Macro Strategy: Stay defensive

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October 11, 2018 News No Comments

Eugene Leow, Rates Strategist
Philip Wee, FX Strategist
DBS Group Research

Rates: Risk-off drives US yields lower

Amid an 800pts fall in the Dow, 10Y UST yields nudged below 3.2% overnight. There was no obvious trigger to the correction that sent the VIX up 7pts to 23, levels not seen since early April. For an extended period, US assets (especially equities and the USD) have outperformed peers (EM and DM alike) as economic data holds firm despite increasing trade tensions. However, this divergence in market performance may have gotten too stretched ahead of US mid-term elections in November. With US yields elevated (by recent years’ standards) and the Fed communicating that further hikes are coming, doubts are building in risky assets. And if US risky assets selloff, this would short-circuit the rise in US yields.

We think US yields are likely to be held down in the immediate term amid the onslaught of negative narrative. Trade war, rising oil prices, Trump’s stepped-up criticism of the Fed and EM worries form just part of the list of worries for the market. However, the 30Y yield bears watching. This tenor has borne the brunt of the rates selloff in the recent few weeks. Despite the sharply souring sentiment, 30Y yields barely drifted lower by 2bps overnight. Comparatively, the shorter tenors saw more sizable rallies. Term premium and longer-term inflation expectations appear supported, suggesting that yields have room to head higher when market sentiment improves.

EM and Asia risky assets have sold off significant over the past few months on the back of tighter higher USD rates and trade war worries. However, respite is not apparent just yet. EM and Asia assets would come under further pressure if US equities sink further.

FX: Stay defensive on EM Asian currencies

The mood at the annual meeting of the International Monetary Fund (IMF) and the World Bank in Bali, Indonesia, has been sober. Unlike the stronger-than-expected growth prospects exactly a year ago, the IMF downgraded its 2018 world growth forecast to 3.7% from 3.9%. Apart from rising trade protectionism starting to weigh on world growth, the IMF has assigned a 5% probability that emerging markets may suffer capital outflows of more than USD100bn over four quarters from an escalation in trade tensions and a tightening in global financial conditions. Put simply, the IMF no longer considers the risk of emerging market stress evolving from country-specific problems into a wider crisis across more countries a zero probability. Fitch Ratings warned that while Asian sovereign ratings remained supported by strong fiscal/external buffers and flexible policy frameworks, they will be tested by further volatility in global markets in the next 18 months. Unlike a few months ago, Emerging Asian currencies are finding it harder to shake off the multiple risks to the region’s economies and markets.

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The IMF’s call for the world to de-escalate trade disputes is likely to be ignored by the US. Any discussion between the US and Chinese officials in Bali is likely to centre on America’s unhappiness over the Chinese yuan’s depreciation, and not on trade. It will come as no surprise if the US Treasury Department names China a currency manipulator in its semi-annual currency report next week. China’s decision to lower, by a fourth time this year, its reserve requirement ratio by 100bps over the weekend has been viewed as a defensive move to cushion its economy from the tariff war with America, which the IMF reckoned would hurt the China more than the US. Not surprisingly, Chinese equities and the yuan exchange rate have headed south again. The central parity for USD/CNY rose to 6.9072 yesterday, above the previous year’s high of 6.8946 seen on August 16. While China has pledged not to weaken to stimulate exports, this should not be viewed as a commitment to defend the exchange rate.

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