ECU's Investment Blog
"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
"The way out of trouble is never as simple as the way in” - E W Howe
After a very quiet day yesterday, with no significant data, the main focus of attention was the release of the June FOMC meeting minutes. With the meeting taking place well before the strong June employment report, and in light of the dovish tone of the press conference that followed the meeting, expectations for the tone of the minutes likely erred to the dovish side. In reality they were broadly neutral and with little new information - the risk sentiment appears to have clearly deteriorated.
On the hawkish side, the minutes revealed extensive discussion on exit strategies (with interest on excess reserves (IOER) and reverse repo operations key to the beginning of the normalisation process), and tidied up the debate over the USD 5B remainder (as a function of the USD 10B per month tapering of the current USD 35B asset purchase pace) by suggesting that it will be wrapped in with the last USD 10B taper in October, ceteris paribus. The minutes also noted a pick-up in capital spending and a "generally improved” labour market and confirmed the view that the Fed sees an ‘economic rebound’ in Q2, as alluded to in the statement.
On the dovish side, and likely the cause of the sell-off in US yields following the release, the minutes made no mention of the likely timing of (or any caveats to) rate hikes and as such gave no real impetus to alter the market pricing of the first US rate rise in Q3 2015. We have stated our views on the US and the USD (that the US economic performance is currently significantly better than the data suggests) a number of times recently, however, it is likely that from here the key to rate hike expectations are wage and / or price pressures.
"The trouble is, if you don’t risk anything, you risk even more.” - Erica Jong
It was also noted in the minutes that some Fed officials saw investors as too complacent. As today gets underway, however, it feels increasingly nervous and we would caution against being overweight equities and risk assets at the current juncture. We have suggested in recent postings that the equity rally is largely driven by the monetary dynamics of zero interest rate policy and QE, that likely force investors in to an equity market as a function of there being nowhere else to go! If an equity market ‘rally’ can be driven by fear then just how fearful could a significant fall be?
"Europe lacks implementation of what has been agreed” - Wolfgang Schaeuble
After the release of the Fed minutes, Mario Draghi spoke in London, where he briefly touched on the currency in warning that "exchange rate behaviour remains among the major threats to prices in the euro area”. The main emphasis, however was on the importance of sticking to existing fiscal rules as a number of European politicians push for a relaxation (perhaps in line with the pace of structural reform) stating "to unwind the consolidation that has been achieved and in doing so divest the rules of credibility, would be self-defeating for all countries”. Political risk amid this disparity in the Eurozone is rising.
On the economic front the risks are also rising in the Eurozone. The sharp fall in German industrial production that we saw for Germany in May has been mirrored this morning in France and Holland. (France IP down 3.7% year on year) and while the survey data across the region remains fairly robust, there have been some concerning weakness in the hard data prints. At the moment, many commentators are comfortable putting these weak spots down to volatility - we caution of the possibility of something more sinister ahead.
In the UK, the trade data disappointed expectations with a wider than expected deficit in May (though only back to the middle of recent ranges), following on from the weak industrial production data earlier in the week. The slightly disappointing data has led some to suggest that the UK may be reaching its limits of growth, yield and consequently GBP outperformance. While we expect GBP gains to become much more difficult against the USD, we continue to view the prospects of GBP against a broader range of currencies, in particular the EUR, as strong.
New BoE Deputy Governor, Nemat Shafik, gave some insight as to where she stands on the MPC ‘hawkometer’, in a written testimony yesterday. While warning of substantial risks in both directions we would pencil in a modest hawkish bias for the new Deputy Governor as she suggested that the medium term equilibrium rate of unemployment may be at 6% ( well above the central BoE projection if 5.25-5.75%) and that the BoE’s next estimates of slack may be lower.
All that Glisters…
Elsewhere, a rise in the unemployment rate in Australia coupled with slightly weaker than expected Chinese trade data has undermined the AUD, and to a certain degree risk appetite. After a long period where the ‘hunt for yield’ has driven investors into equities, sentiment feels increasingly nervous. Against this backdrop, we expect the recent rise in gold to continue as we approach some very significant technical levels.
As the worlds largest annual sporting event, the Tour de France, leaves London in order to fulfill what its title suggests, we continue to look closely at the major driver of financial markets at the current ‘stage’ of the economic ‘cycle’! – global monetary policy.
Business confidence survey data from New Zealand overnight showed a sharp decline in sentiment from the first quarter of the year and, as the ‘Yellow Jersey’ holder of monetary normalisation the implications and connotations of rate rises from the RBNZ will be watched very closely indeed. As yet, while the sentiment data has been more mixed since the onset of the tightening cycle, the ‘hard’ data has held up moderately well – certainly well enough to enable the continuation of the suggested tightening path of the RBNZ (likely to bring 2 more incremental rate hikes this year). Indeed, just this morning rating agency Fitch upgraded the rating outlook for NZ to positive from stable in a further affirmation of their economic and fiscal progress.
If the RBNZ holds the monetary policy yellow jersey, then the chasing peloton consists of just the Fed and the BoE. Many global monetary policymakers have warned of the increased volatility that likely surrounds the process of normalisation from historic (if not unprecedented) global monetary stimulus. In this regard the impact of rate rises on the macroeconomic data in NZ will be analysed very closely by the peloton before they make any change of pace. That said, the timing of monetary normalisation will be purely a function of specific domestic economic (and price) momentum.
In the UK, new figures from the Recruitment and Employment Confederation (REC) and KPMG show starting salaries are rising at the fastest pace since the survey began 17 years ago. Such data contradicts the suggestion from the ONS earnings data which suggests wages are growing at a pedestrian 1.7% annual rate. With the UK economy likely to have grown at around 1.0% quarter on quarter in Q2 and a central bank that appears united in their view that gradual rate rises probably mean starting earlier, wage inflation is expected to be the trigger. This is, therefore, likely the key focus throughout through Q3 – we still expect the BoE rate normalisation process to begin in Q4.
Following on from the very weak German industrial production data yesterday, UK industrial production also disappointed expectations this morning (though it comprises a much smaller part of overall GDP than the German comparison). Whether or not this is a function of lower momentum in global industrial production or simply a correction in what is essentially a very volatile series, the disappointment does not detract from our positive view of GBP (vs. EUR in particular)
In the US, we have had little in the way of ‘new news’ since the extremely strong June employment report. The market will be intently focussed on any revelations to come from the minutes from the Fed meeting on the 17th – 18th June, however, it is very possible that prior to the June employment report sentiment from within the Fed was a touch more cautious than it may be now.
Last week we stated our view that the US economic backdrop is likely much stronger than the official data (and certainly the Q1 GDP data) suggests. The June Fed minutes will likely continue to maintain the moderate dovish bias that we have become accustomed to under Yellen, however, we expect the data to suggest increasingly positive momentum in the US. The US data calendar is light this week, with retail sales next week and CPI data the following week, being the highlights before the all-important advance Q2 GDP estimate on the 30thJuly. If the ‘rebound’ in US activity is as strong as we would envisage (around 4.0% annualised) then the monetary policy bias in the US may begin to change gear.
The term ‘lanterne rouge’ is used to describe the last rider in the race and whilst France is not able to make its own monetary policy decisions, its economic momentum, competitiveness and structural reform efforts are clearly ‘off the pace’.
French objection to the level of the EUR seems to be becoming more audible and while their request to place the exchange rate on the agenda for today’s meeting of EU finance ministers was rebuffed, it is becoming clear that many French companies and politicians are increasingly focussed on the need for a lower exchange rate in order to boost the country’s failing competitiveness. Chief executive of Airbus’s passenger jet business added to the debate overnight by calling for the ECB to intervene to tackle the "crazy” strength of the currency, suggesting that it should be ‘pushed’ 10% lower.
Elsewhere, Japanese current account data, released overnight, showed a mild improvement though the fact that the improvement was driven by income from assets abroad and not by still sluggish exports, lessens any impact. Improvements in Australian Business confidence and conditions overnight have supported the AUD ahead of the important employment report later in the week. With little data to focus on for the rest of the day, FX markets may well find and establish ranges in the near term. Bigger picture, the race is on!
"When in doubt, don’t” - Benjamin Franklin
Earlier in the week we espoused our views that "the underlying growth backdrop in the US is much stronger than the data suggests”, stating that while we still view the USD as undervalued (and the expected rate hike path in the US too low), that the June US employment report was going to be a key barometer. The release of the employment report yesterday, beat expectations on all levels, with stronger payroll growth, a lower unemployment rate (notably on unchanged participation) and higher than expected earnings growth (albeit relatively stable around 2.0%). In the last Fed minutes, there was a distinct reference to "rebounding activity”; yesterday’s employment report compounded that notion.
The official (final) estimate of Q1 GDP in the US was a contraction of almost 3%, which caused many to question the strength of the US (and the USD), however, measures of tax receipts, exports, hiring and relatively stable global growth, are not obviously supportive of such a sharp contraction. We maintain our view that the US economy is stronger than the data suggests. The only thing in this regard that we are questioning is the ‘information value’ (or even validity) of the Q1 GDP data itself.
EURUSD 2 year forward points have now moved through the recent cycle high at almost 150. The last time the differential was at these levels EURUSD was in the low 1.20’s! We are not suggesting that EURUSD is about to slide immediately to the 2012 lows, however, we do view the rate differential as a clear indicator that the interest rate market is beginning to fully price the monetary (and economic) divergence between the US and the eurozone: At some point, the FX market will too.
"I knew the record would stand until it was broken” - Yogi Berra
In the UK, a slight dip in the Service sector PMI in the UK was not enough to dent the markets enthusiasm for GBP yesterday. In fact, the very modest dip left service sector activity (almost 78% of UK GDP) at a very strong level historically, a level consistent with Q2 growth of around 1.0%, when taken in conjunction with construction and manufacturing data. Further, the employment component of the service sector PMI rose to a record high, suggesting that the UK continues to make progress in lowering unemployment, and, as we move closer to the equilibrium level, wage rises (and ultimately rate rises) will likely follow.
"Pessimism leads to weakness…” - William James
Straight after the very strong array of US data, Mario Draghi became the central focus and unusually, in the context of recent ECB press conference days, the market impact was very minimal. Essentially, Draghi’s sentiment was unchanged from last week as he stressed that "rates will remain at present low levels for an extended period” and that the governing council remains "unanimously committed to the use of non-standard tools”. Draghi also used the press conference in an attempt to clarify the modalities of the TLTRO’s. In summary, the ECB are still in need of a boost for aggregate demand in the eurozone, lending continues to decline at a sharp pace (EUR 111B since the announcement of the new measures last month), and while borrowing costs and deficits have fallen in many states, debt remains far too high and against such low growth and low inflation, is not likely to improve any time soon.
Draghi was also clear in the press conference that a full asset purchase programme remains on the table if "the inflation assessment were to change”.
"High level of corporate debt [is an] obstacle to investment” - ECB, Carlos Costa
Drawing this together, the clear signs of a significant rebound in US activity (ignoring for now our doubts over the information value or reliability of the Q1 data) and the transition of the UK economy (as decribed by Governor Carney) from "recovery to expansion”, were both further supported by this weeks data. key macroeconomic differentiators.
While the drivers of econbomic growth in the UK evolve from consumer driven activity into business investment led growth (and productivity gains?), a lack of progress in structural reform and failure of European corporates to follow the deleveraging that has occurred in the US and UK, remains an "obstacle” to eurozone growth.
H2 is all about Q2
As we see things now, the release of the Q2 data in the US, UK and eurozone will be perhaps the most significant juncture yet for the global economic recovery and the onset of policy normalisation. In the UK, we now expect growth at around 1% quarter on quarter which, if the breakdown suggests a continuation of improvements in business investment and broadening recovery will likely spur rising dissent on the MPC. We maintain our long held view that the first UK rate hike will come in Q4 2014.
In the US, the data is likely consistent with a 4% annualised growth rate in Q2, equivalent to that of the UK. While we do not expect an immediate tempering of the dovish bias at the Fed, provided there is not a significant fall back in momentum between now and the Q2 release we find it difficult to see how the Fed maintain such prolonged expectations of monetary stimulus in the face of such defined improvements in output and employment growth.
In the eurozone, we expect a very pedestrian 0.3% quarter on quarter growth in Q2, coinciding with the uncertainty of the TLTRO uptake and the AQR in earnest. History books may note Q2 as the turning point for the US economy and the start of monetary normalisation, the eurozone, however, will likely have to wait.