S&P 500 tests support

By David Morrison  |  08/10/2018 15:02

There was a cautious start to the new week as China returns from holiday and with the US bond market closed for Columbus Day. The S&P 500 dipped back below January highs

The big news first thing this morning was the sharp sell-off in Chinese equities which saw the Shanghai Composite close 3.7% lower. Partly this was a case of investors playing catch-up (or rather ‘down’) after China’s week-long holiday given last week’s sell-off across global stock indices. But it was nevertheless a disappointment given the cuts to the Reserve Requirement Ratios (RRR) made by the People’s Bank of China on Sunday. These cuts reduce the amount of cash that banks need to hold as reserves. It is direct monetary stimulus and should be positive for asset prices. The cuts are significant – 100 basis points taking the RRR down to 15.5% for large banks and 13.5% for smaller lenders.

Yuan at 7-week low

The ‘onshore’ yuan (which was also closed last week) slumped by 0.8% taking the USDCNY to 6.92 – the highest close for the dollar since mid-August. The Chinese authorities are no doubt responding to signs of a slowing economy. However, as the USDCNY closes in on the 7.00 level, this will raise the likelihood that President Trump will again accuse China of manipulating its currency lower to offset the effects of US tariffs. This could result in the US/China trade war intensifying.

US bond market holiday

Meanwhile, investors remain jittery following last week’s jump in US Treasury yields which led to a sell-off across global equities. There’s some relief that the US bond market is closed today for Columbus Day. However, the futures markets are open, and these suggest that yields were a touch down from Friday’s close during the morning session. But it is important not to read too much into this as the cash market is far more important than futures as far as the US bond market is concerned. US stock indices were lower in the open. The S&P 500 retested support around 2,876 – the closing high hit back in January this year.

Hawkish Fed

This week sees a gaggle of regional Fed presidents deliver speeches. These will be studied closely to try and establish if other Fed members are as hawkish and ‘data-dependent’ in their outlooks as their chairman, Jerome Powell. Comments from Mr Powell last week were among the triggers for the bond market sell-off. He said that the fed funds rate could still be a long way below its ‘neutral’ rate, and that the FOMC could raise rates beyond the ‘neutral’ rate, bearing in mind we don’t know what that rate is. Another trigger was last week’s clutch of strong data releases. Not only did yields on many key US bonds hit multi-year highs, but the rate at which they rose really unsettled investors. The yield on the key 10-year Treasury note closed at 3.23% - a seven-year high.

Inversion off the cards?

Suddenly traders are no longer worried about yield-curve inversion (where the yields on shorter-dated debt exceed those on longer-dated maturities) which typically heralds a recession. Now they are worried about the curve steepening at a dramatic rate. This suggests that economic growth will stay ahead of inflation over the shorter term, although inflation is likely to take off down the line forcing the Fed to accelerate its programme of monetary tightening.  The immediate effect is to dump growth stocks which look increasingly expensive as bond yields rise. Much depends on what happens this week. If yields pull back, this will reduce pressure on bond and equity markets and investors will go back into ‘risk-on’ mode. If yields continue to rally then so will the dollar, putting further pressure on emerging markets and we should expect global indices to struggle.

Italian crisis?

Last week began with concerns over Italy’s new coalition government’s budget proposals. Leaders of Northern League and 5-Star want to introduce a tax and spending plan which would see the Italian trade deficit come in at around 2.4% of GDP for the next three years. The plan was subsequently tapered but would still see the deficit as high as 2.0% in 2021.

Euro under pressure

The European Commission has said that this is a clear breach of what Italy was asked to do over the summer – that is, cut its structural deficit every year until it is in balance. But Italy’s government is adamant that they are determined to fulfil their election promises and that there is “no plan B”. The two sides remain at loggerheads with the European Commission set to approve or reject the budget next week. In the meantime, this showdown, together with concerns over the inevitable deterioration in Italy’s debt have led to soaring bond yields and helped to push the EURUSD below support around 1.1500.
 
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