ECU's Investment Blog
During, what has turned out to be, a very action packed January, nine central banks have eased monetary policy, and that does not include the shift back to a neutral bias from the RBNZ last night or the launch of the Russian economy rescue package. It is perhaps not surprising, therefore, that the market held modestly dovish expectations for last night’s FOMC statement. As we see it, they were wrong.
"A little bit of attention can go a long way” Nicholas D. Kristof
Akin to giving a small child a new toy in order to cause enough distraction to remove an old toy from their comfort / security, the Fed introduced the term "patience” alongside the "considerable time” reference in the December FOMC statement, only to remove the "considerable time” in January. Simply removing the term "considerable time” in December, may well have caused a ‘tantrum’.
In our view, however, the rest of last night’s statement was much less surreptitious and significantly more bullish. Firstly, there was no mention of the recent rise in the USD that many commentators had (dovishly) anticipated. Secondly, the Fed stuck to its positive view of the impact of declining energy prices on demand and, maintaining the view that the disinflationary impact is transitory and that it continues to expect inflation ”to gradually rise towards 2% over the medium term”
"European economy lacks demand, needs investment” French Economy Minister, Emmanuel Macron
More significantly, from our perspective, was the upgrade to the descriptive narratives on economic activity (from "moderate” to "solid”) and employment gains (from "solid” to "strong”). In the US (and arguably the UK), strong demand likely means that the boost from lower oil (and broader consumer) prices is a clear positive for growth, and likely to counter further disinflationary forces going forward. In the Eurozone, where demand remains feeble, the impact of energy induced disinflation (deflation?) is, at best, more complex.
Growth in the US is above trend, particularly given the declines in productivity (and thus potential growth). In addition to the extraordinary decline in the US unemployment rate (which could also be viewed as declining economic slack), likely to reach the equilibrium level (viewed by the Fed somewhere between 5.2% and 5.5%) overcoming months, wage inflation is surely just around the corner?
"Good questions outrank easy answers” Paul Samuelson
We are increasingly of the opinion that US monetary policy is too accommodative, despite the low level of underlying inflation and this view was only strengthened by the inclusions (and omissions) from last night’s FOMC statement. Furthermore, we would view last night’s statement as a clear step towards monetary normalisation. The next step (provided the Fed’s data dependence criteria is satisfied) is likely the removal of patience in March, opening the way to a rate hike (yes hike!) in April or June.
"Impact of ECB action is currently underappreciated” Mark Carney
We have stated previously our view that the risks, as 2015 develops, are for higher growth and higher inflation. This is particularly relevant to the US and the UK, where we continue to see economic and currency outperformance. In this regard, we have also stressed our view that the UK (and GBP) is likely the biggest beneficiary of Eurozone QE in the short to medium term (at least until there are some signs of a pickup in broad demand in the eurozone).
To cut a long story short, we see the developments in the US and at the Fed, as supportive of further USD (and US interest rate) outperformance in the near term. In the UK, we expect growth and interest rate expectations to be reinvigorated over coming weeks which should provide a supportive backdrop for GBP.
Following last night’s surprise switch to a neutral bias from the RBNZ, we expect NZD and AUD to remain on the back foot. Indeed, markets have now priced in around two thirds of a 25bp cut from the RBA next week. US GDP, and ECI will be the key focal points for the rest of the week, but as an historic month for financial markets draws to a close, participants may take a breath before activity picks up again in February.
"I refuse to join any club that would have me as a member” Grouch Marx
The focus of financial markets has been very clearly pointed at the Eurozone over recent weeks, with the highly expected initiation of a Quantitative Easing (QE) programme in the eurozone and the contentious Greek General election that delivered a clear (and again highly expected) win for the anti-austerity Syriza Party.
Having chosen a fellow ‘anti-austerity’ coalition partner (Independent Greeks) very promptly, Prime Minister Tsipras will now, over the next weeks and months, work out how he can navigate a path between the political and legal rigidities of Eurozone debt forgiveness / restructuring and the desire of 75% of Greek people to remain in the Eurozone ‘club’. Given this narrow path and the defensive stance of the rest of the ‘club’ (exacerbated by the fact that the EFSF – the European Financial Stability Fund - owns 44% of Greek debt) we would expect this process to be fairly drawn out and, as a result, financial market interest to wane.
"FX market has not stabilised yet” SNB, Jean-Pierre Danthine
Interest in the CHF, however, picked up again this morning as the SNB highlighted that they are still prepared to intervene in the FX market and stated that the current level of EURCHF is "not justified”. The EURCHF rate rallied over 6% from yesterday’s lows (2% in less than an hour this morning). Heightened volatility in the CHF is likely to remain for some time to come. Over the long run we would anticipate that the (significantly) negative deposit rate will have a negative impact on the CHF, as it clearly has on the EUR. In the short term, however, volatility is likely in both directions
"BoE needs earlier rate rise” BoE Kristin Forbes
We have, on many occasions over recent months, stated our continuing view that UK economic momentum is stronger than the consensus view. With just 100 days to go to the UK general election there is clearly a case for a pick-up in GBP volatility as political uncertainty counters economic strength and momentum.
Yesterday, MPC member Kristin Forbes highlighted her hawkish bias in calling for an ‘earlier’ rate rise and, while stating that "the financial crisis impact complicates forecasting”, she highlighted fasterproductivity and GDP growth as risks to the UK outlook. Amid the acute focus on the Eurozone over recent weeks, the removal of the rate hike vote from Messrs Weale and McCafferty was viewd negatively for GBP. Furthermore, as we argued last week, it should be seen as less relevant that the BoE unites behind unchanged rates in the month that the ECB embarked on QE, when the market pricing of UK interest rates does not include a rate hike until 2016. However, we do not expect that Weale and McCafferty will remain in the unchanged camp for very long, particularly if as we (and increasingly, the MPC) expect, wage pressures continue to rise.
This morning’s GDP data disappointed expectations and slowed to 0.5% quarter on quarter. However, we maintain that this ‘slowing’ is more a function of erratic construction and mining productivity than a meaningful slowdown in underlying economic momentum.
The real focus in the FX markets should now shift back to the US with tomorrow night’s FOMC and Q4 GDP data (and inflation expectations) later in the week. There are two things that will be key to market sentiment from the FOMC statement: firstly, whether there is any mention of the USD strength over recent months and its impact and implications for inflation and or policy going forward; secondly, whether there is any further discussion on the wage pressures (after the discount rate meeting minutes continue to suggest wage pressures are growing).
Overall we continue to see further US and UK economic (and ultimately monetary) outperformance. Further, given that weakness in the Eurozone has been highlighted by policymakers as a key risk to the US and more pertinently the UK, Eurozone QE should be a positive for USD and (more pertinently) GBP. In FX, while we concede that heightened volatility will likely persist, so too it is likely that GBP and USD strength against the EUR (in particular) also persists.
"Can NOT afford NOT to have QE in Europe” Larry Summers
In the most keenly anticipated FX event of 2015 (considering SNB action was entirely unexpected), the ECB finally delivered on its widely expected programme of sovereign QE. Mario Draghi pledged the purchase of EUR 60B of assets (which will include purchases under the existing ABS and covered bond programmes) and to keep buying until September 2016, or until the ECB see a sustained improvement in the inflation backdrop. Those purchases will be made by the individual national central banks in their domestic markets (based on the capital key), while overall co-ordination of the purchases (and thus monetary policy) is retained by the ECB.
In this instance, ‘assets’ include securities issued by euro area governments and agencies, as well as European institutions (and will also extend to inflation linked and floating rate securities) across all maturities. There is, however, an investment grade threshold for eligibility, which can be bypassed for countries under a Troika adjustment programme, which is particularly relevant to Greece (or at least to voting intentions), into this weekend’s general election.
Before the main event there were 2 questions on the mind of the market. (i) How much? and, (ii) Will there be risk sharing? The first had been answered in part by a ‘leak’ on Wednesday that the programme was to follow a monthly purchase programme (as we discussed on Tuesday). The second remained moot but, it general, market consensus suggested a low likelihood of risk sharing.
Draghi roundly delivered on both counts (a double negative for the EUR), with the announcement that 20% of the assets purchased will be conducted under full mutual liability (All of the agency, or institutional assets – which can be up to 12% of the total - and 8% of the remainder). In reality, however, while Draghi has finally ‘crossed the Rubicon’ into direct Quantitative Easing, the overall package is broadly in line with expectations and will (now more believably than ABS and covered bond purchases alone) bring the ECB balance sheet back to 2012 levels of around EUR 3 trillion as he has suggested over recent months.
The reaction in financial markets (EUR, Eurozone bonds and European equities in particular) has been significant. In fact, if we look at the level of the EUR the last time the ECB balance sheet was around EUR 3 trillion (the target level of yesterday’s policy announcement), EURUSD failed to break through 1.20, despite significant prevailing fears of a Eurozone breakup. So what is different this time?
"We don’t need no education” Pink Floyd
In our view, the distraction of the Greek elections over the weekend are just that – a distraction. The real drivers of EUR in FX markets are likely the combined factors of a negative rate on what is a global reserve currency and the realisation of formal and more exaggerated monetary policy divergence. We discussed the impact and implications of the falling appetite for EUR in global FX reserves. If we add to this the monetary policy divergence and the fact that the monetary stimulus provided by the ECB will likely support global demand (reducing the likelihood of the US being dragged down by the Eurozone), the case for USD has improved.
Over the last five years, since the aggressive monetary easing of the US, the USD has been very widely used as a funding currency. Recently, the case for raising rates in the US has been improved by the rapid decline in the jobless rate and broad pick up in many macroeconomic indicators. While we have already moved in the region of 10 big figures in EURUSD this year (and thus the most accelerated part of the adjustment may already have occurred), the case for EUR being replaced as the world’s funding currency at this juncture is increasingly strong. EUR can continue to decline broadly in FX.
"Never judge a book by its cover” Floyd Mayweather, Jr
Looking forward, monetary policy will likely continue to be the driving force behind financial markets and FX valuations. In addition to this week’s ECB action, the surprise cut in Canada’s benchmark interest rate and the lower New Zealand CPI reading (causing sharply reduced expectations of NZ rate hikes – if at all) have led to sharply lower CAD and NZD.
In the UK, the headlines suggest that the monetary stance has loosened, with the change of heart from Messrs Weale and McCafferty (removing their respective votes for immediate rate hikes). However, we would argue that this makes little or no difference when the market expectation of the first interest rate hike is not even in the current calendar year.
A lot can change over the course of this year, despite the large adjustments that have already taken place. This morning’s retail sales data release from the UK suggests that economic growth momentum remains on course. Furthermore, the tempering of the biggest risk to UK growth (the threat from the Eurozone) will likely disproportionately benefit the UK, particularly in terms of valuation as contingent risks are pared back.
This year is going to be a very interesting year in FX. Volatility will likely be considerably higher than the past several years and thus the potential opportunity is commensurately far greater. Currently the world remains fixated by the threat of deflation and a lack of wage growth. Personally, I think it is just as likely that, at the end of 2015, we will have seen 2 interest rate hikes from the FOMC, 1 from the BoE, and it will be the fear of inflation that will be the more utilised noun / descriptive narrative from the commentators’ lexicon. Either way FX is key.
"Predictions are difficult, particularly about the future” Yogi Berra
According to the Telegraph, Francois Hollande told business leaders that the ECB will announce a QE package this Thursday, in a move that will support the French economy (later backtracking to refer to the ‘hypothesis’ of QE!). While Hollande’s rhetoric may just be seen as a faux pas, it underlines the broad market (and non-market) expectation that the ECB will announce, if not embark on, a programme of QE this week. Under these circumstances, we feel that it is very unlikely that the ECB disappoint, as the reaction would likely bring about a sharp and unwelcome tightening in monetary conditions as easing expectations are unwound.
The real debates at this current juncture are about size and risk sharing. Against the current backdrop (of expectations and the heightened sensitivity of the market to the absolute size of any bond buying package), we feel there is a higher likelihood of a US QE3 style monthly quota, rather than a total target purchase level. This may also go some way to allay German concerns over the size of the package (liability) and potentially gives the ECB greater flexibility going forward.
The second focal point is about the level of risk sharing or mutual liability of any bond buying programme. Sovereign bond purchases by the national central banks seems most likely. However, it has been argued that central purchases by the ECB (creating mutual liability) would send a stronger message. Our view is that in reality this has little meaningful implication. Indeed, it could be argued that some form of de facto mutual liability through the Target 2 balances at the ECB exists in any case. We therefore see this as a less important dynamic, providing the ECB do not disappoint expectations on the size (implied by monthly purchase amounts or otherwise) of the programme, which currently stand at around EUR 550B.
"ECB must not lower reform pressure by embarking on QE” CDU, Michael Fuchs
It is also likely in our view that caveats or conditions are included alongside any programme of bond buying in relation to retaining (or increasing in some cases) the pace of structural reform. Again, this likely appeases some of the concerns of the German contingent.
"People create jobs, not the government” Scott Walker
In the UK, sentiment has been quite negative over recent sessions, however, we retain a positive outlook for the UK (and for GBP) in the near term. While the general elections in May provide a headwind of uncertainty for the UK and for GBP, we expect that in the near term, there is the potential for the UK data to outperform expectations and thus question any negative positioning in GBP or UK rates. Tomorrow’s employment report is perhaps a case in point, as not only do we expect a further decline in the unemployment rate, but more significantly we see average earnings growth edging up towards 2.0%, further supporting consumer spending into 2015. We will return our attentions (in greater detail) to GBP and the UK over coming weeks. Suffice to say that, in the near term, we retain a positive outlook on GBP.
"Cross currents make for a complicated picture” IMF, Olivier Blanchard
The IMF has just released its World Economic Outlook (WEO) forecast update in which the headline rate for 2015 GDP has been cut 0.3 percentage points from October to 3.5% as the net positive impact from the oil price decline are offset by other factors. Within this headline figure however there are two clear divergences.
Firstly, the IMF, while retaining a broadly unchanged forecast for the advanced economies, has revised up its growth forecast for the US, +0.5 percentage points, largely due to more robust private demand. Against this, the IMF cuts its forecast for the Eurozone, -0.2 percentage points, despite the boost from lower oil prices, easier monetary policy and the recent EUR decline. Growth expectations have also been revised lower in Japan but left unchanged for the UK at a very respectable 2.7%.
The second divergence comes between the advanced economies and emerging markets (EM) where growth expectations in the EM space (and not just Russia, but also China and Latin America) have been revised significantly lower. Perhaps most significantly was the forecast for China GDP to fall below 7.0%, as it expects the authorities to focus on reducing vulnerabilities in credit and investments, rather than the underlying growth moderation.
The IMF view of the world is consistent with (and supportive of) our interpretation of the likely developments in the FX markets. The core view being that the case for US and USD (and UK and GBP) outperformance remains. Furthermore, it is unlikely that the ECB expects any QE to have a major impact on bank lending or private demand. Instead, the desired impact of QE from the ECB is likely to stimulate portfolio shifts and, most importantly, a lower EUR.
"Equilibrium is the very opposite of disorder” Rudolf Arnheim
Around 9:30 (GMT) yesterday morning, just as I was gathering my thoughts to compose a blog, the Swiss National Bank (SNB) changed the rules, and the financial market backdrop. For approximately three years the Swiss National Bank (SNB) has maintained a ‘cap’ for the CHF against the EUR, introduced as a means of curbing excessive appreciation and overvaluation of the CHF during the financial crisis as global macroeconomic and political uncertainty drove capital flows into the ‘safe haven’ of Switzerland. Ever since introducing this cap (at 1.2000 CHF to 1 EUR), the SNB have persistently (most recently on Monday) stated its "utmost determination” in defending the cap, with "unlimited” selling of CHF.
As a function of the asymmetric nature of CHF trading (further exacerbated by the fact that the SNB ‘guarantee’ meant that there was no functional FX options market for strikes below the 1.2000 level), and the implicit SNB guarantee on the maximum value of CHF vs. EUR, the risks to the currency (and the SNB) had become increasingly acute over recent months, resulting in a significant increase in the SNB’s balance sheet over the last quarter. The implications for broader financial markets on the potential liquidation of the SNB balance sheet over time are less clear, but volatility in FX markets has likely shifted to a new paradigm.
The debate over the SNB decision to remove the peg, and impose a negative deposit rate of -0.75% (a deterrent to capital flows – as powerful a deterrent as a pea shooter to an army in the very short term) will likely continue for many months. The market has broadly drawn the opinion that the SNB action was motivated by its expectations of further easing in the Eurozone (QE) and the potential for currency inflows from Greece as a function of uncertainty surrounding next weekend’s general elections. The pace of SNB balance sheet accumulation over recent months (as ECB QE expectations have grown) had reached unsustainable proportions as sustained weakness of the EUR has become increasingly central to ECB policy.
"Cannot solve structural problems with a printing press” Jens Weidmann
In Q3 2014, global foreign exchange reserves peaked, according to IMF data. Further, the EUR share of those reserves is also decreasing. The fall in reserves is far bigger than can be explained by valuation effects and reflects, mostly, the aversion of reserve managers to the Eurozone negative deposit rates. The same theme is visible in euro area balance of payments data, which show a sharp increase in the amount of money deposited abroad by Europeans (as opposed to being invested in bonds, equities …). Both contribute to a lower valuation of the EUR.
Negative deposit rates seem to be having the desired effect on the EUR, which is no longer being driven by capital flows associated with European sovereign risk (tighter spreads do not mean firmer EUR), and is increasingly dominated by interest rates. It could be argued that with Eurozone bond yields as low as they are, QE will have a minimal impact on lowering longer dated interest rates or increasing demand for borrowing in the Eurozone, and we would agree with this sentiment. However, failure to embark on a path of QE at this stage will lead to an unwanted and unwarranted ‘tightening’ in monetary conditions in the Eurozone. At the current juncture, the likely motivation of the ECB is to ease conditions across the region by the only realistic medium that they can influence – a lower EUR.
Overnight governing council member Benoit Coeure said that the ECB will take into account the US and UK experiences when determining the amount of debt to restore confidence and push inflation back up towards 2%. We envisage, at the very least, that the ECB will announce a QE programme next week. It may be that the full details will be delayed until after the Greek elections, but anything less than the announcement of a 500B programme (significantly below equivalent ‘adjusted’ programmes in the UK and US) will disappoint market expectations.
Drawing a distinction!
Earlier in the week BoE governor Mark Carney said "I would agree with the orientation of the governing council that additional stimulus would be consistent with achieving their inflation mandate” and that it is important to "draw a distinction” between situations in the UK and in the euro region, which is suffering through a period of "persistently low inflation”.
We retain the view that the UK economic momentum is stronger than consensus and thus, amid higher volatility (and thus more proactive risk management), we continue to favour a lower EUR in FX markets, specifically vs. USD and GBP.
"Whenever you find yourself on the side of the majority it is time to pause and reflect” Mark Twain
In some respects the financial markets are taking a pause for breath this week, as the lighter data calendar reduces the urgency to act and increases the emphasis on the potential impact resulting from events next week (ECB 22nd, Greek general elections 25th, FOMC 28th). The reduction in the frequency of (significant) data releases also enables reflection on the implications of the sharp decline in oil prices: Negative concerns (that the pace of the decline may create financial instability and increased deflationary behaviour) conflict with the positive connotations of boosting global purchasing power and real incomes.
"Wages are a swing factor going forward” Dennis Lockhart
The USD index has stabilised after reaching a new 9 year high last Thursday, despite a stronger than expected employment report on Friday. The key confusion from the report was the unexpected drop in US wage inflation. Weak US wage inflation could be explained by the high concentration of low paid seasonal payrolls that will likely have negatively impacted the data. If this is the case, we would expect wage gains to bounce back in January but, whatever the true explanation, we would expect any ‘wobble’ in US average earnings to correct higher as we move towards full employment in the US. We retain the view that the progression of US growth, inflation and employment are consistent with a monetary normalisation in the US beginning at the end of Q2.
"I would have answered your letter sooner, but you didn’t send one” Goodman Ace
The big event of today has been the release of the December inflation report from the UK. The market was expecting a decline in the headline rate significantly below the 1.0% level, which triggers the requirement for Mark Carney to write a letter to the Chancellor to explain why inflation is more than one percentage point from the BoE mandated target and what (if anything) he is going to do about it.
Carney has recently stated that the fall in the oil price is unambiguously positive for the UK (sentiment that we would strongly agree with) and thus we would expect the BoE to look through the recent oil induced inflation target miss.
Real wages… wage growth… interest rates… currency
In the UK, as in the US, the fall in the jobless rate has been impressive. Indeed, in the UK, we are encouraged by the tentative signs of wage growth of late which, as a function of further headline inflation declines, push real wages and thus household purchasing power up. This is a significant boost to the economy even though, in the near term the market has been increasingly focussed on falling inflation and (amid rising global economic and geopolitical risks) lower yields. In economies where domestic demand remains well placed (UK, US, …) we would anticipate that, over coming months, the positive benefits on consumption and growth will outweigh the stability concerns. Consequently, we anticipate that a likely re-evaluation of yields and rate rise expectations will have significant positive implications for those currencies.
In essence, we continue to favour the USD and, once the uncertainty of the UK general elections has passed, we would anticipate that the strength of the UK economy will drive higher interest rate expectations (and the currency) higher at a more pronounced pace. We have witnessed a number of prophesies for 2015, many of which include substantial macroeconomic and geopolitical negatives. While of course we need to be mindful of key (geo)political event risks, here and abroad, the big surprise of 2015, may be that things turn out to be much betterthan the general consensus. Oil prices falling more than 50% could well be a primary instigator of this.
In the near term, yields continue to dominate. In Japan, overnight 5 year JGB yields fell through zero and, as the conviction of JPY shorts begins to be tested by a narrowing of 2 year US / Japan yield differentials, the USDJPY exchange rate has felt heavy. Lower US yields, ascribed by Atlanta Fed President Dennis Lockhart overnight as a function of safe haven capital flows, are also moving lower. However, we would anticipate that (at least at the front end – medium term equilibrium yields in the US are still much more of a moot point) US yields will continue to stay supported as growth momentum continues and the impact of lower oil prices makes a transition from causing lower rate expectations to higher growth expectations, something which will surely spill over into currency trends.
Later this week we will shift our focus back to the Eurozone, where the events at the end of next week are likely to shape things to come for the region and its currency.