ECU's Investment Blog

By Neil Staines on 30/10/14 | Category - Comment

"Strong USD good for US, tied to core economic strength” Jack Lew, US Treasury Secretary

Following the violent "taper tantrum” brought on by the Fed announcement in May 2013 that voiced the Fed’s intention to gradually reduce the pace of bond purchases, the FOMC then confounded market expectations (by then, much better prepared for and acclimatised to the notion of winding down the pace of QE3) in September by postponing the reduction, or tapering in the amount of assets bought under QE3. The ensuing market surprise saw a weaker USD, lower US yields and (amid higher volatility) higher equities. The taper eventually got underway in December, again surprising many commentators and participants in its timing.

Since then, despite the volatility of US GDP data over the winter months, the taper has followed an orderly path in reducing the amount of additional stimulus to the US economy. The conclusion of QE3 at last night’s FOMC meeting is, we believe, a very significant milestone for the global economy (and for financial markets) and one which should lead to higher USD, higher US yields and (potentially amid lower volatility?)lower equities.

The Final Countdown?

Going into last night’s statement release, markets were seemingly in full agreement in expecting a reduction in asset purchases to zero and in the view that the "rates to stay low for a considerable time” language would be retained in the statement. Any disagreement about the connotations of the statement therefore rested on the tone through the rest of the economic summary, particularly in relation to the Fed’s view of the inflation backdrop.

In this regard, the statement is as hawkish as we could have expected. Reference to the "solid job gains and a lower unemployment rate” along with the view that "the underutilization of labor resources is gradually diminishing” point to greater confidence (in our view, long overdue) in the labour market. Furthermore, while pointing out that inflation will likely be held down by lower energy prices in the near term, the concession that "the likelihood of inflation running persistently below 2 percent has diminished somewhat” suggests a more balanced view of price pressures in the US; by default, a further hawkish inference.

We view this as the second phase of the monetary normalisation process in the US and stress that its significance should not be understated. Against a troubled global geopolitical backdrop and uncertainty over the ‘true’ medium term equilibrium level of interest rates in the "new normal”, the move up in US yields may well prove modest. Against a slower (and arguably flatter) move up in the US yield curve, any equity declines may also be slower than many would have anticipated after years of Fed policy fuelled rises in equity markets. However, the stand out winner for us at the current juncture at least, is the USD.

Last night’s other central bank meeting was in New Zealand, where the RBNZ left policy unchanged after rate hikes earlier in the year, the impact of slower demand and lower energy prices have weighed heavily on inflation. The key message there (pun intended) was the continued reference to an "unjustified, unsustainable” currency level and the open statement that it expects "further significant depreciation in NZD”.


"Weak Canada dollar is the icing on the cake for exports.” Stephen Poloz, Bank of Canada Gov.

Ultimately, we believe this is the point. The relative economic differentiation case between the US and the rest of the global economy (except the UK) remains compelling and, as global export demand continues to fall, the push for a bigger ‘slice’ of the market increases. A lower currency is arguably the best way to boost export competitiveness and in many countries it is not just "the icing on the cake”, but is an active policy target (whether officially admitted or not).

In two separate reports yesterday, Eurozone prosperity was brought into question. The German DiW institute predicted German growth of 0.1% in Q3 followed by stagnation in Q4 (a long way short of the 3% annualised growth expected in the US for the same period). A second report from M&G Investments suggests bad debt at Eurozone banks may be up to 18.3% higher than previously thought.

In essence, we continue to see further USD strength from here. As the definition of "considerable time” is now a function of the data, we would also view better than expected US data as carrying an asymmetric positive risk for the USD. EUR remains our favoured short at the current juncture (and we continue to expect further EUR declines against GBP) with the case for a weaker AUD and NZD becoming more compelling.

By Neil Staines on 28/10/14 | Category - Comment

"Post crisis uncertainty is more profound” - Stephen Poloz, Bank of Canada Governor

With November nearly upon us, a number of macro themes that, at the start of September, seemed destined to last into year-end have lost momentum and have been replaced by uncertainty. Events, such as yesterday’s release of the European bank stress test results, that were meant to bring confidence and remove uncertainty, appear to have done nothing of the sort. As far as uncertainty is concerned, October still has a long way to go.

With very little in the way of Eurozone economic releases over the next two days (following yesterday’s weaker than expected German IFO survey for October), the market focus will likely fast forward to tomorrow’s key events: (i)The October FOMC, which is expected to herald the end of both tapering and QE purchases (as monthly purchases under the QE programme are tapered away to zero). That is not to say that accommodation will in anyway be reduced in the US, as it is the stock of assets held which provides the stimulus, not the pace or quantity of purchases; and, (ii) the EU deadline for the acceptance of the Eurozone Budget plans. France, Italy, Austria and others have been served letters from the EU asking them to clarify / explain their deficit reducing plans.

In assessing the implications and connotations of these two events, perhaps we should first look at the broader macroeconomic environment at this current juncture.

"There is nothing insignificant in this world. It all depends on the point of view” - Goethe

During Q3, the world seemed a very different place. While there were perhaps growing concerns of the economic and political path and inflation outlook in of the Eurozone, there was strong growth momentum in the US and UK. Furthermore, the Reserve Bank of New Zealand had by then already embarked on the first stages of its monetary normalisation process. The theme of economic and monetary differentiation was evolving and, in many corners, confidence in the strength and breadth of the recovery was increasing.

From that point on, the global economy (or at least the ‘confidence’ in the global economy) has taken a sharp turn for the worse. Eurozone growth prospects (at least anytime in the near future) were all but removed by the deterioration in Germany, which could possibly be deemed in technical recession following the Q3 GDP release (which the European institutes cited last week could indicate stagnation). A sharp decline in equities sent US policymakers running for the protection of (possible further) QE, and interest rate expectations across the globe were reined in by the decline in oil prices and the growing plague of disinflation.

This morning’s action by the Swedish Riksbank is a case in point. The Riskbank cut interest rates more aggressively than expected, to zero, with a downward revision to the repo path and inflation forecasts, in a move that may be indicative of the weakness in the region. Furthermore, the ECB announced yesterday that its latest stimulatory medium, covered bonds, drew just EUR 1.7 billion worth of bonds last week – a pace that by itself would take more than a decade to take the ECB’s balance sheet back to 2012 levels (around EUR 1 trillion higher than today), as suggested by Draghi at both October and September ECB press conferences.

"Nothing to fear but fear itself” Franklin D. Roosevelt

In FX, we maintain our viewpoint: USD and GBP should continue to outperform over coming months as economic outperformance rekindles the interest rate differentiation theme (at least returning to prior levels, following the recent ‘uncertainty’ reversal). In the US, the second step of monetary normalisation will likely be completed this week as the Fed halts its asset purchase programme. While this may not have an immediate implication for US yields, the absence of a significant buyer of Treasuries should allow the market to find its natural equilibrium level more efficiently (in our view 2 year US yields sub 40bps, with the current US economic output, is too low). GDP data out later this week, following the announcement from the Fed, may well bring some confidence back to the US, and thus the USD.

In the UK, we feel that there is a similar theme. Global uncertainty and lack of confidence (again weighed by the disinflationary impact of lower oil prices, which we see as a clear long term economic positive) has led to a mixed performance by GBP. However, GBP has outperformed the EUR of late and we would expect this theme to continue. In the Eurozone, while the debate over national budget plans will likely be contained, it highlights the significant troubles that continue to face the region and, thus, the ongoing differentiation theme.

Uncertainty and caution are clearly warranted in some parts of the globe. However, we also believe that confidence and optimism are warranted in others. The next few days sees FOMC, BoJ and ECB policy meetings as well as US Q3 GDP and October payroll data, all of which may help separate the Wheat from the Chaff.

By Neil Staines on 23/10/14 | Category - Comment

"Europe is ‘Cinderella’ of global economy”Matteo Renzi

I’m not entirely sure what the specific point of reference the Italian PM was making in regard to Europe: that it has two ugly sisters? Unlikely. That it is putting in a lot of hard work sorting its own house out, without the benefits of going to the ball? Unlikely. That at midnight the carriage of European economic prosperity will turn into a pumpkin? Possibly!

It could be argued that the ‘pumpkin’ moment has already happened for the Eurozone as, over the past months, a sharp deterioration in economic momentum and, subsequently growth forecasts, for the region have brought a swathe of unconventional monetary easing measures from (fairy godmother?) Mario Draghi. Perhaps surprisingly, Germany has been at the heart of the growth revisions and after a very disappointing Q2 GDP outcome, recent forecast from the leading European Institutes suggests that growth in Germany is likely to have stagnated in Q3.

In that regard, this morning’s Eurozone PMI data was something of a welcome surprise. Despite further deterioration in French and German service sectors, the bounce (back into expansion) in German manufacturing activity and an unexpected improvement in the composite measure for the region as a whole is a rare positive of late.

Normally at this stage of the month, focus would be shifting towards the expectations and intimations for the ECB meeting at the start of next month. Indeed, the rumours that the ECB are debating the purchase of corporate bonds (although not as soon as November) should have heightened this shift. This month, however, there are two significant events that could not only shape the confidence and activity of the markets going forward, but potentially, could also influence the ECB.

Two ugly sisters?

The first of these is the release of the ECB’s Asset Quality Review (AQR) stress test results for the regions banks. Rumours and reports have suggested that somewhere between 8 and 11 banks will fall short of minimum capital requirements and will thus need to rely on capital raising or national government ‘top-ups’. This comes with the additional complication of being released on Sunday (26th October) when markets are closed and thus ‘gap risk’ on the market open in Asia on Sunday night is heightened.

Secondly, as the political debate within the Eurozone rages on, the EU have until next Wednesday (29th October) to reject the Budget plans of member states. While France has grabbed much of the headline space in this regard, it is also a potential banana skin for Italy, Austria, Slovenia, Malta and, (particularly in FX markets) for the region as a whole.

Likely Suitors?

Elsewhere, in the UK this morning retail sales data for September came in on the weak side of expectations with the annual (ex-Auto) rate of sales growth slowing to 3.1% y/y, from 4.4% y/y in August. In reality, however, this does not suggest any substantial weakness and may in part be explained by the weather (high street warnings about the mismatch between Jumpers in shop windows, yet t-shirt weather outside). Furthermore, yesterday’s release of the BoE monetary policy meeting for September was met with dovish market commentary. In our view, it was not so much dovish, as data focussed. Thus, if the data (economic momentum) does NOT moderate (or deteriorate) as expected and, with interest rate expectations already substantially pushed back, the upside potential for GBP, remains significant – at least in relation to the EUR.

In the US, despite the best efforts of the Fed to undermine confidence, the US data (economic momentum) remains robust. As a result (Bullard comments aside), the Fed should end its asset purchases (QE) in October as planned. Furthermore, following the volatility and capitulation in risk assets last week (and the subsequent sharp decline in US yields as investors fleeing equities and risk assets flooded to the safety of US Treasuries), markets have calmed somewhat. This relative calm has brought an uptick in US yields (and a widening of rate differentials with respect to the Eurozone) that should continue to support the USD.

In essence, we continue to favour USD and GBP against the EUR in FX markets, particularly now that rate expectations have been pushed back so far in the both the US and UK. There has been much commentary over the past weeks about the potential for a loss of economic momentum or even a sharp slowdown in the US and the UK. However, for now, with China data supporting the notion that its economy is slowing, not collapsing (soft landing not hard landing), we continue to view the US and UK economic momentum as sustainable. The first real test for this comes tomorrow with the first estimate of Q3 UK GDP and in our view with the rest of the market looking in one (weaker) direction and with interest rate hikes already pushed out to August 2015, the risks are perhaps skewed slightly to the upside for the pound.

By Neil Staines on 21/10/14 | Category - Comment

"There is increasing Nervosity in markets” - Ewald Nowotny

This morning I heard recent market activity being described as ‘Karate Kid’ trading (risk-on, risk-off). The lack of first tier data over recent sessions has only added to this theme, rendering equity markets and peripheral European bonds as the primary drivers of broad risk sentiment. In the short term at least, the correlations between the movements in risk assets and currency out (or under) performance are at best, unreliable.

"Recovery continues but uncertainty returns” Riksbank 7th Oct

Adding to the near term confusion of the markets is the inconsistency of official commentary, none more so than from the Fed. Over recent weeks, the data from the US has been broadly positive (particularly on employment measures, but PMI and sentiment data has also retained their strength). Despite this, the St Louis Fed President James Bullard’s commentary (especially if taken directly as a barometer for Fed sentiment) has gone off-piste significantly. On the 2nd of October, Bullard stated his view that the "Fed are behind schedule on raising rates as QE3 nears its end”, only to state on the 16thof October (albeit following a wobble in equity markets) that the "Fed should consider a delay in ending QE”! Notwithstanding an aura of uncertainty, we continue to believe the US economic recovery is intact and, while there are indeed risks to the US from a broader and more acute slowdown outside of the US, we still favour a gradual move towards US monetary normalisation, and ultimately, a further appreciation of the USD.

"Sputtering Europe holding back global economy” - James Bullard

Ironically, perhaps, in the current market dynamic, the EUR has found some stability in currency markets. To a significant degree, this is a function of interest rate spreads but, with Eurozone rates (at least for the core) locked in negative territory at the front of the curve, further weakness is less likely. However, nervousness (or nervosity!) in the global economy has driven safe haven flows and or reduced interest rate normalisation expectations in those economies with positive momentum (notably US and UK), and thus narrowed spreads. Ironically, given the weakness is most chronic in the eurozone, this has strengthened the EUR, but we see this as more of a temporary aberration, driven by market positioning factors, rather than any sustainable new development.

Reality Check

In the UK, this week has the potential to be a significant juncture, with data from fiscal (today’s public sector finance data), monetary (BoE October meeting minutes tomorrow) and economic (Retail sales Thursday and the first estimate of Q3 GDP on Friday) inputs. GBP has been caught in the crossfire over the on/off M&A backdrop, as well as enduring a sharp reversal in sentiment on the monetary normalisation front as the September inflation data disappointed. However, our central view of the UK economy remains positive and it is possible that, having pushed back the central expectation for interest rate hikes out to August 2015, that the market gets a more positive reality check from this week’s UK data.

Furthermore, the decline in oil prices since mid-June accelerated in October and, in many respects, added to the feeling of economic uncertainty and the debate over global deflationary pressures. However, as San Francisco Fed President John Williams stated recently, "Lower oil prices will have a short term effect on the inflation rate and a positive impact on US growth”.

The overnight release of China’s Q3 GDP data, which came out better than expected (with strength in industrial production and retail sales maintained), will likely calm nerves and fears of an imminent collapse in global growth, challenging views that there is something more sinister behind the scenes driving the recent dovish shift in (global) central bank rhetoric.

"EURUSD movements are linked to growth differences” - US Treasury Secretary, Jack Lew

Equity and bond markets will continue to drive sentiment in the near term and we certainly cannot rule out more ‘karate kid’ trading. However, we continue to view the current levels of both the USD and GBP as offering buying opportunities, particularly against the EUR. However, it may take a resurgence in US and UK interest rates or rate expectations, whether a function of reduced ‘nervosity’ (thus reduced safe haven demand for US Treasuries) or more a bullish economic backdrop driven by stronger data, before we can break out of recent trading ranges.

By Neil Staines on 16/10/14 | Category - Comment

"If I panic, everyone else panics”             Kobe Bryant

Over recent months we have raised questions of the risks of an overtly dovish bias at the Fed, despite the increasingly strong economic momentum. We have stressed on a number of occasions that while this Fed bias may be keeping long end interest rates subdued, it also risks undermining confidence in the economic recovery. After all if the Fed are continually stressing the downside risks, should we not be worried?

"…sinking like stones”                  - Don’t Panic, Coldplay

Yesterday, financial markets experienced some evidence of those downside risks, at least in the unwinding of positions in equity (and broader) markets. The Dow Jones index dropped by around 600 points from high to low in around half an hour only to regain its composure shortly afterwards. Equity market spill over into FX was, however, not a linear function. The impact of the seeming collapse of the AbbVie / Shire M&A saw a sharp decline in GBP against the USD, however, weaker than expected consumer data out of the US instigated a sharp unwinding of long USD positions against a number of currencies, most notably (and aggressively) against EUR, JPY and CAD.

"…we live in a beautiful world”                                - Don’t Panic, Coldpay

In reality, however, the US economic data was nowhere near bad enough to warrant the kind of sell off that we saw in US yields. In fact, with US 2 year yields reaching a low of less than 25bps, and 10 year yields falling below 1.87%, the balance of risks for US yields and the USD has likely shifted back to the topside.

Comments later in the session from US Treasury Secretary Jack Lew that "it is a mistake to look at hour-by-hour movements in markets to get a picture of where the core is” and that "US core economic growth is very strong” were clearly intended to calm the concerns of the market.

On Tuesday, we warned of the rising uncertainty in financial markets and argued for a correction in EURUSD as a function of lower US yields (making specific reference to the significant decline in the 2 year forward point spread over recent sessions), as the spread of deflation seemingly induced a wave of panic about growth prospects (despite a sharply lower oil price?) in the global economy. Falling equity markets continued to drive investors into the relative safety of Government securities (most notably US treasuries) driving yields sharply lower across the curve.

"There is nothing here to run from”                        - Don’t Panic, Coldplay

Following the clear out of positions in FX (and to a certain extent equity and bond markets), there is now a case to be made for a resumption of the broader trend. If equity markets continue to decline, which we feel is possible (albeit at a slower pace) then there is an increased likelihood of a continued unwinding of USD funded carry trades. In addition to this, we see no signs or rationale for US economic momentum to be materially affected by recent events, in fact, sharply lower bond yields and oil prices should be a significant economic positive.

In the Eurozone, the picture is perhaps not so rosy and if there is cause for concern globally then it should be most acutely felt in the Eurozone. News last night that Italian PM Renzi has proposed a Budget that will cause a jump in next year’s deficit "to within a whisker of breaching EU deficit rules” (FT), has accelerated an increased focus on risk premium in the Eurozone periphery. It is notable that peripheral yields are rising again this morning.

To complete the square (so to speak), Eurozone yield spreads at current levels are no longer supportive of a weaker EUR. However, recent moves in the US and UK (supported by the hawkish references of BoE Weale overnight) yields provide a starting point where the risks are increasingly biased to the hawkish side for Rates and the bullish side for USD and GBP.

"Here we go, here we go.”          - Don’t Panic, Coldplay

For today, the major focus is likely to be on the US equity market open, with data limited to weekly jobless claims data from the US. With reference to our point above (and on many previous occasions) that the Fed dovish bias was at risk of (has?) undermining confidence in the US recovery, it is also likely that the rhetoric of Fed speakers has greater influence on sentiment that would be the case in more rational, orderly markets – and there is perhaps a greater likelihood that near term rhetoric emphasises some of the positive aspects of US growth against a nervous equity market backdrop.

Volatility is likely to remain at elevated levels for the rest of the week, however, after urging caution earlier in the week, we feel that re-entry into long USD and GBP vs. EUR and perhaps AUD now offers greater risk reward. 

By Neil Staines on 14/10/14 | Category - Comment

"Patience is bitter, but its fruit is sweet”                              - Jean-Jaques Rousseau

This morning’s inflation data in the UK was keenly awaited as the market attempts to clarify its expectations amid an increasingly complicated global macroeconomic backdrop. The inflation data for September showed a greater than expected decline in both the core and headline readings and although there was an (anticipated) impact from recent energy price declines, there is also clear evidence that the deflationary haze that has gripped the eurozone is beginning to impact broader global price pressures.

In the short term, this has likely heavily impact GBP in FX markets, as interest rate expectations get pushed back (even) further and the years low at 1.5944 will be a key barometer of that. Indeed, we feel that there are a number of interesting dynamics making the evolution of financial market price developments more complex in the short-term, notably in FX.

If we take the USD as an example, our view remains that the backdrop for the USD in the medium term remains positive, particularly against the EUR, AUD where monetary policy and growth divergence as well as valuation arguments remain. However, in the short term, deleveraging in equity markets has also led to some deleveraging in FX. This risk-off backdrop has also driven up those currencies that are negatively correlated to risk appetite, such as the JPY (quite markedly against the USD from above 110, to below 107 this morning).

One of the most concerning developments over recent sessions has been the decline in US yields. At the long end of the curve, US 30 year yields fell below 3% last night for the first time since May 13 and 10 year yields are now at their lowest level since June 2013. Perhaps most importantly, the 2 year yield is at its lowest since June, and almost a full 25bps lower than it was at the time of the last FOMC meeting.

This decline in US yields, perhaps a function of risk aversion as equity declines drive money into the relative safety of the Treasury markets, have also driven spreads relative to other currencies, most notably the EUR, tighter. We were very audible in our suggestions that the widening of the EURUSD 2 year forward points (which went from 19bps in December 2013, to 233bps in September) should be indicative of a move lower in EURUSD. Since the middle of last week this spread has narrowed back to a low of just 165bps this morning. In and of itself, this would argue for a correction in EURUSD, or at least more of a two way market.

"Euro area must get its act together”     - Dijsselbloem

The overall macro picture in the Eurozone, however, continues to deteriorate. Inflation and growth remain too low and the downward revision to forecasts (most notable in Italy and Germany) highlight that there is no remedy to the ailments of the Eurozone in the short to medium term. This morning, saw a further sharp deterioration in the German ZEW assessment of current situation, and expectations, both back to 2012 lows. On a positive note, perhaps the increasing convergence of (negative) growth across the region will accelerate the structural reforms and accommodative monetary policy that the region so badly needs to avoid the prospect described by French Finance Minister yesterday that "Europe faces a Japanese scenario”.

"Endurance is patience concentrated”   - Thomas Carlyle  

However, outside of the near term we retain our view that the USD, and indeed GBP, will re-engage their outperformance. Economic momentum in the US remains significant and, while there may be a short pause for thought, as the threat of deflation pushes back timing expectations of monetary normalisation, economic and monetary divergence ultimately remains in tact.

In the UK, rate hike expectations, which centred around November when GBPUSD was up above 1.70, are now priced beyond the elections in May prompting GBPUSD to fall markedly. Further, the uncertainty surrounding the Scottish Referendum debate and the subsequent impact and implications on investment decisions and activity in the UK, have also weighed on GBP, helping to bring GBPUSD below 1.60. However, going forward, we expect the economic momentum in the UK to continue, and interest rate expectations to once again edge nearer. On that basis, we view any further near term declines in GBP (particularly against the EUR at the current juncture) as representing good value and providing a buying opportunity over the medium term.    

Sentiment will likely continue to be driven predominantly by equity markets over coming sessions and, with the start of the US reporting season today {Citigroup, JP Morgan and Intel}, this will likely become more acute. FX volatility will continue, and, while more complex in the near term, it is likely that clearer trends re-emerge before long.


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