Rabobank: "The Biggest Explosions Are Still To Come"

Submitted by Michael Every of Rabobank

Civil War, Infinity War, or Endgame?

US consumers are feeling more confident according to yesterday’s data, and they also think things can only get better. Meanwhile, Europe is patting itself on the back over the far right not dominating in the EU elections, even if they did in the UK and Italy, with consequences yet to be seen. Nonetheless, things are going so well on an underlying basis--as the struggle over who will get all the top EU jobs begins--that the Iron German Chancellor Merkel has decided to knife her own named successor in the back and effectively un-retire for the foreseeable future. What confidence in the future that displays. (And in her political judgement in the original pick.) Meanwhile, over in Asia things are looking ugly. The leading indicator that is Korean exports continues to tumble, and now Bloomberg’s leading indicator suggests the Chinese economy will see a further marked deceleration in May data. Like bird-flu, and now ASF, or pig-flu, what starts in Asia doesn’t stay in Asia for long.

Markets seem to get that message – bonds are screaming that a recession is just around the corner – something our Fed watcher Philip Marey has been calling for the US for some time now. The US Treasury curve is now at its most inverted 3-month to 10-year since 2007, not a happy comparison, while the actual 10-year itself is at 2.25% at the time of writing. Recall we started May at over 2.55%, and in January were close to closing over 2.80%. Over in Germany the 10-year Bund is trading at -16bp, which should mean the ECB’s Draghi leaves red-faced – though of course he will walk out declaring “Mission accomplished.” Even the UK, where the political situation is solidifying into rapid No Deal vs. No Brexit and the country is doing an excellent impression of an emerging market, 10-year Gilts have dropped to 0.91%, down 28bp in the last three months: no flight on the part of foreign investors so far spiking those yields.

Overall, there are as many flashing lights and explosions in the bond market as from the climax to an Avengers movie: pick whichever favourite (movie and indicator) you prefer. As such the big question is whether we are already in the Endgame that follows the US-China Infinity War or not. Arguably, even though markets are forward looking--or rather some markets are; others still have their heads in places where very little sunshine enters--the largest explosions are still to come. Consider that:

Steve Bannon is calling for the US to force Chinese firms to delist from the US and for foreign capital not to enter China: MSCI’s call to raise China’s global equity weighting just in time for this entirely-predictable battle is looking every bit as ill-timed as I had feared it was (and I use “ill-timed” as a polite euphemism for other explanations for the decision).

China is looking to press ahead with the ban on rare earths to the US that Xi Jinping’s visit to a production facility. At least that’s the hint as China’s National Development and Reform Commission used a Q&A to state: “Will rare earths become China’s counter-weapon against the US’s unwarranted suppression? What I can tell you is that if anyone wants to use products made from rare earth to curb the development of China, then the people of the revolutionary soviet base and the whole Chinese people will not be happy.” That’s the same argument as Bannon, just replacing capital with the modern-day equivalent of Infinity Stones.

The US Treasury has just declined to declare China a currency manipulator in its semi-annual foreign exchange report – but it has made clear it wants a stronger CNY prompted by Chinese economic reforms, which is not going to happen. Indeed, we are seeing further PBOC warnings of just how stable CNY is and how painful shorting it will be ahead, which is entirely unrelated to any fears of the opposite, honest. Furthermore, lots of other countries are now on the US Treasury watch-list with China: Korea, where the KRW is in trouble; Japan, which is a nice surprise for PM Abe; and Singapore and Malaysia. However, India and Vietnam are no longer trouble-makers, which makes geo-strategic sense at least. Yet outside Asia we see Ireland, Italy, and Germany are all there as one of the key criteria for being on the watch-list has been changed to a current-account surplus of over 2% of GDP, down from 3%. In short, un-retired Iron Woman is in the potential firing line from Captain America, threatening Civil War among The Avengers.

Meanwhile, for those who think China might do the right thing on structural reforms (if you can believe people who wear lycra can fly, then why not?) the PBOC is apparently studying scrapping official benchmark lending rates according to a Chinese press report arguing ‘China is gearing up to make interest rates more market-oriented. Really? The same article notes:

“The country has been moving in that direction since 1996, but a two-track system remains. One track involves interest rates set largely by the market, such as the seven-day interbank pledged repo rate. The other track refers to benchmark deposit and lending interest rates, which are set by the central bank. Current policy rates, the central bank’s monetary policy tool that affects borrowing costs across the economy including rates for mortgages and car loans, haven’t changed in years. They have held at 4.35% for one-year loans and 1.5% for one-year deposits since October 2015 as the PBOC has shifted its approach to trying to guide rates through open-market operations. Although these are reference rates that are no longer compulsory, they continue to loom large in the minds of borrowers and some banks.”

Can I make a suggestion as to why ‘market reforms’ might be kicking in now? It’s not to please the US, and it’s not to make any serious structural change: it’s because market rates are so incredibly low everywhere else that China can happily ride those coat-tails. That’s how markets in China (and, increasingly, everywhere else) work: we love it when they go up, but the problems begin when they go down. That’s apparently when central banks need to use their Infinity Stones to change reality, regardless of the fact that they kill 50% of us in doing so. Anyhow, the US will not swallow that this is the kind of subsidy-removal that they are pushing for when actually it is the complete opposite.

Like I said, the biggest explosions are still to come.