There is lots of news to digest from last week: US-Chinese tensions escalated beyond trade disputes, with the latest navy showdown in the South China Sea and the Chinese hardware hacking scandal. Oil prices continued to march higher to a multi-year high, promising more pain for oil-importing emerging markets. Yields repriced higher across all maturities in the dollar complex, triggering a massive selloff in bonds that took equity traders by surprise.
China Back from Holiday
Offshore yuan traded above the PBOC’s 6.9 threshold several times while China was out on holiday, but it did not stray too far from that target. Everyone is looking to see what China will do this morning in reaction to last week’s events. While the Chinese were out on a week-long holiday, news broke out on a Chinese hardware hacking scandal, in which US corporate and government systems were compromised as a result of supply-chain dependence on Chinese hardware manufacturers. This incident lowers the odds that Trump will come to an agreement with the Chinese. Trump’s threats to upend existing US-Chinese supply-chains are becoming reality for many US corporates.
On a bullish note, China’s exports to the US hit another record. The US trade balance figures came in with a record deficit against China. This was no surprise to us, and we expect new records into the end-of-year holiday season. On 10 September 2018, we wrote:
Despite the trade war, we see China’s 2018 exports exceeding 2017’s all-time as we roll through the end-of-year festivities.
That is exactly what happened. The US trade deficit with China hit another record at $38.6 billion. Further support came from the PBOC this morning, as the central bank wasted no time in reacting to last week’s negative news and announced a cut to the required reserve ratio. This move will effectively improve Chinese banks’ profitability in the next reporting cycle.
We have been beating the drums for quite some time about rising interest rates and increasing global inflation. On 17 September 2018, we wrote:
These hikes are just the beginning because Emerging Market central banks will have a higher hurdle to overcome when rates on the dollar rise further from these levels. We expect to see the Fed Funds Rate rising in September, which will make the dollar funding trade more painful. An escalation of the trade war will not help because import price inflation will be felt more immediately than the effect of the drag on aggregate demand.
Official policy rates are finally beginning to filter down to term structure premiums. The US ISM and jobs reports added fuel to the fire, as fears of the wage-inflation spiral took over the bond markets. Treasuries fell with the 10-year yield hitting a multi-year high of 3.2%. Even equities were spooked by the speed of last week’s bond market sell-off.
This is not just a US dollar story. Rising yields are everywhere to be seen. Even Japan, the country that has been fighting deflation for three decades, is finding reasons to sell Japanese Government Bonds, having pushed its 10-year yields to 0.2%. Rising wages are doing what typhoons and earthquakes could not do to inflation expectations.
We see the correction in US equities as temporary as traders absorb the flood of news from last week and begin to see that the strength in US economic performance will continue for the foreseeable future. The Fed will have to hike rates to far higher levels to put a dent in US economic growth. We continue to be overweight US equities for now.
Oil Price Surprise
On 4 October 2018, Thompson Reuters published our article on its Middle East financial news site, Zawya. In the article, we covered Saudi Aramco’s use of a new formula for its Official Selling Price (OSP) for oil deliveries to Asia, and the impact it has on global oil prices from October 2018 onwards. The pricing formula references the DME Oman crude oil contract with a 50% weight to calculate the price Saudi Aramco is willing to sell its physical crude oil to refineries in Asia.
We see future oil prices highly dependent on the GCC’s monopolistic pricing power, as expressed through published OSPs. Brent closed at 81.87 on the same day the DME Oman crude oil contract for November delivery jumped from 80.70 to 86.15. It took a week before markets corrected for this anomaly, as arbitragers went to work to push up Brent to close at 86.29 the 3rd of October. We urge our readers to take time to read the article on Zawya’s website to fully appreciate what is going on in the oil markets.
The Week Ahead
This week is already promising to exhibit high volatility, as markets digest the bond market rout last week and the building tensions between the US and China. We are also looking forward to the EU’s draft proposal for future UE-UK trade, which is expected for release on Wednesday. The Italian budget is also likely to grab some headlines on the European front. We are also looking forward to seeing what PPI and CPI figures look like in the US.
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