Fears of front-loaded US tightening cycle and China lockdowns drive risk appetite lower. Much lower US rates since Friday's NZ close

It has been an ostensibly risk-off environment since we left for the long weekend, with a chunky fall in global equity markets and the VIX index piercing 30.  Fears of how a front-loaded Fed tightening cycle might play out and China’s zero-COVID strategy resulting in further lockdowns and likely supply chain issues have been in focus. The combination of a risk-off move and significant downward pressure on the yuan saw the NZD break below 0.66 and it is currently just above that mark, down 1.2% from Friday’s NZ close. With USD strength pervasive, most other majors have been as weak, if not weaker. Bonds have been a beneficiary of the selling pressure in equities, with the US 10-year rate down to 2.81%, some 14bps below the level at the NZ close on Friday.

The S&P500 fell steadily through Friday and ended up plunging 2.8%, not helped by some softer earnings reports and market nerves in the face of what is looking to be quite an aggressive monetary policy tightening cycle ahead. The US 2-year rate rose to a fresh multi-year high of 2.78% on calls for a more front-loaded monetary policy tightening cycle, before the weaker equity market backdrop and comments by the Fed’s Mester, helped rein in yields.

Weaker equity markets and falling yields have continued as the new week has begun.  The S&P500 was down as much as 1.7% until a few hours ago but has since recovered and is flat as we go to print. The 2-year rate is now down 18bps from Friday’s high, at 2.60%. The 10-year rate has followed a similar path, down from the approximate 2.95% level at NZ’s Friday close to currently sit at 2.81%.

Adding to the bond market angst on Friday was economists at Nomura predicting two 75bps hikes in June and July, following a 50bps hike in May.  But the appetite on FOMC for hikes of larger than 50bps at any given meeting looks scant, apart from St Louis Fed President Bullard, who has previously suggested the possibility. Cleveland Fed President Mester, a voter on FOMC this year, told CNBC late on Friday that she supported a 50bps hike in May, and a few more to get to a neutral 2.5% level. She didn’t think that an outsized move of 75bps was the right way to go, preferring a more deliberative and consistent path. Other FOMC members seemed to back 50bps moves rather than larger moves to get to neutral quicker, looking to avoid an abrupt move that would scare consumers and markets.

There has been plenty of economic news, most of it released on Friday. Japan CPI data showed CPI inflation lifting to 1.2% y/y in March, the highest rate in 3½ years although driven by “cost-push” than the “demand-pull” inflation desired, as evidenced by the ex-fresh food and energy measure still deflating, with the so-called core-core measure down 0.7% y/y. BoJ Governor Kuroda hasn’t shied away from the current policy stance, even against the backdrop of the plunge in the yen this year, saying that the Bank should persistently continue with the current aggressive money easing.

A number of UK data releases painted a weak picture of the economy, particularly on the consumer side, with consumer confidence in April falling to a record low on the GfK survey that dates back to 1981, a much larger than expected contraction in retail sales in March, and PMI data for the services sector falling by more than expected, down over 4pts to 58.3. This backed BoE Governor Bailey’s comments a day earlier that suggested the central bank was walking a very tight line between tackling inflation and the output effects of the real income shock from higher inflation, and the risk that could create a recession. The market pared back the chance of a 50bps hike at next month’s meeting, dragging rates lower across the curve.

US PMI data were mixed, with the manufacturing indicator unexpectedly rising almost a point to 59.7, while the services indicator unexpectedly fell 3.3pts to 54.7. The latter dragged down the composite measure, and this also showed input and output price indicators rising to new cyclical highs.

The highlight from the European PMI data was an unexpected lift in the services indices for Germany and the euro area, likely a reflection of reduced COVID19-related restrictions. Last night’s Germany IFO survey was also stronger than expected, with both the current assessment and expectations components of business confidence unexpectedly rising in April, despite the ongoing war in Ukraine.

China was in focus last week and remains so.  CNY showed notable weakness, with the yuan weakening by an unusually large 2% last week and CNH weakening by some 2.3%, the largest weekly loss since the surprise devaluation in 2015. Overseas investors have been bailing out of China’s bond and equity markets, given the lack of yield support as US bond yields have rocketed up through Chinese rates and in the face of much weaker growth momentum, with the country’s zero-COVID policy playing a significant role. Last week’s reference rate settings for CNY by the PBoC conveyed a signal of some comfort with a weaker currency, but also not wanting it to be seen as a one-way bet.

The yuan saw further depreciation yesterday, as reports surfaced that parts of Beijing would be locked down to combat an outbreak of COVID19.  However, USD/CNH hitting 6.60 was a step too far and the PBoC cut the FX reserve ratio, to help add dollar-liquidity to the domestic market and it was also a signal that the central bank wasn’t happy with the rate of currency depreciation. USD/CNH is back down to 6.57, while USD/CNY is at 6.56, still a 0.9% depreciation for the yuan on the day, adding to last week’s losses.

The risk-off backdrop has seen considerable support for the USD and the DXY index reached as high as 101.85 overnight, testing the levels back in March 2020 during that liquidity vacuum episode. With the lower rate backdrop, only JPY has managed to keep pace, and USD/JPY is down to 128.0, the yen showing further signs of consolidation after the recent speculative attack.

The risk-off backdrop and depreciating yuan combined to put downward pressure on the NZD and AUD, the latter affected more, as is usually the case when China is in focus. The NZD found some support just above 0.6580 yesterday afternoon and has recovered to 0.6615, down about 1.2% from Friday’s NZ close. The AUD fell to as low as 0.7135 overnight and is now at 0.7170, down a considerable 2.3% from Friday’s NZ close. NZD/AUD has recovered strongly to 0.9225.  Both the NZD and AUD remain vulnerable to further weakness if the yuan continues to depreciate. Some analysts have revised USD/CNY forecasts to 7.00 by year-end. If that forecast comes to fruition, then both the NZD and AUD would likely depreciate further.

NZD performance since Friday doesn’t look out of line, considering the weakness faced by other majors, so NZD crosses have been less affected. EUR is down 1.2% since Friday’s local close, CAD is 1.2% weaker and GBP is down an even larger 2.2%.

EUR showed a small rally on the open yesterday in response to Macron’s decisive Presidential election victory, but has since been overwhelmed by USD strength and overnight it traded below 1.07 for the first time since the March 2020 liquidity vacuum. GBP’s underperformance can be put down to the focus on its weak economy and not helped by the FT reporting “The UK government is preparing legislation that will give ministers sweeping powers to tear up the post-Brexit deal governing trade in Northern Ireland, risking a fresh confrontation with Brussels”. GBP took a peek below 1.27 overnight, since recovering a little, while NZD/GBP is tracking just below 0.52.

In illiquid market conditions, NZ swap and bond rates showed hefty increases on Friday, led by the front end. The OIS market moved to fully price in a 50bps hike in May and a high chance of a follow-up move in July. The 2-year swap rate rose 16bps to 3.74%, while 5-year and 10-year swap rates rose by 12bps and 10bps, respectively, all closing at their highest levels since 2015. NZGB yields showed similar movements. Since Friday’s NZ close the US 10-year rate is down 15bps, while Australia’s 10-year bond future is down about 10bps in yield terms, seeing the scene for lower yields on the NZ market open.

In the day ahead, US data on durable goods orders, consumer confidence, and new home sales are released. Key data for the week ahead include Australian Q1 CPI, which could trigger a May hike ahead of the Federal Election, if significantly stronger than expected. GDP and the employment cost index for Q1 for the US, and GDP data for the euro area will also be highlights. Domestically, only second-tier data are released, including business and consumer confidence from ANZ’s surveys.