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Why optimistic stock market investors and pessimistic bond traders might be wrong about the US-China trade



When it comes to trade and financial markets, maybe everyone is getting it wrong

The bond market "is too pessimistic, the equities market too optimistic, and the FX market complacent," said Bank of America Merrill Lynch currency. Strategists Athanasios Vamvakidis and Adarsh ​​Sinha, in a Wednesday note (see chart below).



Bank of America Merrill Lynch

Read: Investors face a conundrum: Which market is wrong?

"In our view, it is difficult to see the Fed cutting by much as markets expect, if at all, if there is a US-China trade deal, and it would be difficult for equities to remain so strong if there is a trade war, "the BAML analysts wrote.

See: Why the path for stocks and other markets now 'critically on politics'

Stocks have found their footing in June as expectations for Federal Reserve rate cuts have risen, reflecting apparent faith in the central bank ability to avert a severe economic slowdown or recession. The S&P 500

                            
                            
                                  
      
      
      
      
      
      
      
                                  
                                     SPX, -0.20%

is up 4.8% so far in June, trading less than 3% below an all-time closing high set just before a May pullback. The index is roughly 15% in the year-to-date, putting it on pace for its best first half since 1998, according to Dow Jones Market Data. The Dow Jones Industrial Average

                            
                            
                                  
      
      
      
      
      
      
      
                                  
                                     DJIA, -0.17%

is up around 11.6% in the year to date, award for its strongest first half since 2013.

Indeed, even during the May pullback, stock-market investors largely kept their cool. Jim Carney, founder of New York-based hedge fund Parplus Partners, customs MarketWatch that cost of buying "real crash protection" in the options market falls significantly since early May, appearing to reflect confidence the Fed and the European Central Bank will keep monetary policy free traders to avoid a major crisis

Options pricing showed traders appeared prepared for a range that would see stocks move around 10% to 12% up or down, while viewing a "crash" scenario of a pullback or 20% or more than unlikely, he said.

Meanwhile, the sharp fall in Treasury yields – yields fall as bond prices rise – is viewed by many analysts as a signal that recession fears are mounting. Interest rate futures are as many as four Fed rate cuts at the end of next year.

Check out: Here's why this overlooked yield curve measures point to a soft landing

The BAML analysts are not impressed by arguments that the stock and bond markets are pricing in a trade-war scenario that would see the Fed riding into the real economy with rate cuts, therefore boosting the stock market.

Also see: Jobs Jobs Shows stock-market investors see news as good news once again

Instead, a full-fledged US China trade would likely lead to a sharp risk-off market move and a substantial deterioration in the global economic outlook, despite Fed easing, ”they wrote. The pricing of more Fed rate cuts, meanwhile, coincided with the U.S. economic data, including last Friday's disappointing jobs data, although data should also have led to equities, they said. growth from last year's stimulus-induced pace should not be a surprise, they said.

risk of either a rates market selloff, or equities market selloff, depending on whether there are positive or negative developments in US-China trade in the next few weeks. ”

Perhaps more helpful, Vamvakidis and Sinha argue that subdued volatility in the currency market is likely to get higher than volatility in equity and rates markets jumps on trade-related worries – something they probably see as a month-end meeting of leaders of the group of 20 nations draws near. [19659002] The analysts shorted the euro versus the Japanese yen

                            
                            
                                  
      
      
      
      
      
      
      
                                  
                                     EURJPY, + 0.02%

in May as U.S.-China trade tensions escalated and recently recommended selling the U.S. dollar / Japanese yen

                            
                            
                                  
      
      
      
      
      
      
      
                                  
                                     USDJPY, -0.03%

pair, as well. The yen typically benefits during periods of global market unease, often serving as the currency market's premier port.

“We would expect markets to get more concerned about negative outcomes than the G-20 meeting approaches, potentially triggering a risk-off [move]”they wrote. “We have a relatively optimistic view for the end game, but are concerned that things can get worse before getting better. The risk to these trades is a comprehensive deal at the G-20. However, in this case, we think the Fed repricing could limit the risk-on-market move, limiting in turn JPY downside. ”

Trading the euro / US. dollar pair

                            
                            
                                  
      
      
      
      
      
      
      
                                  
                                     EURUSD, + 0.0443%

is more tricky, they said. While a looser Fed should be positive for the euro, the shared currency has strengthened only recently at the European Central Bank. t strike more dovish stance at its June meeting.

Also read: Why Trump's tweets about the U.S. dollar might soon pack a lot more punch

Meanwhile, rising global trade tensions should be a positive for the euro, because of the eurozone's higher dependence on trade, while a trade peace scenario should be a negative for the currency as investors cut expectations for Fed rate cuts. In addition, the U.S.-China trade pact does not preclude the U.S. Pat. putting pressure on the European Union on trade issues, the analysts noted

While emphasizing the caveat that details or any trade pact could have big implications for the currency pair, they argued that investors should expect a stronger euro versus the dollar in the short in the case of US-China trade war – a move that should be used as a selling opportunity. In the event of trade peace, investors should look for a euro, which the analysts should be considered as a buying opportunity.


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