January 4, 2019 / 10:19 AM / 17 days ago

GLOBAL MARKETS-China-U.S. trade talks a tonic to battered markets

* Graphic: World FX rates in 2018 tmsnrt.rs/2egbfVh

By Virginia Furness

LONDON, Jan 4 (Reuters) - World stock markets rallied on Friday after Beijing announced a new round of trade talks with Washington, though recession fears still had markets betting the next move in U.S. interest rates might be down.

News that the United States and China would hold vice-ministerial level talks on Monday and Tuesday to resolve a trade dispute bought some respite to battered markets, with MSCI's world stock index up a third of a percent and U.S. stock futures around 1 percent firmer .

"We're not expecting a major breakthrough on Jan. 7-8," said Edward Park, deputy chief investment officer at Brooks Macdonald.

"That said, where equity markets are in terms of valuations, if you look at the two core risks - U.S./China trade and the Fed – there’s room for markets to be positively surprised in both of those areas."

Global markets have had a rough start to 2019, hurt by a shock revenue warning from iPhone maker Apple and concerns about slowing global economic growth.

But on Friday, European markets tracked a cautious move higher in Asian stocks. Europe's STOXX 600 index rose 0.8 percent while Germany's DAX jumped 1 percent.

In Asia, Shanghai blue chips rose 2.4 percent, while South Korean shares bounced 0.8 percent.

But Japan's Nikkei skidded over 2 percent on its first trading day of the year, weighed by growth worries and the strength of the yen.

The yen edged back from its recent surge on Friday on hopes U.S.-China trade talks would make some progress, but the Japanese currency remains well bid by investors fretting about a global economic slowdown.

The yen fell as much as 0.6 percent against the dollar to 108.31 before recovering some of those losses to trade at 107.94.

The euro held above $1.14. The single currency traded up 0.1 percent at $1.1410 while the dollar index, which measures the greenback against a basket of rivals, was 0.1 percent lower at 96.189.

BOND SAFE-HAVENS HURT

The improving tone also fed through to Europe's bond markets, pushing yields on safe haven assets such as Germany's 10-year government bond off two-year lows hit this week.

But analysts are unconvinced that the trade talks and subsequent relief rally signal sustained improvements, particularly in a new era of tightening liquidity.

"(Central banks) are trying to get markets weaned off the idea that they will come riding to the rescue and people are trying to learn what the new rules of the game are," said Colin Harte, head of research, multi asset solutions at BNP Paribas Asset Management.

Harte added that he was sceptical that the talks would have a meaningful resolution. "The picture will remain unclear for the first half of this year," he said.

German bond yields, while higher on Friday, were set for their biggest weekly fall since October - down around 6 basis points.

The move is evidence of a key change in central bank rate expectations, Bob Michele, chief investment officer and head of fixed income at JP Morgan Asset Management said.

"With rate cut expectations and a slow-down in the U.S., does it look realistic that the ECB will raise rates at all this year?" he added.

In such a risk off-environment, Michele said it was not inconceivable that the European Central Bank would return to quantitative easing, which would push bond yields even lower.

Money markets price just a 30 percent chance of a 10 basis point ECB rate hike in 2019.

The risk of a U.S. economic downturn, or even a recession, has caused a tectonic shift in expectations for interest rates with investors now pricing in the possibility of a cut.

Investors will be looking for any clues from U.S. Federal Reserve Chair Jerome Powell, who is due to speak on Friday, as well as the latest jobs numbers, released later this session.

While the Fed is still projecting two more hikes this year, the futures market implies the next move will be down with around a 40 percent probability of a move by year end.

The market is fully pricing in an easing to 2.00-2.25 percent by May next year, from the current range of 2.25-2.50 percent.

The mounting speculation sent yields on two-year U.S. Treasuries as low as 2.37 percent, taking them under the effective federal funds rate for the first time since 2008. They were last trading at 2.43 percent.

Three- and five-year yields were even lower, an inversion that has sometimes heralded recessions in the past.

Yields on 10-year benchmark paper dropped to 2.54 percent overnight, a staggering turnaround from the highs of 3.25 percent seen as recently as November.

Elsewhere, the news of the U.S./China trade talks boosted oil prices, with Brent crude oil was 1.9 percent higher at 57 dollars per barrel. (Reporting by Virginia Furness in London, Swati Pandey and Wayne Cole; Editing by Jon Boyle)

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