Same Macro Headwinds

New York Fed Governor Dudley’s comments yesterday underscored what we already know: that the Fed is unlikely to lift interest rates while markets panic. But ultimately, the same global macro headwinds, and poor final demand conditions persist.



Dudley’s soothing words, along with a late day surge in Chinese equity prices, has shifted investor sentiment in a positive direction for now. But we maintain that the dynamics of the global economy have not materially changed. The Fed backing off from September could give financial markets some breathing room, but unless the dollar weakens substantially, the poor U.S. profit picture is unchanged.

In addition, DM equity markets are no longer ignoring the risks from China and EM. As highlighted in the next Insights, our EM strategists believe the EM selloff has further to run, implying that a cautious DM approach is still warranted.

Chinese Stocks: The New Unknown

There are two forces driving Chinese stocks:


  • The PBoC is among the few major central banks that can engage in further monetary easing, and China’s ongoing fiscal stimulus programs will likely shift into high gear in the coming months. This, together with a stable household sector and service industries, should preclude major growth disappointments.
  • But investors are no longer just worried about the growth slowdown. Even though the flash manufacturing PMI last week may have contributed to the selloff in Chinese shares, the growth slowdown is not new news, and should not have caused such dramatic market reactions. The new unknown is the Chinese authorities’ willingness and ability to keep things “under control”. Notoriously poor policy transparency has further worried investors, leaving fear and anxiety dominating sentiment. As a result, anything China related is aggressively liquidated.

Our China strategists expect that the growth outlook will eventually matter for stock prices from a cyclical point of view, but it will be an uphill battle for the Chinese authorities to regain credibility. Until then, the risk premium attached to Chinese equities will stay elevated.

Global Deflation Trends To Intensify?

Understanding Chinese policymakers’ motives is tricky and can be contentious. Leaving aside whether the motivations behind the move to make the exchange rate responsive to market movements were economic or political, what is clear is that the risks are on the side of more deflation for the global economy.


Our EM strategists have expected for some time that the Chinese RMB would depreciate around 7-8% this year, while our China-focused strategists have argued that any depreciation would be more benign, because Chinese policymakers have a strong interest in maintaining a stable exchange rate and to avoid being labeled a “currency manipulator”.

Investors should not ignore the irony that today, the PBoC intervened to stabilize the currency after only one day of allowing the market “to play a greater role in determining the currency”. This suggests that it is unlikely that the PBoC will completely give up control and allow the official rate to drift along with spot market rates.

Regardless, the balance of forces were already tipped toward more global deflation. A weaker RMB would only serve to further undermine Emerging Asian currencies, which means that China along with the whole of manufacturing Asia, will potentially further cut export prices in U.S. dollar terms. That would continue to suppress inflation in the rest of the world in general and the U.S. in particular. U.S. import prices from Asia are already deflating.

As for the Chinese economy, one major problem remains the overhang of credit, please see the next Insight, China: Credit Impulse Versus Government Spending.

What Will Dominate The Bond Market?

Fears of a policy misstep help to explain the flattening of the U.S. Treasury curve.


The two-year yield is moving higher as we approach the Fed liftoff date, but the 10-year yield is not reacting as it normally does at this stage of the cycle. Even in the 2004-2006 bond “conundrum”, the long end of the yield curve initially surged when expectations for rate hikes ramped up, just prior to the first interest rate increase. After the initial sell-off, the 10-year Treasury yield drifted sideways for the entire Fed rate hike cycle.

This time could very well play out differently. The rising risk of a nasty equity correction raises the possibility that there is no sharp upward adjustment in our 12-month Discounter; the market could simply assume that the Fed will not be able to follow up with a second rate increase anytime soon and/or that the terminal level of the policy rate is lower. A spike in the VIX and bond volatility related to “policy error” fears would push corporate bond spreads even wider, but would also support the long end of the government bond curves in safe-haven countries like the U.S. and Germany.

Global factors are also helping to offset the impact of higher short-term yields on the long end of the Treasury curve. Inflation expectations continue to fall along with commodity prices. Moreover, QE in the Eurozone and Japan is quietly withdrawing duration and driving the search-for-yield in the background.

Bottom Line: Our base-case outlook calls for higher global yields in the near term, driven by a hawkish repricing of the U.K. and U.S. money market curves, followed by flat-to-lower yields on a 12-month horizon. The risk is growing that the global disinflationary backdrop and an equity correction dominate, allowing global yields to trend lower even in the near term.

Global Policy Divergence Still At Play

Events and economic data over the past couple of weeks reinforce the divergence between U.S. and Eurozone monetary policy.


In terms of the ECB, the rollover of long-term inflation expectations is undoubtedly quite uncomfortable. The last thing the central bank needs is another deflation shock. Lower inflation expectations would push up real short-term interest rates, threatening to tip the Eurozone economy into a Japan-style liquidity trap.

Moreover, upward momentum in credit growth is losing steam, suggesting that growth disappointments will arrive this autumn in Europe. The combination of depressed inflation expectations and slowing growth momentum would send Bund yields sharply lower as investors discount “QE-forever” from the ECB.

In sharp contrast, the FOMC appears determined to hike rates this year. Whether one agrees with the FOMC or not, policymakers are anxious to lift rates off of the zero bound, now that the labor market is in the vicinity of full employment.

The market is still pricing in about a 50% chance of a September rate hike, implying that the short-end of the Treasury curve remains at risk.

Bottom Line: The “policy divergence” theme is still in play; favor Bunds to Gilts and Treasurys.