The sell-off in stocks in China and Asia has further fuelled the bid for US Treasuries. This week, the market’s focus is the meeting of policymakers at the US Federal Reserve.
Covid-19 – An inflection in the UK
The last few days have seen an inflection of Covid Delta cases in the UK. This is potentially a significant development as many investors have been anxiously following the rapid rise of Delta cases in the fully opened UK over the past month, looking for signs of a slowdown or inflection. UK case numbers fell significantly over the week and appear to have peaked. Furthermore, despite the recent rapid rise of cases to near peak levels, mortality is currently 95% lower than during the January peak.
This development offers comfort to continental Europe as the Covid situation in the UK is reckoned to be 8-12 weeks ahead of that in Europe. If this development is confirmed more widely, it could trigger a market rotation back into value stocks, reflation trades and reopening themes.
Vaccination remains the key in overcoming the challenge posed by the Delta variant. In countries where vaccination rates are high, there is an increasing uncoupling of rising Covid cases from hospitalisations and deaths, while in countries with low rates, cases and hospitalisations/deaths are rising proportionately. Risks are high in countries with low vaccine penetration, especially in south and southeast Asia, Africa and emerging economies elsewhere.
Regulatory news roils Chinese stocks
The sharp sell-off in Chinese stocks that began late last week now appears to be slowing. It came after authorities in Beijing launched a crackdown on education and technology companies to prevent market and improve oversight.
Hong Kong’s Hang Seng index is now 20% below its February high, putting it on the brink of a bear market. It fell by more than 5% on 27 July, while China’s CSI 300 index of Shanghai and Shenzhen-listed stocks fell by 3.5%.
Chinese tech stocks plunged as investors reacted to the risk of a broad crackdown on numerous sectors. On 23 July, a leaked memo revealed a sweeping overhaul of China’s USD 100 billion private education industry. The regulatory changes were confirmed over the weekend.
Regulatory tightening is not new in China: It also occurred in 2016 and in 2018. The country’s digital economy accounts for about 40% of GDP, while the tech/internet sector represents about 40% of the weight of the MSCI China index, underscoring its importance to China’s growth prospects at both the macroeconomic and equity market levels.
Our view is that the government does not aim to destroy these sectors as innovative companies will continue to be the drivers of growth drivers. After the dust has settled, some companies will have a harder time, while others will emerge stronger amid the new regulatory paradigm.
For a full analysis of this development by our heads of greater China and Asian equities, click here.
Turbulence in US markets
Last week began eventfully in US markets as the yield on the benchmark 10-year US Treasury plunged to levels not seen since early February and equity markets sold off aggressively, just a week after the S&P 500 index hit a record high.
The explanation advanced was that markets worried economic growth would falter because of the sharp increases in new Covid infections caused by the Delta variant. As the week ended with some hope that Delta might be manageable, markets were back to near where they started.
The week of 26 July began with a significant fall in US real yields to a record low. The real yield on 10-year US Treasuries fell further into negative territory as anxiety over the economic outlook refuelled the recent buying in bond markets. The real yield fell to minus 1.13% as the stock market sell-off in Asia drove investors into safer havens.
Real yields in the eurozone also traded at all-time lows on 26 July; the 10-year real interest rate swap fell to minus 1.65 %.
Fed policy meeting to review outlook, inflation, tapering
The 27-28 July meeting of the Federal Open Markets Committee (FOMC) is important as investors await signals on a tapering of the central bank’s USD 120 billion a month asset purchases. In addition, there are mixed developments: A new Covid wave looms in the US, possibly affecting the growth prospects, yet inflation is stubbornly high, while markets have been somewhat volatile.
The three areas of focus of this meeting are likely to be:
- How the Fed’s characterises the new Covid wave and its impact on the growth outlook
- The Fed’s assessment of the inflation dynamic and labour market conditions
- Any potential signals and details of upcoming tapering.
Our assessment of how the Fed will react to these questions has changed since the 16 June FOMC meeting. We had believed the new Flexible Average Inflation Targeting framework meant the Fed was actively looking to overshoot its 2% target to make up for previously below-target periods. We now believe that, while an inflation overshoot may be an objective, there is no commitment to achieving it.
It now seems that many FOMC members merely want to ensure they do not tighten policy pre-emptively. They still have limited tolerance for inflation overshoots and additional concerns about the financial stability risks of keeping policy too easy (with some highlighting the boom in house prices). If this interpretation is correct, the FOMC’s true reaction function is in fact closer to a more traditional inflation-targeting framework.
If the FOMC is indeed less tolerant of inflation overshoots, there are several implications:
- A more hawkish Fed weakens the rationale for pricing in an inflation overshoot at longer maturities, or pricing in an inflation risk premium. The implication is that 10-year breakeven inflation (BEI) rates should be closer to 2.3% than 2.6%, and longer-dated nominal Treasury yields should be lower.
- The FOMC will act earlier and more swiftly to head off upside inflation risks, which implies a more rapid normalisation of policy. The tapering of asset purchases would likely be less drawn out and interest rate rises would come earlier and be less gradual. The front end of the Treasury yield curve is therefore less anchored.
- Markets will become increasingly sensitive to employment and inflation data as investors seek to assess the state of the ‘sufficient further progress’ conditions for the tapering of quantitative easing (QE) to begin.
Our view is that the US economic recovery should maintain momentum amid ongoing vaccinations, fiscal support and self-reinforcing employment gains. We expect hiring to gather pace in the coming months as temporary restrictions on the availability of labour fall away.
Paradoxically, the Fed’s more hawkish stance at the June meeting has helped to lower US Treasury yields and to further ease financial conditions. We acknowledge that fiscal support will fall away in 2022, but note that it will likely no longer be needed as the economy reaches full employment in the first half of next year.
The primary risk to this outlook is the rapid spread of the Delta variant. For some under-vaccinated communities in the US, the result may be a sharp rise in hospitalisations. With vaccines now freely available, however, we cannot conceive that state governments will ask their citizens to lock down once again to protect those who have declined to protect themselves.
Nevertheless, the surge in Delta infections has unsettled investors and supported a bid for Treasuries. After the June FOMC meeting, we now expect QE tapering to start in early 2022, and the signal will likely come in September, or perhaps even at the August Jackson Hole Symposium.
In our view, rate lift-off is set for March 2023 with the Fed likely to deliver a 25bp rate increase per meeting, taking the fed funds policy rate target to 1.75–2.00% by end of 2023.