Stronger US economic data sets the stage for another surge in US rates and the USD. Global bond sell-off ripples through to NZ - big increase in NZ rates again yesterday with terminal OCR pricing nearing 4.5%

It’s been an action-packed trading session over the past 24 hours, with global rates and the USD lurching higher again, while equity markets have come under downward pressure.  A stronger-than-expected US ISM Manufacturing survey helped push the US 10-year rate up to 3.25% overnight while the BBDXY USD index has powered up to an 18-year high.  USD/JPY has broken through the 140 mark for the first time in 24 years, EUR is back below parity, and the NZD is teetering just above its recent two-year lows.  News that the Chinese city of Chengdu would go into lockdown yesterday has weighed on risk appetite.  NZ rates were sharply higher yesterday, with the 10-year bond rate breaking above 4% for the first time since June, as the market continued to lift its expectations for the peak in the OCR to a little under 4.50%.  The nonfarm payrolls report takes centre stage tonight.

The global bond sell-off continues apace.   After we went to print yesterday, US rates accelerated higher into the New York close, moves that have extended further overnight.  The 10-year rate has punched up to 3.25%, around 13bps higher than this time yesterday and around 5bps higher than at the time of the NZ market close.  The move higher in real (i.e inflation-adjusted) yields has been even more pronounced, with a 20bps increase in the 10-year real yield since this time yesterday pushing it up to 0.80%, now nearing its highest level since 2019.  The sharp increase in real yields is consistent with Fed Chair Powell’s speech from Jackson Hole, which signalled a desire to tighten financial conditions to get on top of inflation.

Stronger economic data has been behind the ramp higher in US rates overnight.  The ISM Manufacturing survey was stronger than expected, coming in unchanged in August, at 52.8, against market expectations for a fall to 51.9.  It was a good news story all round, with the key New Orders and Employment components rebounding back into expansionary territory – a positive sign for economic growth – while the Prices Paid index fell from 60 to 52.5, its lowest level since August 2020, suggesting some easing of inflationary pressures in the sector.  Separately, US initial jobless claims were lower than expected, at 232k.  After trending higher between April and June, jobless claims appear to since have levelled off at historically low levels, consistent with a very tight US labour market.

The market is pricing around a 75% chance of a 75bps hike by the Fed this month, although the all-important CPI and nonfarm payrolls reports are still to come before the meeting.  Payrolls is released tonight, with the market expecting another strong month for job gains.

It’s generally been a case of ‘good news is bad news’ for risk asset markets once again, with the increase in Fed rate hike expectations on the back of the stronger US data overnight putting renewed downward pressure on equity markets.  The logic being that stronger economic data mean the Fed will need to hike by more than previously thought (or hold rates at restrictive levels for longer), increasing the risk of a recession next year.  Fed Chair Powell was clear in his Jackson Hole speech that the economy would likely need to take “some pain” to get inflation back down to target.

Adding to the risk off mood, the Chinese city of Chengdu, with a population of some 21 million people, was locked down last night, the first time a ‘megacity’ has been in lockdown since Shanghai’s ended in late May.  The authorities’ stubborn persistence with their zero-Covid approach, and the ever-present threat of lockdowns in other major cities, remains a major headwind for both Chinese growth and global supply chains.  Chengdu is a production hub for, amongst other things, car production and electronics.  Yesterday saw the Caixin Manufacturing PMI slip back into contractionary territory, at 49.5, consistent with subdued growth in the Chinese economy.

The S&P500 was down as much as 1.3% overnight, although it has recovered over the past few hours and is now back to almost flat on the day.   Tech stocks, which are typically more sensitive to longer-term interest rates, have underperformed, the NASDAQ down 0.7%.  Weighing on tech stocks has been news that Nvidia will need special government licences to sell two of its advanced semiconductors to Chinese customers, as the US government clamps down on the export of sensitive technology.  Nvidia, which is the 11th largest company in the S&P500 by market capitalisation, was hammered 10%, its biggest one-day fall since the initial stages of the Covid shock in early 2020.  Commodities have been hammered as well, consistent with market fears of global recession resurfacing, Brent crude oil down 3.5% overnight, to near six-month lows, and copper 2.5% lower.

USD strength has been the key theme in currency markets over the past 24 hours.  The BBDXY USD index has hit its highest level on record (the index has been in existence for 18 years) while the DXY, which has a large weighting to the euro, has reached a fresh 20-year high.  The relentless rally in the USD over recent months has followed the sharp repricing in Fed rate expectations (which has flowed through to US real yields), a broad-based decline in risk appetite, and expectations that the Euro area is set for a deep recession as the energy crisis hits the region’s economy.

Some big levels have been broken in the FX market over the past 24 hours as US rates have ramped higher.  USD/JPY has broken through the psychologically important 140 level for the first time in 24 years, up 1% from this time yesterday.  Despite reports that the Japanese Ministry of Finance is watching the markets “with a high sense of urgency”, the market remains focused on the widening interest rate differential between the US and Japan, with the BoJ preventing any upward adjustment in its 10-year bond rate via its Yield Curve Control policy.

Similarly, the EUR has fallen back below parity, down around 1% overnight, despite some relative stability in gas and electricity prices.  In response to the energy crisis, Bloomberg reported that the EU Commission would propose a price cap on non-gas forms of power, with governments able to subsidise consumers’ energy bills with any fiscal windfall.  The Commission will also reportedly propose that electricity demand should be reduced, along the lines of the 15% cut to gas consumption over winter previously agreed by EU countries.  While the measures might be helpful in mitigating the acute pinch on consumer costs, the Commission noted that they wouldn’t return energy prices to pre-crisis levels, given the fundamental forces at play.  In the European rates market, the market is firmly on the side of a 75bps rate hike from the ECB next week, with around a 70% chance priced in.

The PBOC set the daily yuan fix at a stronger-than-expected level for the fifth day running, leaning against the pace of depreciation in the CNY.  The PBOC’s action helped stabilise USD/CNY during the Asian session, although it now remains within sight of the psychologically important 7.0 level, at just above 6.90.

The NZD and AUD have come under downward pressure amidst the broad-based strength in the USD and the news that Chengdu would be locked down.  The NZD broke below 0.61 in our time zone yesterday and is now flirting with its recent two-year lows, trading this morning at around 0.6070, down around 0.8% over the past 24 hours.  A push below 0.60 looks only a matter of time.  Likewise, the AUD has broken below the 0.68 mark.

The sell-off in global bonds rippled through the NZ market yesterday, driving another chunky increase in NZ rates.  The 2-year swap rate was up another 7bps on the session, at 4.39%, while the 5 and 10-year rates were 12-13bps higher.  Despite RBNZ Governor Orr recently suggesting the RBNZ is likely to take a pause once the OCR reaches 4%-4.25%, market pricing for the peak in the cash rate continues to push higher, now sitting at around 4.40%.  NZGBs outperformed swaps, with the 10-year yield increasing “only” 8bps, albeit breaking above 4% for the first time since June, while the 30-year bond yield was only 2bps higher on the day.

The nonfarm payrolls report takes centre stage tonight, with the market looking for another month of robust jobs gains (300k consensus).  This would be a step down from July’s blockbuster 528k jobs number, but still likely strong enough to support expectations for another 75bps hike from the Fed later this month.  The unemployment rate is expected to remain at 3.5%, matching its lowest level in more than 50 years, while the pace of wage growth is expected to tick down to 0.4% m/m, still too high for comfort for a Fed which is looking to cool inflationary pressures.