Fed or Nvidia: Who's Driving the Market?

Welcome back to SovereignBeat!

In this publication:

• Cautious Fed Heads Back in Actionl; 2-Year Treasury Note Nears 5%

• China Lets Yuan Slide

• Brent Oil Dips while OPEC makes U-turn

• Nvidia propels equity markets as much as Fed does

• Ghana Nears Completion of Debt Restructuring—First Under G20?

Let’s dissect

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Markets Snapshot

Bond Markets and FX

• The global bond market is projected to remain relatively stable in the near term, with minimal significant fluctuations in government bond yields as interest rates have likely peaked. Nonetheless, inflation continues to pose challenges, delaying potential rate cuts. According to Refinitiv, money market forwards are pricing in rate cuts of 42 basis points by the Fed, 65 bps by the ECB, and 55 bps by the BoE within the year.

• US: On Monday, The Vice Chairs of the Federal Reserve, Michael Barr and Philip Jefferson, as well as the President and CEO of the Cleveland Fed, Loretta J. Mester all expressed caution about inflation. Barr mentioned that the inflation data from the first quarter was disappointing and did not instill confidence in cutting rates at this time. Jefferson noted that it is too soon to conclude that inflation is on a sustainable path toward the Fed’s inflation goal. Mester retracted her earlier statement about three rate cuts in 2024, stating that it does not currently seem appropriate to cut rates three times next year. She also commented that monetary policy is well-positioned at the moment.

• Additionally, Fed board member Christopher Waller suggested that if economic data softens over the next three to five months, the Fed might consider reducing borrowing costs towards the end of 2024, stressing again the importance of observing more favorable inflation figures before initiating any rate cuts. He also reiterated his belief that the neutral interest rate remains relatively low. However, he cautioned that unsustainable fiscal spending could potentially alter this trend.

  The neutral rate is a rather theoretical concept and can be defined as the real interest rate (net of inflation) that supports the economy at full employment/maximum output at which monetary policy is neither contractionary nor expansionary, with inflation anchored at the central bank's inflation target. In the long run, it is determined by the supply and demand for savings. For instance, for companies to undertake new investments, they rely on households and other savers to provide the capital necessary to finance those investments. Consequently, the total investment in the economy must match the pool of available capital or savings. The interest rate that achieves this equilibrium in the long term is called the neutral rate of interest. Hence, lower neutral implies investors are accepting lower risk premiums for their capital, indicating widespread accessibility despite heightened interest rates and risks. A lower neutral rate comes with monetary policy challenges, as it limits the ability to cut rates in a recession.

• Nonetheless, recent consumer price data for April has been encouraging, indicating that inflation is not accelerating and progress towards the Fed's 2% target may be resuming. Recent data highlighted a surge in business activity, the fastest in two years, and a drop in unemployment claims, affecting yield movements across various maturities. Despite this, the two-year yield hit 4.95% this week, reflecting an adjustment in market expectations on rate cuts.

• China: The central bank has allowed the yuan to weaken significantly against the dollar, setting the daily reference rate to its lowest level since January. This adjustment comes in response to rising capital outflows and a strengthening dollar. The bank's modification of the yuan's fixing suggests a possible shift in policy to allow greater currency flexibility, which could indicate an end to its practice of maintaining yuan stability and have significant implications for regional currencies.

• For most of this year, China has maintained a strong hold on the yuan due to a weak economy and the wide interest-rate gap with the US favoring the dollar. Capital outflows, driven by a surge in local firms purchasing foreign exchange and exporters hoarding dollars, have also pressured the currency. Emphasis on currency stability has limited the potential for monetary stimulus, just when it's needed most, as the economy is weakened by the tumbling real estate sector, lower confidence, and rising local government debt.

Equity Markets

• The major indexes experienced varying results over the week, with the Dow Jones Industrial Average marking its largest weekly loss of -2.3% since early April, while the Nasdaq Composite increased by 1.31%, reaching record highs. The broad S&P 500 Index remained relatively unchanged, while small-cap stocks declined. These differences in performance were also evident in the significant underperformance of an equal-weighted version of the S&P 500 Index, which lagged behind its more conventional, market-weighted counterpart by 1.27%.

• A primary factor contributing to the market's divergence was the surge in NVIDIA shares, now ranked as the third-largest company in the S&P 500 by market capitalization. Following the company's first-quarter earnings report on Wednesday, which surpassed consensus estimates, its shares soared by 9.3% on Thursday, adding approximately USD 220 billion to its market capitalization. As Blomberg reported, the S&P 500’s price/earnings ratio has risen more or less perfectly in line with changes in Nvidia’s share price in the 12 months since Nvidia Day.

Commodity Markets

• Oil: Crude oil prices have fallen to approximately USD 78 per barrel, driven by uncertainty over potential Fed rate cuts and unexpected increases in U.S. crude inventories and OPEC U-turn on production cuts. The diminishing geopolitical risk premium, due to stable oil supplies from the Middle East, also played a role.

• The OPEC oil cartel and its allies announced on Thursday that they will gradually increase oil production by approximately 2 million barrels per day from May to July, aligning with the global economy's recovery from the COVID-19 pandemic. The group, which had previously cut production to support prices amid a drop in fuel demand during the pandemic recession, will add back 350,000 barrels per day in May, another 350,000 in June, and 400,000 in July.

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Global Finance

Will Ghana be the first country to Restructure Under G20?

• Ghana has received a draft memorandum of understanding on debt restructuring from its official creditors, which it will now quickly review with the aim of signing soon, the finance minister said on Friday. This memorandum will formalize a provisional agreement reached back in January with government creditors, including China and France, to restructure $5.4 billion of debt (we already analysed it here ). The agreement will also pave the way for the International Monetary Fund's executive board to meet next month to approve a disbursement of $360 million under the country's $3 billion bailout program.

• It is worth mentioning that Ghana and some of its Eurobond bondholders already reached a common ground to restructure debt back in April. This agreement involved Western asset managers and regional African banks and did not include value-recovery instruments such as the macro-linked bonds that Sri Lanka recently offered to its bondholders (you can find a great article from FT on this topic below in the ‘Further Reading Recommendations’ Section).

• However, the IMF indicated that the terms of the proposed deal to the Eurobond creditors exceeded the Debt Sustainability Analysis (DSA) threshold and required adjustments. The IMF has not yet shared its updated DSA with the advisors of Ghana’s bondholder steering committee. Under the proposed restructruing scenario bondholders would have two options: a "disco option," which features three new restructured bonds with a 33% nominal haircut, or a "par option," which involves a new single bond maturing in 2043, with a 1.5% coupon and no reduction in face value. Investor recoveries are estimated in the high 50s based on the "disco option" and in the low 40s on the "par option," using an 11% exit yield.

Our thoughts

• The fast restructuring process is crucial as Ghana navigates its worst economic crisis in a generation. The disbursement of IMF funds will help bolster Ghana’s reserves and provide a buffer for the cedi, which has depreciated 18% against the dollar this year, making it one of the worst performer currencies.

• Given that fourth-quarter data showed Ghana’s economy grew 2.9% last year, beating the IMF’s projection of 1.5% under the original DSA, we expect the IMF to lower its forecast for Ghana's debt-to-GDP ratio. This adjustment will likely to meet the updated DSA, allowing the current agreement with Eurobond holders to be finalised without any changes to the new bond terms, keeping the 33% nominal haircut intact.

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Our Further Reading Recommendations

• Sri Lanka's Restructuring and its Macro-Linked Bonds (FT)

• Hungary seeks to ‘redefine’ its Nato membershipy (FT)