20.03.2017 11:15:00

UBS: Lesson Learned: What You See Is Not What You Get

Major central banks sent subtle messages to markets. For now, policy remains supportive for risk; watch out for oil, inflation and the US soft-hard data gap.

Did the Fed just cut rates?
Despite the hawkish narrative, the market is already discounting a reasonably optimisticFed path. The neutral rate is projected close to 3% — the upper end of our estimates— while the US bond premium and real rates are high relative to others (Fig 1&2). Then, the infamous loop between (higher) US yields and (weaker) pro-cyclical assets made atemporary comeback. At the end, there was no hint of a fast hiking pace in the Fedstatement. So, a dovish Fed hike could justify a short-term reprieve in cyclical assets.

Did the ECB turn hawkish?
A slightly more optimistic policy tone helped European yields to stick out, the EUR-USD to climb higher and European stocks to overtake S&P returns in USD terms for the first time in a while. The EUR, European bond yields and many pockets in European stocksare undervalued. It will not take much for this value to unlock. If the French election produces a market-friendly outcome, it will be the fourth EU election in a row where populist campaigns lost ground. And it will free space for the ECB to contemplate less accommodation (Fig 3). Does this mean an urgent hike too? For that, the threshold is higher, but the message is mixed. For now, this is less relevant for market direction.

Has the BoE just hiked?
The BoE surprised us this week. Politics aside, a less-dovish take on the economy raises the bar for significant and rapid sterling weakness ahead. At the very least, it implies the data needs to slow down a lot more or earlier than we think before they resume into a dovish message (and the pound into the next big leg lower).

Has China just eased?
Chinese authorities raised rates marginally and tightened policies on shadow bank lending; EM and Chinese equities and metals rallied. This was mostly Fed-driven, but ongoing resilience in local data also contributed. Tao Wang has upgraded her GDP forecasts and argues the authorities will keep broader policy accommodative until the fall. Yet, sequentially, we may have seen most of the growth acceleration already.

If not China, Europe or the Fed, what is the risk to equities?
Keep watching the momentum in US data. Thursday's Philly Fed print implies we may have already seen the peak in surveys. With our risk aversion index implying very tight risk premia, unless hard data catches up, we may have also seen peak returns (Fig 4).Having said that, as long as policy is supportive and US yields have room to fall, the downside risk is also contained. And then there is the honeymoon period: even if hard data disappoints, the market could still give the benefit of the doubt regarding the salutary impact from the policies of the new administration.

Is Inflation the Squeaky Wheel that gets the Oil?
For the last 15 years, dollar strength saw lower oil prices, and vice versa (Fig 5). For the last few quarters, higher oil prices amid a strong dollar looked conspicuous. Lately, OPEC signals — amidst a dislocation in inventories and positioning — partly narrowed thegap. A lower price impacts reflation dynamics and the dollar. G3 inflation expectations have been moving hand-in-hand with oil prices. The drop in oil prices undermines headline inflation post the Q2 (base effect) peak. In turn, contained global yields will likely and mostly hurt the dollar. Oil prices below 50 also impact the US credit spaceand thus pose a tightening risk to US financial conditions. And then, there are winners and losers from terms of trade. In addition to the oil price impact, idiosyncratic factors likely weigh on the likes of CAD and NOK (Fig 6). This is why we have been recommending using both currencies to fund long positions in the cyclical AUD, NZDand CLP and why we still like local rates in Brazil, in particular.

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