When bad data is good for equities, and other ramblings

Equity markets are having a wild week. After a disastrous start for global markets, signals from both sides that the US-China trade war could be averted helped stock markets to have their best day for 5 months. The growing prospect of a Fed rate cut also helped to boost the recent mood in financial markets, however, if gains can be sustained could be dependent on the ECB meeting and the US labour market report due at the end of the week. 

Responding to news flow

It is very hard to take a directional view in financial markets these days. Although it looks like stocks have peaked, swift reversals that see the S&P 500 rising by more than 2% in a day, can happen based on the latest news flow from China or the US regarding the ongoing trade war. Put simply, positive rhetoric that sounds as if a trade deal will go ahead, tends to push equities and other risky assets higher, while negative rhetoric and an escalation in the trade war tends to weigh on risky assets. This leaves traders and investors in position of having to be reactive to news, which can be a trading a tricky proposition. In this environment, taking a medium-term directional view can be risky, thus we recommend shorter-term strategies combined with a disciplined approach to risk-management.

When bad data turns good 

The US-China trade spat is not the only event that is driving markets. Another reason for the push higher in equities is comments from Federal Reserve President Jay Powell, earlier this week. He said that the Fed could cut interest rates based on an escalation of the trade war. This is where the justification for a large rally in equities and risky assets comes unstuck, in our view. If the Fed is so worried about the economic impact from the US-China trade spat that it is considering cutting rates, then any “good” economic data in the coming days should trigger a sharp reversal in markets. Thus, this week’s rally in equities is based on bad economic data. 

Wednesday’s market performance is a case in point, private sector payrolls rose by a mere 27,000, compared with 180,000 expected, however US equity markets rallied. The prospect of a Federal Reserve rate cut is a key driver of risky assets right now, as investors start to believe that the new Fed governor has their back.  Expectations that the Federal Reserve will cut interest rates this year is now above 60%, a couple of months ago the prospect of a rate cut in 2019 was closer to zero. 

Banking on the Fed is risky business 

Growing expectations of a rate cut from the US Federal Reserve may have triggered a decline in volatility this week, however, this could reverse if we get a solid non-farm payrolls report from the US on Friday. The market is expecting 190k, down from 263k in April. If the NFP report suggests that US jobs growth is over 150k, then we may see Federal Reserve rate cut expectations decline. This could weigh on equities and other risky assets as we move to the end of the week. Thus, volatility may remain elevated for some time, as bad economic data is good news for stocks, and good economic data is bad news for stocks. 

ECB meeting, a preview

Thursday’s ECB meeting is unlikely to throw any curve balls. We expect the bank to remain in dovish mode, and the market is positioned for an extremely dovish ECB. Draghi and co. are expected to push any potential rate hike to well beyond 2020, and its second round of financing, TLTRO2, is also expected to have generous terms and conditions, further enhancing the role of the ECB as a pillar of monetary support to the currency bloc. Dovish expectations from this meeting are reflected in the performance of EUR/USD, it has fallen back from highs above 1.13 and is now trading around 1.1225.  If the ECB is perceived as being ultra-dovish then it may trigger a sell-off in European banking shares, as it would most likely lead to a longer period of negative interest rates. After anticipating the recent rise in the euro, we now believe that the bias to the euro could be to the downside in the next 24 hours, as risks mount including a dovish ECB and rising Italian bond yields, ahead of Italy’s Budget announcement that is likely to contravene EU fiscal rules. A break below 1.1180 would be a bearish development that could trigger a decline back towards 1.1130, the low from late May. 

Why we are optimistic about NFPs and USD/JPY 

Non-Farm Payrolls are also worth watching, if they are not as bad as some fear, then USD/JPY could extend its recent rebound. There have been some mixed signals from the NFP leading indicators this week, the atrocious ADP report has been counterbalanced by extremely good employment components of the ISM manufacturing and non-manufacturing reports for May, the latter rose to its highest level in 6 months. Other leading indicators for May also point to a positive NFP report including, JOLTS job openings, Conference Board consumer confidence index, the University of Michigan consumer confidence index and the strong payrolls number for April.  Thus, if Friday’s NFP report is not as bad as some expect then two things may happen: stocks fall, and USD/JPY rises. Key resistance levels to watch out for in USD/JPY include 108.75, which, if taken, may open the door to a move back towards 110.00.