Rate Differentials Pack a High Yielding Punch

Thursday July 13: Five things the markets are talking about

As expected, Central Bank action and rhetoric is keeping capital markets on their toes.

In her testimony to Congress yesterday, Fed chair Yellen said that there is no rush to tighten monetary policy as inflation remains consistently “below” target.

The Fed expects the U.S economy to continue to develop in the current direction, which will grant policy makers’ room for “gradual” rate hikes and that reduction in the balance sheet is likely to begin this year.

The market interpreted her comments as ‘less hawkish’ – this has allowed U.S Treasuries to rally, the dollar to underperform vs. G10, and U.S equities to print fresh record highs.

Her counterpart at the Bank of Canada (BoC), Governor Poloz raised interest rates by +0.25% to +0.75% as widely expected, the loonie, however, gained +1.5% outright to record a new yearly high (C$1.2695) as his statement and comments were perceived as being more ‘hawkish.’

The Governor cited “robust” economic activity that’s led to a “significant amount” of economic slack disappearing. It now expects the output gap to fully close before the end of 2017, versus a previous forecast of during H1 2018.

As for future rate moves, BoC said adjustments to be guided by data–which has been strong of late–although adding it will keep in mind continued uncertainty posed by the Trump administration’s trade policy, and issues related to record levels of household debt and frothy real estate.

1. Stocks get a boost from dovish comments

U.S stocks took heart from Ms. Yellen’s speech indicating a slower rate of hikes, as stocks across the board rallied with the Dow reaching a new all-time high and close.

In Japan, equities ended flat overnight, as gains in tech shares offset weakness in financial stocks after U.S yields slipped. The Nikkei closed +0.01% higher, while the broader Topix ended down -0.01%.

In Hong Kong, the Hang Seng Index climbed +1.1% to its highest level in two-years.

In China, stocks also firmed, with the blue-chip index closing at an 18-month high, supported by solid trade data. The blue-chip CSI300 index rose +0.8%, while the Shanghai Composite Index gained +0.6%.

Note: China exports rose +11.3% in June y/y, while imports expanded +17.2%, which suggests their economy is holding up, supported by global demand.

Elsewhere, Australia’s S&P/ASX 200 Index strengthened +1.1% on the back of China’s data, while in South Korea the Kospi rallied +0.7% when the Bank of Korea (BoK) held steady its benchmark rate, as expected.

In Europe, indices opened flat, but have moved higher ahead of the U.S open. Ms. Yellen is to continue speaking today and attention is also turning to the first reports of earning season.

U.S stocks are set to open in the black (+0.2%).

Indices: Stoxx50 +0.5% at 3,539, FTSE +0.1% at 7,424, DAX +0.4% at 12,678, CAC-40 +0.7% at 5,259, IBEX-35 +1.0% at 10,671, FTSE MIB +0.4% at 21,524, SMI +0.4% at 9,049, S&P futures +0.2%

2. OPEC compliance with oil cuts falls to 6-month low, gold stable

Oil prices are again under pressure on worries about oversupply as the IEA this morning warned that a long-awaited market rebalancing could be delayed due to weak compliance with production cuts among OPEC members.

In its monthly report the IEA has issued a stronger outlook for global oil demand, however, with consumption in Germany and the United States increasing in recent months.

The report also noted a dramatic recovery in oil production from Libya and Nigeria and a lower rate of compliance by OPEC with its own output agreement.

Brent crude fell -34c to +$47.40 a barrel, while U.S light crude (WTI) is down -32c at +$45.17.

Note: Oil prices have dropped recently to levels not seen in 18-months as the market loses faith in a deal between OPEC and non-OPEC producers to reduce output, while U.S. shale oil production rises.

Gold prices (+0.2% to +$1,222.99 an ounce, a fourth day of gains) are holding steady ahead of the U.S open, as the Fed seems set to only gradually tighten monetary policy, curbing speculation that interest rates would rise more than once this year.

3. Yields fall on Yellen’s comments

Similar to equities, bond prices have got a lift as the Fed’s Yellen sounded caution on inflation.

Prior to Yellen’s comments yesterday, global yields had been backing up, spooked by what seemed a collusion effort by top central banks about tightening monetary policy.

Fed fund futures are now only pricing a 50-50 chance of a rise by December.

U.S Treasuries have rallied in reaction, clawing back a third of their selloff with yields on two-year notes falling to three-week lows, while U.S 10’s is down another -1 bps overnight at +2.32%.

Germany’s benchmark 10-year Bund yield is flat, trading atop of its psychological +0.5% and has now given back a quarter of the rise triggered by last month’s hint from ECB’s Draghi that it was readying to scale back stimulus.

Elsewhere, the yield on Aussie 10-year notes has dropped -3 bps to +2.69%.

4. Dollar underperforms across the board

The ‘mighty’ dollar has fallen broadly after Ms. Yellen’s comments were perceived as “dovish” and potentially dampening the outlook for future interest rate rises.

Currently, the EUR trades up +0.2% at €1.1423, while sterling is up +0.3% at £1.2928 and the loonie is holding steady at C$1.2732 after gaining +1.5% intraday yesterday. There was a lot of interest from Europe to own CAD on the crosses, especially against EUR (€1.4516) and GBP (£1.6446).

Higher-yielding currencies have been the strongest performers, as carry traders return to take advantage of the rate differential however, with the AUD rising +0.6% to a 16-week peak of A$0.7728 and the NZD up +0.75% at NZ$0.7340. Also supporting the antipodeans is the stronger than expected Chinese trade data showing strong imports.

5. Germany’s June inflation numbers

Data this morning from Germany’s statistics office confirmed last month’s inflation figures – prices grew by +0.2% m/m and +1.6% on the year.

Note: In harmonized European terms, the price gain was +0.2% and +1.5% respectively.

Digging deeper, the data showed that energy prices were stable year-to-date in national terms, while food prices were up +2.8%. Ex-food and energy, prices grew by +1.6% on the year.

Among key categories, package holidays saw the sharpest annual gain, growing by +5.6%, while on the flip side, gas and vegetables both declined by -3.2% on the year.

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