ECU's Investment Blog
"If you follow the trend you will always be right behind it” Lindsey Haun
On reflection, the month of February could be classified as the calm after the storm of January. While there was much focus on the Greek drama that played out in February, the broad markets remained sanguine about the possibility of a resolution (even at the eleventh hour). Amid this, volatility declined and, across the FX markets, currencies regained and retained relatively narrow ranges. As is often the case in the global data calendar, the first week of the month is action packed and as a result we expect March to signal the return of volatility, acute focus and, in many cases, a resumption of some core trends.
In the Eurozone, the data has shown some improvement of late, as the fall in the oil price and renewed monetary commitment from the ECB have underpinned sentiment at both the consumer and corporate level. However, with the exception of Germany (who will likely continue to benefit disproportionately from the monetary stance of the ECB), the continued fall in prices (which have now fallen for the past three months) and still high rate of unemployment confirm the continued headwinds to the economy and, with GDP rising far too slowly to erode spare capacity in the economy, this weakness likely persists.
This morning’s retail sales data from Germany highlights the potential for growing economic divergence within the region, and the difficulties ahead for the ECB, as this growth disparity potentially lays bare the limitations of a one size fits all monetary policy for such a (socially, politically and economically) diverse union.
Yesterday, saw the release of the February global manufacturing PMI data. Across the Eurozone, the manufacturing recovery stalled in February, despite a modest improvement in Germany. Perhaps most disappointingly, Eurozone manufacturers failed to register a significant improvement in export orders despite the recent fall in the EUR.
"Demand excellence” Emmitt Smith
In the UK, by contrast, manufacturing expanded at its fastest pace in seven months. There is some evidence that the weaker oil price is boosting the domestic economy not just by boosting consumption in an economy where domestic demand has remained strong (unlike its Eurozone peers), but also by allowing firms to lower prices and boost margins.
"I don’t measure America by its achievement but by its potential” Shirley Chisholm
Looking ahead this week, the US comes back into focus after a relatively disappointing manufacturing PMI yesterday (though it is difficult to strip out the impact of the recent port dispute on the final data). Wednesday brings the release of the private sector (ADP) employment data which will likely shape expectations for the all-important US employment report on Friday. Wednesday also brings the release of the service sector PMI data, which is more likely a clearer indicator of the strength and momentum of the US economy. We would also expect the service sector data to highlight the strength of the UK economic momentum, and perhaps even of an improved backdrop in Germany, but the rest of the Eurozone’s activity likely remains moot.
On Thursday the Bank of England policy meeting is unlikely to bring any announcement or statement, however, the ECB, while not announcing any new measures will be keenly awaited for the release of further details surrounding its imminent QE programme. The numbers involved in the QE target purchases are very significant (a further reason why yields across the region are otherwise unthinkably and universally low) and thus the way in which those purchases are transacted in order to maintain purchase targets and to minimise price distortion is key.
We will comment further on the US employment report later in the week, suffice to say that we have little reason at this stage to suspect any reversal of the recent strength in the labour markets, or indeed the USD.
"Prediction is very difficult, especially if it is about the future” Niels Bohr
We retain the view that the USD and GBP continue to outperform in FX markets as their economic outperformance implies monetary outperformance, supported by the global backstop of ECB (and BoJ) QE. The extreme weather and the port dispute in the US add to the potential volatility and uncertainty, likewise the forthcoming General Election in the UK could be a potential banana skin.
In 2015, we continue to anticipate further gains in USD and GBP vs. EUR (AUD and JPY). Economic and geopolitical events likely mean that such a move will not be in a straight line. It is possible however, that this means more opportunity for FX, not less
"Looking for a lost transmission”? - Beck; The Information
On Tuesday we discussed our views of the progression of US monetary policy ahead of Fed Chair Yellen’s semi-annual testimony to both House and Senate Banking Committees. We stated clearly that we expect the term "patient” to be removed from the statement in March to allow greater flexibility in asking "why would the Fed wish to constrain itself so as to not enable a first (baby) step towards the normalisation of rates in June should it be warranted.”
Yellen effectively backed this (likely last) iteration of forward guidance, yet maintained that the removal of the term "patient” was not a precursor to an incremental rate increase in two meetings time, more that it would give the Fed the flexibility to make an assessment to normalise monetary on a "meeting by meeting basis” should it be warranted.
"Monetary policy must be forward looking” Janet Yellen
Yellen noted that some "foreign developments could pose a risk to the US”, but that those risks were not just to the downside (perhaps a nod to the potential positive implications of ECB QE). Her reference to the fact that the Fed expects inflation to gradually rise to 2% and that the Fed will raise when they are "reasonably confident” on inflation, was taken by some as a modestly dovish development. We disagree.
Yellen also stated that GDP is strong enough to further gradually lower the jobless rate, and in the Q&A from the Senate, she was quick to defend the Fed’s medium term price stability mandate over the political urge to keep rates low as long as possible. In conjunction with her view (as per Carney) that low inflation in the near term is transitory our view is that the Yellen testimony, Fed bias and US economic momentum are all bullish and we continue to expect higher short term US rates, and a higher USD. In our view, the signal from Yellen was hawkish, yet the care with which the evolution of forward guidance was managed means there is perhaps a small window before such bullishness becomes active!
"We are hearing the sound of transmission” Kraftwerk, Radioland
In the UK, this morning saw the confirmation of robust GDP growth with Q4 rising 0.5% q/q (+2.7% y/y). The breakdown highlighted a slight underperformance of both private consumption and government expenditure relative to expectations, while exports sharply outperformed. The one real disappointment came alongside the GDP report in the form of a contraction in business investment (the weakest reading since Q2 2009), likely, at least in part, a function of the political uncertainty around the upcoming elections.
Our view of the UK and GBP is very similar to that of the US and USD, yet with greater uncertainty due to the general election in just over 2 months’ time. Economic and monetary outperformance remains key and while the negative impact of political uncertainty likely become more acute over coming weeks, the potential for a sharp upward revaluation of UK interest rate expectations and GBP should the election pass without too much drama is, in our view, high.
"QE has high transmission potential to economy” Mario Draghi
Draghi was also on the newswires yesterday as he gave testimony to the European Parliament. Apart from the becoming visibly hot under the collar when heckled by the Greek representative over the removal of Greek collateral eligibility, Draghi was broadly upbeat. His message that monetary policy can provide the conditions for growth but it cannot create growth by itself, was a clear reminder that the central bank has (arguably belatedly) done all it can to stimulate growth, the rest is up to the politicians, governments and countries themselves.
In the near term the messages are mixed for the Eurozone, the anticipation of QE (and the sheer size of purchases relative to the market) have ensured that yields across the Eurozone have fallen dramatically. In fact, the 10 year debt of Ireland (still a programme country) yields less than 1.0% and the German yield curve is now negative beyond 7 years! Lower yields act to undermine the currency. Add to that the increasing political disparity in the growth vs. structural reform debate (not just in Greece, but France, Italy and Belgium) and the case for weakness is compelling.
"And no-ones jamming their transmission” The Police; De do do do…
On the other hand, as noted by Draghi yesterday, the sentiment and confidence in the Eurozone should be given a decent boost by QE across the region and in addition to positive growth surprises in Germany and others (notably Holland and Spain) in Q4, ECB growth forecasts for 2015 are likely to be revised upwards over coming weeks.
For now that likely supports continued range trading in FX, until the data gives the market cause to break out.
"US Economy has turned a corner” Jack Lew, 12th Feb 2015
Today’s main event will be the Testimony of Fed Chair Janet Yellen to the Senate Banking Panel. As regular readers will be well aware, our central expectation for Fed policy remains that US monetary normalisation will begin (albeit at a very moderate pace) at the June meeting. In that regard, the progression of the Fed communication policy or forward guidance would likely require the removal of the term "patient” from the statement at the March 18th policy meeting.
The broad market consensus has become centred on the fact that with inflation at such low levels, and with so many central banks around the world easing policy further, why would the Fed raise rates. The consensus view is that the Fed can be patient in removing "patient” from the statement.
Our view is, in many respects, the exact opposite. Fed forward guidance has evolved a long way over recent years with the latest (and likely the last) iteration being the term patient – explicitly defined as meaning policy will likely not be tightened within the next two meetings. With US employment having risen at a record pace and with the unemployment rate at 5.7%, amid tentative signs that wages are picking up (something which likely accelerates as the unemployment rate approaches its equilibrium level), why would the Fed wish to constrain themselves so as to not enable a first (baby) step towards the normalisation of rates in June should it be warranted.
"Convincing yourself does not win an argument” Robert Half
The argument that other central banks are easing is also not a convincing argument for us either. In terms of US QE, the Fed would argue that it is the stock of assets that provide the stimulus and not the rate of accumulation or purchase of those assets. Accordingly, Fed policy is the most accommodative it has ever been at this point. In our view, this is unsustainable in terms or economic momentum and future (once the oil price drop base effects drop out) inflation trajectories.
We do not, therefore, see the removal of "patient” as showing too little patience, as many have suggested. Rather, we would see its removal as maintaining Fed policy flexibility, giving the Fed the option to initiate the process of normalising rates it would not otherwise have.
In any event, Yellen likely makes it clear that the pace of policy normalisation, once it does start, will be slow and it will reach a much lower terminal rate than historically. Our bias is to suggest that the Yellen will tentatively prepare the market for incremental rate increases, while talking down the pace and peak. This should prevent sharp moves in long rates and equities, but continues to underpin the USD, likely most specifically vs. EUR, AUD and JPY.
"If reforms list rejected, Greece will be in trouble” - Yannis Varoufakis
Today is a significant day in the progress of the extension of the Greek loan / bailout / package (depending on which side of the negotiation you sit) and, while the ‘list’ of measures that must satisfy the ‘extension creditors’ missed the deadline, it has now been delivered. The fact that its receipt is followed by an EU finance minister’s conference call, rather than a physical meeting, suggests a more procedural than negotiation stance to its ratification. This leaves us with a four month period where the real differences between desires of both sides, and perhaps also between the cost cutting measures "in principle” and "in practice” come to light.
Prevention is NOT better than Cure!
This does not bode well for the Eurozone. It may provide time for the region to ‘prepare’ for an exit for Greece, but it is unlikely to be enough time to for the region to ‘manage’ a solution to the debt woes of Greece. QE, coupled with lower inflation and energy costs, may provide a near term boost to Eurozone growth. However, it may also exaggerate the divergences within the region. This morning’s confirmation of German Q4 GDP growth at 0.7% q/q is a case in point. Regular readers of ours will know that we continue to highlight Germany’s entrenched competitive advantage within the Eurozone structure. So, while there were signs in the breakdown of the German data that some of the gains were due to base effects (and thus the smoothed growth is likely lower than the data suggests), Germany is likely to benefit proportionally more than weaker states, particularly if its nascent recovery in domestic demand continues. Overall, however, the region and the EUR are likely to remain weak.
Elsewhere, further falls in Oil and other commodities likely put the commodity currency space (AUD, CAD, NZD …) under renewed pressure. The dominant driver of near term sentiment and direction, however, is likely Janet Yellen’s impact on US rate expectations and the USD.
"Only in our dreams are we free. The rest of the time we need wages” Terry Pratchett
Earlier in the week, we discussed the ongoing poker game between Greece and the rest of the EU. Yesterday, however, while the game theory of the two sides continued, market focus returned to what we see as the ultimate underlying driver of FX in 2015: monetary policy.
First up was the UK. Following on from a strong employment report, which we will expand on later, the minutes from the Bank of England Monetary Policy Committee (MPC) meeting at the start of February were broadly neutral. The MPC voted 9-0 to leave interest rates and asset purchases unchanged at 0.50% and GBP 375bn respectively. On the inflation front, the Committee expects that the headline CPI rate is likely to fall below zero in the first half of this year. However, it also notes that the effects of energy (and some latent effects of previous moves in GBP) on inflation dissipate towards the end of 2015 "causing inflation to pick up towards the target fairly sharply.”
In the UK, the MPC were also clear in their expectations of wage inflation, where they expect "annual wage growth to recover gradually towards 4% in 2 years”. We have stressed for many months now that we maintain a significantly above consensus expectation of wage growth, interest rates and GBP over the course of 2015, and while the political uncertainty surrounding the May elections complicates the progression, the BoE view on consumer prices and wage inflation supports our view.
It is interesting to look at the progression of wages in the UK. In the last six months of 2014, average weekly wage growth rose around 1 percent. At the same time inflation fell from 1.9% to 0.5%. Taking real wage growth from -1.2% to +1% in six months. Real wage growth is back at the level it was before the global financial crisis and, if this dynamic continues to progress as the BoE expects, then the impact and implications for the consumer, for GDP and for GBP are significant. We retain our positive view on the UK and GBP.
"Patience taken too far is cowardice” Holbrook Jackson
In the US, following a theme which we have noted a number of times over recent months, the minutes portrayed a more dovish tone than the policy statement. Essentially, the key issue for US policymakers is, as it is for UK policymakers, a function of the fact that signs of better (medium term) growth are offset (in the short term) by weakness in inflation and geopolitical uncertainty.
The Fed minutes stated clearly that many Fed officials judge that risks, ranging from a stronger USD to the crisis in Greece, had inclined them towards keeping rates near zero for "a longer time”. This outlines the fact that there are differences of opinion, as you would wish and expect at such an important decision making policy meeting. However, we continue to expect that economic momentum in the US, driven by job gains (and likely increasingly wage gains), is strong enough to maintain the positive economic progress and thus to maintain the removal of what is, in our view, an increasingly unsustainable level of monetary accommodation.
Ultimately, while there are some cautious views on the Fed, we continue to anticipate a majority that is hawkish enough to warrant a removal of the "patience” language in March and a small, yet very significant rate rise in June.
For the rest of the week, the focus will remain on the headlines surrounding the Greek negotiations and the situation in Ukraine. The submission of a letter requesting a six month extension of the bailout from the Greek government suggests progress. The fact that Eurogroup president Jeroen Dijsselbloem has called a meeting of Eurozone finance ministers for Friday afternoon concurs with that sentiment and suggests that some ‘can kicking’ near term solution to Greece’s immediate liquidity requirements will be found.
The USD may be modestly on the back foot, following the more dovish tone to the Fed minutes and the resultant lower US rate expectations and yield curve. However, the jubilation over a deal for Greece is likely to be short lived and, following the very short term uncertainty, we expect USD strength to reassert itself.
"Rules are not necessarily sacred, principles are” Franklin D. Roosevelt
In 1823, during a football match at Rugby School, William Webb Ellis caught the ball (which was allowed at the time) and ran with it (which wasn’t). Accounts of the subsequent events are unclear. However, it is likely that the other players who had adhered to the rules of the game for which they had signed up, offered Ellis the option to play by the rules or go and play his own game.
In Greece, the invention of sport and athletic competition is part of their history and heritage. However, at this current juncture, finance minister Varoufakis finds himself running (ball in hand) while the rest of the EU finance ministers (particularly those who have endured the pain of adherence to the rules of the eurozone) protest.
The stand-off is clear. The Greek government were elected on the basis of renegotiating the bailout and reversing (at least some) of the austerity, while at the same time remaining within the Eurozone and the EUR. The rest of the region, having enforced austerity on the programme countries (as well as some non-programme countries - all of whom may feel a little aggrieved about easing the terms for Greece) cannot afford to set a precedent for breaking the rules. Nor can they allow allow concessions that, if applied to the others, would undoubtedly push the region’s finances to breaking point (politically at least).
"There is no passion so contagious as that of fear” Michel de Montaigne
The rise of Podemos in Spain is a case in point. Any leniency towards the austerity, or debt burden in Greece, will surely be followed by a populist vote for Spain to follow the same (confrontational) path following their elections at the end of the year.
There is, however, a further consideration and it is a point that we have raised before. Mario Draghi assured the markets that the ECB had in effect ring-fenced the risks under its QE bond buying programme, through the fact that the national central banks will buy and hold (80% of) their own debt. The money these purchases create can flow freely across the region through the Target2 payment system. Currently within Target2, Germany has claims of around EUR 515bn with all five bailout countries as well as six others, including France and Spain having running negative Target2 balances.
Should a nation build up Target2 liabilities and then leave the union, the remaining member states would be left with the bill. These balances are therefore a key barometer of risks building up within the system and the fact that German claims rose to EUR 515bn at the end of January from EUR 461bn in December is a worrying development.
Policy, Politics and Data
All of this points to continued uncertainty, heightened risks and, at some point in the future, a likely fracturing of the Eurozone. While the risks are increasing of a ‘Grexit’, the most likely scenario is still probably that the Eurozone kick the can further down the road and agree some (likely political) compromise. At some point however, as we have stated repeatedly, the road gets too narrow or runs out entirely!
Ultimately the Greek programme runs until the end of February, so political wrangling’s will likely continue to be increasingly dominant for the EUR as we approach that deadline.
In the UK, however, this week is all about the data with the December employment report and (more importantly average earnings data) on Wednesday, along with the minutes from the February BoE meeting, and then public finances and January retail sales in Friday. We continue to favour GBP outperformance and an earlier rate rise than currently priced by the market, both of which likely accelerate after the election in May.
In the US, while policy is all about the data, the USD is all about policy. Wednesday evening brings the minutes from the end of January FOMC meeting. Our view remains that the Fed will maintain their composure and move towards policy normalisation in June and the January minutes will be a key barometer of this progression.
"Spain has the good deflation” Luis De Guindos
Inflation, or more pertinently the lack thereof, has become the dominant driver of financial markets and global central bank policy alike over past months and quarters. It may seem obvious to suggest that central bank policy is being driven by (dis)inflation, when most have a central mandate to target price stability. But, the sharp decline in energy and food price inflation has distorted the base effects to the point where traditional relationships may not be as informative as they once were.
Sweden is an interesting case in point. Yesterday the Swedish Riksbank unexpectedly cut interest rates into negative territory and announced plans for a (small) programme of asset purchases. These measures have been introduced despite growth running at around 2%, and governor Ingves suggesting that the risks to growth are on the topside. This dovish bias and the explicit Riksbank aim to utilise the currency as a transmission mechanism suggests the currency faces significant headwinds.
In the Eurozone, the monetary bias remains dovish and growth (albeit showing tentative signs of turning) remains weak, both should remain headwinds for the currency.
"UK is not experiencing deflation” BoE Quarterly Inflation Report
In the UK, yesterday saw the release of the February Quarterly Inflation Report (QIR) which contained upward revisions to the CPI projections and a more hawkish supporting rhetoric. The central projection at the 2 year horizon was marked higher to 1.96% and symbolically, inflation at the 3 year horizon projected above target at 2.15% amid upward revisions to growth.
"Cannot justify zero interest rates in the current economy” Charles Plosser
In the UK (and the US), growth is strong and the monetary bias is hawkish. We have outlined our view on a number of occasions that for those countries where there is domestic demand, the "one-off level shift” in inflation (as described by Mark Carney) suggests that the risk to medium term growth and inflation outlooks are to the topside. We have also highlighted our view that the markets had become far too dovish on their BoE rate hike expectations. Those expectations have moved closer over recent weeks, acknowledged by Mark Carney yesterday in stating "markets did slightly overshoot on rate expectations”.
Market expectations for the first UK rate hike remain in 2016, however, and we continue to view this as too far away. The QIR stated that the BoE estimate for the current level of slack is around 0.5%. This is significantly below the 1 – 1.5% that was suggested in the middle of last year. If in the past 6 months or so, the BoE estimates that slack in the economy has declined by 0.5% - 1%, and the Bank favours raising interest rates before the slack has been eroded entirely, then it makes little sense for markets to price the first rate hike in around a years’ time.
The uncertainty surrounding the UK general elections are a headwind for GBP between now and May. However, provided there is a clear government with a clear plan, then we would anticipate that UK growth, inflation and even a rate hike will come sooner than the markets expect, in 2015. GBP may well be a key beneficiary.
"Economy will do better than recently forecast” ECB, Vitor Constancio
In the near term the combination of lower prices (at least in regions where there is any domestic demand) and the boost to stability and confidence from ECB QE (progress in repairing bank lending channels remains to be seen), mean that a bounce in eurozone activity is likely. German economic growth in Q4 highlighted that it is not all bad news in the Eurozone with stronger than expected GDP growth of +0.7% q/q, driven by strength in consumer activity and business spending, driving the Dax above 11,000 for the first time.
In fact as we go into a weekend where there are some signs that Germany and Greece are closer to common ground on bail out negotiations and the world looks to Russia and Mr Putin to uphold their end of the Minsk accord, the bias for risk assets, equities and even the EUR may well be to the upside in the very short term.
However, as the Lithuanian President, Dalia Grybauskaite, very aptly put it "Greece is not the last problem” for the Eurozone!