What changed last week

Good morning. This week is set to serve as a referendum on last week’s mini-panic. Home Depot and Walmart report earnings on Tuesday and Thursday. The July producer and consumer inflation reports land on Tuesday and Wednesday. Retail sales and industrial production, as well as two important manufacturing surveys, round things out on Thursday. Email us your predictions for how we’ll all be feeling Friday morning: robert.armstrong@ft.com and aiden.reiter@ft.com. 

This Wednesday at 12pm UK time and 7am New York time, Rob and an All-Star panel of FT global markets experts will present FT subscriber webinar discussing the recent turmoil and where markets will go next. Register for your subscriber pass and submit questions for the panel at ft.com/marketswebinar.  

Was this trip really necessary?

There was much huffing and puffing in the first seven trading days of August. But the house has most certainly not blown down. Here are some stock returns:

A low single-digit decline, which is what we ended up with, wouldn’t have scared anyone in a normal summer week. After all, the market has been drifting down since it hit a peak a month ago. Not even Japan, the centre of all the frightening headlines, could manage a double-digit fall. Meanwhile, the 10-year Treasury ended right where it started, and the policy sensitive two-year fell by all of twelve basis points. 

Bond spreads followed the pattern. For double-B rated corporates, the highest rung of junk, the spread over treasuries started the month at 2.02 per cent, hit 2.49 last Monday, and fell back to 2.12 (roughly the level of the start of the year). 

All of this raises the question: was all the fuss for nothing? Have we just traced a moronic cul-de-sac and ended where we began?

Not quite. The most basic and most important point is that volatility matters a lot in itself. Investors are of course going to be generally more nervous after mixed economic data and a roller-coaster week, and this suggests more swings ahead. But the point is more general. The fact that volatility is clustered — that big moves up or down make further big moves more likely — is always and everywhere a characteristic of markets.

The Vix index, which measures short term expected volatility, tells the tale — at least in part. It has fallen by half from its peak of 40 a few days ago, but at 20 it is still at a high level, last seen way back in early 2023. 

Another thing that may have changed is the interplay between markets and the Federal Reserve. Futures markets, for their part, have concluded that the Fed’s monetary policy posture has shifted a lot in the past week. According to the CBOE’s FedWatch tool, for example, the chances of a 50 basis point rate cut is now almost 50 per cent. Before the micro-crisis the probability was in the single digits. Part of that may be down to purely economic news — the weak jobs report and manufacturing ISM survey. But the market could be pricing in a Fed that has been spooked by markets, too. 

Markets are a legitimate object of Fed attention, because they can influence the economy in several ways. A sell-off can reduce the availability of financing, for example by widening bond spreads; and it can impact consumer spending and corporate investment just by scaring people. The danger arises when market participants become too confident in the Fed’s willingness to soften policy in the face of weak stock and bond prices. If that happens, and the Fed holds firm, the disappointed market could become even more volatile, leaving the US central bank caught in a trap. 

It looks like the Bank of Japan might have fallen into this snare. As described by the FT’s new Monetary Policy Radar team, when the Nikkei was crashing last week, the Bank’s deputy governor, Shinichi Uchida, walked back the recent decision to raise rates, saying further hikes will wait for markets to calm. But the monetary policy committee’s minutes told a confusingly different story. As Mari Novik sums up, “If there is one thing we can be certain about it is that the [Japanese] policy trajectory now depends a lot on markets, a position a central bank should seek to avoid.”

The Fed is not in quite such a position yet, but it could be soon.  

Chinese government bonds

In the past Unhedged has asked if Chinese equities are uninvestable. The difficulty is the government’s complex and opaque relationship to the corporate sector. Could investing in Chinese government bonds avoid the issue?

China’s economy continues to disappoint. A recent surprise rate cut by the People’s Bank of China (PBoC) suggests that a rate cutting cycle may be starting. Chinese households and wealth managers have responded by piling into the bond market, pushing 10-year and 30-year bond yields to record lows.

Oddly, perhaps, the government is not pleased. The PBoC has criticised the bond rush, arguing that banks’ fixed retail income products could create systemic risks, should rates rise. But a near-term tightening cycle seems unlikely. The PBoC’s warnings could also reflect official frustration that households are pouring their money into bonds rather than the real economy, and concerns that low bond yields signal economic weakness.

The PBoC has said that it would prefer to see 10-year yields, now at 2.2 per cent, rise to between 2.5 and 3 per cent. In early July, it (forcibly) borrowed several hundred billion renminbi of bonds from regional banks and began selling them on the secondary market. It has named and shamed several institutional bond purchasers, and recently clamped down on bond trading, too.

This appears to have raised yields, but only marginally. And many economists still expect rate cuts will be required to stave off deflation, so bonds retain their appeal — particularly to foreign investors. Lei Zhu of Fidelity International describes the opportunity:

The Chinese government wants to attract foreign investors, and has made a tax structure for that purpose. They waive the tax on the [bond’s] coupon [for offshore buyers] . . . And from a dollar-based perspective, the China bond yield is 2 per cent, and [with a currency hedge] you can get as much as 4 per cent . . . Compare that to what you get in US treasuries, where yields came off a bit because of rate cut expectations.

According to Arthur Kroeber of Gavekal Dragonomics, the Chinese government bond market has faced international outflows recently, but that may change:

Historically, I think the major reason that people come into the Chinese bond market is to express a view on the currency . . .

[If you believe] that the RMB has now bottomed out, since the PBoC was intervening quite aggressively in the second half of last year to support the currency, then currency risk is mitigated. And although you are still looking at a negative yield differential between China and the US, nonetheless if you think the yield structure would go down . . . then it makes sense to put money into Chinese government bonds.

As with Chinese equities, investors in Chinese bonds need to believe they can anticipate what the government will do. If a significant amount of global capital enters the already hot market, will the authorities welcome it as a vote of confidence — or take retaliatory action to see that yields stay high?

One good read

Billionaires doing billionaire things.