China and the CNY are key for the global cycle. If USD/CNY continues higher, it may worsen the global slowdown already predicted by our models.
In the latest FX weekly we suggested it was time for a little breather in the trade war, at least between the EU and the US. This has been temporary good news for e.g. cyclical equities but bad news for bonds. However, when we look a bit further ahead, we continue to see worrisome signs for the global industrial cycle, as for instance signalled by recent pain in industrial metal prices. We also suspect EM turmoil will “spill back” on Euro-area and US data after summer, see Global: Could spillbacks trigger a Buenos Aires accord?
Looking at China, the humongous trade surplus in June might also boost China/US tensions. USD/CNY has re-jumped above 6.70, spilling over negatively to ADXY (which has hit new lows), as well as buoyed USD/JPY (sadly erasing earlier performance from our NZD/JPY short).
CHART 1: WHAT CHINA ALLOWS, OR DECIDES, WILL BE KEY FOR THE GLOBAL CYCLE
What China allows, or decides, will be key for global assets and for the manufacturing cycle (a stronger dollar tightens EM financial conditions). If USD/CNY continues higher, then it may worsen the global slowdown already predicted by our models.
CHART 2: EUR SWAP RATES – GETTING READY TO BREAK DOWN?
In the Euro-area, the 10y swap rate has been sniffing at the lows of its uptrend since late 2016. ECB’s minutes and slightly softer US inflation make a hawkish shift seem distant. Trump criticizing of May’s Brexit approach also triggered plenty of Bund purchases on Friday.
CHART 3: ENERGY PRICE BASE EFFECTS PEAK IN AUGUST, DWINDLE AFTERWARDS
In a bigger picture, some of the reflationary ammunition which has helped weaken bonds this year – higher energy prices – is about to run out of steam. WTI spot recently plummeted 6% on the day. Unless oil prices keep rising the effect on US CPI will peak in August, and dwindle afterwards. This may help bonds perform further, and a painful squeeze of duration shorts surely cannot be ruled out at this juncture.
CHART 4: ED CURVE HAS INVERTED
The Eurodollar curve is now inverted between Dec20 and Dec19 for the first time since 2007, and the Fed Funds curve is almost there too (only a ~2-3bp slope). An inversion of ED10 vs ED6 curve has predicted the three recent US NBER recessions while sending a false signal once (in 1994). We suspect real rates are too low to bring about a new recession even as we predict a distinct growth slowdown. Either this part of the ED curve must steepen, or cyclicals will underperform.
CHART 5: GOLD PRICES (IN EUR) MIGHT SOAR IF WE GET A SQUEEZE OF BOND SHORTS
If things are turning sour, and we do get a bond squeeze, one way to play it might be via long gold (or, perhaps gold volatility). Or perhaps, via falling US breakeven inflation?
CHART 6: IF YOU LISTEN TO DR. COPPER, IT’S TIME TO BET ON LOWER BREAKEVEN RATES
Being long cyclical equities vs defensives also seem like a bad idea, if ISM manufacturing starts to mean-revert as we expect.
CHART 7: ISM MANUFACTURING VS CYCLICALS & DEFENSIVES
If ISM heads to its-long-term average of 52.7, cyclical equities could underperform defensives by 15% on this chart.