Markets trade with a risk-off tone after the weekend anti-government protests in China. Market reaction relatively contained so far - police deter further protests and markets sense the inevitable end to the zero-Covid policy next year

Risk appetite has turned more cautious to start the week, with investors focusing on the weekend protests against the government’s zero-Covid policy in China.  The market fallout from the protests has been reasonably contained so far, with the S&P500 off by around 1% and oil prices and US Treasury yields rebounding from their falls yesterday.  The NZD and AUD have weakened, in sympathy with a lower CNY, the NZD falling back below 0.62, while safe haven currencies have outperformed.  NZ rates were lower yesterday, mainly reflecting global forces, with the market paring back expectations for the peak in the OCR to around 5.40%.

The focus so far this week has been on the spontaneous weekend protests in a number of Chinese cities against the government’s draconian Covid policies.  The protests stirred talk of social instability in China, but a heavy police presence appears to have deterred protestors overnight, calming markets somewhat.  There is also a line of reasoning that the anti-government protests could potentially hasten the end to the zero-Covid policy.

The market continues to be caught between the negative near-term growth implications from the current Covid outbreak in China – as the authorities implement further restrictions, albeit not necessarily full city-wide lockdowns – and the more positive medium-term outlook from the likely eventual end to the zero-Covid policy.  As such, the market reaction has been reasonably measured.  USD/CNY opened around 1% higher yesterday, although it has since come off its highs, closing just above 7.20.  Likewise, after slumping almost 4% yesterday, Hang Seng futures have recovered all their losses overnight.

Broader markets have also traded with a risk-off tone, although the moves have been relatively modest in the context of recent volatility.  The S&P500 is currently down 1.1% and the NASDAQ 1%, although these moves follow a strong run for US equities over the past six weeks.  A 2% fall in Apple’s share price, after Bloomberg reported that the recent issues at its huge factory in Zhengzhou would likely see a 6 million shortfall of iPhone pro units this year, weighed on the broader indices.  WTI oil fell to year-to-date lows yesterday afternoon, below $74, on Chinese demand concerns, but it has reversed that move overnight.  Copper futures, another bellwether for global growth, have also recovered most of their losses from yesterday.

Global rates are slightly higher so far this week.  The US 10-year rate fell to a six-week low yesterday afternoon, just below 3.62%, but it has recovered to back above 3.70% overnight.  The US 2y10y yield curve is marginally steeper overnight but, at -76bps, it remains near its most inverted levels since the Volcker era, warning of a severe recession next year.

Fed officials Williams and Bullard have been speaking over the last hour, both reiterating that the Fed has “more work to do” with tightening to get inflation under control. Bullard reiterated his view that the Fed needs to take the cash rate to at least 5%, adding that he thought the market might be under-pricing the risk of Fed hikes next year.  Their comments come ahead of Powell’s speech on “The economy and labour market” on Wednesday night where he is expected to rubber stamp a step down in the pace of tightening to 50bps next month while pushing back against any thoughts of a ‘pivot’ any time soon.  The market is pricing 53bps for the Fed’s next meeting and a terminal rate just above 5%.

Ahead of the all-important European CPI release later this week, ECB President Lagarde said she would be “surprised” if inflation had peaked.  Markets expect a slowdown in the pace of annual headline inflation to 10.4% y/y from 10.7%, but Lagarde, perhaps chastened by the ECB’s poor inflation forecasting record, appears reluctant to endorse that view.  She added that the “risk is to the upside” on inflation.  Meanwhile, fellow ECB official Knott, a known hawk, said talk of the ECB possibly overtightening was “a bit of a joke” considering annual inflation was running in double digits.  The German 10-year rate was broadly unchanged overnight, sitting just below the 2% mark.

The weaker CNY has weighed on the AUD and NZD to start the new week, the two antipodean currencies down 0.9%-1.0%.  The AUD has broken below 0.67 while the NZD has fallen back below 0.62.  After their recent strong runs, around 13% on the NZD since mid-October), some short-term consolidation isn’t a major surprise.  There has been less net movement in the major currencies.  The EUR spiked towards 1.05 overnight, its highest level in almost five months, but it has since reversed back below 1.04, now slightly lower on the day.  The JPY has outperformed (+0.3%) against the risk-off backdrop, with USD/JPY pushing down to around 138.70.

Senior RBNZ officials have commenced their usual round of post-meeting media interviews, with Karen Silk and Christian Hawkesby speaking over the past two days.  Both highlighted the importance of ensuring inflation expectations returned to levels consistent with the inflation target.  Asked whether there was a scenario where the RBNZ could stop short of taking the OCR to the 5.50% peak indicated by its projections, Assistant Governor Silk noted “if the information shows that we’ve reached that [inflation] peak and we see that turn and we’re starting to see real impacts on inflation and inflation expectations, then that does offer us the opportunity to revisit. ”  Our initial estimates are that CPI inflation over the next two quarters will come in well below the RBNZ’s forecasts. This opens up a potential pathway for a lower peak in the OCR, although our central forecast is aligned with the RBNZ’s projections at this point.  Given the emphasis the RBNZ is placing on inflation expectations, the RBNZ’s Survey of Expectations will become a major data point on the calendar for the market.

NZ rates were sharply lower yesterday, responding to the risk-off global backdrop.  The 2-year swap rate was down 6bps, to 5.17%, partially reversing its surge higher last week after the RBNZ’s hawkish MPS.  The market has pared back its OCR expectations, with a peak in the cash rate of around 5.40% now priced in.  Longer-term rates were down by even more, by 9-10bps between 5 and 10-year swap maturities, taking the 2y10y curve even more inverted, to -83bps, a strong signal the market expects a recession ahead.  We should expect some reversal in NZ rates today, with the implied yield on the Australian 10-year bond future around 4bps higher than it was at the time of the NZ market close.

German and Spanish CPI data are released tonight ahead of the all-important Euro Area inflation report tomorrow.  The market is expecting a sharp deceleration in monthly inflation in November, to 0.1% m/m in Germany and 0.2% Euro Area-wide, but that would still leave annual inflation rates north of 10%.  The European inflation data is likely to be pivotal to the debate around whether the ECB will continue with another 75bps hike or step down to a 50bps move (the market is almost 50-50 on the two options).  The US Conference Board consumer confidence index is also released tonight.