FX

Markets are getting increasingly positioned for a cyclical rebound of the global economy. Beliefs in fiscal, monetary and structural policy coordination have increased, made visible not only by the US equity market reaching new historical highs, but also by investors moving away from defensives into cyclicals. G10 bond yields have rallied, with the US 10y yield gaining ~25bp from its post-Brexit 1.32% low, now trading at 1.57%.This behaviour makes sense, provided that there is an economic rebound for good. This is where our doubts come in. Sure, US growth has rebounded strongly, with 2Q GDP due on July 29 expected by the market to show a 2.6% gain following the disappointing 1.1% 1Q reading. Most of there bound has been driven by better US domestic demand.

Investors wonder if there is a paradigm change owards reflation under way. This hope is supported by the belief that fiscal policy will increase DM domestic demand, supporting demand for EM products, helping EM to overcome its overcapacity problem. EM inflows have reached their highest levels since 2013,allowing EM equity and bond markets to rally. Brazil issued US$1.5bn last week, seeing an impressive US$6bn order book. EM bond spreads have declined to their lowest level since June 2015. Importantly, higher US bond yields did not push EM bond yields higher, allowing EM real yields to decline further. As long as this process continues, investors should remain EM asset class-supportive, overlooking bearish information derived from falling commodity prices and the expected continued slide lower of RMB.

When PBOC Governor Zhou Xiaochuan described the Chinese yuan trading stable against a basket of currencies suggesting that “the market has more confidence in the yuan” then it did not sound like China intended to change any of its policy allowing the yuan to decline by just under 7% in the last year. China’s fixed asset investment has slowed to 9.6% during the first half of this year, representing its slowest expansion rate for 16 years. China is putting reflation measures actively in place. Overnight it was the National Development and Reform Commission stating that downward pressure on fixed asset investment has been heavy, suggesting the government implementing a proactive fiscal policy ,expanding aggregate demand and stepping up efforts to improve weak sectors of the economy in order to boost investment and let it play a bigger role in stabilising economic growth. For now investors will likely view China considering more stimulus as a positive, putting this statement into context of the G20 communique promising to increase coordination of expansionary policy measures and restraining from “competitive devaluation”. Investors are willing to ignore that the latest round of fiscal expansion, notably in China, did not show desired effects.

This is why our interest rate strategy team views the current bond yield rise as unsustainable. The outcome of US durable goods orders due on Wednesday should remind investors that fixed investment should remain weak as global overcapacity and related deflationary pressure reduce willingness to put capital to work. Hence, capital demand should remain weak and likely underwhelm the projected increase in global savings coming on the back of global debt consolidation and the necessary reduction of overcapacity. Hence, the market’s current pro-cyclical market behaviour seeing bond yields and share prices rising simultaneously should soon come to fruition.
GFX