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A week is a long time in markets

The capital markets are always a fascinating place.

Germany
Source: Bloomberg

Right now, however, it feels as though if you miss a day’s price action and news flow, you have been out of the markets for over a week or so - such are the gyrations, reversals and counter-moves at present.

Look back a week or so ago and many (including myself) had the German 10-year bund headed into negative territory and as long as the German bund attracted buyers, then short
euro and long European equities were also favoured. A move through 6,000 for the ASX 200 was also on the cards and momentum focused traders were keen to buy the closing break. That hasn't happened, however, and we find ourselves closing out the week closer to 5,800.

The selling in European bond markets have caused massive ramifications in equities and thrown a huge element of doubt into the short EUR, long DAX trade. However, the moves in the German bund are limiting investor appetite for other developed market bonds and actually seem to be driving the US treasury market. There is no denying that the data out of Europe is on an improving trend, while yesterday’s US jobless claims print and Employee Cost Index (both at multiyear extremes) suggest that a rate hike really could be on the cards from the Federal Reserve this year. Perhaps we could even see one in September and December!

What I think is really worth focusing on though are inflation expectations. In Europe, five-year inflation expectations have risen 28 basis points to 1.76% over the last few week and sit at the year’s highs. In the US, 5-year breakeven rates (the bond markets pricing of inflation expectations over a five-year period) have moved from 1.04% in January to currently sit at 1.72%. The US yield curve (two year bonds vs ten year bonds) have blown out to 146 basis points in the last two weeks, so it seems the market is warming to idea of longer-term inflation forces. This seems to be having an effect on equities and sentiment it seems is deteriorating somewhat. The VIX (or US volatility index) rallying 9% highlights the move to portfolio protection.

In upcoming US trade we see manufacturing ISM is expected to show modest expansion and that could get the ball rolling into next weeks’ US payrolls report. Calls at this stage are for a strong snap back to 230,000 jobs, with average hourly earnings expected to grow 2.3% on the year, and a number above here will cause the USD to fly as 2.3% has been a ceiling for many years. Certainly a higher ECI and earnings report will get the USD bulls going again and long USD/JPY seems to be the best way to play this at present, although I am starting to warm to USD/CAD longs again as long as the September uptrend remains intact at $1.2050.

Australia seems to be seeing modest selling in the domestic bond market, despite calls from a prominent Reserve Bank of Australia watcher that the RBA will ease the cash rate on 5 May. The swaps market has responded and are now pricing a 62% chance of a cut. This is supporting the Aussie banks somewhat, although the upside in bond yields is a headwind as it lessens the appeal to hold banks for income. Elsewhere, mining names are being supported on comments that Vale may cut back on future production and while RIO and FMG don't seem too friendly at present they would be huge fans of their Brazilian rival right now. A Chinese manufacturing print at 50.1 has don't little to change anything really and its business as usual here.

We head into May in what is traditionally a terrible month to be long Aussie stocks. Over the last decade the market has lost 2% on average and while last year the index actually put on 0.1%, the prior four years fell 5.7% on average. Interest rate cuts will help to an extent but we need the AUD/USD to head lower as well as it seems this is having strong ramifications on Aussie banks (as seen in the Bloomberg chart). This is similar to Europe where equity markets have almost become a derivative of the currency market and a weak EUR will mean a strong DAX or
CAC.

Still the trade du jour at the moment seems to be long EUR/AUD, which has rallied a lazy 500 pips in two days and is eyeing a move to A$1.44. GBP/AUD also is eyeing a move back to AUD1.96 despite the 7 May election, while AUD/USD is not clear, although I would be playing this pair from the short side.

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