Very weak ISM non-manufacturing survey triggers large decline in US rates, fall in USD. Equities plunge, then recover sharply on Fed rate cut expectations. NZD and AUD outperform as risk appetite turns positive

Another weak US business survey, this time the ISM Non-manufacturing index, sparked a further sharp fall in bond yields overnight.  Equities initially plunged on growing US recession fears, but the falls in Treasury yields and increase in Fed rate cut expectations led to a quick reversal and US indices are now higher on the day.  The lower Fed rates outlook has hit the USD, which has fallen across the board.  The NZD and AUD have outperformed.   

The ISM Non-manufacturing survey released overnight fell to 52.6 from 56.4, much lower than expected and its lowest level since August 2016.  New Orders plunged from 60.3 to 53.7 while, disconcertingly ahead of nonfarm payrolls tonight, the employment subcomponent fell to just 50.4, its lowest reading since 2014.  Following on from the very weak Manufacturing ISM earlier this week, the data suggests that the much larger services sector of the US economy is starting to come under pressure, with impending US tariffs on consumer goods likely to be part of the reason.  Commentators have started mentioning the dreaded “R” word.  The consensus for nonfarm payrolls tonight is for a 145k increase in jobs in September although the employment components of both ISM surveys point to significant downside risks to that estimate.  It remains to be seen whether recent weakness in economic data leads Trump to soften his stance in trade negotiations with China which are due to resume next week. 

There has been a large, front-end led, decline in US Treasury yields on the back of the ISM survey.  The 2 year Treasury yield is 9bps lower to 1.39%, its lowest level since late 2017, while the 10 year Treasury yield has dropped 6bps to 1.54%.  The market has boosted the probability of an October rate cut by the Fed to around 90%, with 43bps priced-in by year-end (implying a better than even chance of two rate cuts) and 90bps by the end of 2020.  The 2y10y curve has steepened up to a two-month high of +15bps.  

The S&P500 fell as much as 1.3% in the immediate aftermath of the data.  However, unlike the market reaction after ISM manufacturing survey on Monday night, equities have quickly recovered amidst the increase in Fed rate cut expectations.  The S&P500 is now trading 0.7% higher on the day, with all sectors (except Financials) in the green.  At face value, the market reaction suggests that investors think that pre-emptive rate cuts from the Fed will prevent the economic slow-down from morphing into a recession and that low rates will catalyse yield-seeking flows into equities; a classic case of ‘bad news is good news’.  Such a regime can persist as long as investors are confident that the Fed can short-circuit a possible recession. 

The decline in Treasury yields has weighed on the USD, which has eased back further from its recent highs.  The USD, in index terms, is down around 0.3% on the day, its third consecutive session of declines.  The weaker USD has seen EUR push up towards 1.10 while USD/JPY fell to a one month low below 106.50 before recovering amidst the turn-around in equity markets. 

The NZD and AUD sit on the top of the currency leader-board, reflecting the improvement in risk appetite and likely some short-covering from investors.  The NZD has risen above 0.63, having reached a four-year low just above 0.62 earlier in the week, while the AUD has increased to 0.6750.  Both currencies are around 0.7% higher on the day.  The appreciation in the NZD and AUD has occurred in tandem with strength in emerging market currencies, another sign of market participants pivoting towards higher-yield investments.   The JPM EMFX index is 0.6% higher, its largest one day change in almost a month, while the Brazilian real and South African rand are both up around 1%.  The NZD and AUD have been closely correlated with EM currencies over the past year, largely due to their sensitivity to the CNY and US-China trade war. 

The GBP has also outperformed and is 0.5% higher to 1.2360.  European leaders have given a frosty reception to Boris Johnson’s plan for Irish backstop, with European Council President Donald Tusk saying that the EU was “open but still unconvinced” and Irish Prime Minister Leo Varakdar saying the proposal would “fall short in a number of aspects”.  The question is how far both sides are willing to compromise ahead of the EU Summit in a fortnight.  According to a Bloomberg report, Johnson’s “Plan B” is to keep the Irish backstop, but put a time limit on it, although this suggestion has previously been ruled out by the EU.  The betting market probabilities haven’t changed materially over the past week; there is a 25% chance of the UK leaving the EU (deal or no deal) by October 31st. 

NZ rates fell further yesterday amidst the global bond rally.  The 2 year swap rate fell 3bps to 0.83% and the 10 year swap rate fell 5bps to 1.14%.  The November OIS contract is now priced at 0.715%, implying a roughly 15% chance of a 50bp OCR cut at the coming meeting, while the terminal OCR is just below 0.5%.  We’re likely to see yesterday’s moves extend somewhat today given the falls in US Treasury yields overnight. 

Besides payrolls, which is released tonight, the market will also be listening out for monetary policy-relevant comments from Fed Vice-Chair Clarida this morning and Chair Powell tomorrow morning.  Speaking before the ISM Non-manufacturing survey, Chicago Fed President Evans said the weakness in the manufacturing sector hadn’t convinced him yet that further rate cuts were warranted but he was “open-minded”.