Markets have become more wary of economic slowdown risks of late, and the foreign exchange markets are playing “a game of two halves”, say DBS Group Research rates strategist Eugene Leow and interest rates strategist Duncan Tan.
The US dollar, for example, will depreciate in 2H2022 after a surge in the former half of the year, say the DBS economists, as the Fed ushers in the fastest pace of rate hikes since the 1990s.
“Although the Fed stepped up rate hikes from 25 basis points (bps) in March to 50 bps in May and 75 bps in June, we forecast three 50 bps hikes in July, September and November, and one final 25 bps hike in December. Our currency forecasts reflect that US bond yields have discounted the Fed Funds Rate rising above its 2.50% neutral rate to 3.50% this year,” write Leow and Tan in a June 27 note.
Fed chair Jerome Powell did not rule out a US recession from the frontloading of Fed hikes to restore price stability.
That said, St Louis Fed President James Bullard played down recession fears, citing the strong US labour market and healthy household savings.
The Fed is committed to lifting rates until inflation eases. “Thursday’s personal consumption expenditures price index (PCE) deflators will influence the Fed’s decision to hike by 50 bps or 75 bps at the FOMC meeting on July 27. Consensus expects PCE core inflation to ease to 4.8% y-o-y in May from 4.9% in April. However, the Fed is paying more attention to the monthly changes which consensus expects will rise to 0.4% m-o-m from 0.3%. As mentioned above, the bond market has priced in this year’s hikes,” write Leow and Tan.
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Europe avoids 1970s stagflation
At a central bank panel discussion on June 29, the European Central Bank (ECB), US Fed, Bank of England (BOE) and Bank for International Settlements (BIS) are likely to agree on preventing a wage-price spiral and averting 1970s-style stagflation, note Leow and Tan.
“The Fed and the BIS will favour frontloading hikes to restore price stability. ECB and BOE will probably favour 25 bps hikes but keep the door open for larger moves if inflation stays persistently high,” they write.
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However, inflation is also becoming a cost-of-living crisis, especially in the UK. “Consumers and voters are unhappy and looking for someone to blame,” say Leow and Tan. “Opposition political parties blamed monetary and fiscal stimulus measures but incumbent governments attributed the higher prices to supply-side disruptions and Russia’s invasion of Ukraine.”
The euro has been in the 1.04 to 1.06 range since June 10. ECB is committed to hiking the deposit facility rate by 25 bps to -0.25% at its July 21 meeting and end negative rates in 3Q2022, write Leow and Tan. “ECB should lean towards a 50 bps hike on September 8 if Friday’s Eurozone consumer price index (CPI) increases to 8.5% y-o-y in June from 8.1% in May, with core inflation rising to 3.9% from 3.8%.”
ECB hawks are vigilant against second-round effects from wage demands and want rates to reach neutral or 1-2% this year. To facilitate this, the ECB should unveil the details of its anti-fragmentation tool at the July meeting, say the DBS economists.
Yen falls again
The USD/JPY pair fell back to 135.23 on June 24 after hitting a high of 136.71 on June 22. The 10-year Japanese government bond (JGB) yield held below 0.25% after the Bank of Japan reaffirmed its commitment to its yield curve control policy.
However, it was also evident that the USD/JPY could not extend its uptrend when US bond yields fell on US recession fears and, to a lesser extent, a unified view from policymakers that a weak JPY was bad for Japan’s economy, write Leow and Tan.
According to US Commodity Futures Trading Commission (CFTC) data, speculators trimmed their net long USD/JPY positions to 58,454 contracts last week, below 60,000 for the first week since March 11. Risk reversals for the next six months also fell to March levels.
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Leow and Tan forecast USD/JPY ending 2022 below 130 this year.
Singapore bonds split takes
There are a few ways to view Singapore government securities bonds (SGS) currently, say Leow and Tan.
“First, similar to US Treasuries, we think that peak duration fear might well be behind us. As the Fed got serious about tightening policy, inflation expectations got contained. Accordingly, SGS will likely enjoy the same benefits as investors start to view 5Y-10Y SGS more positively,” write the DBS economists.
That said, there remains a bit of concern over ultra-long duration SGS due to the heavier issuance schedule in the coming few months, but Leow and Tan suspect that overall demand for these tenors might hold up given the general lack of supply thus far this year.
Alternatively, USD-based investors might find the pickup over US Treasuries to be very attractive from an after-swap perspective, add the economists. “These moments tend to be opportunistic and depend on large flows that skew either the bond-swap spreads or cross currency basis swaps. Currently, the USD/SGD cross currency basis swaps are compressed (more negative than usual). Accordingly, this allows for a greater pickup, especially in the 5Y and 10Y tenor SGS. Note that this also applies to euro-based investors.”
Credit divergence between Asia and other economies
Markets have become more wary of economic slowdown risks of late. The Fed is delivering the fastest pace of rate hikes since the 1990s, Europe faces the prospects of gas supply cuts and elevated energy inflation, while China’s consumption outlook looks more uncertain amid muted e-commerce festival sales, says DBS FX strategist Chang Wei Liang.
“Naturally, a higher level of economic risk should be reflected with wider credit spreads for high-yield credit. Indeed, this is happening across US and European credit markets, with their average option-adjusted spread (OAS) having climbed by more than 200 bps from the lows in 3Q2021,” writes Chang.
Curiously, Asian HY USD credit has diverged from the credit markets of advanced economies, with a sustained decline in Asian HY credit spreads since 3Q2021, he adds.
“Are Asian credit markets mispricing economic risks?” asks Chang. Digging deeper into country level credit spreads, it is easy to see that much of Asian HY spread compression is due to China, he adds.
In fact, Chinese credit which has shown the largest spread compression are those issued by companies in basic materials or industrials, or by local authorities.
Markets look to be favouring Chinese state-owned companies that are set to benefit from stimulus, such as steel producers, construction firms, and infrastructure developers.
A jump in the issuance of Chinese local government bonds earlier this year hints at a pipeline of infrastructure projects that should support profits. However, Asian credit spreads are perhaps a little too thin, and could face asymmetric risks if there is a broad slowdown, says Chang.
