"Rate rise is a sign of strength in economy” BoE, David Miles
Much has been made of the equity market falls, and related (extreme) financial market volatility, placing the blame on the collapse of Chinese growth and Chinese equities as well as global commodity prices. It could be argued, however, that yet another ‘excuse’ for inactivity from the Fed, in the minutes of the July FOMC meeting (and overall a more dovish set of minutes than the market had expected), that undid broader investor confidence. Indeed, the recently released Fed minutes from the July FOMC meeting noted that "a prompt start to normalisation would likely convey the Committee’s confidence in prospects for the economy”.
Likewise, upon leaving the BoE, David Miles gave a speech suggesting that the turning point on UK rates was "pretty soon” and that when it does come, a rate rise would be a "sign of strength in [the] economy”. If this is the case, then the endless excuses and procrastination of the Fed would imply the opposite - a sign of weakness in the economy? It would be ironic if a lack of investor confidence inspired by a Fed lack of commitment were to be the root cause of a delay in the Fed normalisation cycle.
The Great Fall of China
Chinese A shares had fallen more than 28% from the high on the 18th August to the low yesterday (just 5 trading days later), when the much awaited official response finally came. The PBOC cut its main lending rate for the 5th time in a year to 4.6%, and also cut the amount of cash that banks must set aside under the Required Reserve Ratio (RRR)
Global equity markets see Chinese economic weakness and equity declines as undermining global risk sentiment, while the Chinese look at global economic turbulence and "severely weak” external demand [MofCom Chen]. This circular argument further raises uncertainty. Finding the new equilibrium may take some time.
One Direction - No more
The FX world is undoubtedly dominated by global equity market gyrations at the current juncture, and uncertainty - admittedly dominated by acute risk aversion - has generated a regime shift in baseline FX volatility. Daily ranges are significantly wider, correlations have broken down and position unwinding remains a key driver. Against this backdrop a significant reduction of overall risk exposure is likely prudent.
In the US, the debate over the imminence of monetary normalisation continues between those who feel that the Fed should have begun already, and those who feel that a rate rise in the current environment would be catastrophic. We remain firmly of the former view. If equity markets calm, and the August US payroll demonstrates continued progress, then the prospect of a September rate rise in the US is not lost. However, if heightened volatility and risk aversion in global financial markets continues, it is likely that the Fed can provide yet another excuse for inaction.
For the rest of the week, economic data may well be a welcome distraction from equity markets (although likely only temporary). US durable goods orders this afternoon and the (upward) revision to Q2 GDP tomorrow, should provide something of a positive perspective on current US growth. The PCE print also likely provides further confirmation that core prices in the US are in fact fairly healthy at around 1.8% y/y.
"First law on holes - when you are in one, stop digging!” Denis Healy
"We excuse our sloth under the pretext of difficulty” Quintilian
The FOMC minutes on Wednesday read like a discussion of reasons for inaction. Excuses for delaying the prospect of monetary normalisation against a background of knowing that the time for the first hike is approaching. One of those reasons (excuses?) was the concern about the slowdown in Chinese growth, and this was before the the volatility surrounding the CNY (mini) devaluation and further equity market declines. Last night’s Chinese manufacturing PMI fell to its lowest level since the global financial crisis accelerated, adding to concerns over China and its relationship with global growth and further commodity declines. The implication is likely significant further declines in global risk sentiment and, in an increasingly weak equity market, the FOMC may well have found the perfect excuse for delay.
When read in full, the Minutes from the July FOMC meeting are more upbeat than many of the headlines suggest. Some participants even viewed the "economic conditions for beginning to increase the target range for the federal funds rate as having been met or were confident they would be met shortly”. Furthermore, the phrase viewed as most dovish was "Almost all members indicate that they would need to see more evidence that economic growth was sufficiently strong… for them to feel reasonably confident that inflation would return to [their] longer term objective.” At that time, the latest information showed that GDP contracted in Q1 and had rebounded modestly to 2.2% in Q2 - We now know that growth was in fact positive in Q1 (after revisions) and that growth trackers are likely to suggest Q2 accelerated more rapidly to above 3%.
The minutes also contained significant debate and in most cases conclusion about the treatment of reinvestments and of certain aspects of the Fed SEP’s (Summary of Economic Projections) once the process of normalisation begins. This ‘housekeeping’ is further testament to the view that the start of normalisation is imminent.
With FX increasingly driven by two core themes at the current juncture - the continued problems in Emerging Markets (EM), from China slowdown and falling commodity prices and, the changing expectations of the path (and starting point) of the US interest rate normalisation cycle - both volatility and uncertainty are rising.
The minutes have not removed the chance of a September rate hike from the Fed, however, interest rate markets have revised its implied probability to just over a third from just under a half. As the focus of market attention turns to risk sentiment and, more specifically equity market sentiment, drivers for Fed rate hike expectations may transition to broader market confidence.
"Confidence is contagious, so is lack of confidence” Vince Lombardi
In this regard, EM is now the dominant driver of FX in our view - major currency pairs are, against the current backdrop, being dragged around (at times counter to macroeconomic developments) by capital flows and negative sentiment from the developments in EM. The disappointing Chinese manufacturing PMI this morning, bring the weakness of EM and the commodity complex back to the fore.
While we would not disagree that there are huge opportunities for many EM countries in future years, the evolution of EM requires continued reform and restructuring. The huge USD debt burden and issues of capital outflow in the near term by far outweigh the ‘long term potential’ positives. The recent unwinding of EM ‘carry’ trades using USD and EUR as a funding currencies have further increased volatility in major FX. Our broad view remains that the Chinese economy will be OK, however, as resources are shifted from manufacturing to the service sector, and thus demand for raw materials abates further, the correction is likely more painful for commodity exporters (and those central to the Chinese manufacturing network). This is a further negative to a number of EM nations, but also Canada, Australia and even Germany. As ECU Global Macro Team member Stephen Jen puts it "What is a genuine 7% GDP growth for China, will feel like 3% for Australia”
The current backdrop is dominated by confidence. As the Fed noted, a "prompt start to normalisation would likely convey the Committee’s confidence in prospects for the economy”. Hints at a delay likely only contribute to a negative feedback loop between US policy and US Equities. If we add in the backdrop for EM, confidence is at an even greater premium for global financial markets.
"Excuse me while I interrupt myself” Murray Walker
"It will not always be summer, build barns” Hesiod
Summer months in financial markets can often be volatile, illiquid, irrational or all three. In many respects this is true of recent weeks in FX, heightened by the uncertainty over the path of US monetary normalisation and the volatility of the US data upon which Fed policy has become (by the clear emphasis of the Fed) "dependent”.
The economic slowdown in China interlinked with the sharp decline in the commodity complex has created a particularly negative backdrop for the emerging market (EM) currencies. The issue for EM becomes more acute, particularly for those with strong China trade or commodity export links, when you consider the forward extrapolation of decline in projected Chinese growth - and the resultant (compound) downward revisions. Consequently, the backdrop for EM remains very negative.
In the major currency space, the impact on trade and financial market sentiment is split more evenly between the US and China stories. US data continues to dominate. After the disappointing Empire State manufacturing data yesterday, greater emphasis is likely to be placed on the Philadelphia Fed survey on Thursday and the nationwide release on Friday. Housing data, which has been more resilient of late is scattered in between.
In the UK, the monetary normalisation debate is also key. MPC member Kristin Forbes maintained her hawkish stance over the weekend, highlighting her view that "keeping low rates for too long risks distortions” and may even undermine the recovery, "especially if interest rates then need to be increased faster than the gradual path which we expect”. Forbes also stated that the key rate would have to rise before CPI reaches 2%, adding that the low headline CPI may be hiding underlying pressures.
The data focus also turns back towards the UK this week, This mornings CPI release provided a stronger than expected inflation read, with the headline print rising 0.1% y/y and the core (stripping out the volatile energy and food prices) at 1.2% y/y. This is before we start to see signs of the ‘marked pickup’ towards the turn of the year that is the central expectation of the Bank of England.
UK retail sales on Thursday are expected to have risen around 0.4% m/m in July. Overall, we feel that there is a modest upside risk to the UK data relative to expectations. From our viewpoint, and despite the hawkish rhetoric from a number of BoE voting members, UK rate hike expectations remain weak. We remain of the view that the BoE will embark on a (gradual) path of monetary normalisation in November (likely caveated by the Fed going in September) - This is a long way closer than the current market pricing of June 2016 prior to today’s data.
It is likely the US data that is the dominant focus of broader financial markets. However, Japan has also become more central to broader market focus, with the release of the Q2 economic growth data. Japanese Q2 GDP contracted (into a quintuple dip recession), as consumer and business spending disappointed, despite record corporate profits. The prolonged weakness has led some to doubt the efficacy of Abenomics and the potential for further economic stimulus. With USDJPY up against significant technical resistance at 125.00, bolstered, no doubt, by the view that neither MoF nor BoJ are actively seeking to solicit a weaker JPY at this juncture. JPY is likely to become more interesting over coming weeks, months
"Pain is temporary, quitting lasts forever” Lance Armstrong
On Tuesday we suggested that uncertainty surrounding the implications of the actions of China may increase uncertainty around the precise timing of the first step in US interest rate normalisation and that "this may lead to some USD volatility in the short term, but we view any sell off as a longer term buying opportunity.” We maintain this view.
The devaluation of the Chinese yuan (CNY) came as a shock to the market. Neither the implications or direct motivations are clear. It may be that the Chinese authorities are seeking to reverse some of the currency gains that have occurred after 10 years of ‘managed’ appreciation. It may be that they are attempting to get ahead of the Fed and proactively prevent further appreciation relative to the region. Over the past year, the devaluation of other currencies in the region against the USD has been substantial. As the Chinese economy continues to slow, the impact of the falling competitiveness has arguably become more acute. Whatever the motivation, a prolonged depreciation risks increasing capital outflows.
While the Chinese developments are as interesting as they are complex, it is the impact on the global economy that is most relevant - particularly given the significant reaction of global financial instruments to these events. Putting things into perspective, a 3% decline in any currency has very limited significance and the 3% decline in the yuan has only reversed its gains since July. If, as we are led to believe, the decline is not the start of a continued policy of currency depreciation, then any impact should be transient.
"Yuan fixing adjustment basically already completed” PBOC
The slowing of the pace of depreciation of the yuan overnight and the insistence of the authorities that the "yuan is a strong currency in the long term” and that fundamentals do not warrant a continued decline, brought equity and bond market stabilisation. This stabilisation likely warrants a reversal of recent moves.
Furthermore, the return of US data, after a quiet start to the week, brings the focus back to the ‘will-they, won’t-they’ debate about a Fed September rate hike. The events of the past few days have undoubtedly dented market expectations of a September rate hike. However, September remains our central expectation for the (much overdue) first step on the path of US monetary normalisation. After the recent USD volatility, we anticipate that the USD regains a dominant foothold in FX markets over the coming sessions.
The data focus today comes in the form of US retail sales. We look for an above consensus 0.7% for July after a modest dip in June. While we remain positive on the USD, the intensity of the data focus, persistently reiterated by the Fed means that any disappointment in the headline may delay any USD rebound. Temporarily.
"Temporary solutions often become permanent problems” Craig Bruce
In Europe, the implication of progress in the Greek bailout discussions has been viewed as a positive, admittedly against a backdrop of (temporary?) USD weakness. From our viewpoint, however, the issues are far from resolved.
The core issue of debt forgiveness for Greece remains. German Government spokesman Steffen Siebert stated clearly yesterday that "No reduction in Greek debt principle is possible”. While Greece’s deputy PM, Dragasakis, stated that "Greek debt relief will be what makes the deal viable”. The German contingent also maintain the view that the IMF must be part of the new deal, despite their opposing views on the need for debt reduction.
"Now life will return in this electric storm” T’Pau: China In Your Hand
Overnight, China devalued the yuan by the most in two decades calling it a ‘one time’ adjustment that will strengthen the markets ability to determine the daily fixing. The Central Bank set the Yuan central parity at 6.2298 this morning vs. 6.1162 yesterday. This comes after a period of propping up the yuan to deter further capital outflows, which have become increasingly significant of late.
Furthermore, the PBOC said in a statement that the firm yuan is "putting pressure on exports” and that the (daily FX) fix has "deviated from market rates for a long time”. Exports have been on a weakening trend for a number of years and the data released this weekend highlighted a further, worrying, decline in China’s trade growth. This morning’s move is a clear determination by the PBOC to combat this deteriorating backdrop.
It is also likely that the Chinese authorities have half an eye on the (increasingly in our view) imminent prospect of higher US interest rates and thus the pseudo ‘freeing up’ of the yuan is (at least in part) aimed at preventing an unsustainable build up of market positioning against the authorities (a concept that the Swiss National Bank became all too familiar with at the start of this year). It is, however, potentially much more significant than that.
All of this has brought the concept of currency valuation back to the fore. The key point going forward, is whether or not the move by the PBOC is truly a "one time adjustment” or the beginning of a new currency regime for China. Our view is likely the latter. Yu Yongding, a member of China’s Monetary Policy Committee when the yuan was revalued in 2005 said that the yuan exchange rate will likely now enter "a period of stabilisation or even depreciation” and that it is the end of an era for yuan appreciation. Speculation is likely to increase that the yuan will now play catch-up with the currency depreciation of China’s major trading partners. To put this into context, the yuan has gained over 50% against all three of the other BRIC (Brazil, Russia and India) currencies over the past decade.
"A prophecy for a fantasy”? T’Pau: China In Your Hand
Elsewhere, news headlines this morning suggest that Greece and its creditors "agree terms for [their] third bailout”. It is unlikely, however, that any deal agreement is the last we’ll hear from Greece, as highlighted by the Greek Newspaper Kathimerini, which points out that the bailout draft contains no less than 35 prior actions.
This morning’s German ZEW survey exhibited an interesting divergence in the eurozone’s growth engine. The current conditions index improved from 63.9 in June to 65.7 in July, highlighting the impact and impetus of the extreme monetary accommodation in the eurozone as (extremely) cheap funding and a recovery in the eurozone periphery boosted output. On the flip side, however, weakness in global aggregate demand (and weakness in key areas such as China and Russia - not to mention the broader eurozone) and wide ranging global economic uncertainties, continue to weigh on "future” expectations, the index of which fell sharply to 25.0 in July from 29.7 in june.
"Don’t push too far…” T’Pau: China In Your Hand
The biggest winner from all of this has to be the USD, as the primary driver of global growth and likely the "yellow jersey” in the race to monetary normalisation. Arguably, on the grounds that the UK faces less international pressure in its monetary policy setting, the case for a UK rate hike is increasingly clear and thus the case for GBP strength is compelling, although we still expect the UK to follow the US, the market pricing of a UK rate hike is significantly further out.
Policy intentions of the FOMC and MPC were brought further into focus last night with policy board member rhetoric.
Fed voting member Lockhart stated that "Fed policy should shortly reflect [the] economy’s gains” and that the "point of liftoff is close”, highlighting that the July US employment report showed satisfactory improvements.
Outgoing member of the BoE MPC David Miles (formerly referred to as the arch dove on the MPC) was perhaps equally as hawkish, suggesting that the "Rate vote was NOT a compelling clear-cut case” in August and that "rate rises starting well into 2016 may be too late”.
"Eleven minutes late, staff difficulties at Hampton Wick” Reginald Perrin
Travelling to work yesterday morning you would have been forgiven for thinking that "Super Thursday” was descriptive of the collective effort of commuters to utilise their shoes (running or otherwise), bikes (Boris-or otherwise) or even scooters to get to the office in spite of the tube strike. However, while the feat of amalgamating the Quarterly Inflation Report (QIR), the Interest rate announcement and the Minutes of the policy meeting, by the BoE, into a single, consistent release could well be considered ‘super’; the overall market impact (at least at its first attempt), was less so.
"There’s no smoke without the worm turning” CJ, The Fall and Rise of Reginald Perrin
The MPC voted 8-1 for unchanged rates in August, with Ian McCafferty the sole dissenter. While this disappointed many commentators (including ourselves), the progression towards monetary normalisation at this stage is likely not reflected by the binary nature of the vote - i.e the vote gives us no gauge as to how close the remaining 8 members are to voting for a rate hike, or what criteria would be needed, simply (and as we would concur) that we are not there yet. For a significant period prior to the August vote, we have stated our view that the BoE will likely raise rates in November (following a Fed hike in September). Nothing from the QIR, rate decision split or the Minutes of the August MPC has altered this view.
The Inflation Report central projection at the 3 year horizon was left unchanged at 2.14% (rising at the two year point - a modest inflation target overshoot) assuming market rates, which currently only price the first rate hike by the end of Q2. However, the Bank raised its GDP forecasts for 2015 and 2016 as well as raising its forecast for 2015 wage inflation from 2.5% to 3.0%. Slack continues to be eroded.
In the Q&A, there was further emphasis on the inflation outlook and the impact of GBP’s dramatic fall and rise over recent years on headline inflation levels. Carney said that "sterling strength is having an influence on policy” but, that the recent rise in the "pound has not removed the need for gradual rate increases”. Furthermore, Carney pointed out the collective MPC view of the sustainability of the UK consumer spending recovery, labour market tightening and rising wages that, while inflation may be low, inflation pressures are building and the one-off effects on inflation (from the stronger pound, lower energy and commodity prices) will dissipate. But it is not just the consumer driving the UK economic rebound. Ben Broadbent pointed out that the data suggests that business investment has played an even more significant role in the recovery.
Ultimately we retain a positive bias towards GBP on economic and monetary differentials. In the Q&A Carney clearly stated that the August MPC vote decision was entirely consistent with a rate hike focus at the turn of the year and while, at present, the "rate hike need reflects domestic inflation pressure”, any signs of a broader global recovery (or stabilisation in many areas), would, in our view also bring that rate hike need even more into focus.
Carney also touched on a point made by ECU Global Macro Team Member, Professor Charles Goodhart (at the Fathom Monetary Policy Forum earlier this week) that whilst there has been, and continues to be, a number of global uncertainties, that "uncertainty is no justification for policy stasis”. Fellow former MPC member Andrew Sentance adds that "excuses for delaying hikes, such as the level of the pound, low inflation or uncertainty about the global economy would be more convincing if rates were already at more normal levels and rate rises could be considered a genuine tightening of monetary policy.” We would strongly agree with these sentiments. As we have been at pains to point out, there is every difference between normalisation of interest rates (i.e. withdrawing extraordinary emergency and ‘crisis’ induced measures), and embarking upon an active cycle of monetary tightening.
"The early bird catches a cold” CJ, The Fall and Rise of Reginald Perrin
In terms of the practicalities of monetary normalisation, Carney made it clear that the assets held in the Asset Purchase Facility (APF) under the Bank’s QE programmes will not be sold until the Bank Rate is "materially higher”, in order for the MPC to be able to maintain interest rates as the primary tool for the transmission of monetary policy and financial stability.
It is still unlikely, however, that Carney or the MPC will want to be the lead party on global rate hikes. Thus, in the Q&A when he referred to monetary policy being data dependent, he may as well have suggested that they are ‘US’ data dependent. We maintain the view that the Fed raises rates in September and, hot on their heels, on the next ‘Super Thursday’ the BoE hikes - in November.
"Good Newsville, Arizona” Tony Webster, The Fall and Rise of Reginald Perrin
In the US, Wednesday’s Non -manufacturing ISM came in at 60.3, the strongest in a decade, taking the composite PMI to 58.9. These levels are more consistent with a 4%-plus growth rate, than the relatively pedestrian levels we have witnessed in the first half (even if Q1 is no longer a contraction).
Overall, although the US data has been mixed, the progression has been positive. As the realistic prospect of a US rate normalisation moves closer, the emphasis on the data (and thus the likely market volatility) gets greater. Given the Fed’s longstanding focus on the US employment rate (and recent comments from Fed Members) labour market data and the monthly employment report are hugely significant. Weekly claims data have been remarkably stable at historic record lows for months now and we see no reason for a sharp decline in the headline rate. After the disappointment in the ECI data at the end of last week, more acute attention will also be paid to the average earnings section of the report. We retain a positive USD bias, however, in the very short term, like the monetary bias of the Fed and the BoE, it is "data dependent”.