Making sense of the forces driving global markets

By Jamie McGeever, Markets Columnist 

Investors on Thursday drew breath from the recent selling across markets fueled by weakness in long-dated government debt, and pushed up stocks, the dollar and bond prices. But Wall Street's rebound lacked conviction and fizzled out, pointing to a lackluster open on Friday. 

In my column today I look at the dollar. There is no shortage of economic fundamental reasons to be bearish in the long term, but perhaps the recent selling has gotten a little excessive. More on that below, but first, a roundup of the main market moves. 

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The relative calm across markets on Thursday came amid purchasing managers index data that showed the downturn for British and Japanese firms eased in May, and U.S. business activity accelerated amid a truce in the trade war between Washington and China. 

Investors latched onto the 'activity' side of the U.S. report, and parked to one side the 'prices' data that showed rising prices of imported goods for companies and consumers. Inflationary pressures are intensifying. 

Asian markets open on Friday to the latest producer price inflation figures from South Korea, and consumer inflation data from Singapore and Japan. The figures from Tokyo are expected to show Japan's core inflation rose in April at its fastest pace in two years, adding to pressure on the Bank of Japan to raise interest rates.

Japan's bond market is at the epicenter of the global turmoil in long-dated sovereign debt. This week a 20-year auction drew the weakest demand since 2012, and 30- and 40-year yields both surged to their highest levels on record.

Punchy inflation figures could push yields back up again, which would further complicate life for the BOJ - it doesn't want to intervene buying bonds, but it won't be able to stand by and do nothing if yields continue to rise.

Inflationary pressures in the euro zone, meanwhile, appear to be less intense. European Central Bank policymakers reckon the inflation shock is "nearly over" and expect disinflationary forces to dominate in the short term.

Investors will be paying close attention to a speech by increasingly influential ECB board member Isabel Schnabel on Friday. She is seen as an inflation 'hawk' and has been vocal in her opposition to further rate cuts.

Fiscal worries in the United States loom large over markets, despite the respite on Thursday, and the House of Representatives' narrow passing of President Donald Trump's tax bill will do nothing to alleviate those concerns. If anything, it might add to them.

The bill aims to extend Trump's 2017 tax cuts, deliver new tax breaks on tips and car loans and boost spending on the military and border enforcement. All told, it will add some $3.8 trillion to the $36.2 trillion federal debt over the next decade, the nonpartisan Congressional Budget Office estimates.

An auction of 10-year inflation-protected Treasuries on Thursday was smoother than Wednesday's 20-year note auction, and Federal Reserve Governor Christopher Waller said he still sees a path to rate cuts later this year. 

Overall then, it was a quieter, calmer day for markets on Thursday. Can the week close out in the same vein? 

There are plenty of fundamental economic reasons to hold a long term negative view on the U.S. dollar, but the selling and bearish sentiment currently smothering the greenback may be overdone.

The dollar has lost 5% of its value against a basket of major currencies since President Donald Trump's tariff 'Liberation Day' on April 2, and has fallen 10% since mid-January, when it was its strongest in more than two years.

The economic and policy uncertainty caused by Trump's trade war and its chaotic implementation have dimmed the dollar's allure, while Trump's drive to rip up the world economic order of the last 80 years and his attacks on Federal Reserve Chair Jerome Powell have also alarmed investors. 

What's more, if the Trump administration is to revive U.S. manufacturing, reduce the trade deficit and rebalance global trade, a weaker exchange rate must be part of the plan. 

Clarity around some of these issues may not come for a while. The U.S.-China tariff truce expires on July 9 and Trump's tax-cut bill may not be finally approved until the July 4 recess, by which time the debt ceiling issue will be coming on investors' radar again. 

This is the backdrop against which many investors are now reassessing their exposure to dollar-denominated assets. That includes Treasuries, especially longer maturity bonds, which are feeling the heat from burning worries over Washington's debt and deficits. With the world's reserve currency and reserve asset under pressure, it's little wonder U.S. stocks are under-performing most global peers this year too.

Added together, that's a powerful headwind for the dollar, despite the recent tailwind from the U.S.-Sino trade detente. But as is often the case in financial markets, traders and investors may have gotten a bit ahead of themselves.

Bearish sentiment and positioning are now at extreme levels, according to some measures.