Hello there,

A fantastic Friday to you as markets find their footing somewhat after digesting the minutes of the U.S. Federal Reserve's policy meeting in March.

In brief (TL:DR)

• U.S. stocks recovered slightly on Thursday with the Dow Jones Industrial Average (+0.25%), the S&P 500 (+0.43%) and the Nasdaq Composite (+0.06%) following the sharp drop on Wednesday on revelations of the Fed paring back its balance sheet.

• Asian stocks struggled to make headway Friday as the U.S. Federal Reserve’s plan for aggressive policy tightening and China’s continuing Covid lockdowns hung over markets.

• Benchmark U.S. 10-year Treasury yields fell two basis points to 2.64% (yields fall when bond prices rise) but continue to push 3-year highs.

• The dollar was in sight of its highest level since 2020.

• Oil mostly held recent losses with May 2022 contracts for WTI Crude Oil (Nymex) (+0.06%) at US$96.09 as plans to release millions of barrels of crude from reserves and China’s demand-sapping virus outbreak continue to weigh on sentiment.

• Gold was lower with June 2022 contracts for Gold (Comex) (-0.15%) at US$1,934.90.

• Bitcoin (+0.65%) was at US$43,625 as activity in the benchmark cryptocurrency shows signs of returning and investors appearing to nibble at the dips.

In today's issue...

1. China Mulls Monetary Policy Loosening as Economy Slows

2. Can the Fed sell its assets safely?

3. CME is Offering Reference Rate for Cryptocurrencies

Market Overview

Sentiment is suffering from the prospect of sharp U.S. Federal Reserve rate hikes and balance sheet shrinkage, Russia’s grinding war in Ukraine and China’s Covid travails.

U.S. Treasury yields retreated and the bond curve held the steepness it gained in the wake of the U.S. Federal Reserve release of meeting minutes Wednesday, which outlined plans to pare the central bank’s balance sheet by more than US$1 trillion a year.

Meanwhile, U.S. officials warned the war in Ukraine may last for weeks or even years. European Union countries agreed to ban coal imports from Russia, the first time the bloc’s sanctions have targeted Moscow’s crucial energy revenues.

Asian markets mostly fell Friday with Seoul's Kospi Index (-0.13%), Tokyo's Nikkei 225 (-0.29%) and Hong Kong's Hang Seng Index (-0.92%) down, while Sydney’s ASX 200 (+0.64%) was up in the morning trading session.

1. China Mulls Monetary Policy Loosening as Economy Slows

• China's zero tolerance Covid strategy is forcing it to rely on monetary policy tools to spur the economy at a time when rivals are using these same tools to tighten.

• Even where top officials want to move quickly and act decisively to shore up the Chinese economy, they may be hamstrung by Xi’s need to be consulted on even the smallest decision.

With some of its largest cities in lockdown, China is facing a far more unique set of challenges than other countries in the rich world and one that has been largely of its own making.

Whether it’s been the ill-advised crackdown on its real estate sector or tightening the noose around its lucrative tech companies, China has turned its back on decades of capitalist ambitions and frightened the global investing population alongside it.

And now its zero tolerance Covid strategy is forcing it to rely on monetary policy tools to spur the economy at a time when rivals are using these same tools to tighten.

After acknowledging that global risks are now bigger than previously expected, on Wednesday, top Chinese economic officials declared that they would use multiple monetary policy tools at an “appropriate time” to support the real economy.

In a readout from a meeting of the State Council chaired by Chinese Premier Li Keqiang, China’s de facto cabinet acknowledge the “complexity and uncertainty of domestic and foreign environments” and conceding that they had “exceeded expectations” without specifying what measures would be taken to shore up the world’s second largest economy.

While Beijing has made repeated vows to stabilize the economy in recent weeks, strict Covid restrictions have curbed business and consumer spending while a gauge of sentiment in the services sector fell in March to its lowest level in about two years.

Foreign investors have also been leaving in droves, with at least US$6 billion in flows marked leaving Chinese shares from both mainland exchanges and Hong Kong.

And these flows could rise quickly, given Beijing’s refusal to condemn close ally Russia’s invasion of Ukraine and the revelation that war crimes may have been committed by Russian troops.

Unless Beijing disavows Moscow, which appears increasingly unlikely, it risks being too high a reputational risk for some of the biggest global investors, which are now mulling a gradual exit from Chinese assets which have been underperforming for some time now.

Beijing’s ambitious growth rate of 5.5% for this year also seems doubtful, providing even the most optimistic investor on China with limited upside but unlimited downside.

So far, China’s top economic officials have been long on rhetoric but short on action, and despite pledging last month to ease regulatory crackdowns, support property developers and stimulate the economy through monetary policy, few, if any, concrete steps have been taken.

The problem of course could be Chinese President Xi Jinping, who has since he took over, centralized power to himself, and sits on practically every decision-making committee in Beijing.

Even where top officials want to move quickly and act decisively to shore up the Chinese economy, they may be hamstrung by Xi’s need to be consulted on even the smallest decision.

2. Can the Fed sell its assets safely?

• The Fed is burning the candle at both ends, raising rates and paring down its massive US$9 trillion balance sheet.

• Compared to the last time the Fed sought to pare down its balance sheet, this time looks a whole lot quicker and against an entirely different macroeconomic backdrop.

The implied Fed “put” has kept markets buoyant for so long that it’s hard to imagine the visible hand of the U.S. Federal Reserve in retreat.

Since the 2008 Financial Crisis, the U.S. Federal Reserve has served as a backstop for U.S. Treasuries and mortgage-backed securities, shoring up demand for them, keeping yields low and ensuring that borrowing costs remained affordable.

But faced with the highest pace of inflation in over four decades, the Fed is burning the candle at both ends, raising rates and paring down its massive US$9 trillion balance sheet.

What’s causing investors to hold their breath is whether the Fed can clear its balance sheet without causing mayhem.

According to minutes of the Fed’s meeting in March, the central bank will seek to “roll off” around US$60 billion worth of Treasuries each month by not reinvesting the proceeds from maturing bonds, the most benign way amongst all the available options.

Typically, when the Fed has maturing Treasuries on hand it will replace these with fresh sovereign bonds, to keep demand at an even keel.

The Fed is also looking to reduce its holdings of agency mortgage-backed securities, which it started buying during the pandemic, capping the reduction in this asset class to around US$35 billion a month.

Compared to the last time the Fed sought to pare down its balance sheet, this time looks a whole lot quicker and against an entirely different macroeconomic backdrop.

In the aftermath of the 2008 Financial Crisis, the Fed waited seven years to 2015 to raise rates and then another two years or so before it started reducing its balance sheet, which then took another year for the Fed to lift the cap on asset reduction to US$50 billion a month.

This time, the Fed is starting at US$60 billion a month and is raising rates just two years after the pandemic.

To be fair, the post-pandemic recovery has been far more speedy than was the case after the 2008 Financial Crisis, and the Fed has been dialing up the rhetoric to prepare the markets for a new monetary regime.

What happens next?

Borrowing costs have been increasing steadily since last November, when the Fed hinted that it would soon be ratcheting up rates and mortgage rates have been climbing while stocks have come down from their lofty all-time-highs, a smaller Fed balance sheet could accelerate this shift.

As the Fed retreats, the supply of U.S. Treasuries available to investors will balloon, sending bond yields already at 3-year highs, higher still and denting demand for other assets.

The argument for risk assets from stocks to cryptocurrencies was the low-yield environment that investors had to contend with.

But as yields soar, those assumptions will come under question.

The bigger question though is can the Fed pare down its balance sheet without causing a kerfuffle in the markets because the last time it tried to do it in 2019, the short-term funding rate spiked, suggesting that the Fed had withdrawn too much from the market.

There are measures in place to avoid a repeat of that episode though, after it established a permanent facility last year that allows eligible investors to swap U.S. Treasuries for cash and that in and of itself should help to temper runaway yields.

Either way, investors will need to brace themselves on one of the biggest monetary policy experiments to date, and expect the volatility that will inevitably ensue.

3. CME is Offering Reference Rate for Cryptocurrencies

• CME Group (+0.35%) looks set to offer investors broadened access to a greater range of cryptocurrencies on traditional markets, launching 11 new reference rates and real-time indices for cryptocurrencies that represent around 90% of the global market cap of digital assets.

• Reference rates are necessary because investors, especially institutional investors, need a place to keep score from consistently, and are used as a benchmark for other financial products.

Ask any seasoned trader what’s the price of Bitcoin and most will reply that they don’t know and it depends on where you’re asking about.

And that’s because with great decentralization comes great diversity of expression on what the price of any specific cryptocurrency is, which is a major hurdle to broader institutional acceptance of cryptocurrencies.

Because institutional investors have reporting requirements, the ability to formulate something as assumed and basic as a price for an asset, is a necessary prerequisite to participation.

Help could be coming as CME Group looks set to offer investors broadened access to a greater range of cryptocurrencies on traditional markets, launching 11 new reference rates and real-time indices for cryptocurrencies that represent around 90% of the global market cap of digital assets.

CME Group already offers reference rates for Bitcoin and Ether and that’s facilitated their purchase by institutional investors, but will now work with CF Benchmarks and expand those reference rates and indices to Algorand, Bitcoin Cash, Cardano, Chainlink, Cosmos, Litecoin, Polkadot, Polygon, Solana, Stellar and Uniswap.

Reference rates are necessary because investors, especially institutional investors, need a place to keep score from consistently, and are used as a benchmark for other financial products.

The move will allow traders and fund managers to evaluate portfolio risk and create structured products like exchange-traded products (ETPs) based on cryptocurrencies.

While ETPs have been available for many years in Europe and Canada, they have only recently gained approval in the U.S., which saw its first Bitcoin futures-based ETF launched last October.

Analysis by Bloomberg Intelligence earlier this month suggests that cryptocurrency ETPs could swell to over US$120 billion in assets under management by 2028.