Last week market focus was dominated by geopolitical tensions in the US and Brazil. President Trump did not have an easy week after former FBI director James Comey (who was previously sacked by the US President) alleged in a memo that Trump attempted to obstruct a federal investigation into the former National Security Advisor, Michael Flynn. This sent risk markets screeching to a halt, further exacerbated by media reports suggesting Trump could/should be impeached. Some semblance of normality followed the knee-jerk reactions, and the appointment of Former FBI Director, Robert Mueller to act as special counsel to investigate Russia’s involvement in the US elections eased market concerns somewhat.
The DXY (dollar) Index did however retreat further over the week, falling 2.10%, and the Treasury market benefited from the risk-off tone, with the yield on the 10-year falling over 9bps to 2.24%. Markets will focus on Trump's first presidential foreign trip which started in Saudi Arabia over the weekend; where counterterrorism measures and USD 110bn worth of arms deals (amongst other policies) were discussed. He is off to Israel today, followed by Italy and the Vatican, eventually headed to NATO and the G7 summit in Sicily later this week.
Meanwhile, the Fed reiterated that it will be ignoring current political noise and recent market volatility and is due to stay on course to raise rates twice this year. Cleveland Fed President, Loretta Mester commented that one must ‘look through those temporary fluctuations in both economic and financial data and focus on… the medium-term outlook’, adding the Fed should ‘remain very vigilant against falling behind, especially given the low level of interest rates and the large size of our balance sheet’. Meanwhile St. Louis Fed chief, who is forecasting only one further rate hike over the next couple years, said he feels the Fed is ‘overly aggressive relative to actual incoming data on U.S. macroeconomic performance’ , which he sees as ‘relatively weak’. Once again the Fed remain split regarding the tightening cycle; we expect the USD 4.5tn balance sheet will come into play as a further tightening tool. We wonder whether there will be any further enlightenment with a steady stream of Fed members speaking today and tomorrow. A rate hike next month remains firmly in place; despite spikes in volatility through last week which saw the futures market price all number of probabilities for a Fed hike in June.
Markets across Brazil also had a tumultuous week; as corruption allegations and impeachment calls against President Michel Temer mounted. The country’s stock market plummeted a massive 8.8% on Thursday and the Brazilian real witnessed its largest drop since 1999, falling over 7%. Brazil’s 5-year CDS over ~20% over the week as a result, to ~250bps. To add some context, Russia’s 5-yr CDS ended the week trading at 152bps. Having never favoured Brazil issuers amongst our portfolios, regular readers of our daily comments will recall our concerns over the country’s Petroleum company, Petrobras being highlighted on Tuesday. Rated sub-investment grade, we calculate the company's bonds have been trading ‘expensively’ for some time, and continue to do so despite the massive 5-7 point slide on Thursday.
Elsewhere, China’s economic data prints came in pretty much in-line with expectations and the offshore renminbi gained 0.35% against the dollar over the week, on a spot basis. The currency is now up +3.4% against the dollar year to date, on a total return basis. Meanwhile, on Tuesday the central bank along with the Hong Kong Monetary Authority announced plans to establish the ‘China-Hong Kong Bond Connect’, which would create a platform of access between the two nations’ bond markets. Bond connect would allow investors access to China’s government bonds without a quota or other technical hurdles. Whilst it is unusual for international investors to access a bond market in this way (usually bonds are traded OTC) it does make access easier, thus a positive.
The opening of the Chinese bond market is still at a very early stage given that international investors represent a tiny fraction of the overall market. International investors will inevitably hold more RMB assets in due course, and it's important for international investors to be able to access investments with renminbi exposure if the renminbi is going to be widely accepted as a major reserve currency, which we think it should. Initially the focus will be on northbound flows, but eventually it would seem that southbound flows will be allowed as well. That opens up an interesting possibility for domestic Chinese investors looking for other RMB instruments elsewhere, perhaps CGB futures in HK, for example.
Bond Connect is just one of many initiatives that will help the internationalisation of the RMB. At the moment though, internationalisation of the renminbi is hindered by the perception of investors that the renminbi has been weakening. However that perception is largely incorrect with CNH gaining over 10% against the euro and 15% against sterling over the past 3 years with 5% and 12% gains against those two currencies over 5 years for example. The renminbi has fallen against the US dollar but in reality, it's the dollar that has been strong rather than the renminbi being weak. This perception, even if it's not true, does reduce the appetite of foreign investors to hold renminbi assets. That attitude will change at some point and inbound capital will likely pick up from the very depressed levels that we see today.
Looking forward to the week ahead, with relatively light US economic data last week, this week will see the release of the much watched Chicago Fed National Activity Index, PMI data, Q1’17 GDP reading, which is expected to come at 2.3%, and the Fed’s favoured inflation number, the core PCE print. Elsewhere in Europe we will see the release of the German IFO print, Eurozone flash PMI reading and the second estimate of UK Q1’17 GDP. Japan’s CPI reading will be of much interest at the end of the week, where market calls are for +0.4% (from 0.2% previously).