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Fed and PBoC facing Paradox of Choices in June

Jun 11, 2020

 

  • Global equity performances seems to diverge further from economic fundamentals. A very important logic behind is the market believing that the economy will have a steep “V” shape recovery after the pandemic.
  • This applies to the US, as its personal disposable income and household savings have reached historically highest level in April, laying the foundation for a fast recovery of US consumption. The policy options made by the major central banks will affect the economy and capital market. In June, central banks could face another "choice dilemma".
  • The long-term Treasury bond yields in China and the US have risen significantly recently. Without PBoC’s direct bond purchases, the fast rising government debt supply pressure will lead to an earlier and faster overall interest rate level rebound, causing increased financing costs, and squeezing out room of corporate financing, resulting in a tightening of the actual financing environment. Stucked between the rising financing needs and concerned about over-leverage and asset bubbles, the future choice of PBoC is worth paying close attention to.
  • The Fed has reduced its weekly Treasury net purchases to 25 billion last week, but the new issuance of Treasury bonds will remain at more than 100 billion per week in future. Moreover, the rising risk appetite and inflation expectations weakens the market demand for bonds, the US long term bond yield has also risen significantly lately. We should focus on whether the Fed and Chairman, Powell, can achieve its “yield curve cap” during the Fed’s meeting.
  • Short to mid-term focus: Bullish on risky assets, especially US equities. Unless the Fed makes it clear that it will not accelerate its bond purchases, or the 10y treasury yield rises to 1.5%. Cautious on A shares, as Chinese domestic interest rate has risen too quickly recently and we expect that the index has limited upside space. However, if A-shares declines again, it should rebound quickly, as we may see more stimulus and loosening then.We reduce our view on commodities from over-weight to neutral. We have lowered our view on gold to neutral as it will be hurt by rising bond yields.

Hou Zhenhai 
Straits Financial (China) Chief Strategist 

I. Why market trends diverged from near-term economic data? 

This round of global risky asset rebound is too early and rapid, that it is far beyond the expectation of most investors. Data shows that most institutional investors in the US, including mutual fund and hedge fund managers, as well as many famous personal investors, have not participated in this rally, or even sold their positions early into the rebound. From the economic data perspective, their moves seem to be reasonable. Though the Covid-19 pandemic is under control in China and parts of Europe, recent economic data from most parts of the world are still in the doldrums. At the same time, the "George Floyd Tragedy in Minneapolis" has led to a nation-wide wave of protests and riots in the US, which in my view may not only interrupt the resumption of work in many areas of the US, but also increase the risk of further rebound of the virus infections due to large gatherings in the demonstrations.

However, it is clear that the markets ignored these fundamental risks. One reason for that, as we mentioned in our previous report, is the huge amount of money supply has flooded the market with "over-liquidity". But the optimistic market expectation that the US economy may make a “V” shape rebound after the pandemic of the market is also a very important reason.

I think a very important logic behind this is that more investors now believe that Covid-19 will not actually impact the income status and balance sheet sustain ability of most US households. If that is accurate, once the pandemic is over, no matter how long it may take, the US consumption will recover right away. Last Friday’s better than expected employment data added more fuel to that optimism. May’s Non-Farm Payroll increased by 2.5 million, significantly better than market expectations. But the data itself might be flawed, and the U.S. NFP data usually will go through big revision within a few months after its release. We can see from other employment data other than NFP that the actual employment situation in the United States is not as optimistic as NFP shows. For example, the continuous jobless claims were 15.82 million in the week of April 12, the same week when May’s NFP was calculated, while that numbers are above more than 20 million all the time since May (Figure 1), so it indicates that the actual NFP changes in May should be a negative figure.

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Moreover, even among the people with jobs, there are now 9.4 million people in the US are working under part time jobs due to economic reasons, well beyond the 7.1 million peaked level made during the peak of 2008 Global Financial Crisis (Figure 2).

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But the other data is, as I believe, the reason why the market optimistically expects that the US household consumption could recover soon after the pandemic: the household disposal income data. In April, when over 20 million people lost their jobs in the US, the monthly disposable income per capita hit a record of $4288 (constant price), nearly $500 higher than the previous months before the outbreak (Figure 3). In other words, after the outbreak, the disposable income has actually increased, by a big margin! Of course, because of social-distancing and quarantine, the US personal expenditure in April decreased by about 20%, and this resulted in the savings rate of US households soaring to a record 33% in April (Figure 4)! That's a net increase of $512 billion in U.S. household savings, just in April!

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Apparently, this kind of high saving rate is not going to sustain when people comes back to work. Though it may still be higher than before, I expect it to be down to 10% and a significant part of the current savings is likely to become the driving force for the US household consumption to restart afterwards. Besides, some of these savings will enter the investment markets, especially in stocks and real estates. That is also why we saw that small and medium-sized individual investors are the most important contributing buying forces in this rally, while real estate purchasing activities in many areas of the US are already showing early signs of improvement.

That said, on the other hand, this high increase of US household income is currently mostly dependent on the US government's fiscal stimulus, as well as the Fed’s move to monetize the deficits through its asset purchases. In the month of April alone, US fiscal deficits have increased by $740 billion while the Fed net purchased over $1 trillion Treasury. Therefore, it is still the Fed and other major global central banks that decide the direction of the US and global stock markets.

II. The dilemma before the Fed and PBoC

Though the rapid rebounds of global markets, especially in equities, have certain benefits to boost economic confidences, it is also make a challenge for the major central banks such as the Fed and the People's Bank of China (PBoC).

First of all, central banks know that the endogenous downside risks of the economy have not been completely eliminated, so it is still too early to withdraw those loose monetary policies in the near future. Secondly, both the drop of government tax revenue and fiscal stimulus meant a much larger deficit over a longer period. Therefore, if it reduces the pace of asset purchases (in the Fed’s case) or refuses to monetarize debts (in the PBoC’s case), it is likely to result in an early rise of long-term government bond yield. Moreover, increasing risk appetite and inflation expectations led by rising prices in stocks and commodities, will further aggravate the pressure over the long bond yield to rise, thus posing a threat to a fledging economic recovery. So, how to balance these forces will become a "dilemma" for these central banks in the future. And I think it is also the key to determine the trend of global capital market in the second half of this year.

Let’s take a look at PBoC first. At present, the China’s central bank has a clear attitude that it will not "monetize debt". This means that although PBoC will continue to provide short-term liquidity support through reverse repo, MLF and other new facilities, the base money growth in China will remain at a relative low level (Figure 5).

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Of course, this won’t be a problem under normal economic conditions, but due to the impact of this year's pandemic, demand for debt financing has greatly expanded in China. In May, the net increase of government bonds (including treasury, local government bonds and policy bank bonds) issuance in total, reached RMB 1.85 trillion (Figure 6). However, as PBoC does not purchase debts from the markets, the surge in government bond supply soon turned into the pressure on bond yields. In the past month, China's 10y Treasury bond yield has risen 30bps to 2.85%, basically back up to the level before the pandemic outbreak. The yields of local government bonds and policy bank bonds of shorter maturities have increased even more (Figure 7).

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This tightening of bond yields may still be acceptable to government bond issuers. But for the corporate debt issuers, this is not merely a matter of rising funding cost. In May, the total net issuance of corporate debts (including corporate bonds, mid-term corporate bills and short-term corporate financing coupons) decreased to about 300 billion RMB, while in March and April, it was between 700-800 billion yuan (Figure 8). Moreover, during the first week of June, the overall net issuance of corporate debts has also turned negative. In other words, the overall corporate bond financing environment has tightened rapidly. This could be a bad sign to Chinese enterprises which are barely recovering from the pandemic.

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This undoubtedly poses a challenge to the Chinese policy makers. Although PBoC still have room to maneuver, i.e. through open market operations, LPR and RRR cuts and finally even direct debt purchase, it is also concerned about the rising inflation expectations and asset price bubble pressures. Besides, simply cutting LPR or RRR may lead more funds into interest rate carry-trade through tools like structured deposits, instead of entering into real economy circulation. Historically, it is always the PBoC’s responsibility and mission to tackle with these problems, so this time it does not want to create too much of its problems in the future. Therefore, we believe that the room for further monetary easing in China will be quite limited unless Chinese domestic economy shows signs of another significant decline. Before this happens, the actual liquidity situation in China will gradually tighten.

But this tightening will affect different asset classes on sequence. Bond yields have already tightened. But only when the interest rates rise to a certain extent, for example, with 3% in 10Y treasury yield and 7-day repo rate also increasing close to 3%, the level it was at the beginning of the year. This will have a substantial impact on the trend of A-share. After A-share starts to sell-off and the expectation of economic recovery falters, it will have a greater negative impact on commodity prices. At present, I believe this is still an early stage when bond prices fall while stock and commodity prices rise. It is still important for equity and commodity investors to pay close attention to the rapid tightening of domestic bond yields.

For the Fed, it has put in practice of debt monetization, which has substantially expanded its balance sheet by nearly $3 trillion this year. Therefore, although the economic impact of the pandemic in the US is more serious, and the scale of the government's fiscal deficits and funding requirement are much larger, the US bond yields are relatively more stable at a low level, only in last few trading days when we say a little move upwards. That said, we have also noticed that the actual weekly purchases of treasury bonds by the Fed has decreased significantly, from the previous maximum of $300 billion a week to $25 billion last week. But we expect that the average weekly net issuance of US Treasury will remain at least above $100 billion in the future (assuming the US will not launch a new round of fiscal stimulus). And with the stock market rebounding sharply, the overall market's allocation demand for treasury bonds has also declined (Figure 9).

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From the Fed’s standpoint, it certainly does not want to see a significant rise in long term bond yield. So this week's Fed meeting and Chairman Powell Thursday’s press conference are of great importance. The market will pay a close attention to the Fed's introduction of its future asset purchase plan, and even the possibility of introducing a plan of "yield curve cap" to avoid fast rising of long term bond yield. The most ideal outcome is to control the bond yield through market communication instead of direct bond purchases in the future, which can avoid asset bubbles and meanwhile suppress interest rates to help the real economy recover gradually.

We should never underestimate the ability of the Fed’s impact over the market through its public communications, but we are still dubious over how long the Fed can maintain this goldilocks situation. At the end of the day, we believe it’s still up to the pace of debt monetization from the Fed. Do not forget that this is an election year in the US. Over that, there is still a big risk that the pandemic in the US can worsen further, so I think the possibility for the US government and congress to agree on a new round of fiscal stimulus is quite high. Under this condition, if the Fed just maintain its current asset purchase pace, while hoping to suppress the long-term interest rates by affecting market expectations through communication, I think it will be very difficult. However, when the Fed has to increase its bond purchases again, it will further open the upside of US stocks and commodities.

Therefore, for US stocks, no matter how much this rebound has been, its downside risks are still limited, unless one of the following 2 risk scenarios happens: 1. The Fed makes it clear that it will not further accelerate its bond purchases; 2. The US 10Y treasury yield reaches 1.5%.


III. Short to mid-term focus

We are bullish on risky assets, especially US equities, unless the Fed makes it clear that it will not accelerate its bond purchases, or the 10y treasury yield rises to1.5%. We do NOT think the pandemic, near term poor economic data and even the US demonstrations & riots will have a great impact on US stocks.

As China's domestic interest rate level rebounded rapidly, we are generally optimistic but more cautious about A-shares, and believe that the overall index's upside is relatively smaller. Hong Kong stocks can have more upside than A-shares. However, if the tightening of the overall financial environment leads to the slowdown of China's economic recovery and A-shares decline again, we foresee it will rebound quickly because we think that the domestic fiscal and monetary policy is likely to loosen further at that time.

The contango and discount to physical spot price on most commodities have largely returned to normal, and the overall fundamentals show limited upside in the future. Therefore, as a whole, we reduce our view on commodities for over-weight to neutral. At the same time, the rising interest rates have a downward pressure over gold, so we also reduce our view on gold to neutral. The new-entry opportunity on gold may occur when this round of rate tightening ends and/or global central banks begin another round of asset purchases.

About the Author

1998 – 2004, Chief Representative Assistant of GKN Group in China.

2006, obtained MBA degree from Wisconsin School of Business at University of Wisconsin–Madison.

2006 – 2007, served at the Wisconsin Foundation.

August 2007 – July 2013, served at China International Capital Corporation (CICC) as the leader of the overseas strategy team and A-share strategy team. He is also the main report writer and contributor. Mr. Hou and his team received many honors including the top team for the New Fortune Sell-side Strategy Research in 2008, and the top team for the Asia Money China Strategy Research in Hong Kong in 2009 and 2012, etc.

September 2013 – December 2019, served at Discovering Group and was responsible for the Group’s macro strategy research. During the period, the company has accumulated absolute returns that far exceed the market level.

 
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