Today’s podcast

Overview: Ship to wreck

• Slide in oil prices and BoE Carney warning over trade tensions shipwrecking the global economy triggers a rally in core global yields with gold also a beneficiary
• EU and US equities have another positive day in spite of cautious mood evident in bond markets
• USD is little changed – JPY (lower yields) and AUD (RBA) top the leader board while GBP is the laggard (Carney)
• Christine Lagarde nominated to succeed ECB Draghi
• AU Building approvals, China Caixin Service PMI today’s focus ahead of US ADP and ISM non-manufacturing tonight

Did I build this ship to wreck? To wreck, to wreck, to wreck – Florence + The Machine

The move lower in core global bond yields alongside a sharp decline in oil prices are the highlights from the overnight session. Underwhelming reaction to OPEC’s agreement to extend production cuts for nine months was one factor while BoE Carney’s warning of a shipwreck to the global economy, if trade tensions intensify, was the other. EU and US equities had another positive session, although outperformance by defensive sectors point to investors’ cautiousness. Moves in currencies have been relatively modest with the USD little changed in index terms. JPY outperformed on the back of lower UST yields while AUD is the other winner as the market looks beyond yesterday’s RBA decision to lower the cash rate to 1%. GBP is the underperformer following soft data and Carney’s remarks.

All the main action occurred around midnight with oil prices embarking on a sharp decline ( WTI-4.84%, Brent -3.92%) following news that OPEC and Friends had agreed to a nine months production cut. While a cut in supply should be good news for oil prices, the market focus appears tto be on the demand side with the slowdown in manufacturing activity readings throughout major economies the overriding concern. Unfortunately for OPEC, as news of the supply cut agreement was being released, speaking in Bournemouth BoE Carney was warning of downside risks to global and UK growth and the possibility that trade tensions had the potential to “shipwreck the global economy.”

The move lower in oil prices and Carney’s remarks triggered a rally in core global bond yields with 10y UK gilts leading the charge dropping 9bps to 0.72% while 10y UST yields fell 5bps to 1.97%. The market has moved to price a slightly better than even chance of a BoE rate cut (to 0.5%) at its November meeting, which would bring it into line with other central banks planning to ease policy.  A sharp fall in the UK construction PMI, to its weakest level since April 2009, only added to the gloomy market sentiment.

In Europe, German bund yields fell another 1bp to a fresh record low of -0.37%, but the larger moves in the government bond market came in the peripheral countries, with Italy falling another 13bps, on top of yesterday’s 13bp fall.  The sharp falls in Italian yields follow news yesterday that the populist government had agreed to make changes to its budget to comply with the bloc’s rules and in order to avert financial sanctions from EU.  Additionally, the prospect of further ECB rate cuts, and even more negative rates, is likely to create demand for higher (positive) yielding bonds, including Italy.  The Italian 2 year yield briefly went into negative territory for the first time since the new populist government was formed.  57% of the European government bond market, by face value, is now trading at negative yields and, by our estimates, around 35% of all developed market government bonds.

Notwithstanding the cautious mood in core global bond yields, EU and US equity markets had another positive night with all major equities indices on both side of Atlantic showing gains for the day.  That said a closer look at the S&P 500 shows a guarded tone with defensive sectors such as utilities (+1.24%) and real estate (+1.82%) outperforming while the energy sector is the big loser down 1.74%. For all the heightened concern about trade tensions and global growth, the S&P500 remains within a whisker of its all-time high and the VIX measure of implied volatility sits just above 13, a low level on a historic basis.  The equity market clearly expects more central bank support to be forthcoming if growth continues to deteriorate. 

As it has been the case for a while now, moves in currency markets have been more subdued. The USD is little changed in index terms ( DXY @96.77, BBDXY at 91.5) while within G10, JPY is the outperformer (0.5% USD/JPY at ¥107.88) reflecting its sensitivity to moves in 10y UST yields courtesy of the BoJ’s Yield Curve Control policy. AUD is the other modest outperformer, up 0.36% and now trading at 0.6994.

The AUD has been a focus of  attention with the RBA Board expected to and then delivering the second monthly cut in a row.  Yesterday the RBA cut the policy rate to 1.00% and signalled that it would be monitoring developments in the labour market closely and adjust monetary policy if needed to support sustainable growth and support the achievement of the inflation target over time.

We interpret the IF in the statement as the Bank recognizing that it might need to cut again if it fails to achieve “faster progress in reducing unemployment … [and] more assured progress towards the inflation target”.  For FX though, the view that from here the RBA is a reluctant cutter is carrying some weight and probably best explains the post-announcement gains. NAB’s house view is unchanged, i.e. we continue to expect another cut to 0.75%, pencilled in for November.

As for the NZD, the pair is unchanged at 0.6673 and showing little reaction to the soft QSBO survey. The QSBO’s domestic trading activity indicator covering the past three months fell to -4, well below its long-term average of +11 and consistent with annual GDP growth running somewhere around the 1% mark (well below both our and the RBNZ’s forecasts).  Trading expectations for the coming three months fell to -4, the first negative print since the 2008/09 recession (although still significantly above the levels reached at that time).  All-up, the QSBO reinforces our expectation that the RBNZ will cut the OCR to 1.25% at its August MPS, with the growing risk of further easing beyond that.  The market currently prices a terminal OCR of just below 1% by mid-2020.

Looking at other majors, BoE Governor Carney’s speech dented the GBP (-0.3% now at 1.2593), which was the only currency to fall against the USD overnight.  The EUR (+0.05%) reversed an earlier rise linked to a Bloomberg report which claimed the central bank’s current thinking was to leave rates unchanged at the upcoming meeting this month before cutting in September.  The market prices a 30% chance of a 10bp rate cut by the ECB this month, with 13bps priced-in for the September meeting.

The move lower in yields on the back of concerns over the global growth outlook also benefitted gold with the yellow metal gaining over 2% over the past 24 hours. Gold is back above the $1400 mark and the swift move to $1418 will have many wondering whether a test of the $1439 highs reach on June 25 could be in the offing. Iron ore has been the other big mover, up over 3% and closing at $123. Supply jitters seem to be still playing out, but China’s announcement of a RRR cut to support lending to SMEs has not done any harm either.  The AUD continues to take no notice of the price of Australia’s number one export (understandably so if it’s only a short term burst higher from Vale production woes), but the Federal Treasurer will be, each dollar adding more to Federal coffers.

Finally, European leaders agreed that Christine Lagarde, the current head of the IMF, will be the next ECB President, replacing Mario Draghi when his term ends at the end of October.  Lagarde’s appointment is still to be confirmed, but the announcement will be a relief to those worried about the outside chance that Bundesbank President Jens Weidmann could have taken the helm.  Lagarde has been openly supportive of past unconventional policy actions by the ECB, including OMT and QE.

Coming up

• NZ QV House Prices (Jun), ANZ Commodity Price (Jun)

• AU AiG Perf of Services Index (Jun), Building Approvals (May), Trade Balance (May)

We expect that building approvals to have declined further, by 1%, as house approvals continue to fall, by another 3%, with caveat that this data can be volatile.

The trade surplus continues to improve and has been almost continuously underestimated by the market since December. We are forecasting a record surplus of $5.8b on the back of iron ore and coal exports strength. Should the surplus remain this large, that could see Australia record its first current account surplus since the 1970s.

• JN Markit Japan PMI Services (Jun)
• CH Caixin China PMI Services (Jun 52.6 exp. vs 52.7 prev.)
• GE Markit Germany Services PMI (Jun F)
• EC ECB’s Villeroy speaks in Paris
• UK BOE’s Broadbent and Cunliffe speaks

• US Jobless Claims (221k vs 227k prev.), Markit US Services PMI (Jun F), Durable Goods Orders (May F), Trade Balance (May), Factory Orders (May), ADP Employment Change (140k vs 27k prev.), ISM Non-Manufacturing Index (Jun 56 exp. vs 26.9 prev.).

Market is looking for a rebound in the ADP number after a disappointing May print, leading indicators such as the sub ISM employment indices, suggest a rebound is likely.

As for the non-manufacturing index, the market is looking for easing in the headline number to 56 from 56.9, so still comfortably in expansionary mode. That said given the heightened trade tensions over the month of June, one could argue that the risk are to the downside  with sectors such as transportation, trade and financing potentially affected by trade uncertainty. Meanwhile the decline in home sales, also suggest downside risk on the construction sector.

Market prices

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