"The end is where we start from” T. S. Elliot
In our last piece, we discussed the progression of global monetary policy trajectories (and, more importantly, differentials) following on from the minutes of the October FOMC meeting. We stated at the time that, in our view, the minutes confirmed (barring an external shock or unexplained collapse in the data) the intention of the Fed to begin its process of monetary normalisation in December. This week, however, belongs to the ECB, at least until Friday’s US employment report.
On the 20th November, Mario Draghi compounded the dovish sentiment he initiated at the October ECB meeting by expressing his concerns about the potential downside risks to and of inflation. Draghi stated that the "ECB cannot be relaxed about low core inflation” and perhaps more significantly, that the "ECB will do what it must to raise inflation quickly”. Expectations are now high for Mario, but he and the rest of the ECB will be fully aware of the connotations of disappointing a market that they are responsible for ‘revving up’ in the first place.
"Negative rates target overvalued CHF” Thomas Jordan, SNB
Last week’s leak of the ECB’s internal discussions on the technicalities of a two tier deposit rate suggested to the market that the ECB were preparing for a bigger cut to the deposit rate, further into negative territory. In a move that would essentially mirror the SNB, we expect that its motivations are also driven by an ‘informal’ desire to boost inflation "quickly” via a lower currency. The fact that the EUR is a significant global reserve currency could well mean that the impact on its value is far greater than we have so far see with the CHF.
GBP underperformed yesterday, only to rebound later in the day, with GBPUSD trading below 1.5000 for the first time since April. From our perspective, GBP remains undervalued in many respects, particularly relative to the EUR (likely the only currency that has as much to lose from a Brexit as GBP). This morning also saw the release of the BoE 2015 Stress test results which saw all 7 major banks pass. Market concerns over onerous future capital demands were not fully validated, as the BoE stated the countercyclical-capital buffer will rise to 1%, but that UK banks only have a "little more capital to build by 2019”.
"I didn’t mean to turn yuan” Robert Palmer?
Yesterday the IMF formally announced the Chinese yuan’s inclusion into the SDR (Special Drawing Rights - a basket, or unit of account, of foreign exchange assets defined and maintained by the IMF) basket. The allocation, arguably at the lower end of expectations (10.92%), is a big boost to the yuan’s internationalisation progression and a strong positive for Chinese corporates. However, now that the process has been ratified and, given recent further declines in the Chinese data, it is likely that the PBOC now remove some of the support for the yuan and perhaps even allow it to fall modestly as hinted at overnight by PBOC’s Yi, who stated that "normal two-way fluctuation of yuan inevitable”.
"A good beginning makes a good end” Louis L’Amour
For a very long time now we have been proponents of the view that global monetary differentiation will be the dominant driver of FX rates. While many commentators are now suggesting that this is a prospect that is fully priced into markets and expectations, we retain our view. In the US, the pace of interest rate rises priced into the curve is very modest indeed, in the UK, there is only one hike priced for the whole of 2016. As we enter 2016 and the base effects of the 2014 oil price collapse fall out of the annual comparison, the case for rate rises will (to quote BoE governor Mark Carney) "come into sharper relief”. In the very near term it is likely the USD that benefits most from the global; monetary backdrop and our view is increasingly that the risks in 2016 for inflation (at least in the US and the UK, where leverage is lower and domestic demand higher) are in fact to the topside.
On the other side of this differentiation are those economies where there is an explicit easing bias. The most obvious, and urgent of which is the EUR and we maintain the view that Mario Draghi does not disappoint on Thursday. However, we also note the easing bias of the RBA, reaffirmed overnight, which may come into sharper focus if we do in fact see a further decline in the yuan. Lastly, we would not rule out further action from the BoJ in 2016, however, as per the ECB we would emphasise the greater risks of a negative interest rate, than necessarily QQE focused. Differentiation as a theme is beginning, not ending.
"This is what it sounds like when doves cry” Prince, When Doves Cry
With very little of note on the data calendar yesterday, the primary focus of attention was on the release of the minutes from the October FOMC meeting. At the time of its release (28th October), the October statement was a hawkish surprise to the market, upgrading its language in terms of household and business spending, downgrading its language of the threat of global economic and financial developments and explicitly referencing the December meeting as the point at which it will determine "whether it will be appropriate to raise the target range”. The doves that had until then held the majority, were then reduced to a minority.
We argued at the time that this development (in conjunction with that of the ECB) would lead to the reassertion of monetary differentiation as the key driver of FX once more and that the USD would be the main beneficiary. Last night’s release of the minutes from the October meeting, reaffirmed our views. The core theme from the release was the line "FOMC members wanted to convey that a December liftoff may be appropriate...barring unanticipated shocks”.
The suggestion that some on the Committee were uncomfortable with the language change implying a December liftoff and the fact that several said "downside risks to the outlook remained” were a modest counter argument. However, we would gauge that a majority is now in place to begin monetary normalisation in December.
We would also argue that the hawkish bias will likely have been strengthened further following the release of the (very strong) October employment report and even the (albeit very modest) uptick in the inflation rate. Perhaps the most significant line in the minutes, however, was that a "number of Fed officials saw reason to avoid delaying liftoff”. This change of emphasis towards the risks of inaction as opposed to the risks of action is a positive for the US, US rates and the USD. We have expressed our views noted before that the ‘Fed pays out on a draw’, meaning that the data only needs to match, not beat, expectations in order for liftoff. This set of minutes argues for even more generous odds.
If we look back at the interest rate markets since the October meeting, the (surprisingly) hawkish statement stands out as a turning point. 2 US year yields rose from the middle of the years range through to new cycle highs. It is likely that the October Fed meeting will be referenced historically as the turning point in Fed monetary policy and in many respects for the market.
"the future...exists only as a spectrum of possibilities” Stephen Hawking
At the other end of the monetary spectrum, a 15bp cut in the deposit rate from the ECB in December is all but priced in by the markets. ECB executive board member Peter Praet stated clearly this morning that "further interest rate cuts are part of the toolbox” and that it is "essential that uncertainty does not lead to indecision”. We have noted on a number of occasions recently that in our view, a rate cut (further into negative territory) is not only the most likely, but likely the most effective tool to revive the eurozone through a lower EUR exchange rate and we continue to see further medium term eurozone economic (and EUR) underperformance.
In the short term, however, there is likely little to get the markets excited about and the few second tier US data releases this afternoon are unlikely to drive new positioning (in either direction). The risks, therefore, may well be for some short term position squaring ahead of the weekend, and with a Japanese holiday on Monday, USDJPY could also be susceptible to some long liquidation.
Ultimately, however, our views remain unchanged: USD and GBP outperformance, EUR underperformance. This morning’s softer than expected UK retail sales data brings annual retail sales growth back down to a healthy but not spectacular 3.0%. However, an annual report from the ONS this morning showed that real weekly earnings rose for the first time since 2008 as broader optimism rises. We still view the market pricing of the first UK rate hike as too far away and retain a positive bias in GBP and UK rates relative to both its peers and expectations. As we move into 2016, we would expect the MPC doves to go the way of those at the Fed.
"De-anchoring of risk, economic slack: a dangerous cocktail” ECB, Peter Praet
Rising prices for fruit and vegetables pushed the eurozone inflation rate back into positive territory yesterday. However, the uptick in the annual rate to just 0.1% y/y, mirrored by an uptick in the core rate to 1.1%, was largely ignored by markets that are increasingly readying themselves for further action from the ECB early next month. Money market rates are increasingly reflecting expectations of a cut in the ECB’s deposit rate - a view we stated last week was our central expectation.
A similar uptick in the core measure of inflation in the UK was released this morning with an equally limited reaction in markets. This afternoon, an uptick in core measure of inflation in the US (while admittedly not the Fed’s favoured measure of underlying inflation in the economy) would take it to the heady heights of 2.0% and leave an ever diminishing chance that the Fed renege on their intimated December rate rise.
Our view on the USD has been clear and unwavering for a significant while now. However, even after a recent spell of strength, the prospects for the pace of USD appreciation to quicken into year end have likely improved of late and will, most likely, be driven hereon in simply by supply and demand.
"I need a dollar, dollar, dollar is what i need” Aloe Blacc, I need a dollar
When the global financial crisis hit the shores of Europe, the decline in the perception (if not the reality) of credit quality differentials between the US and Europe, as well as the surge in demand for USD funding drove a spike in the cost of USD funding relative to EUR funding - the cross currency basis swap. In 2008 and again in 2011, the situation became so extreme that the major central banks (Fed, BoE, SNB, ECB, BoJ, BoC,...) acted in concert to provide USD swap lines to satisfy the USD demand. While the current dislocation is not as extreme as the levels that caused concerted intervention, we believe that as we progress towards year end, this warrants close attention.
Over recent weeks, there has been a significant widening of this basis, most notable, however, is the fact that it is not singularly related to the EUR, but this phenomena is evident in the cross currency basis against JPY, CHF and GBP (among others) and because it is not seemingly driven by rising credit risk. At the short end of the curve, some of the demand for USD is likely driven by heightened expectations of central bank divergence (as the Fed likely begins its process of monetary normalisation). However, the widening of the basis swap at longer maturities is likely more a function of USD scarcity. It is thus significant that the 10 year EURUSD cross currency basis is trading near the extremes of the 2008, 2011 interventions (that were aimed at liquidity in the front end of the curve).
Furthermore, at the current juncture there is little sign of acute financial distress or weakness in emerging markets (EM), as moves in this spread have often historically implied. However, we have made the point before that the world (EM in particular) is structurally short the USD, after a decade of an abundance of ‘cheap’ and available financing in USD. If we take Mexico as an example, USD debts taken out in 2008 are now 60% bigger, as a function of currency movements. In Brazil and Argentina, the equivalent would be around 3 times the initial borrowing.
"Unlike Europe, China has a long term plan” Angela Merkel
We have noted on a number of occasions the recent rise of Sovereign Nation's blaming external developments for the weakness of their growth or growth prospects. Some more specifically point the finger at China weakness. In many respects, this is certainly true for exporter nations, particularly in the commodity space, that had become reliant on the (extrapolated) future industrial demand of the Chinese industrial powerhouse. As the new Chinese Administration makes its presence felt, it is becoming clearer that the basis for decision making, economic strategy, social development is a long term and, perhaps more importantly, forward looking plan. It is also clear that this plan implicitly takes into account certain necessary reforms that will moderate growth in the near term, in order to prevent wider, possibly uncontrollable, problems in the future.
In Europe, and arguably much of the rest of the world, the ‘plan’ has been focussed on fixing the near term problems that have already occurred. This retrospective policy guidance has not solved any issues in the eurozone, it has merely delayed them or pushed the problem into a different area.
"I just lurch from indecision to indecision” Alan Rickman
While the heightened tensions of the Greek debt debacle earlier in the year took some of the focus away from the troubles of the rest of the region (particularly as Spain enjoyed a cyclical recovery), the troubles remain. The ECB, and the eurozone itself have been almost constantly firefighting issues within the region, with mixed short term success. However, it could clearly be argued that what the eurozone lacks (despite the facade of its irreversibility) is a long term plan. Furthermore, in the near term, it remains very unlikely that we will see one either.
While the UK is far from innocent, the commitment to debt reduction and austerity has likely kept the wolf from the door, so far at least. It could certainly be argued that David Cameron’s attempt to renegotiate the EU treaties are an attempt to provide longer term stability, independence and flexibility. Success in this regard is, however, in no way guaranteed.
"... nought but grief an’ pain, for promis’d joy!” Robert Burns
In the eurozone, as the market intensifies its focus on the monetary policy decisions of the December ECB meeting, the side effects of previous ‘solutions’ to the region's ills are bubbling up once more.
The recent developments in Portugal, where PM Coelho’s minority government was ousted from power after just six weeks following a vote of no confidence. In coming days it is likely that socialist leader Antonio Costa will be invited to form a government. The fact that the socialist (and all other opposition parties) are openly ‘anti austerity’ adds to the fiscal risks, not to mention the risk of non-compliance with the eurozone (SGP) budget targets. To add to the uncertainty, rating agency Fitch have warned that "a less favourable trajectory in government debt to GDP levels could lead to negative rating action, as could weaker growth that had a negative effect on public finances.”
Elsewhere in the eurozone, with Spanish elections fast approaching, the Catalan independence debate is also bubbling up and is potentially a huge banana skin for both Spain and the eurozone. In Greece, the progress of the reform measures that were a precursor to further bailout funds appear not to have met the pre-determined timetable, thereby casting doubt over the timing of the next release of much needed funds. In Italy, the failure to address non-performing loans is ongoing. Government debt as a percentage of GDP is around 150% and growth continues to disappoint. Even Germany, not so long ago the pillar of economic stability in the region, is undergoing a period of sharp underperformance in its industrial and manufacturing sectors, not to mention the potential long term impact and implication of the VW emissions scandal.
"It is a bad plan that admits of no modification” Publilius Syrus
Following a quiet session yesterday (without the US and many others) we would expect the data focus to return, both in the US and the eurozone. In this regard, the week will likely reach another Friday crescendo with the release of the eurozone (and component nation) Q3 GDP reports and retail sales data from the US.
"You must always start with something” Pablo Picasso
EURUSD is, by volume, the most liquid and most heavily traded currency pair in financial markets. Its price action is influenced by large trade flows, M&A, funding (financing), global FX reserve holdings and, of course, speculation. At the current juncture, all of these factors are acutely focussed on the actions of the currency pair’s respective central banks.
We have discussed on numerous occasions over recent months about the increased sensitivity of central banks to the level of their domestic currencies. We have numerous examples, including the RBNZ statement that the level of the NZD was "unjustified and unsustainable” to the Riksbank and its unwavering monetary accommodation (negative rates and significant asset purchases). In the Riksbank’s case, it openly states that its policy is aimed at preventing a meaningful appreciation of the SEK, despite the currency representing an economy running at around 3.3% annual growth.
Recent market commentary and debate emphasises the focus of attention to EURUSD against the current backdrop and, more specifically, the concept of currency valuation. Ironically, we have a predominance of commentators arguing that the Fed may not hike in December (as is now around 68% priced by the market) for fear of USD strength and that others now view that the ECB may take solace in the aggressively negative interest rate in Switzerland and cut the Repo rate further into negative territory.
"Its the job that’s never started as takes longest to finish” J R. R. Tolkein
Our view is that, in their explicit rhetoric, both the Fed and the ECB have started… so they will finish.
For the ECB, as we have stated a number of times, it is likely that the most powerful economic revival tool at their disposal is a weaker EUR and while Draghi et al. officially maintain that the ECB does not target FX (as it is not part of their mandate), a rate cut further into negative territory will likely have the most profound negative impact on the EUR (which after all is a global reserve currency). This is our central expectation for December 3rd.
For the Fed this means that, barring a disaster in the data progression (or otherwise) between now and December 16th, the Fed will (finally) embark on the process of monetary normalisation - perhaps the loosest tightening of all time in terms of the subsequent pace of rate rises - but a tightening nonetheless. Many commentators have argued that the increased reference to the USD in Fed statements of late highlights a greater sensitivity. We would argue that with the Fed debate split between the ‘rates are too low for an economy running at 2.5%, with 5% unemployment’ camp and the ‘why raise rates until we get clearer indications of inflationary pressure’ camp, the heightened discussion of other factors (such as the USD) are a side show. We would suggest that the Fed could live with a higher USD if, as is likely the case for the eurozone, it is good for global growth.
Soft Chinese inflation data overnight further muddies the water between concerns over a China slowdown (spurring renewed softness in commodities) and hopes for further stimulus. Asian equities (those that were open) were caught in the crossfire. Ultimately, we see the continued China fragilities as being a negative for commodity currencies, particularly the AUD and NZD (which the IMF affirmed overnight remains "somewhat overvalued”).
"EUR exchange rate key for growth” Lorenzo Bini Smaghi
Regular readers will not be surprised that our core view remains for a lower EUR vs. the USD (and similarly, but perhaps less obviously, GBP). As we approach the end of a very complex and uncertain year for financial markets, participation is low from a historic perspective, but our conviction remains high that the prospects for a more acute decline in EURUSD are elevated against the current backdrop, and contrary to popular belief, the central banks may well be willing (if not public) participants.
Greek Reform Effort: Outstanding or Outstanding?
Another factor that is worth a mention is the ongoing Greek drama. While Greece does not command the column inches it once did, the negotiations for the release of the bank bailout funds are not progressing as some eurogroup members might have liked. The bailout was granted on the basis that reform measures were strictly adhered to and in accordance with the pre-determined timetable. Recent delays, due to incomplete progress from Greece, is nowadays simply a minor headline. A continuation of the impasse would not be.
"Hindsight bias makes surprises vanish” Daniel Kahneman
Earlier in the year we argued our case for the start of monetary normalisation from the Fed in September followed promptly by the BoE in November. However, the audibility (globally) of the turmoil in Chinese stocks and a surprise currency devaluation brought the troubles of the emerging world to the fore and dented confidence in the global recovery.
Moreover, as the September FOMC approached, the US data had shown signs of slowing in Q3 and concern that the US recovery would be dragged down by the faltering global economy grew. The big question now is whether the ‘slowdown’ in Q3 was a bump in the road, or a pothole that damages confidence, consumption, investment and thus the recovery. This afternoon’s US employment report for the month of October is thus very significant in its implications for the trajectory of the US economic recovery, US rates and the USD.
"Everyone’s quick to blame the alien” Aeschylus
In their most recent gatherings, it is perhaps surprising that most global central banks have pointed to their respective domestic strengths, and almost all have also pointed to external, or international risks. In part this can be explained through the transition away from manufacturing and global trade by China (and to a lesser extent Germany) and the disproportionate negative connotations for commodity exporter nations that have fed off the industrial expansion.
A brief glance around the major central banks at the moment, while offering little action, highlights a clear differentiator in terms of policy bias. While the ECB, SNB, RBA, RBNZ, Riksbank, Norges Bank and the PBOC have all stated and reiterated a clear easing bias, the Fed and BoE have the opposite.
"BoE report highlights global weakness, domestic strength” Nemat Shafik
Yesterday, it was the turn of the BoE to be placed under the monetary microscope. The response of the market (and many commentators) was that the Inflation report (and its accompanying press conference) was singularly dovish. From our perspective, however, we would argue that while the modest downward revisions to the growth and inflation forecast warrant a near term adjustment (down) in GBP and (lower) in rates, such weakness provides a medium term opportunity. Particularly, in the FX space, against a currency where the respective central bank has an explicit easing bias.
The MPC increased the emphasis of the pass-through effects on inflation from the strength of the pound, with the downward drag from the currency to core inflation judged to be persistent and stronger than previously estimated. However, the MPC also judged that economic slack has fallen to just 0.5%, and that while "UK growth has ticked down to around trend rate...private domestic demand remains resilient”. Furthermore, with tighter labour market conditions and higher wage growth than the US, the recent divergence between US and UK rate expectations are not sustainable in our opinion. As the UK unemployment rate pushes ever closer to its long run equilibrium, we would envisage higher wage pressures and broadening inflation pressures (particularly when the base effects of last years oil price collapse fall out of the comparison around the turn of the year) will boost rate expectations, inflation expectations and GBP.
Ultimately we retain our long held positive view of GBP and the USD against those currencies whose central bank has an easing bias. Against the current global backdrop we continue favour USD and GBP longs against EUR as the recent string of very weak German data continues to stoke expectations of further far reaching policy easing from the ECB in December. For today though, it is the US and the relative strength of the October employment report that will dominate the proceedings.
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