Tit-for-tat takes a toll

Philip Wee, FX Strategist, DBS Bank and Eugene Leow, Rates Strategist, DBS Bank

Persistent volatility has taken a toll on risky USD assets. As momentum trading strategies fail amid the tech rout, longer-term US yields have been dragged down, with the 2Y/10Y spread narrowing to 49bps. Curve flattening was probably exacerbated by tighter USD funding conditions that pushed up shorter-term US rates. This combination of tighter USD funding and weaker risk-taking sentiment has also led to wider IG and HY credit spreads. For the stock market, the earnings yield for the S&P 500 is hovering near to the top of its six-month trading range (reflecting the recent sell-off in equities). This increased risk premium in risky assets is simply an adjustment back into a more normal (higher) volatility regime. Notably, the ytd average for the VIX index (17.6) is still lower than the average of 19.4 since 1990. Clearly, current VIX levels are very high compared to the average of 11.1 in 2017.

While the US economic backdrop is still favourable, trade tensions have heightened. Trump is reportedly considering an additional USD100bn in new China tariffs on top of the proposed USD50bn already announced. Volatility is already set to rise and trade tensions are exacerbating the situation. We see safe-haven demand keeping longer-term yields depressed for a while more. At this point, there is lack of clarity on how far tit-for-tat responses between the US and China would go. It is also unclear that a negotiated solution would be imminent. However, Treasury yields face inherent upside as the market has to eventually factor in inflation and budget deficit risks. There should be scope for modest steepening (as longer-term rates rise) once trade fears recede. In the front of the curve, if the Libor-OIS or the TED spread narrows from current wide levels, there would be scope for shorter-term USD rates to stabilise or fall.

FX: The US dollar has held its ground

After a week of escalated tit-for-tat trade tensions between the US and China, the US dollar was stronger and the Chinese yuan weaker. In the first four trading sessions of April, the DXY (USD) Index appreciated 0.5% while the Dow Jones Industrial Average rose 0.7%. On the other hand, the yuan depreciated 0.4% while the Shanghai Composite Index fell 1.2% in the first three days of this week. The above price actions were contrary to the consensus that US would suffer more than China in any trade spat. Then again, it is too early to tell, especially since China was on holiday Thursday-Friday.

For now, fears of a full-blown trade war have receded but not without a sense of uneasiness. While the US and China have continued to trade blows on tariffs, Washington has kept the door open for trade negotiations with Beijing. As witnessed with NAFTA, the US is seen resorting to brinksmanship to push for better terms in its trade relations with major trading partners. Except that Mexico and Canada did not retaliate with tariffs like China did. Given the rivalry between the US and China, worries remain that both countries may have started to stumble into a Thucydides Trap, with Washington not fully grasping how important "saving face" is an important part of China's culture.

Expectations for export-led Asia ex Japan (AXJ) currencies to strengthen this year have started to subside. The factors responsible for the strong appreciation in 2017 have weakened. First, data flow has started to favour US growth overtaking the Eurozone this year. The Fed's hike cycle has been upgraded from dovish to mildly hawkish, with its monetary policy normalization seen well ahead of its peers. This coupled with the latest deterioration in US-China trade relations suggest a less likelihood for the same upside surprises in exports that boosted AXJ currencies in second half of last year. With US rates and US-China trade tensions seen on the rise, most AXJ currencies have consolidated since end-January. Thus, the depreciation in AXJ currencies this week is considered a retreat from the ceiling of their trading ranges.

Source : Equity Bulls

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