With China's 3.0% inflation higher than the 2.79% deposit rate, it is no surprise that trading volumes in Chinese equities have risen more than five times over the past six months and regulators' bubble" warnings are ignored. As the Chinese version of irrational exuberance is muted by accelerating demand, the potential of a sharp correction fuelling a repeat of late February/early March remains considerable. The deepening divergence between U.S. economic growth and U.S. equities remains a concern, especially when U.S. earnings are principally driven by a weak dollar, stock buybacks and robust foreign demand. More below.
Global equities are rallying across the board and foreign exchange carry trades are alive and well after China’s consumer price index retreated back to the central bank’s 3.0% target in April, while New Zealand retail sales rose unexpectedly, prompting rate hike expectations in the already high interest rate economy (7.75% rates). These two data items are driving traders to chase high yield plays in the United States dollar, Aussie, gold and equities at the expense of the low yielding yen and Swiss franc.
But the risks of an unwinding of these carry trades looms large for the following two reasons:
China’s 3.0% consumer inflation remains above the one-year deposit rate of 2.79%, giving Chinese depositors a negative return on their savings, thus further prompting them to buy equities. Thus, a 27-basis point rate hike in the deposit rate should be expected before month end. The fact that China’s securities regulatory commission issued a notice on Friday about the risks of investing in equities reflects the preoccupation and warnings by authorities. The Commission posted on its website: “investors should be fully aware that there exists no stock on earth whose prices only surge and never slump; neither can they expect investment instruments which will only bring in money and not cause losses." The fact that Chinese investors continue to ignore such warnings from the central bank and regulatory bodies carries dangerous implications for local and overseas markets, especially from the inevitable rate hike. Despite the central banks’ recent hikes in banks’ reserve requirement ratio, an increase in interest rates remains needed to temper inflation in consumer and asset prices.
A high probability of a market jolt from this week’s key U.S. economic data could make an extended repeat of Thursday’s market drop. This week’s releases include April CPI, April housing starts, May housing market index, April industrial production, May Philly Fed survey. The likelihood that one of these reports raises fears of a hard landing is more than 75%. Industrial production was negative in five out of the last seven months. The Philly Fed survey fell over the past four months, while housing starts and the housing market index remain on the downside
Euro still sees risks ahead, focus in EUR/GBP
One of this week’s few releases from the Euro zone is German and E-12 first quarter gross domestic product (GDP), both expected to weaken to 0.5% and 0.3% q/q respectively, which will likely raise expectations of a cooling in the Euro zone and scale down chances of ECB tightening this year. We expect today’s upside to be capped at 1.3575, until tomorrow’s key CPI figure from the United States. . With the April CPI from the United States already slowing to 2.5% from 2.8% y/y and core PCE price index down to 2.1% from 2.4%, one more month of slowing inflation (core cpi below 2.5%) should be an all round negative for the U.S. dollar and may prop EUR/USD to as high as 1.3620. Support stands at 1.35.
But the action continues to be in EUR/GBP. The cross pair has hit two-month high at 68.43 as the sterling is increasingly losing the favor of currency traders amid mixed outlook for the Bank of England’s future rate hikes. More on UK CPI below. EUR/GBP has now reached the 10-month trendline resistance, paving the way for 68.50 and 68.65.
USD/JPY firms with uncertainty
We deem USD/JPY as increasingly vulnerable to the next bout of carry trade unwinding in light of the aforementioned factors as well as the this week’s release of Q1 GDP. Friday’s release of the Bank of Japan monthly report is expected to issue a guarded improvement on the economy. The pair will be largely influenced by the avalanche U.S. data and speeches from Federal Reserve officials. U.S. equities will also play a role as the inverse correlation between the Japanese yen and the equity indices continues to hold.
We also caution about the possibility of an interest rate hike from the People’s Bank of China, which we deem a high probability event (above 85%) in the next seven days given the fact that inflation is above the level of interest rates. Upside capped at 120.50, followed by 120.75. Support starts at 120, with prolonged downside at 119.80 and 119.30.
Sterling drops as soft PPI implies cooling CPI
Sterling drops across the board after April PPI slowed to 2.5% from 2.8% (revised from 2.9%). This raises expectations that tomorrow’s April CPI release will show a 2.8% reading following 3.1% in March. Sterling remains subjected to downside risks as long as the threat of risk reduction trades and equity correction has not waned. Last week’s 0.2% decline in March industrial production was an initial catalyst to the decline.
Key support stands at the six-week trendline support of 1.9770, a break of which calls up 1.9750. Upside capped at 1.9820 and 1.9850.
Ashraf Laidi
Chief FX Analyst
CMC Markets US
140 Broadway, 30th Floor
New York, NY 10005
(212) 644-4220
a.laidi@cmcmarkets.com
