Saturday, 21 July 2018 22:20

"This Is Market Shock #1", Or Why The Fed Suddenly Has A Very Big Problem

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Like most other banks, Deutsche Bank remains sanguine on the future: it expects the S&P to keep merrily rising toward 3,000, and its house view is that the Fed will stick to its indicated tightening path, raising rates twice more in 2018 and another 4 times in 2019 (although Trump may have a nervous breakdown long before that happens and "resigns" Jerome Powell), while 10-year yields will eventually resume rising toward 3.5% as the curve ultimately resteepens removing concerns about an imminent recession.  To be sure, the latest earnings season provides fuel for optimism as a whopping 90% of the companies that have reported so far have beaten on earnings, with earnings that are 4.5% above the estimates.

Still, as Deutsche Bank admits, it is getting increasingly nervous about the prospects for both the economy and the market, and as a result its forecast is not sanguine about the risks to the forecasts, particularly given the uncertainty around trade tensions, coupled with building inflation risks given the strength in the labor market.

As a result, the bank has proposed some "distinct alternative scenarios that we think markets should consider either as hedges to the current market consensus or to the House view."

We think these potential “shocks” are very much still lurking in the wings. There are plenty of arguments for why they may not materialize, but to appreciate them early will allow investors an opportunity for efficient hedging strategies.

To address these "potential shocks", DB's credit strategist Dominic Konstam is launching a series of 5 pieces, and overnight published the first part in which the bank focuses on market shock #1: a sharp weakening of the Renminbi as part of the reaction to the ongoing trade tensions.

In other words, currency war (something which Goldman already tacitly admitted has begun).

In light of recent developments, including a series of sharp "back and forths" between President Trump and Beijing which has resulted in some fairly dramatic moves in the yuan and the dollar...

... the bank thinks this is a very real threat because:

  1. trade tensions are hard to resolve when the goal is to rebalance economic power, and
  2. it is a reasonable response for China to maintain market share but at the expense of reserve accumulation.

Of course, a  weaker yuan should be seen in the context of general EM weakness and a tightening of US financial conditions via the stronger US dollar, unless somehow Trump manages to talk down the greenback.

So why is the biggest German lender so nervous? Because, as Konstam writes, "this is as much to do with the uncertainty of the outcome as it does with the nature of the dispute." Or, as he clarified, "that uncertainty is a necessity of the unknown reaction function of both parties."

And while one can...

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