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Why investor appetite for sustainability-linked bonds is growing

Despite representing a relatively small proportion of sustainable bond issuance today, sustainability-linked bonds are rapidly becoming more popular. Xuan Sheng Ou Yong looks at these performance-linked securities and their advantages and disadvantages…

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Despite representing a relatively small proportion of sustainable bond issuance today, sustainability-linked bonds are rapidly becoming more popular. Xuan Sheng Ou Yong looks at these performance-linked securities and their advantages and disadvantages.

Climate action is high on everyone’s agenda, and as such, there is a lot of focus on green bonds. The Covid-19 pandemic has also shone a light on social bonds – securities designed to fund measures aimed at addressing social issues including the impact of the coronavirus. Sustainability bonds, those that include both green and social use of proceeds, are also in vogue.

There is, however, another member of this increasingly diverse club – sustainability-linked bonds (SLBs). What are they, and why is their popularity growing?

BOND TYPEDescription
Green bonds Use of proceeds linked to environmental projects (e.g. renewable energy installations)
Social bonds Use of proceeds linked to social
projects
Sustainability bonds Use of proceeds linked to the Sustainable Development Goals
(SDGs)
Transition bonds Use of proceeds linked to projects which are not generally considered sufficiently green, but still contribute to CO2 avoidance
Sustainability-linked bonds Coupon payment is linked to the sustainability performance of the issuer (e.g., lower greenhouse gas emissions)
Environmental or social impact bonds Coupon payment is linked to a specific impact objective (e.g., prison recidivism rate; flooding incidence)

Source: BNP Paribas Asset Management, July 2021

The growth of thematic bonds

Demand from investors for financial products with a sustainability theme has been reshaping capital markets. One of the consequences has been significant growth in the sustainable use of proceeds bonds and sustainability-linked bonds.

According to the Environmental Finance Bond Database, thematic bond issuance – incorporating green, social, sustainable and sustainability-linked bonds – passed USD 600 billion in 2020, nearly doubling 2019’s USD 326 billion. Furthermore, the amount of thematic bonds issued in Q1 2021 was double that of Q1 2020.

Specifically, SLBs look to be rapidly growing in popularity, with some estimates indicating that in the first five months of 2021, SLB sales increased by 7 000% (albeit from a small base).

How do SLBs differ from other sustainable bonds?

With sustainable use of proceeds bonds, the proceeds are used exclusively to fund projects with environmental and/or social benefits.

In comparison, SLBs are usually issued as general obligation bonds with contractual links to the achievement of a sustainability target or targets by the issuer. Usually, an issuer agrees to pay a higher coupon to the investor if they fail to achieve a linked sustainability target.

Italian energy company Enel, for example, recently raised USD 3.96 billion through SLBs. Under the deal, if its GHG emissions exceed a certain level by a set deadline, the coupons increase by 25bp. UK retailer Tesco has issued a bond with payments contingent on improvements in emissions, renewable energy use and food waste.

Benefits and drawbacks of SLBs

Compared with green bonds, the issuer of a SLB can use the proceeds for general purposes and is not required to track the projects funded by the issuance. This provides the issuer the freedom to choose how it intends to achieve its sustainability targets.

An SLB allows issuers to demonstrate a commitment to sustainability, even if they don’t currently have dedicated green or social projects planned. An SLB focuses on a company’s future trajectory and the achievement of more sustainable outcomes.

Do SLB investors not benefit from higher coupons and thus a higher running yield if an issuer fails to meet sustainability targets? Yes, but this view can be shortsighted. If a firm fails to meet its targets, it could lead to reputation damage that may represent a greater credit risk for investors.

What about the relative opacity of SLBs? Since SLBs have no restrictions on how capital will be spent, investors do not have a clear idea of the impact they will have. Some investors will prefer use of proceeds sustainable bonds since they clearly support sustainable projects.

The flexible nature of SLBs can make them prone to the risk of greenwashing. For instance, some issuances have been tied to KPIs that are clearly readily achievable. Investors should thoroughly check the KPIs to ensure they are sufficiently ambitious.

In addition, since SLBs are relatively new, and internationally agreed principles do not prescribe any standardised metrics to be linked in SLBs, issuers may select metrics that are unique to their situation. This makes it difficult for external stakeholders to compare issuers and issuances.

The future for SLBs

The unpredictable nature of SLB coupons has not made them popular with some regulators. The European Banking Authority has said banks should not use SLBs to meet capital requirements. If sustainability targets are not met, banks would face redemptions or weakened credit ratings.

At the same time, the ECB, after previously not accepting SLBs as collateral, has started to do so, provided the coupons link to a performance target related to the EU’s taxonomy or the UN’s SDGs.

Surveys have indicated that around two thirds of financial advisers believe SLBs are most likely to meet the growing demand for ESG-linked fixed income assets. S&P Global Ratings anticipates the global issuance of sustainability-linked debt instruments to surpass USD 200 billion in 2021.

Despite the impressive recent growth, it is important to note that in May, SLB issuance was just 25% of that of green bonds. For SLBs to become leading investment products in the sustainable bond space, measures are needed to prevent greenwashing and ensure clarity on how capital is allocated. Standardisation of the KPIs to facilitate performance comparability across issuers is also key.


Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

Writen by Xuan Sheng Ou Yong. The post Why investor appetite for sustainability-linked bonds is growing appeared first on Investors' Corner - The official blog of BNP Paribas Asset Management, the sustainable investor for a changing world.

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Bonds

Lower for Longer

The Delta variant of the virus has emerged as an important economic force, just as more countries appeared to adopt the attitude that we should now live with it like we do with the flu, which kills hundreds of thousands every year.  While the existing…

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The Delta variant of the virus has emerged as an important economic force, just as more countries appeared to adopt the attitude that we should now live with it like we do with the flu, which kills hundreds of thousands every year.  While the existing vaccines seem to have lost some of their ability to prevent the illness, they remain a power prophylactic against hospitalization and death.  Nevertheless, new social restrictions have been introduced in some high-income countries, even those like Israel, that have been fairly successful in vaccinating a large part of their population.  

The virus is once again raising the prospects of slowing the economic recovery that was unevenly unfolding.  The preliminary July PMI for Australia, UK, France, and the US disappointed. Expectations for the trajectory of monetary policy are being impacted.  Consider that the implied yield of the December 2022 Eurodollar futures fell to 40 bp in the middle of last week from 55 bp on July 1.  A similar futures contract in the UK, the December 2022 short-sterling implied yield fell from 58 bp in mid-July to almost 40 bp on "Freedom Day" as the UK dropped all social restrictions and mask requirements.  The implied yield of the December 2022 Bank Acceptances in Canada fell 20 basis points from July 14 to nearly 105 bp ahead of the weekend.   In Australia, the December 2022 bill futures contract's implied yield fell a little over 60 bp on July 6 to 36 bp last week.  

The December 2022 Euribor futures contract has been considerably steadier as it is widely accepted that the European Central Bank will not lift rates until after 2023.  The implied yield has been confined to a -42 bp to - 50 bp trading range since the end of April.  The yield finished last week at -49 bp, falling about five basis points since the ECB meeting.  The ECB's new forward guidance signaled that bond purchases and low rates will prevail until the staff forecasts that the 2% target can be sustained.  In June, the staff forecasts projected 2023 CPI at 1.4%.  

The signal of lower for longer helped drive European bond yields to new 3-4 month lows. The French 10-year bond yield had been offering a positive yield since the second half of April but recently moved back below zero.  One has to pay Greece 50 bp to lend to it for two years, which is a little more than one would pay to Italy for the same maturity.  Greece takes about 15 bp a year from those lending to it for five years, while Italy's five-year yield has dipped below zero for the first time since early April.  The amount of negative-yielding bonds in the world has increased to almost $16 trillion from below $13 trillion in late June, and that does not include Japan's 10-year bond, where the benchmark yield is less than a basis point. 

The ECB's dovishness likely minimizes the impact of the preliminary July CPI figures.  In July 2020, the eurozone saw consumer prices fall by 0.4% on the month and again in August.  This speaks to a likely acceleration of the year-over-year pace from 1.9% in June.  Also, note that since at least 2000, prices gained less in July than in June (and consistently rose more in August than July).  The monthly increase in June was 0.3%.  The Bloomberg survey shows economists anticipate sharp month-over-month declines in Italian and Spanish prices.   French CPI is also expected to have fallen slightly in July.  German inflation may have ticked up. These considerations suggest the year-over-year rate may have edged above 2%.  

The eurozone will provide its first estimate of Q1 GDP at the same time as the CPI figures on July 30. Recall that in Q4 19, before the pandemic struck, the eurozone economy was stagnant.  Last year contracted in H1 before recovering in Q3.  However, unlike the US experience, the eurozone economy contracted against in Q4 20 and Q1 21.  Despite the spread of the Delta mutation and the floods in parts of Europe, including Germany, the recovery now appears to be on more solid footing, and the EU Recovery Funds are at hand.   The regional economy likely expanded around 1.4%-1.5% in Q2 and is poised to accelerate further here in Q3. 

The highly contagious, though less lethal mutation (if vaccinated), has pushed investors to reconsider the recovery theme that had two drivers last November, the US election and the vaccine announcement.  Of course, this does not mean that it is the only development in the market, but it seems to be a relatively new and powerful one.  The US dollar rallied as the pandemic first struck, partly as a safe haven as US Treasuries were bought and partly as a function of the unwinding of dollar-funded purchases of risk assets (e.g., emerging markets).  

When things began to stabilize at the end of last March 2020, and the NBER now dates the end of the US recession as April 2020, the dollar trended lower and accelerated into the end of the year and began to recover in early January.   From the end of March through December last year, the Antipodeans and Scandis led the move against the greenback and appreciated roughly 20%-25% against the US dollar.  These currencies are often perceived to be levered to world growth and are often more volatile than the other majors.  Over the past three months, they have been the weakest, losing 3.0-6.50%.  

The opposite is also true in the sense that the Swiss franc and Japanese yen, other currencies often used for funding, hence the appearance of safe-haven appeal, were the worst performers against the dollar in the last nine months of 2020 (rising about 8.25% and 4.5% respectively). However, over the past three months, they have been among the most resilient in the face of the dollar's surge.  The Swiss franc is off less than three-quarters of a percent, while the yen is off by about 2.4%.  

A challenge for investors and policymakers is the evolution of the virus that renders some of the high-frequency data rather dated and arguably less impactful outside of the headline risk posed.  The Federal Reserve has succeeded in securing for itself much room to maneuver and is not tied to a particular time series, like the monthly jobs report or data point.  The FOMC statement is likely to hardly change from the previous one.

Discussions about the pace and composition of the Fed's bond-buying will continue.  Still, Fed Chair Powell was speaking for the central bank when he told Congress recently that the bar to adjust the purchases (substantial further progress toward the Fed's targets) has not been met.  The Jackson Hole symposium at the end of August has long been seen as the first realistic window of opportunity for the Fed to signal its intention to slow, possibly alter the composition of its bond purchase, and shape it more formally at the September FOMC meeting.  Ahead of Jackson Hole, there is one more jobs report, and the early call is for around a 750k increase.   

Reporters may try to draw Powell out but are unlikely to have much more success than the US Senators and Representatives.  There is ongoing interest in the size of the reverse repo facility, for which the Fed now pays five basis points at an annualized rate, the same as a six-month bill. In addition, Powell pushed back against suggestions by some officials that the central bank's MBS purchases are lifting house prices beyond the access of many American families.  Will reporters press him on this or the buying of inflation-protected securities that arguably distort the price discovery process and the break-even metric?  

Stable coins' regulatory framework may be questioned.  Recall that just before Biden took office, the Comptroller of the Currency allowed federally chartered banks to used distributed ledgers (blockchain) and conduct business with stable coins.  There is a push to treat stable coins as securities for regulatory purposes.  While the ECB recently announced it was going forward with a research and design phase of its development of a digital euro, the Federal Reserve's report is expected in September.  Powell said what many officials seem to believe that the introduction of a digital dollar would likely dry up demand for stable coins and crypto.  

The day after the FOMC meeting concludes, the US reports its first estimate of Q2 GDP.  The median forecast in Blomberg's survey has crept up in recent days to 8.5% at an annualized pace, up from 6.4% in Q1.  The NY Fed's GDPNow model puts growth at 3.2%, while the Atlanta Fed's model is closer to the market at 7.6%, while the St. Loius Fed Nowcast stands at 9%.  

Even before this surge in the virus in the US, where about half of the adult population is fully vaccinated, we suggested there was a reasonable chance that Q2 marks the peak in growth.  Fiscal policy will increasingly be a drag, pent-up consumer demand will be satiated. Monetary policy is near a peak. Perhaps the recent increase in the rate paid on deposits at the Fed and on the reverse repo facility and the recent sales of corporate bonds bought in 2020 mark the end of the easing cycle.   We have also underscored the restrictive impact of doubling the oil price since the end of last October.  

While there does not appear to be an iron law, it would not be surprising to see price pressures peak with a bit of a lag.  This dovetails with the timeframe suggested by both Powell and Yellen. Some recent industry data suggests that the US used car market (accounting for around a third of the recent monthly increases in CPI) is normalizing in terms of inventory, and prices have softened in the wholesale markets.  We note that input prices and prices paid components Markit PMI have fallen in June, and the preliminary report suggests a further decline is taking place this month.  Airfare and the price of hotel accommodations, and food out of the house, appear to be a one-off adjustment rather than persistent increases.  

The US will report June personal income and consumption figures ahead of the weekend, but the data will already be embedded in the GDP estimate.  On the other hand, the PCE deflator, which the Fed targets rather than the CPI, may draw attention.  It is expected to post a sharp 0.7% increase on the month for around a 4.2% year-over-year.  It rose by 0.4% in May and a 3.9% year-over-year rate. The core rate, which the Fed does not target but makes references from time to time, is expected to accelerate to 3.7% from 3.4%.   

Lastly, the infrastructure debate in the US Senate looks to come to a head in the days ahead.  It could, in turn, shape the political climate until next year's midterm elections. The latest wrinkle is that what might serve as the basis of a compromise in the Senate may be rejected by a number of Democrats in the House.  The failure to find a bipartisan solution for even the physical infrastructure components will not defeat the Biden administration but force it to rely on the reconciliation mechanism, which is confined to fiscal policy.  It would likely hamper the administration on non-budgetary fiscal issues.  The debt ceiling looms.  The Congressional Budget Office sees the Treasury running out of room to maneuver in October or November.  Biden's spearheading of a 15% minimum corporate tax rate might not need their approval, but the approval of 60 Senators may be needed for the other component of the global tax reform, the agreement to link the sales and taxes for the largest companies.     


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Economics

Shortest Recession In History Sets Up Next Recession

Shortest Recession In History Sets Up Next Recession

Authored by Lance Roberts via RealInvestmentAdvice.com,

It’s now official that the recession of 2020 was the shortest in history. 

According to the National Bureau of Economic Research, t

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Shortest Recession In History Sets Up Next Recession
Authored by Lance Roberts via RealInvestmentAdvice.com, It’s now official that the recession of 2020 was the shortest in history.  According to the National Bureau of Economic Research, the contraction lasted just two months, from February 2020 to April 2020. However, during those two months, the economy fell by 31.4% (GDP), and the financial markets plunged by 33%. Both of those declines, as shown in the table below, are within historical norms. Here it is graphically. The chart shows the historical length of each recession and the corresponding market decline. However, while the effects of the “recession” were all within historical norms, the recession itself was not. Let me explain.

A Non-Standard Recession

The statement from the NBER is as follows:
“In determining that a trough occurred in April 2020, the committee DID NOT conclude that the economy has returned to operating at normal capacity. The committee decided that any future downturn of the economy would be a new recession and not a continuation of the recession associated with the February 2020 peak. The basis for this decision was the length and strength of the recovery to date.”
As I said, the recession was non-standard. Conventionally, the NBER defines a recession as two consecutive quarters of negative GDP growth. Notably, while the recession did technically meet the criteria after GDP fell 5% in Q1, recessions tend to last more than three months historically. The difference was the massive interventions of 20% of GDP beginning in Q2, which created an “artificial growth surge” in the economy by pulling forward consumptive activity. That led to an explosive recovery in GDP in Q3 of nearly 30%. It is essential to note that the NBER stated that any subsequent downturn would get labeled as a “new” recession. That view accounts for the recovery driven by massive interventions even though that growth is not sustainable. As such, the “next recession” may not be as far off as many currently expect.

Why Recessions Are Important

Our discussion must begin with a basic concept: “recessions” are not a “bad thing.”  It is a given you should never mention the “R” word. People immediately assume you mean the end of the world: death, disaster, and destruction. But, unfortunately, the Federal Reserve and the Government also believe recessions “are bad.” As such, they have gone to great lengths to avoid them. However, what if “recessions are a good thing,” and we just let them happen?
“What about all the poor people that would lose their jobs? The companies that would go out of business? It is terrible to think such a thing could be good.”
Sometimes destruction is a “healthy” thing, and there are many examples we can look to, such as “forest fires.”
Wildfires, like recessions, are a natural part of the environment. They are nature’s way of clearing out the dead litter on forest floors, allowing essential nutrients to return to the soil. As the soil enrichens, it enables a new healthy beginning for plants and animals. Fires also play an essential role in the reproduction of some plants.
Ask yourself this question: “Why California has so many wildfire problems?”  Is it just bad luck and negligence? Or, is it decades of rushing to try and stop fires from their natural cleansing process as noted by MIT:
“Decades of rushing to stamp out flames that naturally clear out small trees and undergrowth have had disastrous unintended consequences. This approach means that when fires do occur, there’s often far more fuel to burn, and it acts as a ladder, allowing the flames to climb into the crowns and takedown otherwise resistant mature trees.
While recessions, like forest fires, have terrible short-term impacts, they also allow the system to reset for healthier growth in the future.

No Tolerance For Recessions

Following the century’s turn, the Fed’s “constant growth mentality” not only exacerbated rising inequality but fostered financial instability. Rather than allowing the economy to perform its Darwinian function of “weeding out the weak,” the Fed chose to “mismanage the forest.” The consequence is that “forest fires” are now more frequent. Deutsche Bank strategists Jim Reid and Craig Nicol previously wrote a report that echos this analysis.
“Actions are taken by governments and central banks to extend business cycles and prevent recessions lead to more severe recessions in the end.” 
Prolonged expansions had become the norm since the early 1970s, when President Nixon broke the tight link between the dollar and gold. The last four expansions are among the six longest in U.S. history. Why so? Freed from the constraints of a gold-backed currency, governments and central banks have grown far more aggressive in combating downturns. They’ve boosted spending, slashed interest rates or taken other unorthodox steps to stimulate the economy.” – MarketWatch
But therein also lies the problem.

The Darwinian Process Of Recessions

As we discussed in our series on “Capitalism,” if allowed to operate, is a “Darwinian System.” As with Darwin’s theory of evolution, corporate evolution has the same essential components as biological evolution: competition, adaptation, variation, overproduction, and speciation. In other words, as an economic system, companies either adapt, evolve, and survive or become extinct.  However, in 2008, the Government and Federal Reserve began a process of “bailing” out companies that should have been allowed to go “bankrupt.”  The consequence of that process is the failure to enable the system to “clear itself” of the excess debt, which diverts capital away from productive uses. I have illustrated the continual increases in debt used to create minimal economic growth. Specifically, since 2008, the Federal Reserve and the Government have pumped more than $43 Trillion into the economy. But, in exchange, that debt generated just $3.5 trillion in economic growth, or rather, $12 of monetary stimulus for each $1 of growth. Such sounds okay until you realize it came solely from debt issuance. As Ruchir Sharma previously penned:
“Modern society looks increasingly to government for protection from major crises. Whether recessions, public-health disasters or, as today, a painful combination of both. Such rescues have their place. Few would deny that the Covid-19 pandemic called for dramatic intervention. But there is a downside to this reflex to intervene, which has become more automatic over the past four decades. Our growing intolerance for economic risk and loss is undermining the natural resilience of capitalism and now threatens its very survival.”
Such is an important concept to comprehend. Just as poor forest management leads to more wildfires, not allowing “creative destruction” to occur in the economy leads to a financial system that is more prone to crises.

Structural Fagility

Given the structural fragility of the global economic and financial system, policymakers remain trapped in the process of trying to prevent recessions from occurring due to the extreme debt levels. Unfortunately, such one-sided thinking ultimately leads to skewed preferences and policymaking. As such, the “boom and bust” cycles will continue to occur more frequently at the cost of increasing debt, more money printing, and increasing financial market instability. It is clear the Fed’s foray into “policy flexibility” did extend the business cycle. However, those extensions led to higher structural budget deficits. The cancerous byproduct of increased private and public debt, artificially low-interest rates, negative real yields, and inflated financial asset valuations is problematic. However, these policies have all but failed to this point. From “cash for clunkers” to “Quantitative Easing,” economic prosperity worsened. Pulling forward future consumption, or inflating asset markets, exacerbated an artificial wealth effect. Such led to decreased savings rather than productive investments.

The Fed’s “Moral Hazard”

A growing body of research shows that constant government stimulus is a significant contributor to many of modern capitalism’s most glaring ills. Wealth inequality is the most obvious. However, another more important but not noticeable side effect is that it keeps alive heavily indebted “zombie” firms.  When a company is “kept alive,” it comes at the expense of startups, which typically drive innovation. All of this leads to lower productivity which is the prime contributor to the slowdown in economic growth and a shrinking pie for everyone. (See chart above.) By not allowing “recessions” to perform their natural “Darwinian” function of “weeding out the weak,” it creates a macroeconomic problem. As previously noted by Axios:
“Zombie firms are less productive, and their existence lowers investment in, and employment at, more productive firms. In short, a side effect of central banks keeping rates low for a long time is it keeps unproductive firms alive. Ultimately, that lowers the long-run growth rate of the economy.”
If “recessions” are allowed to function, the weak players will fail. Stronger market players would acquire failed company assets. Bond-holders would receive some compensation for their debt holdings. Shareholders, the ones who accepted the most risk, would get wiped out. Furthermore, assuming capitalism was allowed to function, investors would require appropriate compensation for the risk when loaning money to companies. As such, credit-related investors would get compensated for their risk rather than the current state of abnormally low yields for junk-rated debt. The consequence, of course, is that since the “Darwinistic process” of a recession did not occur, and the macroeconomic system is even more fragile than previously, the next downturn could happen sooner than later.

The Next Recession

While the interventions certainly salvaged the economy from a more prolonged recessionary event, they also made the economy more fragile. Furthermore, by dragging forward future consumption, the interventions only gave the appearance of economic activity. As excess stimulus fades and assuming interventions don’t repeat, the economy will return its pre-covid growth trend of 2% or less. Such should not be a surprise given that economic growth is roughly 70% consumption. With wage growth well below inflationary pressures, consumption will get impacted by higher prices. With Treasury yields dropping and the yield curve reversing, these are early warning signs that economic growth is indeed slowing. While the NBER declared the 2020 recession the shortest in history, such does not preclude another recession from occurring sooner than later. All the excesses that existed before the last recession have only worsened since then.
  • Excess Debt
  • High Stock Market Valuations
  • Investor Complacency
  • Financial System Fragility
  • Weak Economic Underpinnings
  • Declining Monetary Velocity
  • Low Interest Rates Detering Productive Activity
  • Financial Liquidity Required To Keep Asset Prices Elevated
Given the dynamics for an economic recession remain, it will only require an unexpected, exogenous event to push the economy back into contraction. Such is why the NBER is clear in saying they will classify the next downturn as a separate recession. If you are quick to dismiss the idea, remember no one expected a recession in 2020 either. But we did warn you about it in 2019.
Tyler Durden Sat, 07/24/2021 - 10:30

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Government

New Record Cases in Sydney Casts a Pall over Australia

Overview: The combination of the dovish ECB’s forward guidance and the unexpected rise in weekly US jobless claims to a two-month high sent bond yields tumbling.  The US 10-year pulled back from 1.30%, and benchmark yields in the eurozone fell to new…

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Overview: The combination of the dovish ECB's forward guidance and the unexpected rise in weekly US jobless claims to a two-month high sent bond yields tumbling.  The US 10-year pulled back from 1.30%, and benchmark yields in the eurozone fell to new 3-4 month lows. The $16 bln 10-year TIPS auctioned yesterday resulted in a record low yield of a little more than -1.0%.  The bond market is quieter today, with the US 10-year yield little changed at 1.29% and European bond yields mostly 1-3 basis points higher.  Equities were mixed in the Asia Pacific region.   China's crackdown on Didi may be scaring investors.  Chinese, Hong Kong, and Taiwanese markets fell, while South Korea, Australia, and Indian markets advanced.  European shares are higher for the fourth consecutive session, lifting the Dow Jones Stoxx 600 to around 0.2% from record levels.  US futures are firm.  The dollar is firm against most of the major currencies.  On the week, the Canadian dollar is the strongest of the majors, up about 0.35%. The Swedish krona is the only other major currency to have gained against the greenback this week.  Emerging market currencies are mixed.  South Africa's central bank did not hike rates yesterday, and the rand was the weakest emerging market currency yesterday and retained that distinction today.  The JP Morgan Emerging Market Currency Index is slightly softer for the second consecutive session.  The dollar is falling for the fourth consecutive session against the Russian rouble as the central bank announces as expected that is hiking rates 100 bp to 6.50%.  Gold is consolidating between $1800 and $1810, but it needs to get back above $1812 if it is going to extend its recovery for the fifth week.  Crude oil is softer after three strong advances that recouped most of Monday's sharp losses.  September WTI stalled near $72 and is little changed on the week.  Canadian wildfires are raising concerns about lumber supply, and the September futures contract rallied 10% yesterday on top of 7.7% on Wednesday.  Copper is up for the fourth consecutive session, and the CRB Index is up about 1.8% this week, coming into today.  

Asia Pacific

New record virus cases in Sydney cast a pall over Australia.  The preliminary PMI's weakness gives a sense of the economic impact.  Manufacturing slowed to 56.8 from 58.6, but it was services that are bearing the brunt.  The service PMI fell to 44.2 from 56.8.  This was sufficient to drive the composite below the 50 boom/bust level to 45.2 from 56.7.  This is the lowest since last May.  The poor report will fuel ideas that the RBA will provide more support through increased bond purchases at its meeting in early August.  

Don't expect much from the weekend meeting between the US Deputy Secretary of State Sherman and the Chinese Foreign Minister Wang.  It is the highest-level meeting since March and apparently almost was aborted when China offered to have Sherman meet one of Wang's deputies.  The underlying purpose seems to lay the groundwork for a possible Biden/Xi meeting at the October G20 meeting that has long been anticipated.  Although the Biden administration has made it clear that it is not ready to renew regular high-level talks, it does not mean that there is no communication between the two rivals.  While China is a poor actor on the world stage, Biden is using the confrontation with Beijing to further its domestic agenda and shape its efforts to reassert America's leadership.   

The US dollar was tested at JPY109 at the start of the week and is now near JPY110.50, a seven-day high, and could close above the 20-day moving average (JPY110.40) for the first time in two weeks.  Tokyo markets were closed yesterday and today.  The preliminary July PMI will be reported as the markets re-open on Monday.  The composite PMI stood at 48.9 in June.  Nearby resistance is in the JPY110.70-JPY110.80 area.  The Australian dollar approached resistance near $0.7400 and was turned back.  A A$460 mln option at $0.7380 expires today.  Without closing above $0.7400 today, the Aussie will extend its loss for the fourth consecutive week and six of the past seven.  The dollar edged higher against the Chinese yuan for the second consecutive session. The upticks were minor, and the greenback is set to finish the week less than 0.1% lower but sufficient to snap a seven-week advance. The PBOC set the dollar's reference rate at CNY6.4650, near the median projection picked up by the Bloomberg survey of CNY6.4655. Note that floods in the Henan region, which is an important transportation and logistics hub, maybe a disruptive economic force, are slowing activity and boosting prices. Stay tuned.   

Europe

The ECB did not disappoint.  It had to bring its forward guidance in alignment with its new 2% symmetrical inflation target.  ECB President Lagarde seemed more resolute.  Rates will not be hiked while inflation is below 2%. Next week, the risk is that headline CPI moves above 2%.  Lagarde, like the Fed's leadership, sees the current price pressures as temporary. The staff forecasts take on more significance.  It sees CPI at 1.4% in 2023.  While the Fed now targets the average rate of inflation, which means that it will encourage somewhat higher than average to offset the past undershoot.  Lagarde explained that in the eurozone, an overshoot is incidental, not deliberate.  The ECB was buying bonds before the pandemic struck and will do so after the economic emergency passes and the PEPP envelope closes (now March 2022).  

In broad strokes, the ECB is buying around 80 bln euros a month in bonds under PEPP and about 20 bln euros under the previously launched asset purchase program.  This latter facility has limits (issuer limit, capital key) that make it less than an ideal flexible tool.  Yet, it is precisely these limits that made it acceptable to  Germany's constitutional court.  At the same time, the ECB re-committed itself to buying bonds under this facility until just before it raises interest rates.  Finally, some reservations expressed by the German, Belgian, and Dutch central bankers are not very surprising. The unanimity of the new inflation target still masked underlying differences, and the hawkish contingent could be a little larger than those that expressed reservations now.  The Bank of England and the Federal Reserve seem to be entering a phase where dissents may be expressed as well.

The preliminary July PMI showed a divergence between Germany and France.  German readings were stronger than expected, and the composite PMI rose to a new high of 62.5 (from 60.1).  The French reports were softer than expected, and the composite slipped to a still firm 56.8 from 57.4.  For the region as a whole, the preliminary manufacturing eased to 62.6 from 63.4.  The preliminary services PMI rose to 60.4 from 58.3, which was stronger than expected.  The result was that the composite stands at 60.6 compared with 59.5 in June.  Next week, the eurozone reports the initial estimate for July CPI and Q2 GDP.   The CPI is expected to push above 2%, while the regional economy is expected to have expanded by 1.5% in the quarter.  

The UK reported stronger than expected June retail sales but a bit softer of a flash PMI.  Retail sales rose by 0.5%.  The median projection in the Bloomberg survey was for a small decline.  Excluding gasoline, retail sales edged up by 0.3%.  May's slide was pared slightly (-1.3% vs. -1.4% at the headline level).  The PMI shows a strong economy that slowed slightly.  The manufacturing PMI stands at 60.4, down from 63.9.  The service PMI moderated to 57.8 from 62.4.  The composite slowed to 57.7 from 62.2. 

The euro set the week's high as the ECB's initial headlines with the wires near $1.1830 but quickly came back off.  It is in about a quarter-cent range so far today, mostly below $1.1785.  Support has been found near $1.1750 this week, but it may not be solid.  There is an option for 920 mln euros at $1.1725 that will be cut today.  The euro has managed to close higher only twice in the past two weeks and in only two weeks since the end of May.  This looks like the first week since the end of last October that the euro settles below $1.18.  Sterling recorded five-month lows on July 20 near $1.3570.  Its bounce stalled yesterday around $1.3790 (the 20-day moving average is slightly below $1.3800). The roughly GBP455 mln option at $1.3775 may expire today with little fanfare.   A close below the $1.3705-$1.3715 would likely keep sterling under pressure at the start of next week.  

America

There appears to have been some progress on the bipartisan infrastructure initiative in the United States, but to appease some Republicans may alienate some Democrats.  The key to the compromise was to delay Medicare regulation approved by the Trump administration that would eliminate the drug companies give to benefit managers under Medicare Part D.  The goal was to reduce out-of-pocket costs.  However, the Congressional Budget Office estimates that it will boost Medicare spending by the government by $177 bln in the 2020-2029 period. If this forms the basis of the deal in the Senate, the progressive-wing of Democrats in the House could resist.

The US sees the preliminary PMI today, and expectations are for it to be little changed at elevated levels.  The US reports its first estimate of Q2 GDP next week.  The median forecast in the Bloomberg survey calls for an 8.3% annualized expansion after 6.4% in Q1.  Canada reports May retail sales today, and a 3.0% loss is anticipated after a 5.7% drop in April.  Nevertheless, subsequent data suggest the Canadian economy has emerged from the soft patch. The economic highlight next week is the June CPI and May GDP figures.   Mexico's May retail sales are on tap today, and a modest gain of 0.5% is expected after a 0.4% decline in April.  Mexico reports its Q2 GDP next week.  Economists look for around 1.6% quarter-over-quarter expansion, twice the Q1 pace.  

The US dollar is trading quietly within yesterday's narrow range against the Canadian dollar (~CAD1.2530-CAD1.2595).  It finished last week slightly below CAD1.2615.  The momentum indicators have turned lower, but a break of CAD1.2500 is needed to boost confidence that a high is in place.  The greenback peaked in the middle of the week near MXN20.25 and has been slipping since it was recorded.  It is trading at a three-day low in the European morning (below MXN20.09).  Support is seen in the band from MXN19.98-MXN20.02.  However, provided it stays above the MXN19.90, the greenback will secure its third consecutive weekly advance.  


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