By Matein Khalid: Chief Investment Officer and Partner at Asas Capital
US equities markets went ballistic after the Federal Reserve confirmed Wall Street consensus that it will cut the overnight borrowing rate by 50 basis points if the economy weakens. This did not surprise me. The current Fed Funds target rate is 2.25% – 2.50% and US inflation is just under 2%, so the real policy rate is 0.5% and the June FOMC conclave only confirmed, the US central bank would not hesitate to take out a preemptive insurance policy against potential US recession risk due to an economic slowdown in the EU, China and Japan amid global trade tensions. After all, the FOMC statement was unambiguous when it stated, the US central bank will “act as appropriate to sustain the expansion”. Only sudden acceleration in US economic growth non-farm payroll, retail sales, industrial production, or new speculative record highs on Wall Street will avert the momentum for a 25 basis point rate cut at the July and September FOMC.
A long position in the 10 year US Treasury bond futures contract traded in Chicago has been wildly profitable as the yield on the Uncle Sam 10 year note tanked from 3.25% in October 2018 to a mere 2.05% now. This dramatic fall in US Treasury bond yields has enabled US investment grade corporate bonds to be a winner asset as the record highs on the corporate bond ETF (symbol LQD) attests. In fact, the 10 year US Treasury note even traded below 2% on Thursday in New York for the first time since the 2016 China-triggered global financial contagion. Wall Street folklore contends the “the trend is your friend until the trend comes to an end”.
The trend suggests the yield on the bellwether 10 year Treasury note could fall as low as 1.80% unless the US-Iran geopolitical confrontation in the Gulf escalates into war or an oil shock that disrupts tanker traffic on the Straits of Hormuz, the world’s most strategic and volatile energy chokepoint. As long as a new war does not break out in the Middle East, the bull market in US Treasury debt will continue.
The macro case for lower for longer US Treasury bond yields is anchored by the slowest Chinese GDP growth rate in a generation, the political malaise in Europe (Brexit, Italian budget brinkmanship with the EU, the German far rights’s ominous challenge to Frau Merkel’s CDU/CSU coalition in Berlin) and Japan’s failure to achieve Kuroda-san’s 2% inflation target.
The US-China trade dispute is also a time bomb that not even a Trump-Xi meeting in Osaka will defuse. So it is premature to expect a U-turn in Treasury bond yields just yet. As long as the Fed delivers two rate cuts in 2019, the front end of the US Treasury yield curve is not crazily overvalued. This has profound implications for the fate of the US dollar and the shape of the US Treasury debt yield curve, where I expect rising inflation risk premia will lead to a bull steeper milieu this summer. I find it significant that dollar-yen sank through the critical 108 level and traded as low as 107.50 for the first time since the January 3 flash crash. I expect the Japanese yen will rise to 106 against the US dollar in the next month.
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It is also significant that the Chinese yuan has appreciated to 6.85 in Shanghai, a clear metric of optimism about the odds of a trade deal at Osaka. Yet the financial markets will go berserk if the “Osaka pact” unravels. While it is premature to expect that King Dollar will be dethroned in 2019, I expect a kinder, gentler and softer greenback on its trade-weighted index this summer down to 94 on the DXY.
The Norwegian kroner is the anti-dollar currency de jour for me. Why? The Norges Bank defied the global central bank easing trend by hiking interest rates and jawboning tight money guidance. This is a compelling argument to accumulate the Norwegian kroner against both the US dollar and the Euro.
I expect the soft dollar trend will gather momentum next month as Boris Johnson moves into 10 Downing Street as the most controversial Tory Prime Minister since Mrs Thatcher and promptly flies to Brussels to secure “peace in our time”, a Brexit deal (as Neville Chamberlin learnt in Munich/Berchtesgarten, if at first, you don’t succeed, fly, fly again!). I still remain a Nervous Nellie sterling bull yet alert to any political landmines in Westminster, Threadneedle Street or Brussels in the endgame to Brexit. My call? Cable 1.32.
Mario Draghi stunned the markets (and Trump) with his plea for more ECB monetary accommodation in the absence of Eurozone inflation. For now, the markets will ignore Super Mario and the Euro will trade higher to 1.15.
Gold is the asset class de jour, up 7% in June and the highest price since 2013 at $1390 an ounce. The macro tailwinds for the yellow metals are in place. Imminent Fed rate cuts, a dovish ECB, geopolitical risks in the Middle East, slower US non-farm payroll growth, the lowest GDP growth in China since 1990. Above all, the fall in the US dollar index to 96.50 makes me bullish on a gold breakout. I expect at least a 25 basis point rate cut at the July 31 FOMC and an inverse correlation between gold and the US dollar only increases when the Fed pushes the easy money throttle.
Gold will also attract central banks eager not to increase their US dollar reserves. After all, China and Russia have tripled their gold reserves in the past decade. The Hong Kong protests also mean capital flight into gold as the Chinese Communist Party now faces its first popular uprising since the Tiananmen Square massacre in June 1989. Hong Kong has the most leveraged banking system in the world, with private sector credit 350% of GDP. China’s Daesung Bank has gone kaput, depositors were wiped out and the interbank market faces a liquidity squeeze. A financial panic in Hong Kong means gold at 1600 an ounce, that much, at least, is certain.