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While there are a number of complex and inter-related factors shaping financial market developments of late, the key driver of recent market volatility has been the possibility that the US Federal Reserve Bond purchases will slow, and the long road towards eventual policy normalisation will begin. Along with this, Bonds have taken centre stage as the barometer of financial market sentiment.

In theory, this US monetary policy development should cause a US-led upward adjustment in bond yields, reflecting relative US outperformance and ultimately a stronger USD. In reality, 2 year euro rates are rising faster (and are higher) than US rates. In some respect, recent positive surprises in eurozone economic data have helped, but as we see it higher yields in the eurozone are neither justified nor sustainable.

"Worried euro crisis has not finished its course”                                - BoE Paul Fisher

EUR has seemingly benefitted from a number of factors. Its status as a reserve currency has meant that currency appreciation in China has generated an increasing demand for EUR to rebalance reserve allocation weightings. Positioning of the markets has also been a factor, as weight of positioning (long of USD), has led to (at times sharp) corrections as volatility has increased. The recent tone of ECB President Draghi, has pointed to an improvement in the economic backdrop in the second half of the year and a broader recovery in 2014. Add this to the lack of bad (economic as well as socio-political) news over recent weeks and a mild EUR appreciation can be understood. However, in relation to the US and the UK, the relative economic strength coupled with the on-going fragilities in the eurozone (albeit not a current focus of late) should warrant EUR underperformance ahead.  

EMplosions

Perhaps most audibly, however, has been the Emerging Market (EM) volatility. China induced commodity weakness has been a major influence here and as global aggregate demand falters, and money that has flooded into EM over recent years starts to question its investment rationale in light of rising US yields, volatility has spiked accordingly. It is yet to be seen whether or not the recent EM sell-off has been driven purely by position squaring or is the start of a more sinister ‘risk-off’ phase for global asset markets and EM in particular. In this regard we reserve judgement at this stage. China growth concerns are likely to linger.   

UK: "Economy in Q2 is looking good”       - BoE Paul Fisher

This morning’s UK data has also helped to underpin the UK’s position of relative economic outperformance, and despite some recent strength against the AUD, we continue to see a broader and more prolonged period of GBP outperformance ahead. We have been strong advocates of the relative strength of the UK economy for some time now and without repeating the arguments in great detail, we feel that the underlying pace of UK activity is higher than the official data projects and indeed that the Q2 GDP data will be closer to 1% quarter on quarter. In part this is due to the base effects of the Q1 growth trajectory, but it is also a function of increasing real world strength, driven by a bounce in private sector activity.

Activity for the rest of the week is expected to be fairly limited on the data front, but retail sales and jobless data will be keenly watched from the US tomorrow. In Asia, where we expect continued heightened volatility, Australian employment data for May, and Japanese portfolio flow data will be of interest.

With real yields in the US now positive for the first time in 18 months the backdrop for the USD should help it to benefit (perhaps disproportionately) from stronger macroeconomic data and overall we expect bonds to remain shaken… even if not (yet) stirred!

"Certainly have observed an increase in global volatility”                               - Mario Draghi

Over the last couple of weeks there has clearly been a step change in the underlying baseline volatility as a result of various factors and developments. On a relatively quiet Monday, perhaps it is worth taking a step back and evaluating these dynamics.

"US Fed should reduce bond buying ‘now’”         - Charles Plosser

Perhaps the greatest influence on financial market volatility has been the US tapering debate. It is clear that there is not an explosive recovery in US (or indeed global growth) but it is also clear that at some stage the US authorities must begin to ‘normalise’ monetary policy. The modestly better-than-expected payroll data on Friday may keep rate rises at bay in the US in the medium term, yet, in light of the weakness in both manufacturing and service sector survey data, the reality of the US employment situation and broad economic recovery as a whole suggests a "slowing of the pace of easing” – not yet tightening as the Fed moves towards monetary policy normalisation. The prospect of such a move has caused US Treasury volatility and arguably global equity market volatility, but from where I stand US (QE) Tapering, and by the end of the year expectations of actual policy tightening, are inevitable.

"Policies are NOT being set for the benefit of markets”  - Japan Cabinet Secretary, Suga

If the concept and implications of Fed Tapering and, more broadly, the ‘normalisation debate’ has been the key basis for rising volatility, then the key medium for the expression of rising volatility has been the Nikkei, and thus by extension, the JPY. Following on from Fed Chairman Bernanke’s testimony at the Joint Economic Committee, towards the end of May, the Nikkei fell by over 20% from the highs (technically into bear market territory), however, the speed and veracity of the adjustment gave rise to broader position squaring across asset and currency markets alike. This volatility was exacerbated by the month end position adjustment flows that appeared large at the end of May.

"OMT has brought stability to markets worldwide”          - Mario Draghi

In many respects the ECB meeting and resultant press conference last week were a non-event. After leaving rates and (perhaps more importantly) the deposit facility rate unchanged in a consensus (not unanimous) vote, the press conference really added few new indications or implications to the debate. Draghi acknowledged that the recent survey evidence had shown some economic improvement from low levels and that the ECB continue to expect a gradual recovery starting from the second half of this year. While he continued to state that downside risks to growth remained, the ECB staff estimates for Growth and inflation were towards at the upper end of market expectations.

Overall the statement and conference was relatively upbeat (in part deflecting from the ingrained economic and socio-political that remain the elephant in the room) and the announcement that Target 2 balances have now been reduced to pre LTRO levels (and that German liabilities have now fallen around EUR 160B from the highs) added to the positive backdrop. The debate on negative rates was maintained in the context of further measures that the ECB are currently discussing {LTRO’s, ABS, Collateral, credit claims…} but it was decided to take no further action at this point.

However, the key foundations for growth still need to be enacted by the national governments not the ECB. Delaying of fiscal deficit targets will only likely delay the pain, not solve the issue. EUR weakness has been a very slow burning concept over recent weeks, yet as the focus of attention turns to strengthening fundamentals, recovery elsewhere, growth remains conspicuously absent across the eurozone.

"A lot more confidence around in recent months”            -Vince Cable

In the UK the change in the situation has been very significant. Falling inflation projections and rising growth prospects have led to a sharp turnaround in sentiment towards the UK (and GBP) of late. For many months now, we have been proclaiming the growing signs of a more stable UK economy with tentative signs of recovery in parts. Indeed, our view that the consumer activity and employment data pointed to a stronger economic backdrop than the official data suggested, has been upheld. The base effects of the Q1 GDP data, lead us to now expect a Q2 print closer to 1.0%. However, we still have until the 25^th July for the first estimate.

Against the recent backdrop of position unwinding it is perhaps interesting to note that the futures data suggests that (at least up until last Tuesday) that the market is (was) close to record short of GBP. From here we continue to see the upside for GBP as stronger macroeconomic fundamentals and position squaring add pressure to the market positioning.

Winners and losers

Recently we have been arguing that there is a potentially very significant flaw in the plan of a large number of economies to focus their growth strategies on exports, despite what is becoming an engrained weakness in global aggregate demand. Chinese data over the weekend was a disappointing example in this regard, suggesting that exports contracted sharply (although there are some technical reasons put forward by way of explanation). Either way we see a great deal more as likely to emerge in the global economic recovery story that will create both volatility and clearer winners and losers on the way.  

Overall we continue to believe that the big winner from the US tapering debate will likely be the USD, closely followed by GBP, while on the flip side, AUD, JPY and EUR will continue to suffer. This week is a touch quieter in terms of high profile economic data and as such we may see a little less emotion and a little more rationality in position taking and the direction of markets. 

"Fed approaching period to consider reducing QE”           - Dennis Lockhart

On Friday I discussed the market’s focus on the future trajectory of US monetary policy and the implications for, among other things, Emerging Markets. This debate took another turn yesterday as the US ISM manufacturing index disappointed expectations and registered a sub 50 (or contractionary) reading. It is here that I think the market focus is a little too binary. As I suggested on Friday and maintain after the data, the debate should not be about the imminent normalisation of US monetary policy, nor is it about the need for higher rates (or not) in the US. As I see it, the debate should focus on whether the Fed reduces the pace of monetary expansion.

In this regard it is worth taking a step back at the development of the global financial crisis and the creative, activist monetary stimulus measures that were borne out of the need for further economic stimulus once the traditional monetary tool of interest rates had hit the effective zero bound. The debate from here therefore should not be whether the US economy is growing at a pace and level of sustainability to reduce the stimulus from the current $85B per month level, but whether the US economy requires continued further stimulus. After all, it is the absolute quantity of the assets that are held by the Fed, driving investment into other assets, that acts as the stimulus, not the pace of accumulation.

While the US manufacturing data was a disappointment yesterday, the manufacturing sector in the US accounts for a mere 12% of the economy, and at this stage I am still happy to see this particular data point as transitory (at least given the bounce in some of the broader economic data from the US since the March lull). In this regard, the US data for the rest of the week will be very significant (Service sector ISM and the May employment report in particular) and I continue to anticipate that the data will be better than expected – helping US markets and the USD.

UK Outperformance?

In the UK the picture is arguably clearer. Following on from the more upbeat data (and sea change in comment and rhetoric in the press) the manufacturing data in the UK surprised to the topside. Most notably, amid a growing trend for major economies to focus their growth efforts on boosting exports (despite the continued fragility of global aggregate demand) it is perhaps more encouraging that the UK manufacturing activity boost came from rising demand in the UK itself. Exports, however, did rise and the ratio of new orders to finished goods hit a 25 month high.

While I continue to maintain a positive view on the UK, and indeed GBP, that is not to say that the UK is without fragilities. This week brings the final meeting of the BoE’s Monetary Policy Committee with Mervyn King at the helm. Any change in policy or bias is unlikely ahead of the changeover at the top of the Bank of England, but the Service sector PMI data is likely the key to the fortunes of the pound on foreign exchange markets this week. I remain firmly in the glass half full camp as far as the UK is concerned. We may not be at the end of the monetary stimulus for the UK, and Mark Carney may take up the reins just as economic activity starts to accelerate.

"Credit data do not signify FLS failure”    BoE, Andrew Bailey

The BoE also released bank lending data yesterday under the Funding for Lending Scheme (FLS) and while it was very apparent that the state-backed banks were still reducing their balance sheets to the extent that lending continues to fall, Barclays and the Building Societies are increasingly making up for the shortfall.   

Europe underperforms (at a slower rate)

In the Eurozone, where the manufacturing sector makes up a larger proportion of GDP, the PMI data was more of a moot point. There was an improvement in the national indices across the zone, with Spain and Greek readings reaching near 2 year highs. The issue, however is that the indices still represent declining activity and the bounce merely a reduction in the pace of that decline. More broadly the IMF article IV consultation with Germany led to a lowering of growth expectations for 2013, citing banking system vulnerabilities and continuing euro area recession.

In reaction to yesterday’s US data (and despite a weaker comparable index in the eurozone) the EUR rose on foreign exchange markets as the USD fell. Positioning in the USD was likely a significant driver of the move as heavily ‘owned’ trades were unwound across the board. Our view towards the eurozone economic prospects and indeed the prospects of the EUR remain firmly negative, with the only caveat that, this week’s ECB press conference holds the risk of a further EUR positive in the form of progress on a plan to boost bank lending through Asset Backed Securities (ABS), as touched upon by Draghi at the last ECB press conference.  

"Forex is having ‘complicated’ movements”        Akira Amari, Japan Economy Minister

As the Japanese Economy Minister Amari pointed out overnight, recent FX moves have been increasingly volatile and overcrowding of positions in some instruments and currencies has increased this further. I continue to expect markets to maintain a higher baseline volatility level throughout this week as the high profile data and monetary policy meetings shape expectations for the medium term. As discussed above and despite the near term volatility we continue to favour the USD and GBP over EUR and JPY, yet for the week I favour removing the USD from the equation and see GBP outperformance against the EUR as a key theme to develop.

"Life is about timing”      - Carl Lewis

Sound as a pound?

The data from the UK this morning was mixed, with modestly disappointing money supply growth and mortgage approvals, partially offset by modestly better consumer credit data. Modest improvements in the underlying UK data is something that we continue to expect going forward, and indeed overnight the British Chamber of Commerce raised their UK growth forecasts for 2013, 2014 and 2015, following what seems like a sea change in commentator rhetoric towards the UK recovery.

In fact, the prospects in the near term for the UK may continue to outperform expectations. The Q1 GDP print in the UK beat expectations and rose 0.3% q/q. The significant factor in the breakdown of the data is that in the final month of the quarter the level of GDP was around 0.6% above the Q1 average. The base effect of this is that a modest 0.1% growth for each of the three months in Q2 would equate to a +0.8% q/q outturn.

It all about…    …timing!

Monetary policy in the UK is likely to stay extremely accommodative and indeed I would not yet rule out further stimulus (although I doubt the efficacy of forward guidance as a policy tool). However, Mark Carney’s timing as he embarks on a 5 year term at the head of the BoE may well prove to be the turning point for the UK (not through anything he has done, but through the timing of his appointment).

On a currency note it was interesting to see the ex-MPC uber-dove, Adam Posen’s, comments this morning that "BoE [is] not likely to talk down the pound anytime soon” and that "Carney will not have [the] tools to have [a] weaker pound”. His comments are striking, especially in the aftermath of the Pimco suggestion that Carney would look to devalue GBP by around 15% in order to regain export competitiveness. My view on this remains that a weaker pound will be a net negative for the UK through higher inflation and weaker consumer activity. Accordingly, Posen’s view is encouraging.

Eurozone backtrack?

In Europe, this morning’s data is a stark reminder that fundamental issues remain at the heart of Europe. Unemployment continues to make new record highs and the 11 countries that signed up to a Financial Transaction Tax (FTT) appear to have all but scrapped the idea, reducing it to a minimal quota limited to (likely only domestic) equity markets. The FTT u-turn should be viewed as positive for global financial markets, but also as another failure for eurozone governance and unity. This week has also seen extensions for EU states in the deficit reduction targets. If the time is not used wisely to implement national structural reforms, extending the deadlines will likely just delay the pain. Europe remains the primary economic concern for the global economy.  

Start of EM unwind?

Over recent sessions the decline in the South African Rand (ZAR) has been very significant. While there are some specific macroeconomic and socio-political deterioration in the region, it is likely that the decline is a precursor to a broader trend of Emerging Market (EM) weakness. The proliferation of global monetary easing over recent years has driven huge amounts of global capital out of the major economies and markets and into the EM’s, not as a function of sound fundamentals or greater growth potentials in EM, but rather as a result of the ‘near zero’ returns in developed market securities.

We have discussed here on many occasions that the subtle shift in the bias of the Fed towards tapering its asset purchases, does not amount to a tightening (rather a second derivative move towards a deceleration of easing) yet it is nonetheless significant. The implications of potential contagion in EM are a risk to the whole of the global economy. At the very minimum I would expect baseline volatility to pick up.

In this regard the JPY is likely to become very interesting, if global market volatility picks up, then the likely impact is position reduction. Following on from EM, the next most likely major economic / market vulnerabilities lie in the JPY and arguably the Nikkei. In a world where global central banks have pursued extreme policies, singularly aimed at their own domestic economies, the potential ramifications on the financial system as a whole have increased. Watch this space.   

"Someone call a somnambulance, quick”              -The Economist (May 25^th)

The (bank holiday delayed) start to the week was hardly one of great fireworks, indeed with the school half term holidays and minimal first tier data, the close to the month of May will likely be a rather subdued affair. The spot value date for the end of the month is today and thus we may see some heightened volatility around the fixing times as global portfolios are rebalanced but, beyond that, it appears the focal point of market attention has already shifted into June. Along with the arrival of the June data (discussed below) there are a few themes that it is worth taking a step back from and looking at more closely.

Consumer confident?

The first interesting theme I would raise at this stage is the prospect of a growing economic differentiation between the major economies. Yesterday’s consumer confidence releases from France and the US were a case in point; the US sharply outperformed expectations while France sharply underperformed. As I see things this is a key differentiator going into June and beyond. The eurozone macroeconomic data is likely to underwhelm, particularly from the FISH {France, Italy, Spain and Holland} relative to the rest of the union. In the US I feel that we see further evidence that the March slowdown was (as we have continued to suggest) a transient weakness.

Equity market value

There will undoubtedly be regional variation in equity performance as we move towards and into the second half of 2013, but the old adage ‘sell in May and go away’ is likely to prove a missed opportunity from where I stand. Recent volatility in the Nikkei (which I feel will likely continue) aside, there are a number of reasons to be positive including: accommodative global monetary policies amid a dearth of credible investment alternatives and some might argue attractive earnings and cash flow valuations (as well as in many markets, such as the UK, relative valuations). In the US, the FOMC are likely to move towards a tapering of QE asset purchases over the coming months. This reduction in the rate of additional stimulus should, however, continue to be supportive of growth and equities. In Europe further easing seems increasingly likely.

UK renaissance?

In the UK there are a growing number of reasons to be cheerful. Last Friday I discussed the likelihood that the very disappointing growth rate numbers in the UK since the crisis will likely be revised up (albeit modestly) and that in addition to the healthier historic trajectory of growth, future prospects have been boosted by a lower than expected inflation trajectory and thus a reduced squeeze of consumer finances. UK data is also likely one to watch closely over coming weeks and months.

Bill and Ben?

Lastly, the dynamic of the JPY, and the interaction of Abenomics with Japanese Government Bonds (JGB’s), the Nikkei and the JPY will continue to be a headline grabber. After failing to extend higher over the start of this week the risks are beginning to move back in favour of a weaker JPY (though I certainly do not rule out one last spike higher). Likewise we remain long term bulls of Japanese equities, at least for as long as Abenomics retain their credibility. It remains to be seen whether or not the goal of higher inflation can be reached in the right way. Kuroda said yesterday "yield rise [is] negative if not lead by economic hopes” and this is likely the key criteria for the historic assessment of the Japanese fight against deflation and indeed the fortunes of the Nikkei and JPY. Japan and its monetary activism are in uncharted territory and as such demands increased scrutiny.

Short term pain?

For the rest of the day the focus of attention will swing towards Canada and the last monetary policy meeting chaired by Mark Carney, before he heads for the arguably more complicated shores of the UK. The Canadian dollar has been modestly weaker over recent sessions as the prospects for the US improve and commodity prices disappoint. In this regard I feel that the AUD and CAD have further to go and the economic resurgence of the US will likely compound the rationale for further commodity currency downward revaluation. However, market volumes are light and with month end flows adding to the complexity, irrational or unexpected movements or volatility cannot be ruled out. In this regard I would rather be reactive then proactive at this stage of the proceedings. 

The underlying tone to the Fed minutes (released on Wednesday evening) and indeed the testimony of Chairman Bernanke to the Joint Economic Committee (JEC) remained prudently dovish. The maintenance of ‘tapering rhetoric’ despite the March data slowdown, which was referenced but not emphasised by any increased concern, was enough to see the USD regain the upper hand in the immediate aftermath. The real fireworks, however, came from Japan.   

Thursday’s Asian trading session saw the Nikkei 225 fall back sharply (-7.32%), following a pull-back in US equities after the suggestion that the Fed may be close to tapering asset purchases came from the FOMC minutes from the April 30^th Meeting. The move was perhaps exaggerated by weaker than expected China manufacturing activity index and comments from Japanese Economy Minister, Akira Amari, that "the rise of stock prices was faster than expected”. Rather ironically he also stated that the Japanese "Government will conduct ‘down to earth’ policies” – and equities complied – with a bump.

"… on a razors edge”

The link between the fortunes of the Nikkei and those of the JPY have been firmly (negatively) linked since the implementation of Abenomics and the further comment from Amari that "such a big stock decline can lead to yen gains” was also enacted by the markets.

"Hitching rides on magic carpets” ?

Last night, US equities closed modestly lower (after the futures threatened a much larger decline before the markets opened) and the Nikkei too was better behaved. There was, however, some talk overnight of Japanese Government Price Keeping Operation (PKO) behind the 400 point bounce in the Nikkei 30 minutes before the close. Which, if true, is potentially very concerning. This aside, success of the Japanese deflation-fighting monetary activism, will likely continue to see a continued appreciation of the Nikkei and likely (if not less pronounced) decline in the JPY. Failure, however, could be devastating for Japanese assets, AND the JPY. I would suggest that there is further room for USDJPY to correct lower in this environment in the short term, but the increased volatility likely adds to the complexity of the dynamic.

"Don’t wanna wanna be misled…”

The other major mover in FX this week has been GBP and here I feel that the market is a little misled. The Quarterly Inflation Report last week lowered the central projection for inflation and at the same time raised the growth forecast. With inflation now expected to fall back to target in 2 years as opposed to 3, the squeeze on consumer incomes that has been a consistent drag on domestic consumption may well go into reverse, as we see real wages growing. Indeed, in the years following the crisis (since 2008) the Bank of England has consistently raised its forecasts for inflation and cut its expectations for growth. As disinflation takes a global stronghold, we could well be in for a period where the opposite is true.

For a long while now we have held the view that the level of employment and consumer spending was not in line with the trajectory and/ or weakness of the UK growth story. Our view now appears to be confirmed, as not only do we now see a period of better than expected growth, we also believe that the historic data will likely be revised higher as suggested by BoE’s Paul Fisher this morning.

Expectations are still firm in the financial markets that there will be further easing in the UK, under the guidance of the new BoE Governor Mark Carney. This is likely the trigger point for GBP strength, either as a result of the implementation of further (growth supportive) easing – or a market disappointment that ‘rate guidance’ implementation is not the ‘easing’ the market expects.

"it’s a fairy tale to me…”

In the Eurozone the position is perhaps reversed. This morning’s German Ifo Business Climate index showed an improvement and the EUR duly rallied. While the fortunes of the eurozone economy may not be at the forefront of the market’s vista at the moment, and the timing of any further eurozone deterioration (or economic or socio-political incident) may not be imminent, the backdrop is far from rosy. This morning’s German GDP data maintained the initial estimate of a 0.1% rise in activity, however, the breakdown highlighted concerning deterioration in net trade, investment and domestic demand.

"You’re looking for a lead and in the distance”

As we close the week ahead of a long weekend in the UK, I would expect volatility to pick up and further position squaring to take hold. In this respect established positioning is potentially under threat. For today therefore we may see further JPY appreciation vs. the USD (and potentially others) amid heightened volatility, yet in the longer term I continue to hold the view that USD and GBP will outperform EUR and JPY