ECU's Investment Blog
"Dissent is the highest form of patriotism” - Howard Zinn
On Tuesday we highlighted our increased conviction that the US economic momentum is stronger than the general consensus and clearly stronger than what we view as the ‘noisy’ (to paraphrase Janet Yellens comments in relation to Inflation) Q1 GDP decline in stating that "We would anticipate a strong rebound in US economic activity in Q2, potentially above 4% on an annualised basis, and following the recent run of stronger US data … the statement may be more hawkish than expectations.”
Yesterday, the release of the Q2 GDP data not only confirmed our views that the underlying US economic momentum is stronger than consensus, but also highlighted that (on the Fed’s preferred measure of pricing pressure in the economy, core PCE) inflation was at the target level of 2% in Q2 (From just 1.2% in Q1). In addition to growth and inflation, the private sector employment report for July (ADP), continued to point to US payroll growth consistent with further declines in the unemployment rate.
Laying these factors out in simplified terms, the US is now running at an annualised growth rate of 4% (admittedly flattered by the ‘rebound’ from a weak Q1), inflation is running ‘at target’ at the same time that employment gains are bringing the unemployment rate down at a significantly faster than expected pace, yet the FOMC are still conducting further monetary easing in the form of asset purchases under QE. Cue the July FOMC meeting!
"Ireland’s front row need to spread out… in a bunch” - Keith Wood
In many respects, the emphasis of last night’s the Fed statement was to try and be both upbeat and dovish at the same time. The improvement in the assessment of economic outlook is clear, and the statement that "the odds of persistent sub 2% inflation diminished somewhat” adds further to the hawkish case. On the dovish side the reference to "significant underutilisation of labor resources” and that the Fed see "rates staying low for a considerable time after QE ends” highlights the Fed’s stance of being purposefully behind the curve. It was the latter statement in reference to the ‘considerable time’ that drew a dissenting voice from Charles Plosser.
"…that germinates the seed of dissent” - Slayer, Implode
We have stated before that the Fed are treading a potentially very dangerous line in (purposefully) remaining so far behind the curve. The dissent from Plosser, while of little or no significance to the July meeting, is likely to become increasingly significant. Continued employment growth amid the (likely smoother) recovery going forward will increasing put pressure on wages and the Fed. We continue to view the first rate hike in the US as coming sooner than the market consensus, likely in Q1 2015.
Over recent sessions some of the shine appears to have come off GBP in FX markets but here perhaps the theme of dissent is more imminent. Overnight, BoE deputy governor Ben Broadbent, suggested that Q3 growth forecasts may be” revised up” and that "some increase in wages is likely”. In stating that he sees "the case for raising rates earlier” and that "the first rate increase should not be a massive shock”, he highlights the growing hawkish bias of the MPC, one which we now feel may bring a hawkish dissent as soon as next week’s meeting. We will find out when the minutes are published on the 20th August.
As dissent grows on both sides of the Atlantic we continue to view the USD and GBP as being well supported and while the outright direction of their direct relationship (GBPUSD) is more complicated, both are likely to extend broad gains against the wider currency universe.
"Half the lies they tell about me aren’t true” - Yogi Berra
In the Eurozone, the inflation data this morning highlights the continued need for monetary accommodation in Europe. Headline inflation disappointed expectations at just 0.4% and, while the core rate sits at 0.8% y/y, if it is viewed at constant tax rates, core inflation is just 0.25%. Hawkish dissent within the ECB governing council remains a long way off.
Putin pressure on German exports?
In fact as the EU signs off further sanctions against Russia it is interesting to note the implications on European trade as a result of the geopolitical tensions. Yesterday the Committee on Eastern European Relations in Berlin quantified the impact on German exports in the 5 months to May, where exports to Ukraine were down 32% from the same period of 2013 and exports to Russia down 15% (valued at around EUR 2.2B). Further, German machine makers group VDMA said this morning, "The business risks and the accompanying uncertainty for investors has significantly increased in recent months. The conflict with Russia is affecting not just bilateral trade but is generally impairing demand in important export markets for our industry." This drop in exports will only get worse over coming months as the sanctions restrict trade further and accelerate this negative trend.
While the US and UK progress towards monetary normalisation amid economic recovery, Eurozone growth continues to struggle, further monetary accommodation may well be needed and as a result of this divergence the EUR likely remains very much on the back foot.
"Feel the sterling Crumble”? - 10cc, ‘Wall Street Shuffle’
In September 2013, we published an in-depth research note entitled "The Case for Sterling” in which we highlighted a number of technical and fundamental reasons why we believed GBP would outperform from what we considered to be substantially undervalued levels. In many respects, therefore, it is interesting to pick up the Sunday papers this week and see so many headlines in which UK based multinationals (or significant exporters) are putting disappointing earnings results, predominantly down to the unexpected strength of GBP over the past year. Ironicall,y the opposite did not appear to be the case when GBP fell 25%-50% from its peaks in 2007/2008!
This basic concept is also of particular importance to the broader UK investment sector, where during the crisis years (where there was a consistent and substantial decline in the value of GBP) the value of foreign investments (which have become a very significant proportion of most diversified investment portfolios), was inflated by the decline in the value of the pound.
The Case for Sterling argued that as GBP recovers, the necessity to manage foreign exchange exposures rises sharply and simultaneously. We argued further that GBP appreciation should be viewed across a broad spectrum of currencies and, although it has been GBPUSD that has made all the headlines, we continue to view The Case for Sterling as relevant in the broader currency universe going forward.
"Apathy their stepping stone” - Metallica, ‘…and justice for all’
Over recent years, and perhaps increasingly of late, there has been another factor to add to the multivariate, multidimensional conundrum of foreign exchange markets: that of reduced participation and / or market apathy. In part, this has been induced by the increased regulatory focus and uncertainty, as well as the economic uncertainties and valuation disjoints that have come from global zero interest rate policy (ZIRP) and quantitative easing (QE). It is likely that an increased regulatory burden across all financial markets is here to stay, although over time we expect regulatory uncertainty to decline. From a monetary policy perspective, however, we are at a critical juncture. A juncture that may be defined more clearly as a turning point after the events of this week.
"The final Countdown” - Europe
Yesterday the Fed released foreign exchange volume survey data on its website for the month April where it stated that spot transaction volumes fell 32% from a year earlier. After a quiet open to the week, the data and events to come over the remainder of the week are very significant. The US is the core focus with Q2 GDP, FOMC (no press conference), July employment report, manufacturing ISM and personal income and expenditure data. If we are right in our view that this week offers something of a watershed, the theme of apathy and lower volumes could well be about to change. Many commentators are suggesting that the slew of US data this week will have little impact or add little impetus to the market. We disagree!
We have discussed recently how we are much more bullish than consensus on the underlying momentum of the US economy. Indeed, we have also expressed our doubts as to the ‘information value’ of the sharp contraction in official Q1 GDP print in a period where sharp employment gains, steady and rising tax receipts, and consistent, strong expansion in both manufacturing and service sector survey data. Our view is that the risks are significantly skewed to the upside for the USD, and for FX market activity in general.
"Clenching the fists of dissent” - Machine Head
We would anticipate a strong rebound in US economic activity in Q2, potentially above 4% on an annualised basis, and following the recent run of stronger US data (perhaps with the exclusion of some housing indices), as well as the growing hawkishness of some Fed voting members (most obviously from Richard W Fisher), the statement may be more hawkish than expectations.
"Built on shifting sands” Paul Weller, ‘Changingman’
In the Eurozone this week, we get the July inflation release, which is expected to remain unchanged at just 0.5% y/y, and, on Friday, the manufacturing data. While the EUR has declined broadly since Draghi mentioned ‘further measures’ at the end of the May press conference, the balance of risks as we see them are increasingly to the downside. If the US data continues to show improvement, as we expect, then the economic and monetary divergence between the US and the Eurozone will become more acute and visible. Last week, IMF head Christine Lagarde stated that "markets are too upbeat about Europe’s recovery”, and around the same time the Bundesbank suggested that German growth stagnated in Q2. Yet despite this (and with their unemployment rate above 25%), Spanish 10 year yields traded at their all-time low yield yesterday.
In Japan, uncertainty over the impact of Abenomics (amid a rise in the consumption tax just as incomes are being eroded by rising prices) was brought back into focus overnight, as the unemployment rate rose unexpectedly to 3.7% from 3.5% and June retail sales disappointed expectations. Further stimulus, if the BoJ deem it necessary, is unlikely to come this year. In the meantime, as the geopolitical backdrop appears far worse than those risks priced into the market, the complexity of USDJPY remains high.
"It’s something unpredictable, but in the end is right” - Green Day, ‘Good Riddance’
After a long period of relative inactivity in foreign exchange markets, the next few days are potentially game changing, for the USD, for market activity and for volatility.
"I cannot afford to waste my time making money" - Louis Agassiz
UK monetary policy and thus, by definition, economic progress came under the microscope yesterday with the release of the Minutes of the Bank of England’s July meeting. While some were perhaps looking for an explicit ‘hawkish’ dissent from among the MPC members, the reality (to maintain the microscope analogy) was that the data, and the interactions by which that data evolves, require a ‘closer look’.
Overall, the minutes were broadly as we and the majority of the market were expecting, culminating in a unanimous vote to maintain interest rates and the stock of asset purchases at current levels. On the hawkish side they suggested that "the risk of a rate hike derailing the recovery had receded”, although they acknowledged that an early rate hike may increase the "economy’s vulnerability to shocks.” (similar sentiment to Fed Chair Yellen last week.)
"Victory must be assured in advance.” - Evan Thomas
While cautioning that there were tentative signs (though not as clear as was the case at the May Inflation Report) that there may be a modest output slowdown in H2, the Bank was clear to state that "economic momentum is looking more assured.”
There were also encouraging signs in the suggestion that revisions to the Q1 GDP data highlighted that growth in Q1 was driven, to a greater extent, by investment and exports. This is expected to continue into the Q2 data (the initial estimate of which will be released on Friday). With growth in bank lending to non-financial corporations having turned positive in May for the first time in 5 years, there was further indication of a broadening of the improvement.
"One man’s wage increase is another man’s price increase” - Harold Wilson
So, why the need for a closer look? Behind all the positive progression and economic momentum, one thing continues to disappoint – wages! The Bank infers in the minutes that they will further explore their evaluation of the lack of wage growth in the recovery and that the findings will likely feature in the August Inflation Report. Effectively there are two sides to the argument:
On the one hand, there is the view that with the recovery becoming more established and sustained that the key variable for determining the necessity for a rate hike is estimating the rate at which the economic slack in the economy is being used up. The faster we are closing the output gap (or removing the slack) or reaching the equilibrium level of unemployment, the earlier a rate hike will be needed.
On the other hand, there is the concern that the lack of wage growth is a result of a structural change in the relationship between the labour market and inflation. This would likely suggest a later date for the initiation of monetary normalisation.
Keep Calm and Carry On!
Base effects from the timing of last year’s bonus payments (as a function of a change in the higher rate of tax) add to the complexity of the evaluation. Ultimately, however, the August Inflation Report is key and, barring a U-turn in the view of interaction between labour markets and inflation, we maintain our view that the tightening cycle in the UK begins in Q4 2014 and that the continuing strength and breadth of the UK economic recovery continues to erode the slack and support GBP.
Unjustified and unsustainable
Elsewhere overnight, the Reserve Bank of New Zealand (RBNZ) raised rates a further 25bps to 3.50% as expected, however the accompanying statement was very purposeful verbal intervention over the strength of the NZD. The RBNZ stated that while the tightening bias remained, there would be a period of assessment, which may have disappointed some rate hawks, however, the statements that the "currency level is unjustified and unsustainable” and that they see "potential for a significant fall in the currency”, need no interpretation. In this respect and while in the bigger picture we view NZD as significantly overvalued, in the very near term its attractive yield may (at least) slow any decline.
Elsewhere, HSBC Chinese manufacturing PMI rose to an 18 month high of 52 in July from 50.7 in June, highlighting an acceleration of manufacturing growth which likely impacted the German (and Eurozone flash) equivalent, also up on the month. Ultimately, with the global macroeconomic backdrop broadly positive, yet with concerns over wage growth and or inflation damping rate hike expectations, the near term backdrop remains conducive for further asset price gains and a continued search for yield.
"One person’s data is another person’s noise” K C Cole
We argued last week that the relative (growing) economic differentiation between the US and Eurozone would likely translate into widening (perhaps sharply) monetary policy divergence over coming months. As the geopolitical implications of the Ukraine and perhaps more pertinently the impact and implications of Russian support or involvement continues to ruminate, rising sanctions will increasingly impact not just Russian growth prospects in the near term, but also those of European, and more importantly Germany. This could add significantly to this divergence.
"People who make no noise are dangerous” Jean de la Fontaine
So far this year the ‘anticipated’ decline in the EUR has frustrated a large proportion of the market with its absence, despite the region’s considerable woes. One of the factors that has kept the EUR supported is the balance of payments bias of the Eurozone. Friday’s Eurozone current account data continue to show a significant flow of money into European bond and equity markets (adding to the inflow of cash from the current account surplus). However, we anticipate the importance of the current account flows on the valuation of the EUR will decline over coming months as the global macroeconomic and geopolitical backdrop changes.
The Eurozone current account surplus is also based on extreme levels if unemployment (and the negative demand bias that this generates), and thus likely to decline or reverse as the economy recovers. Also, in the near term, the weak inflation trajectory and the significant likelihood that Eurozone monetary policy could become significantly looser (with the introduction of QE) is likely to weigh increasingly on the EUR.
In the US, the risks to wage inflation, interest rates and the USD are in our view all undervalued at current levels and will all likely rise faster than the markets currently expect. US 10 year rates below 2.50% are not just a function of the risk aversion of the global geopolitical backdrop, but also of the ingrained (misplaced?) confidence that US, and arguably global, monetary policy will remain ‘super easy’. Our core view remains that the US economic momentum is currently (and sharply) underestimated by the data (particularly the Q1 GDP release). In this regard, the US Q2 GDP release a week on Friday, and the July employment report the following Friday, are very important.
"The worst wheel of the cart makes the most noise” Benjamin Franklin
In the press conference following the last FOMC meeting, Fed chair Yellen dismissed last month’s 2.1% annual rate of inflation as "noise”. Higher oil prices for the month should be supportive of a sustained headline rate above the Fed’s 2.0% target this afternoon, and in turn supportive for the USD. Further, as 2 year EURUSD forward points make new cyclical highs, their level continues to argue in favour of a lower EURUSD. Technically a close below 1.3476 and the 200 week moving average at 1.3425 would also be very significant.
"Go placidly amid the noise and haste” Max Ehrman
In the UK, the Bank of England minutes tomorrow will be keenly watched and while we maintain our view of a rate hike in Q4, those looking for one or more dissenting votes from the July meeting may well be disappointed. The shift in the geopolitical backdrop has increased the bias to hold USD (safe haven) and while we continue to favour GBP in FX markets our bias towards EURGBP shorts as opposed to GBPUSD longs has been strengthened by recent events. GBP will likely continue to be a central focus as the week progresses with retail sales data for June on Thursday and the first estimate for Q2 GDP (likely to highlight the economic divergence between UK and Eurozone further) on Friday.
Elsewhere, tomorrow will likely see another 25bp hike from the RBNZ taking the cash rate to 3.50% and in those nations at the other end of the monetary policy scale (Eurozone and Japan) Japanese inflation data and Eurozone PMI data will be keenly watched on Thursday.
On Tuesday, we suggested that the risk of a hawkish surprise from the Fed is rising and, while the semi-annual ‘Humphrey Hawkins’ testimony of the Fed governor could not be categorised as hawkish, it wasn’t dovish either. In fact we view the subtle optimism that Yellen expressed in the statement as the start of the Fed transition to monetary normalisation.
There are some areas of the economy where concerns remain, not least the slower than expected momentum of the housing market. The fact that the recent moderation in housing momentum coincided with rising long term rates will only strengthen the Fed’s ‘forward guidance’ in relation to a lower equilibrium interest rate. However, the statement that the Q2 growth rebound "bears watching closely”, only reinforces our view that the GDP print is key to the progression of rates and the USD. While the revisions played a significant role in the Q1 data, our expectations remain that the ‘rebound’ generates a 4% annualised rate of growth in Q2.
"Only in our dreams are we free, the rest of the time we need wages” - Terry Pratchett
Yesterday’s UK employment report was again very strong, and, in all but the ‘last piece’ of the puzzle, wage growth (which continues to disappoint at just 0.3%, driven by sharply lower bonus payments), the path to normalisation is becoming increasingly clear.
The detail of the employment report is perhaps more encouraging, where most of the gains in employment in the last quarter (254k), were in the ‘full time employee’ category (216K). Added to this the rise in average working time also rose alongside continued a significant rise in vacancies, providing a backdrop of more jobs and more people working longer hours. Further, the single month ILO unemployment rate for June fell to just 6.2%, from 6.4% in May which suggest further significant unemployment declines (reduced slack) over coming months.
As bonuses continue to fall, perhaps unsurprisingly, most significantly in finance and business services (-19.6% in the 3m to June compared to the same three months last year), wage inflation remains absent. Base effects suggest that wage growth is unlikely to bounce next month, but beyond July we anticipate that wages will start to rise.
Those market participants who have recently began to raise the case for an August rate hike from the BoE will be disappointed by the continuing lack of wage price pressure. However, we maintain our (now very) long held view that the rate normalisation process will begin in Q4 in the UK. In relation to wages we would echo the sentiment of Fed Governor Charles Plosser, who commented on Friday that "wage growth is a lagging indicator of inflation, not leading”, particularly in light of the recent bounce back in UK headline (and core) consumer prices.
"Those who don’t know history are destined to repeat it" - Edmund Burke
As we look at the USD, and its potential for a significant rise, it may be worth considering the dynamics of GBP prior to and during its recent ascent. On reflection, the core instigator of GBP strength was likely the transition of Bank of England Governor, and the removal of the inclination to verbally depress GBP in order to foster economic rebalancing towards manufacturing and exports. The ambivalent acceptance that as the economy recovered GBP would likely rise, fostered a path of lower inflation, a narrowing of the decline in real wages, and ultimately a consumer led recovery in the first instance. Obviously, the removal of the existential threat of the Eurozone (and the advent of OMT) was also a significant factor, as was the cumulative effect of interest rate cuts and QE.
"The Fed are not behind the curve… They are the curve!” - Fatih Yilmaz
In the US, the situation is perhaps a little more complicated. We have discussed on a number of occasions that we view the US economic momentum as being stronger than the (most significantly Q1) data suggest and we maintain our view that the US will follow the BoE rate rise in Q4 and start tightening (likely ultimately at a slightly faster pace than the UK) in Q1 2015
Yields will continue to play a significant part in the puzzle also. While the 2 year forward points for EURUSD are currently at cyclical highs, 10 year treasury yields, often the key barometer of US prosperity, struggle to maintain much above 2.50%. Herein lays a significant issue. Yellen, in what seems like a deliberate plan to stay as far behind the curve as possible to ensure that the strength of the US (and global) economy can withstand the modest tightening, begets many risks. While we believe that the subtle change in rhetoric from Yellen is the start of the turn to a less dovish (more hawkish?) bias, the turn likely has the turning circle of the QE2, at least as far as the implications for 10 year yields are concerned as she utilises forward guidance to emphasise and re-emphasise the new equilibrium level of rates (2.5?). This uncertainty likely continues even into the onset of the tightening cycle in the US.
USD Higher? Watch This Space
We have argued over recent months that the economic (and ultimately monetary) divergence of the US and UK in relation to the Eurozone is growing and that this divergence should induce a (potentially) sharply lower EUR against (at least) USD and GBP. While US 10 year yields have frustrated the short duration bias of the market, we can envisage a situation over coming months where the USD rises significantly, even if yields continue to frustrate. As Yellen shifts from uber-dove, to data watcher…watch this space!
"Risk of euro area stagnation amid stalled reforms” IMF, Article IV consultation
Last Thursday, an editorial in the City AM by rating agency S&P’s chief sovereign rating officer, Moritz Kraemer, argued that "with the deleveraging process in the Eurozone barely underway, efforts to reduce the persistent debt overhang are likely to stunt growth prospects in the periphery for many years to come” and warned about the threat to (often unpopular) political reforms as a function of economic fragility exacerbating "political polarisation”. Political risk to the EUR is significant and, with elections in many states over the next couple of years, is likely to become increasingly so.
As a result, the recent stabilisation of economic growth, particularly in the (stimulus led) periphery has brought with it increasing political pressure for governments to take their foot off the austerity and structural reform brakes. Indeed, Monsieur Hollande added to the complexity of the debate by suggesting that there is only growth in countries that have received a bailout, whereas the French recovery is "too weak", as he called for "margin not to do just austerity”. Unfortunately, this sums up the Eurozone in many respects.
"Economic, monetary union still an incomplete structure” - Mario Draghi
Following the financial crisis, US and UK corporates were much quicker to deleverage and thus today we are seeing signs of a pick-up in business investment in the US and UK, while Hollande grumbles that French "company margins are too thin for investment”, as the debt burden drags. In the Eurozone there has been a blanket failure to implement pre-agreed reforms, let alone the progressive ‘growth-enhancing’ structural reforms that are ultimately needed.
On a positive note in Europe, the EU nations gave their formal sign off to the legislation that creates a Single Resolution Mechanism (SRM), a single system for the containment, protection and resolution of failing banks within the EU. Legislation will begin to take effect next year; however, the ‘common fund’ will take 8 years to build up!
"Fed likely to raise rates sooner than investors expect” - Bullard
While the progress of the US transition to normalisation in monetary policy has been painfully slow, we continue to believe that the underlying strength in the US economy is significantly higher than the data (particularly, but not exclusively, Q1 GDP) suggest. As we move further into Q2, we believe that the risk of a hawkish surprise from the Fed is rising.
Many Fed speakers have warned of the reach for yield and investor complacency. This is likely mirrored in expectations from Fed watchers with the overwhelming majority expecting the Fed to maintain its ultra-dovishness for a long time to come. While this week’s testimony to Senate and House panels is likely still a touch early, we are increasingly attentive to the possibility that Yellen does not live up to her uber-dove moniker, particularly (as we have discussed previously) if our expectations are met with a 4%+ Q2 GDP print later this month. We believe the risks are becoming increasingly skewed in favour of the USD.
In the UK, the last few sessions have seen a sharp rise in those questioning the rationality of continued GBP strength. This morning’s much stronger than expected CPI data has revived those expectations somewhat and, ahead of tomorrow’s (likely strong) UK employment report, November rate hike expectations and GBP strength have been given a boost. One caveat to this view, however, is that as we see increasing risks of a sustained period of USD strength on the horizon, EURGBP likely remains the most efficient medium for the expression of this view.
All roads lead to Yellen!
Elsewhere, the Reserve Bank of Australia July meeting minutes maintained their dovish bias, suggesting that demand is likely to remain weak over coming years and that the exchange rate, which is "high by historic standards”, offers "less assistance in balancing growth”. Foreign Direct Investment (FDI) and bank lending data from China overnight added to the risk positive backdrop to financial markets that saw the Dow Jones close at a record level in the US.
Until we get a more hawkish sounding Fed, the positive equity (and stubbornly high EUR and AUD) likely continue. All eyes will be on Yellen this evening and while she is expected to maintain her unwavering dovish bias, from our view, the hawks are circling