A 10 million upside surprise

There have been plenty of shocks this year and here’s another jaw-dropper for markets. An unexpected rise of 2.5m US jobs during May, when expectations were for a decline of 7.5m.

A 10m upside surprise in US jobs comes with the caveat that the collection of survey data was affected by shutdowns and the latest employment report does not tally with millions of new unemployment claims in recent weeks. Bluntly, there still remains a large hole of job losses that requires filling as Oxford Economics shows.

Still, the latest headline jobs figure has only bolstered the increasingly bullish market vibe in recent weeks whereby reopening economies are set for quite a comeback. The S&P 500 is now down just 1 per cent on the year, while the Nasdaq Composite reached a record peak during the day, and is up some 9 per cent for 2020.

Before the US jobs figures arrived, global market sentiment was basking in the afterglow from the European Central Bank’s upsizing in stimulus. European and global stocks have outpaced Wall Street this week, while another barometer of global risk appetite, the Aussie dollar, has traded north of 70 cents versus the US unit for the first time since the start of the year.

This all makes sense up to a point, because any rebound from the depths of the shutdown will look good coming from a low base. The tougher questions are those around how long it takes to fill such a deep economic hole, and corporate earnings.

After the summer has ended, the economic and earnings story should be clearer alongside that of defaults and other financial dislocations.

Alan Ruskin at Deutsche thinks:

“As long as virus data does not deteriorate, and the financial sector stress helped by unprecedented official support looks contained (which appears likely and is fundamentally different from 2008), the market will be able to look on the bright side.”

Just how long equities and credit can look past big economies not recovering their late 2019 growth levels until 2022 or later depends a great deal on central banks. The current market backdrop brings us to next week’s meeting of the Federal Reserve. Expect officials to look through the latest jobs data and focus on an extended recovery process that requires plenty of stimulus.

One interesting market development is that the jobs data has pushed the 10-year Treasury yield towards 1 per cent. A significant rise from here in this yield should tell us how dependent risk appetite is upon a low discount factor.

A rapid rise in long-dated Treasury yields may prompt a stronger commitment from the US central bank in terms of anchoring them near zero for a substantial time. The rise in long-dated US yields also reflects the intention of the US Treasury financing a hefty deficit via that sector of the bond market. Locking in low long-term rates is a sound approach for debt managers, but it may also lead to a rise in yields that tightens financial conditions, an outcome that likely worries Fed officials.

Bill O’Donnell at Citi says the market is awaiting “whether the Fed accepts these higher rates or deems it necessary to dial up the balance sheet further to support bond prices and keep borrowing rates contained”.

At what level long-dated Treasury yields close after the Fed meeting on Wednesday will certainly be of great interest.

One aspect of quantitative easing over the past decade or so has been a rise in Treasury yields, reflecting investors selling out of that market and placing the proceeds into higher-yielding corporate debt. Currently, the Fed is also buying corporate debt exposure via exchange traded funds and this policy approach highlights the importance of keeping US interest rates well contained and for an extended period.

But a further rise in 10-year Treasury yields will clip corporate debt returns in a key maturity for investors when they own credit as a spread over government bonds. This was the case in 2013 and 2018 and Fidelity International’s Stuart Rumble argues:

“In the Covid-19 era, the Fed is trying to avoid repeating this pattern by promising unlimited QE. With no end to QE in sight for the markets to price, this should put more downward pressure on yields, whether the Fed’s balance sheet continues to expand or not.”

This suggests the Fed will accentuate the open-ended nature of QE soon and control the long end of the bond market, even as the Treasury fires up debt sales.

Stuart concludes that a commitment to keeping QE open-ended “is a powerful tailwind for assets and, in particular, investment grade corporate bonds”.

In that respect investors certainly agree, given record weekly inflows into bonds. EPFR recorded flows of more than “$30bn into all bond funds — a new weekly record — with high-yield bonds posting their second-largest inflow ($8.5bn) since EPFR started tracking them and US bond funds their biggest in over 17 years”.

Quick Hits — What’s on the markets radar?

The gathering of oil producers is on for Saturday and expectations are that the current Opec+ deal on production cuts will be extended to the end of July. Beyond that is where things get interesting as Brent crude sits at its highest level since the price war between Russia and Saudi Arabia hammered the market.

Callum Macpherson, head of commodities at Investec, is focused on a couple of issues. If producers “cut hard for longer now, might cuts planned for the future be reduced”, while the issue of compliance is also crucial.

“The market will also be looking to see whether there is any decision around how to deal with non-compliance, particularly as there has apparently been a decision about a mechanism that forces those that do not comply to catch up later. This would be a tall order for Iraq given the challenges it faces, but it will be in an even worse position if the Opec deal falls apart and prices collapse again.”

Source: Economy - ft.com