Recent days saw a rapid decline of US corporate bond spreads with the BBB spread seeingnew cycle lows this morning. EM tends to rally when US corporate bond spreads decline. NAFTA talks have turned into an idiosyncratic MXN downside risk with Mexico’s Secretary of Economy Ildefonso Guajardo Villarreal saying the country has the strength to face any long-term structural challenges in the absence of a NAFTA agreement. Overnight data releases including Japan’s machine tool orders and Australia’s consumer confidence have come in on the strong side supporting our view of an increasing pace of global economic synchronization.
Semiconductor stocks have hit a new high, oil has remained bid, but the CRB Rind index has turned offered telling us to stay short the AUD. US 10-year Treasury yield has bounced from its 200-day MAV working in favor of our bearish JPY and CHF calls.
The USD has halted its three day decline against the RMB, but China’s Ministry of Finance starting this week to discuss issuing its first USD denominated bond since 2004 tells us that USD stabilization will be short-lived. In 2004, China’s RMB was pegged to the USD and it was the outlook of USD weakness which prompted China to consider ‘currency hedging’ its strongly rising reserves by issuing USD denominated bonds. It finally converted its USD peg into a ‘dirty float’ in July 2005 starting to fix the RMB against a non-specified basket of currencies. This marked the time when global reserve managers started reallocating their currency reserves, pushing in particular the weighting of the EUR higher.
Moreover, RMB stability seems to attract foreign capital making its way into the RMB. Net investment flowing into mainland China from Hong Kong through the Shanghai-Hong Kong Stock Connect and the Shenzhen-Hong Kong Stock Connect totaled a daily record of CNY7.68bln on Monday. As of the end of August, foreign investors had put a total of CNY857.36 bln into the Chinese bond market, representing a CNY15.9 bln increase from the end of July. The RMB inflow combined with the increasing issuance of private and sovereign accounts should boost China’s FX reserves, compensating for the decline of its current account surplus of 2.9% in 2015 to 1.34% in Q22017.
Concerning the EUR we need to differentiate between noise and what determines the long-term trend. Catalan’s President Carles Puigdemont backing away from breaking the link to Madrid should normalize Spanish markets, allowing sovereign spreads to come in and the IBEX to rally. However, the long-term outlook of the EUR will be driven by reforming EMU institutions and turning EMU towards deeper integration. All this seems to be happening within an environment of strong global liquidity conditions and increasing signs of synchronized global growth creating an ideal backdrop for the EUR to rally.
Importantly, EMU’s debate has turned around and with Chancellor Merkel opening the path to creating a small and tax funded pan EMU budget, the starting signal for a move towards deeper fiscal integration has been provided. This is an important signal for the still undervalued EUR. Real money including reserve managers may increase its EUR holdings from here keeping the EUR bid. Moreover, moving away from EMU sub-optimality allows the ECB to move away from providing accommodation for its weakest link. This is why we believe markets will turn from what we called ‘trading the Italian EUR’ towards trading the EUR up towards is fair Eurozone valuation level of around 1.30. A daily closing price above 1.1850 suggests EURUSD seeing new cycle highs.