Treasury markets are pausing for breath after a sell-off that drove yields to post-2007 highs, equity futures are seeing a modestly-stronger tech-powered open, and the dollar is slightly softer against its major counterparts.
One-month implied volatility in the equity and currency markets remains depressed relative to history, even as the level of turbulence in Treasury markets hits elevated levels. This is reflective of the extent to which global rates are moving in sync with US yields, but also looks fragile as we move through the typical late-August lull and enter more strained global conditions in the early autumn. We rarely say this so explicitly, but for corporates, now might be the time to consider hedging – waiting for volatility to kick up again could prove hazardous to the bottom line.
Volatility indices, z-scores
Federal Reserve Chair Powell’s speech at Friday’s central bank symposium in Jackson Hole looms as the biggest event risk on the calendar, but his remarks might be a “known unknown” (to use Donald Rumsfeld’s framing) of the type that often leaves markets relatively unshaken. With three strong possibilities – a relatively-hawkish “mission unaccomplished” message on inflation, a more dovish wait-and-see approach, or an ivory-tower discussion of post-pandemic neutral rates – in play, directional position-taking should be fairly minimal, meaning that there should be no major washout occurring in the minutes after the content is released. Instead, we should get a clean read on any shifts in the market’s outlook for US rates.
The Canadian dollar is almost unchanged relative to Friday’s close with traders hoping tomorrow’s retail sales report or Friday’s Jackson Hole speeches will provide the catalysts for a break out. Both two- and ten-year yield differentials have narrowed slightly in Canada’s favour in recent days – and crude prices have provided support – but with global financial conditions tightening at a blistering pace (as illustrated using real yields below), the economy looks vulnerable to a consumption-led slowdown and markets are taking a more sceptical view on longer-term growth prospects.
10-year inflation-protected bond yields, %
Anticipation is building ahead of European Central Bank President Lagarde’s appearance during Friday’s proceedings in Jackson Hole. Data out earlier in the day are likely to show the German economy slipping into contraction in the second quarter with domestic demand remaining weak even as exports to China run at half pre-pandemic levels. Madame Lagarde’s words will be carefully parsed for guidance on the central bank’s September meeting, with odds on a hike currently looking relatively well balanced.
The pound lost a little altitude this morning after running into resistance around the 1.2800 round-number handle against the dollar – but remains well supported from a yield differential perspective. Investors believe the Bank of England will deliver another three rate hikes in coming months, making it the last major central bank to pause its tightening cycle. We think these expectations are overwrought – the economy seems likely to spoil the party long before a third move is needed, but for now, the yield pick-up is driving the bus.
China’s yuan moved up overnight after the central bank set its daily fixing rate at 7.1992 to the dollar, well above market expectations and prevailing spot rates. State-owned banks have reportedly pulled back on providing yuan liquidity to offshore markets, making it more expensive to fund in the currency and putting upward pressure on the exchange rate. These efforts could slow the yuan’s decline, but we think underlying conditions could remain sluggish as the government works to rebalance the economy and let the air out of the world’s biggest – and probably history’s biggest – property bubble.
Ten-year Japanese government bond yields are trading near nine-year highs – near the 0.67-percent mark – as global fixed-income markets move in sympathy with Treasuries. The Bank of Japan adjusted its yield curve control policy on July 28 to cap rates at 1 percent, but has bought bonds twice in the intervening weeks in an effort to slow the pace of increases.
10-year Japanese government bond yields, %
In theory, higher yields could persuade some of Japan’s life insurers and pension funds to bring assets home, while also diminishing the yen’s role in funding carry trades. But with rate differentials against other developed economies remaining extraordinarily wide, we see very little evidence of this occurring in practice – instead, institutional investors seem to be reducing hedge ratios, and carry trade activity is growing, putting the yen under sustained selling pressure.