Eugene Leow, Rates Strategist
Philip Wee, FX Strategist
DBS Group Research
The British pound is under pressure despite the endorsement of the draft Brexit withdrawal agreement by EU leaders at the EU Summit. UK Prime Minister Theresa May now faces a hard sell with her divided Tories and the Democratic Unionist Party (DUP), the Northern Irish party that the Conservative Party depends on for its majority. While Chancellor Philip Hammond supported May’s Brexit deal as “better than staying in the EU”, he also threatened to resign and take 4-5 ministers with him on a No Brexit outcome. Opposition Labour Party spokesman said that its leader, Jeremy Corbyn, would accept May’s challenge to a live debate over Brexit. The pound has been consolidating between 1.27 and 1.33 since the Chequers white paper published in July. The odds for a No Deal Brexit are set to push GBP/USD into a lower 1.20-1.25 trading range ahead of the March 2019 deadline.
The euro is unlikely to divorce itself from the battle of wills between Italy and the European Commission over the former’s fiscal spending plans. Like his British counterpart, Italian Prime Minister Giuseppe Conte is hopeful of reaching an agreement with Brussels over his country’s 2019 budget that will not satisfy the ruling populist and far-right parties. The EC has threatened to discipline Italy with financial penalties of up to EUR9bn or 0.5% of Italy’s GDP. For now, the widening spread in the 10Y Italian bond yield over its German counterpart has been viewed as a non-compliance penalty by the market.
Rates: Fragile sentiment supporting USTs
Within the year, the ongoing bout of market volatility is easily the most serious, with ramifications across asset classes. Taking the start of October as reference, the S&P 500 is down by 9.5%. HY and IG spreads have also widened by about 25bps and 100bps respectively. Unsurprisingly, USTs are supported with 10Y yields some 20bps off their recent high. Comparatively, the risky asset selloff that occurred in Feb/Mar primarily hit equities and did not impact the credit space much. While rising rates have often been blamed for the correction in risky assets, we suspect that the Fed’s balance sheet reduction also plays a significant role (draining liquidity and thereby impacting asset prices).
The adverse market reaction is sufficient to prompt market participants to significantly pare down rate hike expectations. The collapse in oil prices does not help. As Brent crude prices drop below USD60/bbl (down from above USD85/bbl in early October), market-based measures of inflation expectations have tumbled accordingly. Taking December’s rate increase as a given, Fed funds futures are now pricing in just one hike in 2019, down from two hikes just two weeks ago. At these levels,we wonder if the market has become overly bearish on the US economy. News narrative has been negative of late as the fall in US equity market, oil prices, trade war, Italian budget woes and China slowdown risks dominate headlines. Under the hood, US high frequency data (aside from some softening in housing numbers are still holding up. A re-pricing in of rate hike expectations could take place when volatility subsides from current elevated levels.