Asian markets rose on Monday amid news that China and the United States managed to ward off the threat of a trade war, striking a peaceful deal. Minister of Finance, Stephen Mnuchin, shared with investors the joyful news on Sunday that the countries agreed not to fence off each other with tariffs and are now in the process of working out a more detailed agreement on trade cooperation. As Mnuchin put it, the trade war was put «on hold».
On Sunday, Trump’s two main assistants, Larry Kudlow and Stephen Mnuchin, reported that the Chinese and American negotiators laid the foundation for the rapid elimination of trade imbalances in the future. Judging by the reaction of the markets, most investors took it as a guarantee that Trump could no longer exacerbate the situation in this direction.
As the demand for defense assets fell, the yield on US bonds rose above the opening on Monday and approached the level of 3.1%. On Friday, the yield reached 3.128% against the backdrop of the onset of buyers in the oil market due to signs of supply contraction.
The increase in energy prices is the main source of inflationary pressure which helps economy to overcome low-inflation state. The increase in energy costs as a basic raw material for production forces firms to raise prices for final products, which inevitably entails an increase in the cost of the consumer basket, that is CPI. This reduces the purchasing power of future cash flows on long-term bonds, so that to compensate for inflation risk investors require higher returns on their investments or switch to short-term bonds with subsequent income reinvestment strategy. Actually, the inflation risk slightly outweighs the risk associated with the change in interest rates of the Fed, so the differential between the yield of a 10-year and 2-year Treasury bond has slightly grown to the level of 0.54%. Before that, it declined as the level of uncertainty with inflation was lower, but the Fed’s interest rate risk was higher. Hence, we saw the contraction of the differential between long-term and short-term bonds.
Inflationary risk has clearly manifested itself after the crisis of 2008, when the long-term outlook was highly uncertain – therefore, the strategy of investors in the bond market was initially to leave long-term bonds with transition to investments in short-term securities with subsequent reinvestment in the interest rates which could adapt to the economy. Long-term yields immediately grew after the crisis, short-term rates decreased, the difference between them expanded.
It is important to remember that long-term treasury bonds (for example, 10-year bonds) can be more sensitive to changes in yield to maturity and not interest rates. Unlike short-term ones, as the value of more distant payments streams depreciates significantly to payments of the near future. To determine the sensitivity of the bond price to a change in yield, the duration is usually calculated.
The yield itself is determined from the balance of demand and supply (investment and savings). If there are investment opportunities in the economy, more firms are likely to want to borrow at the current rate, and a shortage of borrowing is likely to lead to an increase in profitability in the economy in order to attract more savings. Therefore, the increase in economic activity could be associated with an increase in profitability.
As for the interest rate of the Fed, its impact on the yield on the bond market is slightly more difficult – through the control of money supply in the economy. Since the rate for federal reserve funds is the minimum rate at which banks can provide each other with short-term loans (to maintain the necessary reserve ratio), then raising it could cause a reduction in the money supply in the economy. This might shift the equilibrium to a new point where the cost of borrowing is higher in the economy, so old bonds offering the same flow of payments in the future could fall in price in order to interest investors.
However, the relationship between the interest rate of the Fed and the yield on the bond market is not as simple as described above. For example, if the Fed makes a mistake with rates of rate hikes, investment activity may slow, then inflation will fall, which could cause demand for long-term bonds. If the market is confident now that the Fed is mistaken with a decision, then this market reaction will quickly affect the market for long-term bonds that will grow in price. In this case, short-term bonds will decline due to Fed actions, their yield to maturity grow, and hence the structure of rates will increasingly approach the flat line. Excessive bear policy of the Fed immediately after the crisis led to the fact that “growing calm” about the inflation risk on long-term bonds, forcing investors to take advantage of their yields, in exchange for short-term. This trend is still present in the US Treasury bond market.
Back to the news. According to White House statement, the US was able to persuade China to increase purchases of energy resources and agricultural products; China was essentially interested in these before trade spat. The state party-voice newspaper described the tradeoff as a win-win cooperation with no major Chinese concessions. No concessions in the competitive industries, according by official data, ZTE access to US market remained unchanged. Sudden momentum from Trump’s harsh rhetoric that could help to increase pressure on China is now lost and it can be hard to get substantial benefits for American corporations in China, particularly solving on intellectual property issues.
Despite the retreat of the immediate threat of a trade war, some investors doubt a happy ending. As a result, any confirmation of Mr. Munchin’s words that the war was indeed “postponed” and not “finished” can provoke a strong decline in the dollar.
Today, the US currency is trading 0.22% above the opening on Monday, the biggest decline among major currencies against the dollar is observed on the Japanese yen, which sank by almost 0.5%. then it is followed by a pound sterling which lost almost as much against the dollar. The previous forecast for GBPUSD last week at 1.33, EURUSD at 1.16 and USDJPY at 112.50 remains unchanged, unless of course there will be unpleasant surprises in Trump’s statements on the trade dispute with China. For example, the president may find that the agreement reached is still unfair which could possibly cast a longing for the markets.
On Tuesday, Mark Carney could support the pound with comments on the timing of the next rate hike, and on Wednesday the CPI data, in particular a positive deviation, may cause the pound to strengthen as a response to a possible shift in the interest rate hike by the Bank of England.
Oil prices have now fallen back from a round mark, Brent is trading at 78.77 per barrel. Baker Hughes showed that the drilling activity did not change compared to the previous week – the number of towers was the same 844 units. From a technical point of view in the upside channel, prices need to work out a correction before further growth, the target of correction is the level of 76-75 dollars per barrel. The main wave of selloff could be expected from the level of $ 80 per barrel, which is likely to be backed up by EIA data and possible speculation about the increase in production within OPEC for the replacement of Iranian oil.
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