Eugene Leow, Rates Strategist
DBS Group Research
FX: Weaker US stocks can’t help EM Asian currencies
In line with our expectations, the Monetary Authority of Singapore (MAS) has slightly increased the slope of the Singapore dollar nominal effective exchange rate (SGDNEER) policy band. According to our model, this should increase the band’s gradient by another 0.5% to 1% a year. The width and the mid-point of the band were left unchanged. The decision to further normalize the SGD policy was consistent with the central bank’s upgraded inflation forecasts. CPI inflation is now expected to pick up to 1-2% in 2019 from an average 0.5% in 2018. The projection for MAS Core inflation in 2018 has been narrowed to 1.5-2% from 1-2% before moving higher to 1.5-2.5% next year.
The upside to the SGD will be limited around 1.3730 against the USD this morning; the SGDNEER is currently only 0.2% below the ceiling of the band. Looking ahead, we have not changed our view for the USD to keep appreciating in the final quarter of the year and sees USD/SGD eventually rising above 1.40.
We are cautious against reading too much into this week’s appreciation in Emerging Asian currencies on weaker US stocks. The ADXY Index (which measures the performance of Asia ex Japan currencies) was, as of yesterday, up 0.2% for the week. The S&P500 Index fell 5.4% over the same period on US President Trump’s incendiary attacks on Fed hikes. On relative basis, the outlook for the US economy remains stronger than its peers such as the Eurozone and Japan. The Fed is unlikely to be too concerned with the US stock market sell-off and keep to its stance to gradually increase rates.
More importantly, the depreciation in EM Asian currencies has been on the back of their weaker stock markets which are likely to be further pressured by the latest sell-off in US equities. Pro-growth EM currencies perform best (like in 2017) when their economies and markets outperform the US in a constructive global growth upcycle and not vice versa. Looking ahead, the IMF and Fitch Rating have warned this week that the next 12-18 months would remain challenging and volatile for emerging markets. Lest we forget, Trump’s threat to impose tariffs on the rest of Chinese goods (USD267bn worth) remains real. This coupled with the fourth cut in China’s reserve requirement ratio this week have also increased prospect for a slowing Chinese economy to show up in the coming quarters.
Rates: A reminder that bonds and stocks can sell off together
This week’s market action was largely in equity markets. After staying largely resilient for the most part of the year, US stocks has tumbled, dragging down equity indices across the region. Rising UST yields are blamed for the risk-off sentiment; this is partly true with 10Y yields rising by some 40bps over a span of 6-7 weeks. As risk-free rates rise, there should be a re-pricing across all asset markets.
We are reminded, for the second time this year (the first was in Jan/Feb), that a bond selloff can coincide with an equity selloff. Looking further back, the next comparative instance was in 2013 during the taper tantrums. However, these instances of positive correlation between US government bonds and equities do not typically last long.
In the initial phase of yield increase, the US equity market tends to rise in tandem. The feedback loop tends to be positive – strong sentiment, strong equity prices, higher yields. However, the market has problems digesting higher rates if the pace of increase is too rapid. When that happens, the loop gets snapped as USTs suddenly look a lot more attractive than risky assets. This prompts a different kind of feedback loop – weak sentiment, weak equity prices, lower yields. The current bout of volatility appears to closely resemble that of February. The key difference is that US interest rates headed up from a much higher base in September.US yields, while not quite fully pricing the likely Fed hikes, can no longer be considered overly low.
Bursts of volatility tend to linger and it may be a while more before the VIX returns to a calmer levels. US yields would be lower than they otherwise would have been. US high frequency data will be closely watched. If the US economy stays strong as we expect, then the decoupling between the market and the real economy should prove short-lived (relatively speaking). Once equity prices adjust to the world of higher yields, volatility should subside. Our assumption of Fed hikes (one more in 2018 and four in 2019) would hold. Conversely, if US data weakens, there may be a need to revisit our assumptions.