Tanker, turning

​​​​​​Today's news headlines:

  • ‘Tory rebels check Johnson threat to force through no-deal Brexit’. MPs voted by a margin of 41 to implement measures to prevent the next Prime Minister from forcing a no-deal Brexit. This is somewhat ironic in that no-deal is the legal status quo; to leave in another form requires passage of a withdrawal agreement. 
    (Financial Times)
  • ‘Turkey’s tilt to Russia risks rupture with NATO allies’. Recep Tayyip Erdogan, Turkey’s President, has elected to take delivery of the Russian S-400 air defence system, setting him at odds with NATO allies. The Trump administration has already cut off Turkey from receipt of F-35 jets. (Financial Times)

Irrational exuberance

Coordinated central bank easing is decreasing global interest rates and pushing much of the world's assets into negative-yielding territory. Investors have been forced to chase increasingly risky assets to make a return, but now this 'reach for yield' is taking an unexpected turn. Many are now snapping up illiquid investments, like private equity, which may pose a systemic risk when the next downturn arrives.

In the event of a market downturn, investors in less liquid assets will not be able to exit their positions and will instead be forced to sell traditional assets, leaving greatly diminished but unsellable assets on their books. As the reach for yield drives up traditional asset prices, the risk becomes attenuated across entire sectors. Markets have changed since the Global Financial Crisis and it’s no longer clear who will step into the breach to provide liquidity when the stress does come.

Bottom line: The shift in investor appetite to higher-yielding assets and unconventional investments seems counterintuitive when the world is worried about slowing global growth. Economists might argue that rising risk appetite and asset prices should be countered by higher interest rates. Continued interest rate declines risks propelling this phenomenon.

Leading the Fed

As downside risks to global growth mount, several members of the Federal Reserve have emphasised the need to reduce interest rates quickly. Yesterday afternoon, dovish remarks from Fed members Richard Clarida and John Williams reinforced market expectations of an immediate cut in July’s meeting and raised the probability of a larger 50bps cut. Williams suggested that it pays to lower rates at the first sign of economic distress while both expressed worries over a lack of inflation. Markets are pricing in 37.5bps of cuts for the July meeting although consensus forecasts remain at 25bps.

Speaking proverbially, when a great US tanker signals a turn, all the little ships get out of the way. With the US set to cut rates, authorities in EM economies can safely ease monetary policy without an exodus of capital flow back to America. In the last few days, South Korea, Indonesia, and South Africa have all lowered interest rates in an attempt to stave off deteriorating economic conditions and perhaps to get out in front of the big tanker. All things being equal, coordinated easing means the Fed must do less of the heavy lifting, particularly since external factors were highlighted as a great source of concern in Jerome Powell’s testimony before Congress.

Bottom line: Although it’s been a pretty positive week for US data, the expectation of a July rate cut remains. The Fed’s ‘quiet period’ begins tomorrow, so today will be the last opportunity for central bank members to hint at upcoming policy action.

GBP/USD

Fed statements caused a Dollar sale in yesterday’s late-day trading, nudging the pair back into the prior trading range. Some attempts have already been made to qualify those statements, which might cause a reversal of this dynamic. Sterling benefited from this perception of Fed easing and a bright UK Retail Sales figure, but has started the morning on the back foot.

GBP/EUR

Both Sterling and the common currency gained from Dollar selling, but this had little effect on the GBP/EUR pair. Unexpected UK data has offered some support for the Pound, despite a continuation of the Tory leadership contest debacle.

EUR/USD

Dollar selling and Euro support caused a meaningful uptick through the 100-day moving average in late-day trading. Despite retracing somewhat this morning, the 100-day moving average has become a support level. Later this afternoon, US Consumer Sentiment and a selection of Fed speakers could have the capacity to shift the landscape heading into the weekend and data-light Monday.