The most surprising thing in financial markets at the start of a new week was not the surge in the oil price or the fact that markets are treating the Evergrande default like it was yesterday’s news. Instead, it was the stock market’s nonchalance at the 18-basis point rise in 10-year Treasury yields that started at the end of last week. After a delayed reaction to last week’s Federal Reserve meeting, it appears that the markets are now ready to start pricing in the prospect of a rate rise from the Federal Reserve and the Bank of England for 2022. This sparked a renewed interest in the reflation trade, where yields rise alongside value stocks. Hence the tech heavy Nasdaq index fell 0.35% on Monday, in contrast to the Russell 2000, which rose some 1.7%. Amidst all of the mounting risks: US debt ceilings, surging energy prices and the prospect of rising prices hurting economic and corporate earnings growth in the third quarter, some corners of the stock market are in jubilant mood.
Debt ceiling concerns spook the Fed
Let’s take a look at US politics first. The financial markets are very good at ignoring the twists and turns that go on in Washington, however, the US needs to raise its debt ceiling by September 30th, the day that funding for the Federal government is set to run out. On Monday, two senior Fed officials warned about the “catastrophic consequences” that could arise if Republicans in the Senate go ahead with their plan to block a bill that would increase the borrowing limit and thus stave off the threat of a government shutdown. At the time of writing this vote has not taken place, however, we would expect markets to react negatively to a result where there is no increase to the US debt ceiling. The Fed’s John Williams said that this could lead to a rush to the exits and cause an “extreme reaction” in financial markets. If the debt ceiling is not raised, then the US government could default on its obligations as early as mid-October. This is no over-reaction from John Williams, back in 2011 when the debt ceiling was not raised and the US Federal government experienced a shut down, stock markets fell sharply, and the US government lost its top credit rating. If it gets to the point where the US is not paying its obligations, then we could see a dramatic reduction in risk taking around the world. Last week, Fed President Jerome Powell said that no one should assume that the Fed can protect the financial markets from a shock of this magnitude. With warnings like this coming from top central Fed officials, here at Minerva we are happy to be extremely selective about our choice of trades for this week, and we are wary of this latest renaissance of the reflation trade, especially when all 50 Republicans in the Senate are set to vote against the Federal government spending bill, and the Democrats only control the Senate by the slimmest of margins. If one fiscally conservative Democrat joins their Republican rivals, then we would expect all hell to break lose in financial markets later this week.
More politics and weak Treasury auctions
Elsewhere, we will also be watching the US infrastructure bill, which is also set to reach the floor of the Senate. Nancy Pelosi hinted that there would be a vote on the bill this week, and that she was only willing to bring it to a vote because she expects it to pass. We shall have to see. An interesting dynamic for the markets would be no increase in the US debt ceiling, yet the US Infrastructure bill passes. In this case we could see a limited sell off in risky assets, as the market may look towards a brighter future where the US government props up US economic growth with its own spending. We will be watching the future of US Treasury yields closely, as another reason for their surge this week has been weak demand for US sovereign bonds at recent auctions. If the debt ceiling issue is not resolved, then we could see more weak demand that may trigger a feedback loop where bond yields continue to rise sharply for 10-year Treasury yields, the global benchmark, current resistance is at 1.5%, if this is breached then 1.6%, a key level from earlier this year, could be the next target.
Energy demand shifts to crude
Elsewhere, the markets have swapped out long natural gas positions for crude oil, as replacement for rip off gas prices. The price of Brent crude oil is close to $80 per barrel, however, the front month Brent contract sold off slightly on Monday and was down 0.13%. The price of WTI’s front month contract is $75.50, a 2% jump on Monday. Thus, the premium between Brent crude and WTI is narrowing, however, it is also technical, with the Brent crude price likely to come under pressure as it reaches a major milestone level like $80 per barrel. We expect the price premium for Brent crude oil futures to remain pronounced due to the current energy crisis in the UK that threatens the rest of Europe. If this spreads to the US, then the spread between Brent and WTI could narrow. See the chart below. If you believe the crude analysts at Goldman Sachs then $90 per barrel is possible before year end, thus there are plenty of people who are expecting more upside for the oil price in the coming weeks. It is worth remembering that the oil price gains were triggered last month by the slow tapering of Opec’s Covid production cuts. Thus, the oil price is being somewhat artificially propped up. However, Opec’s slow return to production normality is a powerful prop keeping the price of oil high. For those sceptics, or those who like to prove GS wrong, there are concerns about US growth after a weaker reading for the Dallas Fed Manufacturing survey for September, which is more up to date than the better-than-expected durable goods orders for August. There are also big concerns about China’s growth and the fall-out from the Evergrande scandal, which is still a major concern for financial markets even though the financial media may have lost interest in it this week. Right now, we think that Opec’s production cuts combined with higher-than-expected demand for oil and goods post the end of Covid lockdowns around the world is a reason to believe that the oil price could move higher in the coming months. Even if we see disappointing economic data in the coming weeks, we believe that this is is likely to be temporary, thus, I think I just talked myself back into liking the reflation trade.
Oil majors gain on the back of crude price rise
Another way of getting exposure to the energy trade is through an oil company, such as BP. It’s share price surged by more than 3% on Monday and it has been on a rip higher for most of this month. While a lot of the good news is priced in for BP, we think that there could be further to go in the long term. In the short term, there could be a pull back when the government finally get the petrol shortage sorted out, which we are told will be later this week.
Why GBP could keep pace with USD gains
The FX market has been fairly sanguine today. The dollar is rising on the back of the surge in Treasury yields, which could be a prolonged trend. EUR/USD is down a touch as it brushes off the news of the German election and the fact that it could take months of horse trading to confirm the new coalition government in the Eurozone’s largest economy. In contrast, GBP/USD is up 0.3% on Monday, as sterling ignores the UK’s woes and concentrates instead on the 16-basis point rise in 10-year UK Gilt yields in the last three trading sessions. The market is assuming that the UK and US central banks will move together when it comes to tightening policy, thus we could see GBP and USD rise in tandem in the coming weeks. If you want exposure to a stronger dollar, we would stick with the euro.
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