Notes from the Trading Desk – Europe

Last week’s equity market performance was somewhat lackluster. The extreme rotation we saw the previous week eased off. Focus was on central banks amid a number of monetary policy meetings. Notably, the US Federal Reserve (US Fed) cut interest rates by 25 basis points (bps), as expected.¹  Interestingly, however, the views of the Fed members regarding the future path of rates were mixed.

The Digest

Central Banks in Focus

Last week the US Fed, Bank of England (BoE), Bank of Japan (BoJ), Swiss Central Bank (SNB) and Norges Bank all unveiled interest-rate decisions. The Fed decision dominated attention, with the other central bank meetings largely passing off as expected.

US Fed: On Wednesday, the Fed cut its main refinancing rate by 25 bps, to a new range of 1.75% – 2%. The move was in line with market expectations. Fed Chairman Jerome Powell stated: “We took this step to help keep the US economy strong in the face of some notable developments and to provide insurance against ongoing risks.”

As at the July meeting, Powell said uncertainties about outlook remain. He added the Federal Open Market Committee (FOMC) would “continue to monitor the implications” and would “act as appropriate.” This essentially leaves the door open for further easing, in our view.

Looking to the dot plot—the expected path of interest rates—we see some divergence among the views of Fed members.

The median projection for the benchmark interest rate for 2019 fell 50 bps to 1.875%, indicating no further rate cuts this year. However, seven participants projected one further cut this year and five were opposed to last week’s easing. The 2020 median projection was also 1.875%, indicating no additional easing next year.

The equity market reaction was interesting, in our view. Markets initially fell on the headlines, but then rallied during Powell’s press conference as he commented the Fed might need “to resume organic growth of the balance sheet”. He said he was open to a “more extensive sequence of cuts” if needed. The Fed funds futures see a 49% chance of a 25 bps cut in October, and a 72% chance of a hike by the November meeting.² 

Ultimately, the decision was broadly in-line with expectations, and we think Powell has left himself options for further easing should he need it in the future. The rate cut was largely priced in, based on the muted weekly equity market performance. There were not too many fireworks (aside from a  critical tweet from US President Donald Trump).

BoJ: Elsewhere, the BoJ continued its dovish narrative. Japan’s central bank kept Japanese interest rates on hold at -0.1% as expected, and left forward guidance for policy rate unchanged.

BoE: The BoE seems to be keeping its powder dry until it has better visibility on the Brexit outcome. Interest rates remained on hold at 0.75% with a unanimous committee vote. Monetary policy committee members predicted that if Brexit uncertainty persists, inflation will likely be weaker.

Others: The SNB also kept rates on hold at -0.75%.  Norway was the lone hiker, as the Norges Bank raised its interest rate to 1.5% as expected.

Finally, as a reminder of the challenges facing central banks, on Thursday the Organization for Economic Co-operation and Development (OECD) cut its 2019 global growth forecast to 2.9% from 3.2%, with outlook “increasingly fragile and uncertain” in the context of trade tensions.

Brexit Update

Sentiment improved towards the end of last week following comments from European Commission President Jean-Claude Juncker, who said he was doing “everything” he could to prevent a no-deal Brexit. He added he believed a deal could be reached.

Juncker indicated that he is not tied to the Northern Irish backstop if a credible alternative was put forward by the UK. It’s important to note nothing has fundamentally changed, with no reports of any progress in negotiations. There is also a question over whether legal preparations for a deal could be met before the October 31 deadline.

Still, investors seem to have taken the comments well, with sterling rallying on Friday.

It looks to be a busy week ahead on the UK political front. The opposition Labour Party is holding its annual conference this week with decisions on its Brexit policy high on the agenda. In addition, we expect the UK’s Supreme Court to rule on Tuesday whether Prime Minister Boris Johnson’s decision to suspend Parliament was lawful.

Crude Oil Volatility

It proved to be a very volatile week for oil prices and energy stocks after the drone attack on a Saudi Arabian oil refinery the previous weekend. The attack on the world’s second largest oil producer saw Brent crude oil prices post their largest ever intraday increase during Asian trading last Monday, up 20% at one point.

These events are a reminder how quickly things can change in the oil market. On Tuesday, the Saudi authorities appeared to paint a positive picture (in relative terms) around the timescale of getting the Abqaiq refinery fully back online. They said that they had managed to restore almost half of the output lost, and predicted production would return to pre-attack levels by the end of the month.

While that quelled some fears, investors remain downbeat on the clean-up and the true impact of this incident. Over the weekend, media reports suggested disruption might last up to eight months.

These attacks also raise questions about geopolitical risks in the region.

Any escalation of tensions in the region could increase the likelihood of outages. Should that occur, global reserves may become very limited and inventory draws could be much larger. For now, both the International Energy Agency (IEA) and President Trump have said they do not see the need to release strategic oil reserves. Further sanctions from the United States on Iran are possible.

We are in “wait-and-see” mode with regards to the oil market, and this week has the potential to deliver some further market-moving events in the aftermath of what was a very volatile week for the space.

Last Week

Europe

European equities enjoyed their fifth straight week of gains. The strength was more muted than previous weeks, but volumes were elevated. The rotation out of momentum and into value stocks that we had seen in the prior week paused for breath. Cyclicals—such as basic resources, autos and industrials—underperformed, while defensives, such as real estate and health care, outperformed.

Oil and gas names were the week’s clear winners, however, driven by unfolding geopolitical events. Italian bonds widened and Italian shares underperformed as the prospect of further political instability rose after former Italian Prime Minister Matteo Renzi broke away from the Democratic Party.

Following the European Central Bank (ECB) meeting last week and ECB President Mario Draghi’s push for fiscal stimulus, we started to see signs that individual governments had taken note. Sweden is now looking to expand its budget by SEK30 billion, the Dutch government launched a €50 billion national investment fund, and Germany pledged €54 billion to tackle climate change.

Americas

US equities underperformed their European counterparts, with all major US indices softer last week. The FOMC meeting was the main focus. The pause of the rotation dynamic was also evident as defensives outperformed and cyclicals struggled. Mirroring what we saw in Europe, energy names were the week’s stronger performers after the Saudi oil facility attack.

Trade generated headlines. Expectations for a US/China deal any time soon remain low despite talks continuing in Washington.

US Trade Representative Robert Lighthizer said there had been movement on several issues but stressed that it was “an extraordinary challenge” to get a complete deal.

Donald Trump also tempered expectations, saying agriculture purchases would not be enough to reach a deal. He reiterated he wants a complete deal with China, not a partial one. Following this, China’s trade delegation cancelled its scheduled tour of US farms, implying sentiment had cooled.

Another widely discussed theme was US dollar funding pressure. The cost of borrowing US dollar cash versus US Treasuries overnight via repurchasing agreements (repos) spiked on Tuesday morning as demand increased, leading to liquidity shortages.

Repos are key to the US financial system as they give companies access to cash overnight, using US Treasuries as collateral.

There has been additional stress for the system in recent days with companies using the mechanism to pull cash in order to pay tax bills. Lenders’ reserves have also been declining since the Fed pulled its bond-buying programme in 2014, which reduces the amount of cash it is willing to lend through repo operations.

High funding costs are a concern as they imply a sharp tightening of financial conditions, which in turn is negative for the value names within equities. This may have played into that pause of the rotation dynamic last week, but the impact on markets was dampened as the Fed announced several operations to bring the level back in line with targets.

Asia   

Asian equities were mixed last week with country-specific headlines driving moves. Hong Kong was the key underperformer amid continuing protests.

Onshore Chinese equities were also weaker last week, with trade headlines remaining in focus. China will be closed from October 1 to 7 to celebrate the 70^th anniversary of the founding of the People’s Republic.

Equities were better off in Japan after Trump announced the United States had signed an initial trade agreement.

Also, as expected, the BoJ left rates unchanged and policy settings unchanged while noting rising risks from overseas. It also reiterated the inflation target of 2% remains a key focus as it continues to monitor progress towards that goal.

South Korean equities likewise were solid performers in the region. Meanwhile, Australian equities were also stronger with energy stocks supporting the advance.

Week Ahead

Politics

The United Nation General Assembly meeting will be a focus at the start of the week. We will be watching for commentary around the tension in the Middle East. In addition, UK Prime Minister Boris Johnson is attending, so we may see some Brexit headlines.

Macro

• Tuesday: US: (Sep) Consumer Confidence, (Jul) Federal Housing Finance Agency (FHFA) House Price, (Sep) Richmond Fed Manufacturing Index; France: (Sep) Business and manufacturing confidence data
• Wednesday: US: (Aug) New home sales;
• Thursday: US Second-quarter gross domestic product and core personal consumption expenditures (PCE); Initial Jobless Claims;
• Friday: US: (Aug) PCE deflator, durable goods; (Sep,) China: (Aug) Industrial Profits;

 Central Banks

It should be a quiet week after a flurry of interest-rate decisions last week. A number of ECB and Fed officials have speaking engagements, however.

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1. A basis point is a unit of measurement. One basis point is equal to 0.01%.
2. Source: CME Group. There is no assurance that any estimate, forecast or projection will be realised.