When it comes to trade and financial markets, maybe everyone is getting it wrong.
The bond market “is too pessimistic, the equities market too optimistic, and the FX market complacent,” said Bank of America Merrill Lynch currency strategists Athanasios Vamvakidis and Adarsh Sinha, in a Wednesday note (see chart below).
The analysts are homing in on the seeming disconnect reflected by a simultaneous rally in the stock and Treasury markets.
“In our view, it is difficult to see the Fed cutting by as much as markets expect, if at all, if there is a U.S.-China trade deal, and it would be difficult for equities to remain so strong if there is a trade war,” the BAML analysts wrote.
Stocks have found their footing in June as expectations for Federal Reserve rate cuts have risen, reflecting apparent faith in the central bank’s ability to avert a severe economic slowdown or recession. The S&P 500
is up 4.8% so far in June, trading less than 3% below an all-time closing high set just before a May pullback. The index is up roughly 15% in the year-to-date, putting it on pace for its best first half since 1998, according to Dow Jones Market Data. The Dow Jones Industrial Average
is up around 11.6% in the year to date, gunning for its strongest first half since 2013.
Indeed, even during the May pullback, stock-market investors largely kept their cool. Jim Carney, founder of New York-based hedge fund Parplus Partners, told MarketWatch that the cost of buying “real crash protection” in the options market fell significantly since early May, appearing to reflect confidence the Fed and the European Central Bank will keep monetary policy loose enough to avoid a major crisis.
Options pricing showed traders appeared prepared for a range that would see stocks move around 10% to 12% up or down, while viewing a “crash” scenario of a pullback of 20% or more as unlikely, he said.
Meanwhile, the sharp fall in Treasury yields — yields fall as bond prices rise — is viewed by many analysts as a signal that recession fears are mounting. Interest-rate futures are pricing in as many as four Fed rate cuts by the end of next year.
The BAML analysts aren’t impressed by arguments that the stock and bond markets are pricing in a trade-war scenario that would see the Fed riding into save the real economy with rate cuts, therefore boosting the stock market.
Instead, a full-fledged U.S.-China trade war would likely lead to a “sharp risk-off market move and a substantial deterioration in the global economic outlook, despite Fed easing,” they wrote. The pricing of more Fed rate cuts, meanwhile, coincided with weaker U.S. economic data, including last Friday’s disappointing jobs data, although deteriorating data should also have led to weaker equities, they said. And in any case, a weakening of U.S. growth from last year’s stimulus-induced pace shouldn’t be a surprise, they said.
Unfortunately for those wondering how the disconnect will resolve itself, the analysts say it’s a case of time will tell: “Bottom line, we see a risk of either a rates market selloff, or an equities market selloff, depending on whether there are positive or negative developments in U.S.-China trade in the next few weeks.”
Perhaps more helpful, Vamvakidis and Sinha argue that subdued volatility in the currency market is likely to get dragged higher if volatility in the equity and rates markets jumps on trade-related worries — something they see as likely to happen as month-end a meeting of leaders of the Group of 20 nations draws near.
The analysts shorted the euro versus the Japanese yen
in May as U.S.-China trade tensions escalated and recently recommended selling the U.S. dollar/Japanese yen
pair, as well. The yen typically benefits during periods of global market unease, often serving as the currency market’s premier haven.
“We would expect markets to get more concerned about negative outcomes as the G-20 meeting approaches, potentially triggering a risk-off [move],” they wrote. “We have a relatively optimistic view for the end game, but are concerned that things can get worse before getting better. The risk to these trades is a comprehensive [U.S.-China trade] deal at the G-20. However, even in this case, we think the Fed repricing could limit the risk-on market move, limiting in turn JPY downside.”
Trading the euro/U.S. dollar pair
is more tricky, they said. While a looser Fed should be a positive for the euro, the shared currency has strengthened only recently amid apparent disappointment that the European Central Bank didn’t strike more dovish stance at its June meeting.
Meanwhile, rising global trade tensions should be a positive for the euro, they said, because of the eurozone’s higher dependence on trade, while a “trade peace” scenario should be a negative for the currency as investors cut expectations for Fed rate cuts. In addition, a U.S.-China trade pact doesn’t preclude the U.S. putting pressure on the European Union over trade issues, the analysts noted.
While emphasizing the caveat that details of any trade pact could have big implications for the currency pair, they argued that investors should expect a stronger euro versus the dollar in the short in the case of U.S.-China trade war — a move that investors should use as a selling opportunity. In the event of trade peace, investors should look for a weaker euro, which the analysts said should be viewed as a buying opportunity.