ECU's Investment Blog
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 30th 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
"More tailwinds than headwinds for the US economy” - Lloyd Blankfein
Financial markets have become very efficient at pricing the relative probabilities and inter-correlated connotations of binary events. Since the onset of the financial crisis the most obvious example of this has been the risk on / risk off relationship that dominated all asset classes and the inter - and intra-correlations of assets. From here, at least in foreign exchange markets, I expect that there will be an increasing focus on differentiating between those economies that are facing (continued) ‘headwinds’, such as the eurozone economies and Australia, and those who are arguably now aided by ‘tailwinds’, such as the US and the UK. Heads or tails?
Broadly I feel that this continues to favour the USD and GBP over EUR and AUD (and JPY but in this regard the JPY remains the exception to the rule, where despite the increasing prospects of growth and the ‘artificial tailwinds’ of aggressive monetary activism, the prospects for the currency are likely for further weakness)
FISH head and tail risks
Yesterday’s data saw the eurozone record its biggest trade surplus in its history, however, any positive connotation that a trade surplus may theoretically convey would be misleading. The surplus was almost entirely driven by falling domestic demand for foreign goods as exports stagnated and imports fell by around 10% on the year. In many ways though it was the (arguably more backward looking) GDP data earlier in the week that grabbed the headlines, with France and Holland (the head and tail of the FISH) falling back into recession and the eurozone as a whole extending its long-running contraction.
Reading between the lines of comments made by eurozone officials of late, there does seem to be rising tension (publicly denied) between France and Germany. Hollande’s almost spectacular collapse in popularity (the biggest post-election decline in support in French political history) has occurred amid what The Economist referred to as a ‘time bomb’ in respect of France’s economic trajectory and composition, backed into a politically uncomfortable corner, Hollande is likely to step up his ‘growth over austerity’ rhetoric and, as growth continues to falter, France is likely to continue to miss deficit reduction targets. Franco-German tensions therefore are potentially just beginning.
Publically, Hollande stated yesterday that the "Euro crisis is behind us” (sparking images of the hapless pantomime character being told "it’s behind you!”). The problem is, that with consumer confidence faltering and no obvious plan from either the French, or indeed Europe as a whole, to boost domestic demand, the ‘euro crisis’ may well be behind Monsieur Hollande, but it is close enough to tap him on the shoulder.
"…the first time I have been able to say that since before the financial crisis” -Mervyn King
In the UK, the Quarterly Inflation Report earlier in the week, with its raised economic forecast may well be viewed as a turning point for sentiment towards further easing in the months and years ahead. While the Bank of England continued to forecast a protracted overshoot in inflation, their assessment on the growth prospects of the UK were given a far more upbeat assessment. Medium structural issues remain but, to quote the outgoing Governor, "a recovery is in sight”.
With only days remaining before Mark Carney takes over as the Governor of the Bank of England it is interesting to note the comments of the IMF and BIS yesterday who both warned of the dangers of ultra-low interest rates. "Inflation may be hard to get back under control, and the eventual raising of interest rates will become tougher and more dangerous” Jamie Caruana, BIS.
Hints last night from Fed member (non-voting) Williams that QE3 could be tapered as early as this summer, add to the view that the relative momentum of monetary policy in the US is starting to move in the opposite direction of that in the eurozone and Japan.
In the UK, my view is that the market has too much expectation of further monetary accommodation from the new Governor. The debate about guidance and / or threshold criteria will likely build as we approach Carney’s first meeting but further monetary easing now seems less likely.
"There is no bird flu in commercial stocks” - Michael E. Mann
Stronger than expected trade data from China overnight will likely keep the overall market risk sentiment positive with export and import activity both sharply above expectations. Indeed, on the face of things, despite hitting record levels in the US, it is hard to argue against further equity market strength. In a world where monetary accommodation and activism are at such extremes support for asset markets is high (Bernanke, Draghi and more recently Kuroda ‘puts’). Further, with yields at such low levels and with a diminishing prospect of inflation in the developed world it is hard to argue the case for either bonds or Gold. Equities on the other hand are, if no longer cheap, fairly priced to expected earnings and will likely retain their attraction.
"…the recent growth revival is no surprise to economists of a ‘monetarist’ persuasion” – Simon Ward
In the UK, there is growing evidence of a recovery (if albeit very modest at this stage) in fact if you strip out the volatile (and declining) North Sea oil production, bank holiday and Olympic effects the rising trend in UK GDP could be argued to be gaining traction. GBPUSD has fallen back from the heady heights of 1.5600 on Monday, and as I see things it would likely take a more prolonged improvement in the data for GBPUSD to push on above this level. GBP strength in other areas (vs. EUR and AUD), however, seems a stronger prospect.
"…decided to use some of its rate cut scope” - RBA
The Reserve Bank of Australia (RBA) cut in the interest rate to a record low of 2.75% yesterday was significant. Significant because of the fact that there was an element of ‘leeway’ in the RBA’s considerations, not because it was unexpected. Indeed while surveyed economists had not committed to the rate cut, the interest rate market had. The 2 year swap rate was trading below 2.8% on Friday. The issue in Australia is likely the rapid deterioration in the public finances as a result of non-resource sector frailty. Indeed with the resource investment peak likely this year, I would suggest that confirmation that the dip in US activity in March, was a transient phenomenon could be enough to spark a marked deterioration in the AUDUSD rate, back into the mid .90’s. Employment data tomorrow will be keenly watched.
"ECB ready to act again if needed” - Mario Draghi
German press reports overnight suggest that the ECB is looking at the possibility of buying bad loans or asset backed securities. Recent comments from Yves Mersch and Mario Draghi lend some credence to this prospect with their suggestions that the ABS market is being looked at to be used to create a lending programme for SME’s (something which we alluded to ahead of last week’s ECB meeting). This, along with yesterday’s German data and a strong return to the bond market for Portugal yesterday, have continued to support the EUR, even while JPY weakness is beginning to calm. From here I would expect that the primary driver of near term currency trends will come from the data.
Weak FISH tail
The data emanating from the eurozone continues to be mixed. German Factory orders yesterday were surprisingly strong and will likely drag up expectations for today’s Industrial production, however, the correlation between the two data sets is not strong and there is perhaps some room for disappointment. The weakness that concerns us most, however is in the core or more specifically the FISH. In fact following on from last week’s ECB action it is significant that Draghi stated yesterday that "ECB cut rates due to economic slowdown in euro core.” While German prospects remain a moot point, the tail of the FISH (or Holland) highlighted the frailty of the core this morning with industrial production falling sharply below expectations.
Lost in space?
Overall activity in the FX market has failed to get started in earnest after the long bank holiday weekend in the UK. Data will likely inspire some position adjustments but with little first tier data for the rest of the week and half an eye on the G7 meeting at the weekend I would not expect much in the way of significant breakouts. However, FX markets adjust very quickly and once (what I see as the) transient economic factors give way to broader and more dominant themes I feel that there may be some very strong opportunities in FX. Watch this space.
"There’s certainly reason for hope” Ben Broadbent
Commentary from the Bank of England’s Ben Broadbent last night suggested his concern that the financial crisis has induced a "shift in things that, for a long period of time, we have been happy to treat as unchanging constants”, intimating that the correlations and forecasting models that the BoE use to predict inflation and growth (and the interrelationship between the two) may have been affected by the crisis and that the ‘new normal’ may indeed be a lower level of trend growth and / or a higher level of baseline inflation. Indeed, the fact that the Bank has consistently underestimated inflation and overestimated growth may well be testament to this, however, I continue to believe that the underlying pace of growth in the UK is underestimated in the official data and while perhaps the consumer and employment data is also modestly overestimated, the anomaly between these signals remains.
Indeed, following on from the stronger than expected UK first quarter GDP release, yesterday saw a modest bounce in the manufacturing activity index. While the index is still fractionally below the expansion line, there is evidence that the manufacturing sector is stabilising after the fall. This cannot be said for the eurozone where, despite a modest outperformance in Germany, the whole of the eurozone manufacturing sector continues to contract. Looking ahead, the UK Manufacturing data will likely raise hopes that the manufacturing sector will not weigh down on second quarter growth. Officials have played down the significance of the UK Q1 GDP release but I, for one, expect this to be the start of a (albeit modest paced) recovery.
USD fortunes remain data dependent
Over the last weeks I have laid out the view that the current weakness in the US data is a transient phenomenon and not the ‘new normal’. Whilst I concede that the fixed income markets had perhaps got ahead of themselves in pricing the pace of monetary normalisation, I still view the current correction in the USD as an opportunity to buy, as opposed to the start of a structural decline in the fortunes of the US and the value of the USD.
Last night’s FOMC meeting gave no clue as to the level of concern over recent data weakness from the Fed. There was an explicit strengthening of the assessment of fiscal policy from being "somewhat more restrictive” in March, to "restraining economic growth” in May. The main new inclusion, however, was the statement "The committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation change”. In reality there was no new information from the US monetary policy announcement and the data releases will continue to dominate interest rate (or tapering) expectations and USD sentiment from here.
Weaker private sector employment data and a weaker than expected reading to the employment component of the manufacturing ISM, yesterday, will likely have reduced expectations for the US employment report tomorrow. Economists’ expectations are for 145k on the headline payroll figure and for no change in the unemployment rate at 7.6%. If pushed I would err on the side of a better than expected payroll number, but back revisions and likely changes in the labor force (impacting the unemployment rate) will likely be the dominant driver of post data activity and thus prudence suggests being reactive rather than proactive.
BoE FLS For ECB?
Today’s main focus, however, will be the ECB meeting and resultant press conference. A 25bp cut in the refi rate is largely expected on the back of a steady flow of weak data and a sharp decline in eurozone inflation, to a 3 year low. I have suggested a number of times that there will be limited real impact of an ECB rate cut with the eurozone curve trading at a deep discount to the official refi rate already. The main impact, however, will be to reduce the funding costs of the peripheral banks.
This is likely the key point. In addition to the likelihood of a cut in the refi rate I would also expect some form of new non-standard measures targeting lending to SME’s within the eurozone, similar to that of the Bank of England Funding for Lending Scheme (FLS). Recent narrowing of eurozone bond yields will be seen as a significant repairing of the transmission mechanism for monetary policy and thus a refi cut would likely have greater impact than when intra-eurozone bond spreads were more fractured. Further, any form of FLS style non-standard measures will likely be seen as a clear EUR positive as SME’s within the eurozone account for around 60% of the workforce.
In the very short term, therefore, the balance of risks for the EUR are arguably to the topside - more clearly against the USD, where sentiment is already dented by a correction in the expectations of the US growth trajectory. Outside of this we continue to favour USD and GBP vs. EUR and JPY (though JPY is currently side-lined by a greater focus elsewhere) and view the recent currency dislocations as providing great opportunity going forward. Volatility is likely to be higher over the remainder of the week and waiting for the dust to settle will likely provide a better risk reward profile.
"Oh no, this is the road to hell” Chris Rea
Despite there being fairly limited data released yesterday, there was a theme of lower than expected inflation across the eurozone. German inflation was possibly the most glaring undershoot, which will inevitably cast some doubts about the strength of German domestic demand. This morning the theme continued with the eurozone aggregate data highlighting an April decline in the rate of consumer price rises to just 1.2% annually, from 1.7% in March. In reality, this does little to change the backdrop. A rate cut from the ECB is already the central expectation and its impact has already been (predominantly) priced into interest rate, fixed income and FX markets.
For the EUR, the real driver has been in the peripheral bond markets where yields have declined sharply over the month of April. Declining spreads will be viewed positively by the ECB as being remedial for the transmission mechanism for monetary policy. In fact yesterday’s 10 year Italian government bond auction drew strong demand, encouraged doubtless by the formation of a new government and the lowest yield since October 2010, at 3.94%.
"This ain’t no technological breakdown”
This is where the sustainability of the current scenario is drawn into question. There is no doubt that in the current market, the quest for yield driving equity markets and bonds higher is positive for broad risk assets and perhaps even the EUR in the short term. As we look forward however it is difficult to see 10 year Italian yields below 4% and Spanish 2 year yields below 1.9% as sustainable. If, as Milton Friedman famously coined, "markets can remain irrational for longer than you can remain solvent”, it is likely prudent to wait for a new impetus, or event in order to trigger a decline in the EUR. However, it is less likely that such a trigger comes from within the eurozone.
"All the roads jam up with credit”
The stubborn bid in the EUR and Eurozone bonds, amid a rapidly declining macroeconomic backdrop could be (at least someway) explained by three distinct factors. Firstly, the flow of money or indeed the expectation of a flow of money out of Japan following the BoJ’s ‘shock and awe’ monetary expansion likely drove down peripheral European yields. This arguably made sense following yet another display of unwavering political will to maintain the eurozone, after all, if the union remains intact (and the threat of default removed by bailout from the core), then the periphery is arguably just a higher yielding version of the core.
"This ain’t no upwardly mobile freeway”
Secondly, and as far as I see things most interestingly, is the recent ‘dip’ in the US data. Yesterday’s Dallas Fed manufacturing outlook index was a case in point (although the housing data continues to be encouraging). However, as suggested last week, I continue to expect the US economic slowdown to be transient and certainly not enough on a relative value basis to support anything other than a transient upward trajectory of the EUR vs. USD. Convincing signs that the US recovery is back on track and that April was a bump in the road to recovery will likely be the next trigger for a leg up in the USD and down in the EUR. Friday’s employment report will be the first focal point in that regard.
Lastly, the announcement from Spain (welcomed by the rest of the eurozone) that they would delay reaching the EU deficit target by 2 years until 2016, as employment rises could also be seen as a positive for the single currency and the bond market in the short term, particularly amid a global economy that appears to be slowing in unison. Once there are signs that the US recovery has not been derailed then the impact of delaying austerity is likely a further drag on the EUR. Ollie Rehn said on Friday that he is "neither an austerian or a spendanigan” which may sound non-discriminatory, but ultimately without reducing the deficits in the eurozone, sustainable growth will remain illusive.
"but the water [liquidity] doesn’t flow”
So for the rest of the day activity is likely to be fairly light and with most of Europe off for the May Day holiday tomorrow this could extend into Thursday’s ECB meeting. First up, however is the Fed (Wednesday evening) and the market will be closely watching the intimation of tapering QE purchases to be confirmed and hence confidence that the dip was just a dip and not something more sinister. Thursday’s ECB meeting is likely a done deal, with a 25bp refi rate cut firmly expected – The press conference will be the core focal point as the market attempts to gauge the sentiment at the ECB in relation to slowing inflation and / or growth. Lastly, the US employment report on Friday will be interesting. I would personally err on the side of a stronger than expected report, but would argue that the current backdrop likely favours being reactive after the event and not positioned ahead of it.