The Chinese government has made it pretty clear from the outset that it has little appetite for bailing out global bond investors and that it would concentrate its efforts on supporting homeowners and the real estate market in general. Both the government regulator and the People’s Bank of China have been very vocal in their criticism of the Evergrande management team, blaming individual mistakes for a crisis which will not impact wider market stability. In other words, they will ringfence Evergrande as best they can to stop it’s troubles from infecting the rest of the Chinese property market so that if-and-when the developer officially defaults, the losers will be contained to on-shore and off-shore bondholders, who will take a severe haircut, and equity investors who will probably lose their entire investments.

Whilst not completely ignoring any potential ramifications of an Evergrande default, the global financial markets are taking a business as usual approach with any fallout expected to be limited to the lower investment grade bond markets. Global stock markets remain buoyant and typical risk-off trades are showing no signs of gaining traction in any financial markets. Investors are not taking the potential fall-out of an Evergrande default too seriously. Even reports yesterday out of HK that trading in another property developer, Kaisa, had been suspended amid reports that it also was unable to meet a payment deadline have failed to rattle investors.

If the global financial markets continue with these non-reactions to Evergrande headlines, then the headlines will gradually disappear. On the other hand, at the first sign of contagion, watch for risk-off instruments like the JPY crosses in the FX market (lower) or the precious metals (higher) to be leading indicators that the market is indeed more nervous than it’s making out to be.

With AUDUSD closing at .9302 (below yesterday’s low) we completed a bearish outside day. We would now expect AUDUSD to test the recent lows of .9239, with a break through that level suggesting further losses towards .9203 – .9211, the lows from May.

The Reserve Bank of New Zealand increased the cash rate to 3.00%, as unanimously expected by economists and financial markets. In its statement, the RBNZ reiterated the main message that the OCR is set to rise over the next couple of years. Also as expected, the press release acknowledged two important downside developments since the March MPS: (1) The RBNZ said export commodity prices remain very high, but it acknowledged that auction prices for dairy products had fallen 20% recently. (2) The high exchange rate seemed to shift higher in importance. The bias sentence this time was “The speed and extent to which the OCR will be raised will depend on economic data and our continuing assessment of emerging inflationary pressures, including the extent to which the high exchange rate leads to lower inflationary pressure.” By comparison, back in the March MPS the exchange rate was not mentioned in this context. However the RBNZ’s acknowledgement of recent low inflation outturns was quite low key. It reiterated that headline inflation is moderate now, but inflationary pressures are increasing. This was enough to spark a bounce in NZD/USD from 0.8585 to highs above 0.8620. Our expectations for the OCR have not changed. We are forecasting further hikes of 25bps each in June, July, and December this year – although we admit that the July hike is a very close call. Markets are also divided on July, currently priced at 3.34%.

“SocGen comments- This correction differs from your run of the mill. It was clear some EM reduction was already on the way a few days before the correction turned vicious and little of it showed classic contagion. The size of the EM pressure was of such a large size in more exotic destination (e.g. ARS) that some very large funds or banks must have been involved, otherwise reserve managers would have smoothed the pressure.
So who are the behemoth of such large scale re-allocation of capital. The WSJ reports a major Asian equity fund was unwound by its SWF backer last week. This is a decent clue. Ahead of Fed tightening, SWFs may be scaling down their hedge fund, equity and alternative investments holdings to concentrate into short dated government bonds (reserve managers run the short end). That is presumably very short dated UST and European bonds.
The price dynamics and ECB promising to fight deflation means that core and soft core European bonds are promising alternatives to equities. This suggests that the EUR should stay strong relative to its satellite currencies (smaller reserves will be squeezed for some USD liquidity).
While the Fed is widely expected to accelerate the pace of tightening, the adjustment in positions changes very little. USDJPY is likely to base and rebound quickly in the next 24h as VaR risk reduction runs its course. USDCAD even with such large long positioning barely budged in the past few days. That suggests the trend up is very much impact, the BoC there is clearly your friend”.

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