Despite the sharp focus on US-China tensions in recent months. DBS rates strategists Eugene Low and Duncan Tan see this sabre-rattling generating more heat than light for interest and FX rates. Key indicators do not suggest an impending sell-off, with the pair expecting Asian interest rates to remain stable despite potential geopolitical escalation before US Presidential Elections in November. Key pillars of interest rate stability, they say, remain intact.
Asian central banks, claim Low and Tan, are likely to continue supporting government budget financing and smoothen rates volatility against the context of relatively static policy rates. Developed market central banks are also expected to keep policy settings accommodative for an extended period, suppressing rate volatility in the process. An environment conducive for carry is therefore likely to arise.
Swap pricings at the moment suggest that policy rates are likely to be broadly stable across Asia. “This is largely a function of the exhaustion of conventional monetary policy space in many countries, with policy rates close to or already at their lower bounds,” write the DBS strategists. Malaysia and India are exceptions, however, where swap markets appear to be pricing for one last cut in the present cycle of monetary easing, add the duo.
China has been withdrawing liquidity from markets via open market operations to normalise the spread between market and policy rates. This has been the case since the People’s Bank of China (PBOC) allowed the 7D interbank repo to deviate 60-90bps below its reverse repo rate in April and May.
So far, around RMB1.4 trillion ($1.92 trillion) has been withdrawn via MLF/TMLF and repo operations. With the seven-day (7D) interbank repo rate back up to 2.15-2.25% range compared to the People’s Bank of China’s (PBOC) 2.2%, normalisation has been completed, allowing volatility in onshore funding markets and China Government Bonds to abate.
“That said, current market pricing is slightly more hawkish, with onshore swaps pricing for the 7D interbank repo rate to [approximately] rise a further 30bps, essentially some overshooting above the policy rate. We however do not think the 7D repo rate will stay elevated beyond the short term,” continue Low and Tan.
The US is expected to ease monetary conditions at the Federal Reserve's next Open Market Committee meeting in September, says Bank of Singapore (BOS) currency strategist Sim Moh Siong. Renewed Covid-19 outbreaks, disappointing jobless claims and weak consumer confidence could lead to some US growth moderation, prompting the Fed and Congress to maintain strong fiscal and monetary stimulus. Falling US real yields and rising risk assets will exercise further downward pressure on the greenback, argues Sim.
“We expect the Fed to shift to ‘average inflation targeting’, which means the central bank may not start raising interest rates from their current levels near zero for up to the next five years,” says Sim. He sees the Fed shifting to “average inflation targeting”, which would see the central bank holding low interest rates for as long as the next five years. Risk assets will benefit from a greenback downtrend, observes the BOS currency strategist, with economic uncertainty unlikely to undermine demand for such assets.
Two risk factors could, say Low and Tan, change present circumstances. The first involves November polls in the US, where a sweep by the Republicans or Democrats of the Presidency, Senate and House of Representatives could see financial markets pricing in increased likelihood of fiscal stimulus and reflation. US rates bear curves steepened following the 2016 elections following a Republican sweep, dragging Asian rates along. Even if bear-steepening were to be more limited this year, the US economy and the global economy could still be hit.
Pre-election sabre-rattling could also affect the exchange rate between the USD and RMB as well. “We lower our 12-month US dollar/Chinese yuan target to 6.75 (previously: 6.80), with the extent of spill-over from a weaker USD outlook limited by rising tensions between the US and China -- a trend that should continue as the US presidential election enters a more intense phase,” argues Sim, who notes that theTrump Administration will avoid anti-China policies to avoid destabilising US financial markets so close to the upcoming polls.
A Biden victory would see a strengthening of the RMB, since his administration will probably look to move away from tariffs as a tool of enforcement and take a less disruptive approach to US-China relations. “Historically, [the] RMB has moved notably on tariffs but less so on other types of escalation events,” observes Sim. The Democratic nominee’s lead in both pills and prediction markets over Republican Trump suggests that this is the most likely outcome of the elections.
Low and Tan also suspect that inflation could rear its ugly head should central banks accidentally overstimulate their economies with their unprecedented stimulus packages. Despite strong recessionary pressures across regional economies, the risk of an inflation surprise to the upside later in the year via flush liquidity, supply side disruption or even stronger than expected recovery could see Asian real rates too low to combat inflation. India is a particular concern for the analysts, with domestic inflation near the top end of its central bank’s 2-6% target range.
Low and Tan are forecasting gross bond issuances in Asian credit markets to come in at 1.50-1.75 times that of 2019. Most countries have completed 40-45% of their full-year projected issuances by June. “Revised budgets in 2Q due to COVID-19 is the main reason why issuances appear to be behind the run-rate,” note the DBS duo, who anticipate the possibility of a slight pickup in the pace of issuance in 2H2020.
