Backdrop remains grim as countdown to the Fed begins

While the Fed meeting is front and centre for this week, there are developments elsewhere that could steal the limelight from Jay Powell. The key market developments on Monday included an epic sell off in Chinese stocks, fresh Chinese lockdowns, another round of high-level talks between Ukraine and Russia, worrying geopolitical news,  a surge in US Treasury yields and a sharp decline in commodities. There is never a dull moment in these markets, and the question now is, will the Fed be swayed by external events or will they keep their eye on domestic price stability in the US? 

China attempts to snuff out more of its corporate exports 

Turning to China first, it was carnage on Chinese stock markets on Monday. The Hang Seng fell nearly 5%, including a 10% drop for Tencent, while the Shanghai Composite was down more than 2.5%. There was worse for Chinese shares listed in the US, with DiDi, the ride sharing app, down more than 6.4% and Alibaba down more than 10%. There was a troika of bad news for Chinese share prices. Firstly, China announced new lockdowns to combat their highest ever rate of Covid infections. Schools have shut in Shanghai, the tech powerhouse of Shenzhen is also under lockdown, along with 18 other provinces. Secondly, news broke that the US had told its allies that China had signalled an openness to provide Russia with military support for its invasion of Ukraine. This has been denied by Chinese officials, however, the US fears that China is helping Russia while at the same time its diplomats are calling for an end to the war in public. The fear is that China’s close relationship with Putin will lead to punishments from the West. Right now, being linked to Russia has negative economic consequences, and the fear is that China could be led down an economic cul-de-sac by Russia. We tend to think that China sees Russia as a junior partner in the relationship, thus we don’t think that Beijing will want to be publicly linked to Russia, especially if there are economic consequences at the same time as Chinese economic momentum is slowing, but we will have to see if Beijing publicly distances itself from the Kremlin in the coming days. 

Beijing bursts its tech bubble 

Lastly, there were renewed regulatory risks, after reports that Tencent, the payments network, could face a record fine for anti-money laundering regulations. Growing regulatory risks have weighed on Chinese tech stocks in recent months. This is a particular concern for stocks listed both on and offshore. There are close to 250 Chinese stocks listed in the US, last year they were enjoying a boom in line with US tech stocks, however, since October last year they have fallen by more than 72%, it is worth noting that the Nasdaq fell 78% in the dot-com crisis. Thus, the bubble for Chinese stocks listed in the US has been popped by Beijing. Each week there is new risk to consider, which is why these stocks have been dumped so aggressively. For example, last week there were reports of forced de-listings for some Chinese companies listed in the US. Whereas European and US sanctions are destroying the wealth of Russia’s richest, Beijing seems intent on snubbing out entrepreneurial gains in China, especially if those in charge have international ambition. 

Waiting for a recovery rally 

It is worth noting that some US-listed Chinese stocks started to claw back earlier losses in post-market trading, while the sell-off in Alibaba paused, however, they remain at the mercy of Beijing, and we do not think that the market will be in any rush to buy these stocks in the current environment. Sentiment towards US stock indices also soured as the day progressed. As the war between Russia and Ukraine continues on, the newest information that markets have to digest is that China could take sides with Russia. This is pretty seismic for global security, which does not make for a cheery market backdrop that could keep markets on edge for some time. US indices closed lower on Monday, their seventh decline in eight sessions. Investor sentiment remains weak, but there is a reluctance to sell out at these levels in case there is a sharp rally. While expectations that a swift end to the conflict in Ukraine have scaled back, the markets are looking for an intermediate bottom to use as a base for a recovery rally. We are not there yet, although we will keep our eye on the 4,100 level to see if it attracts buying interest, with 4,050, the low from May 2021, another level that we are watching. 

The impact of falling commodity prices 

Interestingly, all of the above are reasons why commodity prices fell so sharply on Monday. The price of WTI fell below $100 per barrel at the start of the week, while Brent crude dipped below $106 and fell nearly 6%. Commodity markets are extremely volatile right now and need to be treated with caution. As an overall sector, the Goldman Sachs commodity index fell more than 3.3% on Monday, and wheat, copper and natural gas all saw large declines. While events in Russia are obviously important for commodities, lockdowns in China are weighing on growth and demand expectations. Added to this, fears that the Fed will strike a hawkish tone are also exacerbating the decline in commodities. If commodities continue to retrace recent gains, then the FTSE 100 is likely to underperform due to the large number of energy and mining companies. Added to this, commodity currencies’ including the CAD and AUD may also come under pressure. AUD/USD fell more than 1.3% on Monday, while USD/CAD was higher by 0.56%. 

The Fed’s rate hike and the big unknown 

We mentioned above that investors are also focussed on the Fed meeting. CME Fedwatch has a 98% probability that the Fed will hike rates by 25 basis points on Wednesday. We doubt that the Fed will disappoint markets, after all, if the ECB was hawkish last week, then the Fed has to be hawkish, especially with a 7.9% annual inflation rate. The question is, how hawkish will the Fed be? For financial markets, of much more importance than an actual rate hike this week will be the Fed’s projections and its dot plot. The question everyone wants to know is, will sky-rocketing US inflation or the Russia/ Ukraine war win the day? If the Fed focuses on inflation, then the market will perceive it to be aggressively hawkish, however, if it scales back its tightening plans due to geopolitical events then the market could see this as a dovish move, US and European stocks could rally and the dollar could get trounced. Of interest to us at Minerva Analysis is the what the Fed’s plans are for its balance sheet. The $9 trillion behemoth is a thorn in the Fed’s side. Later this month when the Fed ends its asset purchases, it will continue to reinvest proceeds from the bonds that it holds. This is still significant; however, we think that the Fed could step away from announcing its plans to stop reinvesting proceeds and shrinking the balance sheet until events in Ukraine have stabilised. 

Where EUR/USD could go next 

Also, worth watching is the dot-plot and the Fed’s economic projections. We expect GDP to be revised lower, while inflation could be revised higher to 3.5-4% this year on the back of surging commodity prices. Regarding the dot-plot, the market is expecting five 25bp hikes this year, if conservative members price in more hikes then this would be considered hawkish, with anything less than five hikes considered dovish. In the FX space, we are watching EUR/USD and EUR/GBP closely this week. After closing below $1.10 last week, EUR/USD remains vulnerable, especially with the dollar index looking strong around 99.00, although it is finding some resistance at this level. The surge in Treasury yields this week, the 2-year yield rose 11 basis points on Monday to 1.86%, supports further dollar upside, in our view. If EUR/USD comes under pressure, then key support is $1.0800 in the short term. EUR/GBP could also erode recent gains if EUR/USD falls further, key support lies at £0.8360 in the short term.