ECU's Investment Blog
"I have come to the conclusion that politics are too serious a matter to be left to politicians.” – Charles de Gaulle
There is an interesting dichotomy in financial markets at the current juncture. While we maintain the view that the key driver remains that of monetary policy (and, more specifically in the FX market, differentials in the relative trajectory of monetary policy), the drivers of global monetary policy appear to be becoming increasingly divergent.
In the US, there has been a clear transition to "data dependence” with regards to both the timing and trajectory of the monetary normalisation process. We outlined our views clearly last week in stating that, although Yellen had maintained the forward guidance verbiage in the statement, her explanation (or lack thereof) removed its meaning. Therefore, if (as is our central view) you believe that the current momentum in the US economic recovery will be maintained in the short to medium term, then the USD remains cheap relative to expectations and the monetary policy trajectory of other countries.
There is, however, an increasingly significant caveat. The other side of the dichotomy that we allude to above, is the likely (re-) emergence of political and geopolitical risks as a core driver of financial market sentiment and activity.
"Monetary, fiscal stimulus needs structural reforms” - Draghi
In the Eurozone, political risks are becoming more acute as growth falters. Opinion polls (pointing to a lead by the Greek opposition party, Syriza amid rising popularity for alternatives across the region) highlight the austerity fatigue within the region and the growing popularity of political parties that offer an alternative.
Perhaps more pressing, however, is the growing emphasis on national governments within the Eurozone to effect structural reforms. ‘Growth friendly’ consolidations, while at the same time encouraging investment as the emphasis of economic support in the region, is passed from Draghi and the ECB back to the national governments. The suggestion that Draghi enacted rate cuts and ABS in return for national government reform (the Eurozone equivalent of the third of the ‘three arrows’), was played down by Draghi yesterday, but with no central Eurozone government (no political union) any link can only be informal.
The much publicised French deficit target miss is a further political case in point as many French ministers push back against the austerity targets, while the Germans and Italians among others point the finger of discontent back at them. Germany’s Export Federation Head Boerner said last night that the "EU commission must be ‘very severe’ on French deficits”.
Weak growth and persistently low inflation have been the dominant drivers of sentiment towards the EUR of late. From our perspective, however, politics will play an increasing role as we move forward.
In the UK, after the near miss (not so near in the end) of the Scottish Referendum, the sigh of relief for GBP was relatively short lived. The market had pushed back rate hike expectations due the risk premium attached to the referendum. However, with the vote now past, this premium has been largely priced out. However, it is likely (at least in the near term) that the cloud of political turbulence will also hang over GBP. With the leader of the opposition due to give a speech that effectively heralds his election manifesto, increased emphasis on the potential political ramifications and increased scrutiny on the state of the UK public finances may weigh on GBP in the near term – at least until the next round of first tier economic data provide more clarity on interest rates.
In FX, the rising political and geopolitical risks will likely induce a pick-up in volatility and could perhaps undermine (at least in the short term) some established themes. We continue to favour the USD in broad terms; however, the heightened risk backdrop likely suggests a certain degree of selectiveness in this regard. While in the bigger picture we continue to favour further JPY and EUR weakness, the near term may see the battle of the ‘three arrows’ won by the EUR (EURJPY lower). It is also possible that GBP underperforms in the near term – at least until the macroeconomic data can reaffirm the case for maintained recovery momentum, and thus rate hikes.
In the run up to last night’s FOMC, arguably the main event of the week so far, the emphasis of expectation was squarely on whether the Fed maintained their forward guidance. In essence, the forward guidance had been distilled into two words "considerable time”, in relation to the likely period that rates will remain at the zero bound after the (tapering of) asset purchases had finished.
Having left the "considerable time” wording in the statement, the emphasis turned to the press conference where, following the statement, the first two questions to Governor Yellen were: (i) Which of the Dots (economic forecasts for the projected Fed Funds ‘range’ out to 2017 – provided by all 17 Fed members) is your personal expectation? and, (ii) how long is a ‘considerable time’?
"Don’t tell him your name Pike!” - Captain Mainwaring
After evading the first question in an incredibly convoluted manner, she went on to the (acutely important) concept of ‘considerable time’. The extent to which she confused her interpretation / explanation of the concept was very surprising given its importance. Essentially, her inference was that the amount of time that is ultimately deemed as ‘considerable’ will be entirely dependent on the progression of the economic data. Yellen clearly stated that rate rises will occur sooner and more rapidly if economic improvements imply a faster convergence on unemployment and inflation targets. Therefore, a quantitative definition of the "forward” guidance will only be apparent - in "retrospect”!
Earlier in the week, we argued that the current juncture gave the Fed the opportunity to move "towards data dependent (rather than time-dependent) monetary policy without inducing an immediate tightening of expectations”. With Fisher joining Plosser in dissenting from the forward guidance, its credibility is further tarnished. In essence, Yellen left in the words ("considerable time”), but took out their meaning!
Unchanged wording, unchanged view!
However irrelevant they have now become, the forward guidance words likely continue to provide some support to equities (likely the predominant reason that the wording was left in). In FX, in our view it is very simple – if you subscribe to the view that the US economic momentum (at least in the near term) is strong (as we firmly do), then the USD should outperform – at least against those currencies were growth is weak (at least in the near term) such as EUR and JPY, or against those which are most acutely sensitive to rising US yields, such as AUD and NZD.
"Somewhere, something incredible is waiting to be known” Carl Sagan
In the UK, while we wait with baited breath for today’s Scottish Referendum results, it is worth noting yesterday’s stronger than expected employment report and the release of the Bank of England’s September Monetary Policy Committee meeting minutes, which maintained the 7-2 split in favour of unchanged policy.
The minority of the MPC continue to suggest that wage growth may pick up quite sharply, echoing Weale’s sentiment last week that he sees CPI pressure "above the central MPC forecast”. While the wider MPC continues to view inflation as moderating in the near term, it is expected to rise into year end.
Eurozone weakness, it was noted, was the most significant development on the month. However, the minutes suggest that while the implications of the recent bout of eurozone weakness would likely have only a modest impact on the UK, a more prolonged period of poor growth and very low inflation could have a larger impact. "As a result, downside risks to UK growth in the medium term had probably increased.”
"Doubt grows with knowledge” - Goethe
On the growth front, the MPC appear to be losing confidence in the longevity of the ‘above trend’ expansion in the UK. The minutes suggest the early signs from business expectations, manufacturing, exports and housing may point to growth easing in the 4th quarter. However, the MPC have pushed back their expectations of UK growth moderation on several occasions over the past year. We reserve judgement on a Q4 slowdown on impending events that are likely to shape UK consumer and business confidence and growth.
Suffice to say that without shocks, a ‘Yes’ vote today being the most obvious, UK economic and monetary outperformance (bar perhaps the US) is likely to continue, albeit perhaps after a short period of ‘hesitation’ brought about by the unexpected closeness of the Scottish Referendum outcome. Thus, ultimately, we retain our broad positive view on the UK, and more specifically GBP.
"Revolutions are something you see only in retrospect” - Alan Greenspan
Finally, as we await the outcome of the Scottish Independence Referendum we spare a moment to reflect on the potential loss of diversity, history and unity in the event of a ‘Yes’ vote. As sad and disappointing as this prospect may be, if it were to occur, the remainder of the UK would have a higher life expectancy, and a lower average rainfall!
"What you’re proposing…” Status Quo
By reading the UK press you would be forgiven for believing that there is only one event this week: the Scottish Referendum. A ‘Yes vote’ will induce enormous political, historical and economic ramifications. The uncertainty over debt, energy, monetary policy and business investment will significantly dent sentiment towards the UK, confidence (business and consumer), and likely lead to significant weakness in GBP, and UK equity markets. It is perhaps little wonder, therefore, that the three main political parties in the UK are falling over themselves to offer Scotland"Whatever you want…” to stay in the union.
These panic measures being promised will no doubt have a considerable political and constitutional impact on the UK now, even in the event of a ‘No’ vote. Whatever the outcome the political wrangling ahead seems likely to be protracted and heated. There is no longer a status quo to be kept.
"Rockin’ all over the world”? Status Quo
With the FOMC meeting (at a current critical juncture for monetary policy in the US), the Swiss National Bank meeting (where further measures to defend the CHF cap are increasingly anticipated – including negative interest rates), and the first of the ECB’s new Targeted LTRO’s (not to mention G20), this week offers perhaps the greatest ‘event risk’ of the year so far.
This morning’s UK inflation data was broadly in line with expectations, as the annual rate softened a touch to 1.5%. Some persistent stickiness in the core was the only marginal positive for GBP and interest rate expectations BUT, with Thursday’s vote taking centre stage, it is likely that the CPI data, and any inference from tomorrow’s employment report and Bank of England minutes, will be widely disregarded until the outcome of the Scottish vote.
"Down, down… deeper and down” Status Quo
The developments in the Eurozone are becoming a little more complicated. It is increasingly apparent that September’s monetary easing from the ECB comes with caveats for fiscal progress and structural reforms. Indeed, comments from the Eurogroup that "Fiscal policy, investment must accompany ECB moves” are further consistent with the view that the ECB (and the Eurozone) are effectively aiming to replicate the ‘Three Arrows’ of the Japanese record economic stimulus (massive monetary and fiscal stimulus, accompanied by structural reform).
"Accident Prone”? Status Quo
In the near term (and again similar to the intention of the BoJ), ECB policy is likely also to encourage a weaker EUR. Draghi’s continued reference to the "Significant differences in policy cycles globally” is testimony to this.
This week’s major event risk for the Eurozone and the EUR (outside of EURGBP, as a function of the Scottish vote) is the first of the long awaited Targeted Long Term Refinancing Operations (TLTRO’s). The maximum possible drawdown of the regions banks over the two offerings (September and December) is EUR 400 billion. On this basis, it is reasonable to suggest that somewhere in the region of EUR 200 billion would be deemed successful, anything closer to EUR 100 billion, more of a disappointment.
This morning’s ZEW report highlighted the continued deterioration in the current situation index (and indeed expectations) within the Eurozone. Against this backdrop, it is hard to see where the boost in demand for lending is going to come from. If anything, the 20bp charge for funds held as excess reserves in the system may make banks more cautious about over-borrowing – making Thursday’s TLTRO announcements significant. (One key area of analysis will be whether the French and German banks take up their allowance and also how the Italian and Spanish banks will replace their LTRO borrowings that are significantly above the proposed new lower maximum under the TLTRO arrangements).
Next month in the Eurozone, we will get (at least) further information and possibly the first purchases under the ECB’s Asset Backed Securities ABS programme. ABS is designed in some respects to remove the significant dependence the Eurozone economy has on bank lending, by improving access and efficacy of access to capital through capital markets (the dominant form of financing in the US).
"Beginning of the end” Status Quo
In the US, the main focus is on the FOMC, as the last of the asset purchases comes within reach. The emphasis of expectation is skewed towards the words and not actions of the FOMC statement. Will the statement omit the "extended period” and "for some time” language? Will the forward guidance take a new form (or be removed altogether)?
The latest (weaker than expected) employment report from the US may offer Yellen a window of opportunity to move towards data dependent (rather than time dependent) monetary policy, without inducing an immediate tightening of expectations by playing down the ‘rebound’ in Q2 GDP and playing up the still below target inflation. From our perspective, however, this maintains the positive bias towards the USD against a group of major currencies that all have seemingly worse concerns ahead.
"In my chair” Status Quo
With the Scottish vote (GBP), Three arrows (JPY and EUR?), the possibility of negative rates (CHF?), overvaluation and a political desire to devalue (AUD, NZD and CAD?) all weighing on major currencies, it may well take a lot to knock the USD off its perch in FX.
"I would walk 500 miles…”
In the UK, the Scottish referendum continues to drive a higher baseline volatility level in GBP as political risk remains acute. The release last night of a Survation poll suggesting a lead for the ‘No’ campaign (while also showing continued positive momentum for the ‘Yes’ vote), drove GBP higher but focus now returns to the new polls over the weekend, particularly after the RBS, Lloyds and Standard Life stated their intentions to move their headquarters south of the border in the event of independence. We still view a ‘No’ vote as the most likely outcome but nervousness looks set to remain in the near term.
"just to be the man …” who said it’s not about the effing Tories!
Beyond the dominance of the political uncertainty, the macroeconomic backdrop remains positive in the UK. Yesterday’s testimony from Carney et al. to the Treasury Select Committee brought a number of positive intimations. While (arguably the most dovish member of the MPC) David Miles stated that there is "no immediate urgency to start normalising BoE policy”, Carney maintained that "the point where rates need to rise has moved closer”. Further, MPC members Weale and Shafik revealed bullish expectations about the path of productivity and wage growth in the months ahead, with Weale stating that he sees "higher UK CPI pressure than the BoE central forecast”.
From our view of the global macroeconomic backdrop, GBP remains in a strong position (boosted by the sharp correction vs. USD over recent weeks / months) and while the political uncertainty likely outweighs economic prosperity (amid higher volatility) in the near term, the case for GBP remains strong in the medium term.
"A letter from America”?
While the case for GBP may be temporarily on hold at the current juncture, the case for USD remains. Early next week we will go into further detail about our expectations for the FOMC meeting on the 17th, where pre-emptive focus has already returned to the possibility of the removal of the "extended period” wording in the statement (in relation to rates being on hold, post the end of asset purchases in the US).
Despite the disappointing employment report last week, US rates and the USD have remained firm. In fact, we maintain the view that the August payroll data was anomalous to the current employment trend and will likely be revised higher (or be countered by a strong bounce in Sep). This week, however, the data calendar has been light and thus sentiment has been a key driver in FX. Nonetheless, the stable political backdrop in the US, and its (relative) bullish economic progress continue to favour USD in FX.
"…the man who’s [not] havering to you”
Slightly further afield, the Reserve Bank of New Zealand held rates steady overnight at 3.50%, as expected, and maintained their strong verbal intervention in the NZD clearly stating their view that "NZ dollar level is unjustified and unsustainable” and that they "expect a further significant drop in NZ dollar”.
In Australia, the release of the August employment report sparked some volatility overnight as the headline unemployment rate fell sharply and unexpectedly to 6.1%, from 6.4% in July. However, the breakdown of the data suggests a huge surge in part time workers, perhaps even re-joining the workforce in order to take such work (indicated by the rising participation rate). Recent rhetoric from RBA that it will be "some time before the unemployment rate drops consistently” amid sharply declining resource sector spending, suggest continued economic uncertainty in the near term.
We concur with the assessments of the RBA and RBNZ that the AUD and NZD are overvalued, and in conjunction with our expectations that the US economic strength and normalisation process are ahead of consensus expectations, we would also agree with the RBNZ and expect a "further significant drop” in the AUD and NZD.
"I’ll pass almost every penny on to you”
The data calendar remains fairly light for the rest of the week with weekly jobless claims and retail sales in the US the main highlights. This is very much the calm before the storm however as next week brings the Scottish referendum vote count and the FOMC meeting. The week also brings the result of the first Targeted Long-Term Refinancing Operation (TLTRO) from the ECB.
"One should always play fairly when one has the winning cards” - Oscar Wilde
Over recent weeks, we have witnessed a sharp rise in short term US interest rates, an aggressive rate cut and Asset Backed Securities (ABS) purchase programme from the ECB and rising political uncertainty in the UK. More significantly, coming after a protracted period of uniform zero interest rate policy across much of the developed world, this economic, monetary and political divergence is bringing life back into foreign exchange market activity. All of this, we feel, will generate sizeable opportunities, not just for the directional moves for specific currency pairs, but also for FX as an asset class.
It’s NOT the economy stupid!
In the UK, the macroeconomic backdrop continues to show signs of improvement. Data from the Manpower global survey for Q4 suggest that hiring in London is rising at its fastest pace since before the crisis and that pay is rising as demand for staff in key sectors suggest that London could well be leading the UK out of the recent period of wage stagnation. August retail sales data from KPMG and the British Retail Consortium (BRC) highlighted renewed growth, as sales rose at their fastest pace since January. However, the current concerns over the UK (and GBP) are clearly a function of political uncertainty, not economic prosperity.
"right about now I’m 50/50” - Lemar
Following the Sunday Times poll that put the Scottish ‘Yes’ camp in the lead, another poll overnight showed the ‘Yes’ and ‘No’ camps neck and neck. With the referendum fast approaching (18th September), this uncertainty is unlikely to dissipate until after the vote.
In the near term, we believe the economic and political risks and uncertainties associated with a vote to break the union can outweigh the core fundamental and technical positives for GBP. Such a vote would bring significant uncertainties surrounding UK monetary policy, inward investment and consumer confidence, as the outcome clearly affects the debt and fiscal backdrop for the remainder of the UK. Indeed, companies that straddle the border create a risk to the sustainability of the business investment cycle that is increasingly important to the UK recovery. For now we sit on the side lines in relation to GBP.
Joining the dots?
In FX, the theme of USD outperformance continues and in the near term we see little to derail the recent trend. We have mentioned on several occasions of late that we disagree with the inference that extended net short EUR positioning in futures markets implies an extended and saturated net speculative short position in FX – price action continues to support this view.
While in the UK, the Scottish uncertainty has damped interest rate expectations, in the US, the rate outlook is becoming increasingly hawkish. At their June meeting, the FOMC published the Summary of Economic Projections (SEP’s) or the ‘Dots’. Interestingly, despite the economic outperformance since that point, and even the recent hawkish bias to the US rate curve, the current market implied interest rate curve is still significantly below that of the FOMC median expectations (particularly further out the curve). Next week we get the new projections from the FOMC, the new ‘dots’.
Last week’s US employment report for August disappointed expectations, however, we strongly believe that this was anomalous (it does not fit with broad survey data over the period which showed further improvements in employment metrics) and that it will be revised higher over time (or at least form the basis for a strong rebound in September). In fact, we feel that the US economic data will continue to show steady improvement over coming months. Yellen has told us that better US economic data will bring forward the timing of monetary normalisation and on that basis we continue to favour improvements in the US data, higher short (and medium) term US interest rates and a higher USD.
The data calendar this week remains fairly light and as such markets will be more susceptible to changes in sentiment. Indeed, sentiment is likely to continue to weigh on GBP as the Scottish referendum approaches. Equally we would anticipate EUR sentiment to remain negative after the surprisingly aggressive easing from the ECB last week, amid warnings from ECB’s Ewald Nowotny last night that this is not likely enough, saying "expansive monetary policy is needed, but is not sufficient for growth.”
As sentiment towards the JPY also deteriorates amid growing perception that further stimulus from the BoJ is likely later in the year, there is likely one winner in the developed FX market at the current juncture… the USD.
"My personal philosophy is not to undertake a project unless it is manifestly important and nearly impossible.” Edwin Land
It is not often that we witness a leading global Central Bank introducing new measures before the old ones have been implemented. Yesterday, that is exactly what we got from the ECB as they cut interest rates by 10 basis points (taking the benchmark rate to 0.05% and, perhaps most significantly, the deposit rate to -0.20%)almost certainly in order to encourage take up in the (previously announced) TLTRO’s later this month. In addition to the rate cuts the ECB announced an ABS purchase programme, the details of which will be announced at the October ECB press conference, as Q2 economic data signal a "loss of growth momentum” combined with the view that "downside inflation risks are increasing”.
… divided we fall?
The Governing Council did not unanimously back the new measures and it is likely that Weidmann dissented against both the interest rate cut and the ABS programme. However, in our view it is also likely that there was some kind of ‘understanding’ between Draghi and Messrs Hollande and Renzi that further monetary and credit easing from the ECB must be accompanied by structural reforms which Draghi stated were "important for stimulus efficacy”.
It’s the Currency Stupid!
Ultimately, however, it is not the impact of (almost) free loans, to provide lending and liquidity to the broader economy, that will boost aggregate demand and break the drag of ‘lowflation’ in the Eurozone; nor is it evenlower rates, that may well boost the take up of the TLTRO’s later this month, in order to facilitate this. Indeed, against a backdrop of high unemployment, weak global exports and weak domestic demand, we would doubt if the implementation of full blown asset purchases (QE) would have a dramatic effect either. However, a lower currency will. It will likely have a bigger impact on the prevention of further disinflation (and would likely boost price pressures) than any of the other introduced measures. This, in our view, is the key take-away from the September ECB.
If the measures that the ECB introduced left markets in any doubt that Mario Draghi desires a lower EUR, the press conference and Q&A session must have removed it. Draghi reiterated his comments from the August press conference that the monetary and economic divergence between the Eurozone and the US (and UK) will increase for an extended period. He then compounded this ‘valuation comparative’ by suggesting that the implementation of the ABS programme would substantially increase the size of the ECB balance sheet (reversing the trend of a declining ECB balance sheet, importantly relative to the Fed balance sheet – a theme which contributed to an appreciating EUR through early 2014) relative to the US. The official line from the ECB is that the exchange rate is not a policy target, in that respect Draghi’s inference was as clear as he could have been.
All roads lead to 1.20?
Back in June we highlighted the progression of the EURUSD 2 year forward points, which at the time were around 114bps and suggested that this should extend further (in line with economic and thus monetary divergence between the two regions), thus suggesting a significantly lower EUR vs. USD. This morning, the 2 year forward points are above 220bps, above the previous cyclical high of 212 back in 2012, when EURUSD traded as low as 1.2043.
In further support of the potential magnitude of the EUR decline, ECU Global Macro Team member Kit Juckes said yesterday: "If I plug in plausible Fed / ECB policy paths and even if I assume that neither the VIX or peripheral spreads widen back out at all, the fair value models point to EURUSD falling below 1.20 over the next 2 years”. The measures introduced yesterday, likely accelerate this.
This afternoon, the markets’ focus of attention will shift back to the US and the August employment report. Expectations are for a 7thconsecutive payroll number above 200 (broadly speaking the level consistent with further unemployment rate declines). In light of yesterday’s ECB action we would consider an asymmetric risk to EURUSD, where stronger data will induce a greater positive reaction than weaker data will induce negative.
In the UK, at least for the next couple of weeks, the impending Scottish referendum brings a negative asymmetric risk to the GBP. GBP has been a core view of ours for a very long time now, most specifically against the EUR. In the medium term, the macroeconomic case for GBP outperformance remains clear. In the near term we have reduced our exposures.