Last week, we delved into the Chinese stimulus package and its almost immediate impact on the global financial market. This week, the tide turned. The rally in commodity-linked currencies was short-lived as United States (US) inflation and the Middle East conflict have seen a move back to safe-haven assets.
Key themes for the week:
- Emerging market currencies make a U-turn
- US Treasury yields soar as uncertainty mounts
- Oil continues to make steady gains
- Dollar at three-week highs
IT ALL COMES DOWN TO SENTIMENT
The performance of currencies and bonds is closely tied to global economic developments, and sentiment, for that matter. The past two weeks have been no exception. Last week we witnessed the benefits from the stimulus measures from China, particularly on commodity-driven currencies like the South African rand, the Brazilian real, and the Australian dollar. This week we contrast the Asian scenario with what has happened this week as broader concerns around inflation, US monetary policy, and global growth have resurfaced, along with an escalation in the Middle East conflict.
Last week’s positivity
Last week, China announced a $142 billion stimulus package, which is aimed at reviving the country’s slowing economy, particularly the real estate and infrastructure sectors. As the world’s largest consumer of raw materials, this news out of China was greeted positively by commodity-driven economies. Their currencies strengthened as commodity prices, such as iron ore and copper, saw an immediate uptick due to expectations of increased demand from China.
Following the stimulus announcement, the rand initially gained ground, benefitting from its close economic ties to China through commodity exports. On Monday, the rand was trading near R17.00/$, as market optimism around China’s recovery prospects lifted sentiment towards emerging markets (EMs). Similarly, the Australian dollar saw gains also driven by Australia’s commodity trade with China, particularly in iron ore.
The stimulus also influenced the bond markets, with emerging market bonds seeing some inflows as the global risk-on sentiment increased. Investors looking for higher yields, compared to the relatively low yields in developed markets, moved to higher-yielding emerging markets. The South African government bonds saw increased demand, as yields remained attractive amid improved sentiment following the formation of the Government of National Unity (GNU), and broadly adopted global rate-cutting cycle.
The rapid shift in sentiment
Despite last week’s rally, sentiment quickly made a U-turn this week as a combination of factors reversed the markets’ recent gains. Following hawkish signals from the US Federal Reserve (Fed), the US dollar strengthened significantly, erasing some of the gains made by EM currencies. The Fed’s cautious tone around inflation and its signalling that further rate cuts may not be imminent led to a surge in US Treasury yields, with investors making a hasty retreat from riskier EM currencies like the rand.
Adding to EM currencies woes was a muting of sentiment around the Chinese stimulus package. The continued weak growth in China and the inability of the stimulus package to deliver immediate economic results or to fix structural and policy issues also led to a loss of momentum for these currencies.
The EM bond market saw a similar reversal as global yields moved higher, driven by the Fed’s hawkish stance. Rising US yields make it harder for emerging market bonds to attract investors, as the risk-adjusted returns become less compelling compared to safer US assets.
Key factors to watch moving forward
1. Global inflation and US monetary policy: The US dollar and Treasury yields will remain pivotal in determining the future performance of EM currencies and bonds. If the Fed signals a more dovish stance or if US inflation continues to ease, we could see renewed inflows into emerging market assets. However, if inflation, or inflation risks persist, the dollar is likely to remain strong for a prolonged period, putting further pressure on EM currencies.
2. China’s economic outlook: The effectiveness of China’s stimulus measures will be crucial for commodity-driven currencies. If China’s growth picks up, it could provide support for the rand, real, and Australian dollar. However, if the stimulus fails to generate the expected demand for commodities, these currencies could face continued weakness.
3. Local economic and political factors: For South Africa, in particular, domestic issues like political stability and the upcoming Medium Term Budget Policy Statement will be critical in shaping the rand’s performance. Any signs of fiscal slippage, political fragmentation, or further economic declines could lead to renewed rand weakness.
4. Geopolitical risks: Geopolitical tensions, particularly in the Middle East, and ongoing global political fragmentation may further weigh on investor sentiment, driving a flight to safe-haven assets like the US dollar.
5. Upcoming US elections: While markets are not paying much attention to the upcoming US election at the moment, it could become a point of contention rather rapidly. One can expect volatility in the currency markets as the race heats up and the election plays out.
The rapid change of the tide from one day to the next once again reminds us of the phrase often used in the Citadel realm: “The future will surprise”. As the tides continue to turn, it all really comes down to sentiment and how risky investors deem the landscape to be.
MARKET SUMMARY
US bond yields climb to one-month highs
The yield on the US 10-year Treasury note has climbed above 3.8%, nearing its highest level in a month. The US ADP National Employment Report showed a robust gain of 143,000 jobs in the private sector for September, beating expectations and providing evidence of a resilient US labour market, which will reduce the urgency for aggressive Fed rate cuts. While rate cuts curtail investor interest in fixed-income assets, rising rates, along with geopolitical concerns, like the escalation in the conflict between Israel and Iran, support the demand for safe-haven US government bonds.
Similarly, the United Kingdom’s (UK’s) 10-year Gilt yield is hovering near 4.01%, reflecting four-week highs as markets assess the prospects for economic and monetary policy shifts in the UK. The country’s inflation concerns have eased, leading Bank of England (BoE) Governor, Andrew Bailey, to hint at further interest rate cuts, with a 25-basis point reduction expected in the near term. However, UK growth figures have been revised slightly downward, with second quarter GDP expanding by 0.5%, which is weaker than initial estimates. This data has contributed to a more cautious tone in bond markets, where inflation is a key indicator for future policy actions.
South Africa’s 10-year government bond yield sits just above 9%. Weaker local bond yields contrast with global bond markets and are being driven by positive economic sentiment on the back of expectations of key reforms from the recently formed GNU. In addition, South Africa is expected to benefit from China’s stimulus measures, which will further boost the local economy. The South African Reserve Bank (SARB) also cut interest rates recently following a decline in inflation, setting the country apart from EM peers. Traders are also regaining confidence in the country’s economic prospects.
Cautious sentiment sees red amid uncertainty
US stocks ended Thursday lower, with the S&P 500, Nasdaq, and Dow Jones all recording losses. Investors remain cautious as they keep a close eye on US labour market data and geopolitical developments. The S&P 500 shed 0.3%, the Nasdaq declined by 0.2%, and the Dow Jones dropped 190 points. Materials and consumer discretionary sectors led the losses, while tech stocks managed to stay in the green. Major tech players saw mixed results, with Nvidia gaining 2.6%, while Amazon, Alphabet, and Meta ended in negative territory.
The UK’s FTSE 100 was flat on Thursday after two days of gains, as declines in insurance and investment companies balanced out gains in the oil and gas sector. Financial services companies, Phoenix Group and Hargreaves Lansdown saw drops as they traded ex-dividend. Meanwhile, oil and gas stocks continued their upward trajectory, driven by concerns about supply disruptions in the Middle East. Grocery retailer, Tesco’s stock gained after revising its profit guidance for the fiscal year, reporting a 10% increase in core profits.
In Germany, the DAX lost 0.6%, dragged down by auto and technology stocks. Rising geopolitical tensions dampened enthusiasm despite a slight upward revision in the composite PMI (Purchasing Managers’ Index). Major automakers like BMW, Mercedes-Benz, and Volkswagen saw declines of around 1.6% to 1.9%, while tech companies, such as SAP and Siemens, also traded lower.
South Africa’s JSE Index also saw a decline of over 1% as traders reacted to both local and international factors. Resource-linked sectors, particularly precious metals, were hardest hit, with financials and industrials also posting losses. Domestic private sector growth has shown signs of recovery, but external factors, including the waning impact of China’s stimulus, weighed on investor sentiment.
Brent crude edges higher
Brent crude oil prices continued to rise toward $75/barrel, buoyed by escalating tensions in the Middle East. Fears of supply disruptions due to conflict between Israel and Iran have driven prices up. Although US crude inventories showed an unexpected increase of nearly four million barrels, concerns over potential threats to oil supply from the Middle East, which accounts for about a third of global production, continue to drive the market.
Gold remained near $2,655/ounce, benefitting from its status as a safe-haven asset amid the Middle East conflict. However, gains were tempered by strong US labour data, which has reduced expectations of a lenient monetary policy from the Fed. With more jobs added to the US labour market in September than anticipated, the market is pricing in a more modest rate cut from the Fed, which could limit gold’s upside.
Dollar glimmers at three-week high
The US Dollar Index climbed to 101.8 on Thursday, hitting a three-week high after stronger-than-expected private-sector employment data. The robust labour market report dampened expectations of aggressive rate cuts by the Fed, providing further strength to the dollar. Investors will closely monitor upcoming employment data to further gauge the direction of Fed policy.
The euro traded around $1.12/€, under pressure as the dollar strengthened. Despite easing inflation in key eurozone economies like Germany and Italy, dovish comments from the European Central Bank (ECB) suggest that more interest rate cuts are likely. ECB President, Christine Lagarde, indicated that inflation would reach the 2% target soon, aligning with the broader expectations of easing ECB monetary policy in the coming months.
The British pound weakened to $1.31/£ as markets reacted to comments from the BoE Governor. His remarks hinted at a UK rate cut in November, further contributing to the pound’s decline after reaching highs in late September. Despite the general weakness in the pound, it has been supported by expectations of a more cautious easing cycle from the Fed.
South Africa’s rand fell to 17.50/$, down from a recent high, as the dollar strengthened amid rising geopolitical risks. However, the rand is still supported by optimism about South Africa’s economic recovery following the formation of the GNU and a more favourable domestic outlook. The SARB’s cautious start to its rate-cutting cycle also supports the currency’s longer-term prospects.
Key Indicators:
USD/ZAR: 17.43
EUR/ZAR: 19.23
GBP/ZAR: 22.90
GOLD: $2,666.30
BRENT CRUDE: $77.43
Sources: Bloomberg, Investing.com, Investopedia, Trading Economics and Reuters.
Written by: Citadel Advisory Partner and Citadel Global Director, Bianca Botes.