Market sentiment remains broadly positive with the S&P500 closing last week at a record high and the US 10-year rate pushing up above 1.50% on Friday. Currency moves were modest, but with the NZD and AUD outperforming again. The market continues to bring forward the timing of RBNZ rate hikes, with a better than even chance of an OCR hike now priced by November.
It was a far better week for risk assets last week as markets recover from the hawkish surprise at the June FOMC meeting. The S&P500 increased 0.3% on Friday, bringing its gain on the week to 2.7% and leaving it at a record high. Bank stocks led the way on Friday with the release of the Fed’s ‘stress tests’ clearing the way for the resumption of share buybacks by US banks. The NASDAQ was flat on Friday but 2.4% higher on the week. Likewise, commodities fared far better last week with copper gaining 2.9% (after its 8.6% fall the week prior) and Brent crude oil up 3.6%.
Friday morning’s news that a bipartisan group of senators had reached an agreement on a US infrastructure package was seen by some commentators as supporting the risk-on mood. The package will include $579b in new spending and be funded largely via repurposed Covid-19 recovery funds, rather than higher corporate tax rates, as originally proposed by the Democrats. Biden still hopes to pass a separate, multi-trillion dollar spending package (on such things as child support and climate change) under the so-called budget reconciliation approach (i.e. without Republican support). Centrist Democrat senator Joe Manchin, whose vote will be needed to pass the latter bill, told ABC that he could support a package as large as $2 trillion which included an increase in the corporate tax rate to 25% and increase in the capital gains tax to 28%.
In economic data, the US core PCE deflator, the Fed’s preferred inflation measure, increased 3.4% y/y in May, in-line with market expectations but still the highest annual rate of increase since the early 1990s. Market reaction was limited, with the already-released CPI report having largely foreshadowed the jump in inflation. The debate about whether current inflation pressures are transitory, or something more permanent is probably going to rage for some time yet. Former US Treasury Secretary Larry Summers, who is widely followed in the market, told Bloomberg that his personal view was inflation would be running “pretty close” to 5% by the end of the year.
Boston Fed President Rosengren was the latest Fed official to highlight the possibility of a 2022 rate hike. Rosengren outlined his criteria for rate hikes, namely “that we have a sustainable inflation rate, that’s 2% or above, and that we’re at full employment”, which he saw as “quite possible” by the end of next year. So far, it has just been the regional Fed presidents, as opposed to those on the Board of Governors (including the Chair), that have voiced support for potential rate hikes in 2022.
Like risk assets, long-term US Treasury yields continue to recover from the unexpected (largely positioning driven) falls seen after the FOMC meeting. The US 10-year rate increased 3bps on Friday, to 1.52%, while the 30-year rate rose 5bps, to 2.15%. In Europe, the 10-year German rate was also up by 3bps, reaching a one-month high of -0.16%.
Elsewhere, the corporate credit market is still running hot with Bloomberg reporting the market for Collateralised Loan Obligations (CLOs) was growing at such a “breakneck pace” that bottlenecks had emerged, with multi-month waiting times emerging for the likes of S&P to rate deals. Separately, last week saw a high yield (i.e. ‘junk’) issuer set the record for the lowest interest rate on a new bond with a maturity seven years or longer, at 2.45%. The strength in credit markets reflects both the search for yield, amidst still very low government bond yields, and expectations for very strong economic growth, which should keep default rates at low levels.
Currency moves were modest on Friday, with all the G10 currency pairs within +/-0.3% of the previous session’s close. The Bloomberg USD index (BBDXY) was down marginally on Friday amidst the recovery in risk appetite, bringing its loss on the week to 0.8%. The BBDXY has now reversed around half the previous week’s (pre and post-FOMC) move higher.
Continuing the trend last week, commodity currencies were the outperformers on Friday, although the moves were reasonably limited. The NZD was up 0.2% Friday and almost 2% on the week while the AUD increased 1.5% last week. The NZD pushed up towards previous support levels around the 0.71 mark in the New York morning before pulling back to close the week around 0.7070.
In Australia, the NSW Premier has announced a two-week lockdown for greater Sydney, as the authorities try to contain community transmission of the delta variant. In the Northern Territory, a 48-hour lockdown was put in place for Darwin while the emergence of cases in Queensland and Western Australia have seen new restrictions imposed in those states. Markets have tended to look through such news recently. Yesterday, the NZ government announced an extension of Covid Alert Level 2 for Wellington until Wednesday, despite no community cases being discovered, and said the ‘travel bubble’ with all of Australia would be paused for three days.
The market continues to bring forward the expected timing of RBNZ OCR hikes. February is now fully priced for a 25bp rate hike while November is now up to 0.39%, implying a better than even chance of a rate hike before the end of the year. This saw the 2-year swap rate push 4.5bps higher, to 0.77%, its highest level since March last year. The yield curve resumed flattening against a backdrop of rangebound 10-year yields in Australia and the US during our time zone. The 10-year swap rate was 2bps higher on Friday, to 1.92.
The RBNZ decided to keep its QE purchase pace unchanged for this week, at $200m. With nominal government bond issuance stepping up to $500m this week, from $300m previously, this means the market will need to start absorbing more supply. The market reaction may provide some clues as to how the market will adjust when the RBNZ stops purchases altogether (there was little reaction on Friday). Taking market pricing at face value (a greater than even chance of an OCR hike in November), the implication would be that the RBNZ might stop QE purchases in the coming months, since the RBNZ would want to stop adding to its stock of bond holdings before it starts raising the OCR.
The nonfarm payrolls report on Friday night is the highlight of the week ahead. The median estimate on Bloomberg is for a 700k jobs gain in June and a 0.1% fall in the unemployment rate, to 5.7%. With the Fed linking its decisions on tapering (and, eventually, rate hikes) in part to the improvement of the labour market, the market is likely to be sensitive to the release. Last month’s big downside surprise to payrolls saw bond yields fall and equities rise, with the market seeing it as likely to reinforce the Fed’s dovish stance (as it turned out, the Fed’s June meeting proved to be a hawkish surprise). The US Manufacturing ISM on Thursday is expected to remain at historically elevated levels (consensus is for 61). A range of central bankers are speaking including ECB President Lagarde on Friday and BoE Governor Bailey, who is giving his annual Mansion House address on Thursday. OPEC+ also meets this week to decide on oil supply.