ISM manufacturing avoids contraction but beware

US equities and currency rally across the board on relief that the February manufacturing ISM remained in expansion territory at 52.9, shrugging the broad collapse in contraction territory in Friday’s release of the Chicago Purchasing Managers index to six-year lows. The Feb ISM’s 52.9 was the lowest figure since January 2014, while the decline in the new orders and employment components was the lowest since May 2013 and June 2013 at 52.5 and 51.4 respectively.

The bullish side of the story attributes the disappointing figures to bad weather in the North East and the strikes in California.  And with manufacturing sector accounting for a shrinking part of the US economy, more attention ought to be placed on the services sector, whose ISM release is due on Wednesday. All of this is valid and the question remains whether the manufacturing ISM is showing the after-effects of a deterioration that’s focused largely on the oil patch and that the worse is behind us. Let’s assume that is true.

Careful when comparing previous recoveries

In assessing whether the current lows in the components of the manufacturing ISM would see similar bounce this time, let’s compare the events prevailing at the time of the bounce to today. The chart below shows each of the recoveries in ISM lows were triggered by a new stimulus program from the Fed, namely Fed’s Operation Twist in September 2011 (after QE2), and Fed’s QE3 in September 2012, coinciding with Draghi’s “whatever it take” speech.  Yet, as the ISM hits new cycle lows this spring, can we expect a recovery to emerge despite fears/expectations of a Fed rate hike? Some may say the ECB’s QE throughout 2015 and another dose of QE from the Bank of Japan would do the trick. 

But what about weakness from China?

Another China rate cut is just the beginning

China’s weekend rate cut in lending and borrowing rates, reduced 1-year lending to 5.35% from 5.60% — the lowest since Dec 2008—and the 1-year deposit rate to 2.50% from 2.75% – the lowest since Sep 2010.

The new 2.50% rate on 1-year savings deposits means the real interest rate (after inflation) is at 1.74%, just off the six-year highs of 2.03%.

With Chinese loan demand at its lowest level since Q4 2009 and inflation at 5 ½-year lows, real interest rates hover near five to six year highs, making further rate cuts inevitable this year. These will likely take the form of reductions in the reserve ratio as well as benchmark lending/borrowing rates, combining with periodic increases in liquidity injections.  What will follow is another 5-7% decline in the Chinese yuan, which will only worsen the disinflationary risks in the US.

China’s rate cut may enforce expectations of an Aussie rate cut tonight, expecially after the Aussie has rebounded against the USD. Traders looking to short the Aussie on a rate cut ought to take note of the risk of a subsequent rebound shortly thereafter on the reasoning that today’s easing is an insurance policy and may not be followed by additional easing before end of Q2.