US treasuries jolted by payrolls; USD finds support
Friday's payrolls were better than expected (actual: 224k, consensus: 160k), jolting US Treasuries. US yields were up 7-9 bps across all tenors as market participants had a re-think about the probability of Fed cuts this month. Ahead of payrolls, the market was pricing in between 1-2 Fed cuts in July. We thought that the USD rates space was overly complacent on Fed cuts (see Macro Strategy, 2nd July) and was vulnerable to a squeeze higher if payrolls (a historically volatile series) surprise on the upside. With the immediate threat of China-US trade war out of the way, the urgency for Fed cuts has waned. At this point, the market is still fully pricing in a cut by July but bets of a 50 bps reduction have been removed.
Given these developments, we think that the odds for a July cut are probably closer to 50-50 and short-end USD rates might drift modestly higher in the coming few weeks. It is important to distinguish between insurance cuts (2-3 cuts) and recession cuts (four or more). At this point, it is too early to say that a recession is imminent. We do not think that the market will remove Fed easing expectations even if the data proves strong. With China and Eurozone numbers still lacklustre, guarding against downside risks is probably the priority. In any case, we think that upside to longer term USD rates may be limited as long as the European Central Bank (ECB) keeps policy ultra-loose.
FX: USD supported ahead of Powell testimony; GBP worried about hard Brexit
Fed Chairman Jerome Powell’s semi-annual congressional testimonies on July 10-11 will be important for the US dollar. Last Friday’s stronger-than-expected US nonfarm payrolls for June (224k actual vs 160k consensus) propelled the DXY to 97.2 from its 96 low on June 24. The sessions will also be an opportunity for Congress to stand behind the Fed’s independence and to insulate the institution against short-term political interests. If asked, Powell will reiterate that it is not the Fed’s job to weaken the US dollar but to achieve its “price stability, full employment” dual mandate. Hence, the recent upside surprises in in US data and the China-US tariff ceasefire should support the Fed’s case for “insurance cuts” against global headwinds and not “a rate cut cycle” against recession risks. What the US dollar bears fear most is probably a signal from the Fed that it will be patient on cuts in favour of keeping the powder dry.
According to YouGov, Boris Johnson is leading 74-26% in the Conservative Party leadership contest to become Britain’s next prime minister later this month. Most of his supporters believe that Johnson is more determined than Jeremy Hunt to lead the UK out of the EU without a deal on October 31. The reason alone is enough to keep the British pound on its depreciating path towards its post-2016 referendum low of 1.20. To avoid a disorderly Brexit, UK needs EU’s support to renegotiate the deal or work on a new deal, or another request to delay Article 50. Brussels has, however, responded to Johnson’s pledge to take UK out of EU with or without a deal with its “withdrawal agreement or nothing” stance. Unless both sides break the deadlock, UK lawmakers will struggle to overcome the legal default position of a no-deal Brexit.
Equities: Selective approach warranted to Asia markets
As weak US economic data have bolstered expectations that the Fed will cut rates, we believe equity markets will continue to focus on monetary easing till the first rate cut occurs. We think it is likely to be in September as the US data are just not weak enough to justify a rate cut as yet. However, before Friday, Fed futures are already almost pricing in a 100% chance of a rate cut in the next Fed meeting. The tussle between growth and rate cuts will likely drive investors to rotate between the two benefitting groups – export-oriented or domestic-demand economies / sectors. After Friday’s strong non-farm payrolls report, we believe the markets of South Korea, Taiwan, and Thailand could see some relief.
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