Fragile Sentiment

March 24, 2021

• Fed Chair Powell stuck to the script on transitory inflation pressures
• The Bank of Canada said it is ready to start winding down its emergency programs
• The EU is drafting new vaccine rules that could lead to reduced exports, but recent comments have been more conciliatory
• Euro area PMIs surprised on the upside, while UK inflation on the downside
• Political uncertainty in Israel continues after the elections
• The downdraft in many Asian equity markets is deepening
• Oil prices have been struggling as the reflation trade loses steam

Risk sentiment remains fragile across markets. U.S. 10-year Treasury yields are stable at just over 1.60% after a large downward move yesterday. Global equity markets are broadly weaker, especially in Asia, though U.S. equity futures are slightly higher. The dollar is mixed, weakening against commodity currencies (NOK, ZAR, MXN) but broadly weaker against most major currencies. Oil prices are staging a tentative rebound after the sharp drop over the last few sessions.


Fed Chair Powell and Treasury Secretary Yellen didn't say anything market moving in yesterday's comments to the House of Representatives. Powell still seems confident that resurging inflation pressures will be temporary because the labour market remains frail. Yellen said asset prices are elevated but didn't seem concerned about financial stability risks. Treasury yields were little changed immediately after the comments, but the 10-year ended the session down 7 bps and are a couple of bps higher this morning to 1.62%. Also of note, the 2- to 10-year yield curve has been flattening a bit over the last few sessions, and real yields are slightly lower along with the move in nominal rates.

The Bank of Canada said it is ready to start winding down its emergency programs. Deputy Governor Toni Gravelle said the bank will halt its short-term financing facility in May and won't extend its other asset purchase programs (corporate bonds, commercial paper, and provincial bonds). He also said the bank would "start gradually dialing back the amount of incremental QE stimulus" to a point in which new purchases will no longer accelerate and only maintain the level of stimulus. Yields were broadly lower across Canada's yield curve, but the moves were in line with those in U.S. Treasury markets.

The Brazilian central bank minutes reinforced the message delivered by the larger-than-expected hike in the previous meeting, providing extra support for the real. The language focused on inflation expectations, fiscal risks, and gradually improving growth prospects. All this means that another 75-bps hike is all but assured, validating current market pricing. After that, we imagine that the currency will play an increasingly important role: if it continues to underperform other EMs (as it did earlier in the year), that would skew the balance towards a more protracted cycle. Otherwise, we imagine the bank will want to refocus on growth, which doesn't look very promising with the pandemic still in full force.


The EU is drafting new vaccine rules that could lead to reduced exports. The new measures could mean that exports to countries that do not reciprocate will be blocked. The UK might be the prime target here, but the new rules would also affect exports to many other countries, including Canada and Australia. That said, the latest round of comments from both the UK and EU members had a more conciliatory tone. UK PM Johnson said he was "encouraged" by what he had heard from the Continent." German Chancellor Merkel also stressed they would "seek dialogue" and warned about the risks of bans and supply chain disruptions.

Political uncertainty will continue in Israel as none of the sides has a clear path towards a coalition. PM Benjamin Netanyahu's Likud party and his right-wing allied parties fell eight seats short of the threshold to form a government. The country enters a coalition-building period now, but the risk of new elections (the 5th in two years) is a serious prospect. The balance could rest on the small right-wing breakaway party Yamina, but the former Netanyahu allies have not yet declared their intentions. There has been little reaction in Israeli assets.

Preliminary PMI readings for the euro area were higher than expected. The manufacturing component jumped to 62.4 (57.6 exp.), the service came in at 48.8 (46.0 exp.), leaving the composite at the expansionary level of 52.5, considerably higher than the 49.1 expected and the 48.8 reading from February. Of note, the German manufacturing PMI came in at 66.6, well above forecasts. As usual, the industrial sector's recovery is outpacing that in services over this period, a trend that should continue with the new lockdowns across the region. The euro got a little boost from the numbers, but it's still slightly weaker against the dollar on the day.

UK CPI for February came in well below forecast but driven mainly by transitory factors. Inflation rose only 0.4% y/y, half of Bloomberg's consensus forecasts and well below the 0.7% y/y level in January. Core also undershot expectations coming in at 0.9% y/y. The surprise was due to large discounts by retailers, especially clothing (-1.5%). We don't think the numbers consequential for policymaking, nor will it change the BoE's and market's expectations for a pickup in inflation later this year. Indeed, breakeven inflation rates for the UK little changed. Consistently, gilt yields are only slightly higher and moving in line with the global trend.


The downdraft in many Asian equity markets is deepening. Chinese indices are being especially hard hit, with the CSI 300 now down 5.5% for the year, vastly underperforming most indices in the region, in part due to the crackdown in the country's tech sector. Korea and Taiwan indices have been range-bound, failing to regain momentum. Much of this is down to global factors, including the stronger dollar, broad weakness in global equity markets, and especially tech. But accumulated heavy positioning overhang by locals and foreigners in some of these markets is likely playing a role, as investors had bet heavily on the region's better outcome from the virus.


Oil prices have been struggling as the reflation trade loses steam. Brent crude fell 6% yesterday, after declining nearly 7% last week. Much of this is likely down to a retreat of speculative capital as news of new lockdowns deflates the reflation trade. The stronger dollar is another factor weighing on commodities more broadly, along with no signs that OPEC+ is ready to take decisive action to support the price. Crude prices are over 1% higher today, partly helped by ship blockage in the Suez Canal. Of note, the deep backwardation in the Brent curve is rapidly disappearing, meaning the curve is becoming less inverted.

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