Signs of USD rally starting to hurt inflation expectations

We should see a somewhat firmer open for the Australian equity market, with our call currently sitting at 5550 (+18 points).

Source: Bloomberg

We may see some modest weakness in the Nikkei 225, but the Japanese index has gained for the past six weeks in a row. As we know at this time of year, it can be tough to short these markets when the underlying trends are just so powerful.

The leads from Wall Street are lacklustre, with the S&P 500 falling a mere 0.2%, but the losses were seen more substantially in the financial and, to a lesser extent, material spaces. However, whether this filters through to weakness on Aussie financials is yet to be seen. It has become quite apparent that inflation expectations have started to roll over, with US five-year inflation expectations falling five basis points (bp) on Friday to 1.97%. Some of the wind has come out of the selling in US fixed income, but the idea that ‘real’ (ie. inflation-adjusted bond yields) have increased from -43bp to currently sit at +23bp is starting to be seen as a strong headwind for further equity appreciation. High ‘real’ bond yields are a genuine tightening of financial conditions.

The USD index has gained for eight of the past eleven weeks, helped by a sizeable increase in the yield premium demanded to hold US treasuries over German bunds and Japanese government bonds. We can take the US/German ten-year bond spread, which at 222 basis points is the widest premium (in favour of the US) since 1999. It’s no wonder we have EUR/USD closing below the $1.1500 to $1.0500 range that it’s been in since the beginning of 2015. Parity calls are now deafening; it is a concern that everyone is a USD bull here and there is no greater consensus trade for 2017 than being long the dollar.

AUD/USD is also on the radar, with the exchange rate closing out Friday below the 21 November pivot low of $0.7310 and the lowest levels since June. Falls in bulks on Friday are probably not helping, with steel, iron ore and coking coal futures falling 2.8%, 3.9% and 0.4% respectively.

We are now hearing that St Louis Federal Reserve (Fed) President James Bullard has opened a can of worms by starting a discussion that the Fed should allow its $4.5 trillion balance sheet to shrink in 2017. This view seems earlier than most have expected and by allowing the bonds on its balance to mature, without rolling them over and re-investing the proceeds here, would limit the need to raise interest rates three times in 2017. However, the combination of a balance sheet contraction (at a time when the European Central Bank and Bank of Japan are still rapidly increasing their balance sheets through quantitative easing) makes it hard to be anything else other than a USD bull.

We need to ask whether the moves in the USD, driven by higher ‘real’ bond yields, actually start to hurt the US equity markets and become a major headwind not just for emerging markets but the US economy?

This is a question for 2017 as trend and momentum are currently spurring on buyers and we all know this is one of the strongest times of year for most equity markets, including the ASX 200. There will be some focus this week on the Australian Mid-Year Economic and Fiscal Outlook, with Scott Morrison handing down his budget update and some belief that we could see a response from any one of the three main credit agencies. I am personally sceptical of a near-term downgrade but sit in the camp that it shouldn’t affect economics in any real way over the medium-term even if we saw a downgrade, although most economists would suggest this forecast is tough to predict.

The ADRs (American Depository Receipt) of BHP, CBA and WPL are largely unchanged, but given the likely buying in Aussie fixed income, one suspects it will be a day to be long REITS and higher yielding equities, with some buying in oil stocks.

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