approval for a deal. Leaving the tariffs in place has the potential to be highly disturbing for equity markets.

And then there are currency considerations. The US has reversed its long-standing policy of asking China to allow its currency to float freely on foreign exchange markets, and now the US wants China to manage its currency to avoid depreciation. If economic fundamentals were to pressure the Chinese yuan to depreciate versus the US dollar, then the Chinese would need to sell some of their massive holdings of US Treasury securities to buy yuan and prop up their currency. That is, if the trade deal talks were to falter, the Chinese yuan would be vulnerable, while a trade agreement could lead to managed stability.

The US debt ceiling is back in play at the level of debt on March 1, 2019, of something north of $22 trillion. Given the various ways the U.S. Treasury Department can move money around, the debt ceiling is unlikely to bite until August or September. End-September is also when the US government again runs out of authorized spending. So, a government shutdown and a technical debt default will be on the table in September and that looks to provide plenty of political fireworks.

The twin scenarios of a shutdown and technical default are low probability outcomes, yet they would typically hit equities hard. Treasuries might have a flight-to-quality rally despite the default possibilities. The U.S. dollar might also be weak, as the US brand in global markets would be diminished and U.S. risks would be rising. The Fed would more than likely remain on “hold” until it could see the outcome. Finally, any new shutdown is likely to be much more damaging to the economy than previous ones, as more economic players are now keenly aware of the costs of a shutdown and will move to anticipate the problems sooner than before.

The Federal Reserve appears ready to end its balance sheet shrinkage program sooner than initially planned. The problem is that liabilities which the Fed does not control and provides on demand, such as currency and non-bank deposits at the Fed, are rising a much faster clip than anticipated. This is occurring even as the Fed is draining federal funds from the system and effectively reducing the quantity of bank reserves held as deposits at the Fed.

The Fed would also like market participants to believe that the balance sheet shrinkage (aka QT, or quantitative tightening) is not having an impact on markets – more like watch paint dry. This is not the case. Quantitative easing or QE had the effect of supporting equities and reducing market volatility. The unwinding of QE, or QT, is having the opposite effect by creating the conditions such that any given market surprise or catalyst is having a much larger impact than the same catalyst would have had in the era of QE.

We also note that QE had virtually no impact on economic growth or inflation. Indeed, the Fed has had little to no ability to create any inflation, even though it has tried very hard, as have other central banks such as the European Central Bank and the Bank of Japan. There is no longer any “on” switch that central banks can pull to create inflation. The latest idea, proposed by the President of the NY Fed, is to allow a temporary higher inflation target after a period of under-shooting the current 2% target. Our perspective is that raising the target inflation rate will not raise inflation expectations. Raising the target rate of inflation is simply Fed-speak for telling market participants that the Fed plans keeping rates on “hold” until inflation rises above 3%, regardless of how tight labor markets might seem as viewed through the lens of the unemployment rate. Of course, if the economy decelerates, as it well may already be doing, the next rate move by the Fed could be a rate cut.

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By: CME Group

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