"No varnish can hide the grain of the wood” Charles Dickens, Great Expectations
At the December FOMC meeting the Fed raised interest rates by 25bps (the first rise since 2006) and signalled that it was prepared to tighten borrowing costs by a further 100bps in 2016. However, as the calendar year changed so too did global economic sentiment. In January, falling Chinese currency (driven largely by a sharp rise in capital outflows), widening corporate credit spreads and a plunging oil price sent global equity markets, risk assets and investor confidence lower from the outset.
Mario Draghi’s interjection in the form of a pledge to "review and possibly reconsider” the monetary stance of the ECB gave some solace and stabilisation to equities and risk assets and the surprise Japanese rate cut (into negative territory - albeit on a scaled basis) generated a significant bounce in risk assets, Japanese equities and decline in the JPY. However, we have long argued that the ‘shot in the arm’ for markets in the form of QE has lost popular support (ECB) or is reaching its operational limitations (BoJ) and that there is a strong case to be made that QE (and by extension any further monetary easing measures) face significantly diminished returns. Yesterday highlighted the substantially reduced marginal benefit of monetary easing from current levels as both JPY and Japanese equities unwound all of the rate cut impact.
"America is gigantic… a gigantic mistake” Sigmund Freud
The main driver of market sentiment and focus yesterday, however, was not the ECB or the BoJ, it was not China or EM. It was singularly and distinctly the US. At one point in the London trading session markets had completely unwound ALL expectations of Fed normalisation this year equities fell and the USD suffered its biggest one-day loss in 7 years.
Since the start of the year there have been two key dynamics evolving within the US macroeconomy. Firstly, while the labour market data in the US has remained inexorably strong, other survey and activity data have painted a less rosy picture so far in 2016, leading markets to revise down US growth forecasts. Secondly, there has been a clear and significant divergence between weakness in manufacturing (likely in recession) and strength in the service sector. Furthermore, all (if not more!) of the labour market gains of late have been from the service sector. It is perhaps not surprising therefore that a weaker than expected service sector ISM yesterday caused a sharp unwinding of growth and interest rate expectations in the US.
"Do I think the current level is a blip or a trend? I would say it’s a trend” Ed Miliband
In addition to the economic data, Fed vice Chair William Dudley also fuelled the re-evaluation (and thus the unwind) in suggesting that financial conditions are "considerably tighter” than in December and if they remained in place by March "we would have to take that into consideration in terms of that monetary policy decision”. While it is this relative tightening of monetary conditions (fuelled by lower and increasingly volatile equity markets) that has driven the unwinding of US rate expectations for most of 2016, the explicit caution from the FOMC vice Chair (while he would be considered towards the dovish end of the Fed spectrum) likely led to the capitulation in the USD, equities and broader risk assets. At the other end of the Fed spectrum FOMC voting member Esther George maintained her view of continuing on the path of normalisation stating that "policy can’t respond to every blip”. Even (as would be our central expectation) she proves to be correct, this is a big blip!
"The scars of others should teach us caution” St Jerome
Ultimately, the events of yesterday leave us (and the markets) reassessing our expectations. At this stage I am yet to be convinced that the US economy is falling off a cliff (as yesterday’s movement in the USD may have suggested). Furthermore, we are not yet minded to change our expectations that inflation (not deflation) will be an issue for the US by the end of 2016. From our perspective, therefore, US Treasuries offer significant potential downside (as yields have fallen around 50bps since the start of the year) and the USD offers significant potential upside…at some point. However, there is a caveat to both of these views.
According to Folklore, if it is cloudy when the groundhog emerges from its burrow on this day, then spring will come early; if it is sunny the groundhog will supposedly see its shadow and retreat back into its burrow, and the winter weather will persist for six more weeks.
This year, the groundhog day folklore translates surprisingly well into global financial markets. After the extreme volatility of January (and December) February, may well be more contemplative as markets review and reflect on recent events and the implications not just for the for the ‘coming of spring’ but also what that spring is likely to look like.
A core focus of financial markets at the current juncture is the trajectory of global monetary policies. With the key policy meetings from the ECB and Fed in March (10th and 16th respectively), the uncertainty (if not winter weather) will likely ‘persist for six more weeks’.
"...Difficult should be a walk in the park” Mission Impossible II
Federal Reserve System Vice Chairman Stanley Fischer gave a speech last night where he stated that it was too difficult to gauge the impact on the US economy from recent turmoil in financial markets and uncertainty over China and that "If these developments lead to a persistent tightening of financial conditions, they could signal a slowing in the global economy that could affect growth and inflation in the United States”. To moderate this cautionary tone, however, Mr Fischer added that "we have seen similar periods of volatility in recent years that have left little permanent imprint on the economy” and that the FOMC will look to the data (not Punxsutawney Phil) for guidance on the pace and trajectory of Fed normalisation.
Despite the caveats, it is increasingly clear that the recent market volatility and uncertainties from China, oil (and related credit) and broader equity markets are tempering rate expectations in the US. Treasuries have taken the lead on this front with 10 year yields having fallen more than 30bps to firmly below 2.00% this year. Last night rating agency S&P added to the momentum with which US rate expectations are moderating by cutting their expected number of US hikes this year to two from four, and stating that they no longer see the Fed raising rates in March.
On the other side of the monetary coin, it is far from clear that Mario Draghi will garner the support for his ‘heavy threat’ of further accommodation in March. In yesterday’s testimony to the European Parliament he reiterated that the "ECB will review and may reconsider its stance in March” yet appeared more contemplative than at the January ECB press conference.
"Economic recovery is cyclical, not genuinely structural” Peter Praet
This relative shift from both the Fed (less hawkish) and ECB (less dovish) could lead to an extension of the recovery in EURUSD in the near term and likely more broadly undermine the backdrop for the USD. In the medium term we continue to expect significant USD outperformance vs. EUR as the UK EU debate outlines some of the numerous floors and fragilities inherent in the currency union and as current uncertainty gives way to renewed divergence of monetary policy trajectories. Europe may be experiencing a cyclical bounce, yet it is likely a long way behind the US in the fundamental recovery process. Thus, we view any substantial bounces in EURUSD as medium term opportunities for USD appreciation.
Overnight the RBA left rates unchanged but reignited their dovish bias with the suggestion that "low inflation may provide scope for easier policy” as "inflation is likely to remain low over the next year or two” (broadly the monetary policy forecast horizon). We continue to see downside risks to equities and broad risk assets (despite the heightened volatility) and in this regard, continue to view AUD as vulnerable.
With little first tier data this week (ex BoE ‘Super Thursday’) until US payrolls on Friday, you may be forgiven for thinking it is ‘groundhog day’ all week, however, going forward we see little reason for baseline financial market volatility to subside any time soon.
"It was the best of times, it was the worst of times” Charles Dickens, A Tale of Two Cities
Earlier in the week we suggested that market focus will be brought back to the progression of global monetary policy as the Fed, RBNZ and Bank of Japan scheduled meetings arrived. Amid declining equities and equity market sentiment and with a backdrop of faltering global aggregate demand and economic activity, financial markets were once again looking to global central banks for guidance (or in some cases support). The responses from the three CB’s this week were diverse.
First up was the Fed. With US equity markets having fallen significantly since the start of the year in tandem with the deterioration in global macroeconomic activity (and sentiment) market participants and commentators had increasingly been looking for some concession from the Fed - whether explicitly via reference to the pace of normalisation or implicitly by reference to global weakness. In reality, while the Fed repeated that the economy was expected "to warrant only gradual rate increases” and that it was "assessing” global economic and financial developments, the overall tone of the statement was little changed from December.
"Stock market indices have predicted 9 out of the last 5 recessions” Paul Samuelson
While there were some participants hoping for indications that the Fed may reverse course and cut rates (or even dust off the prospectus for QE4), Fed Funds futures as well as 2 year Treasuries (yield ~ 79bps) continue to discount a perceptible (albeit slow) increase in rates for this year. Amid the heightened global economic volatility and uncertainty, there is no reason for us to believe that the Fed know more than the capital / financial markets. In this regard, equity market declines have not been (and in our view will not be unless there is a significantly bigger decline than we have seen ~10-20% further) a good guide to Fed monetary trajectory.
This whole process is complicated even more by the oil price. While the Fed noted that inflation compensation (or inflation expectations) have declined further of late, global inflation expectations have become increasingly driven by the oil price and given the fact that oil prices have risen more than 20% from their lows, this may be less of an immediate concern for the Fed. Furthermore, if our view (outlined Tuesday) that the oil price can stabilise and, even rise from these levels, while equity markets continue to decline is correct, the amount that equities need to decline in order to bring about a response from the Fed is likely even greater.
Second up was the RBNZ. Market expectations of action were limited going into the meeting, however, while the Overnight Cash Rate (OCR) was left unchanged the RBNZ re-engaged its dovish bias, suggesting that further rate cuts may become appropriate as inflation may take longer than expected to reach target. Furthermore, the RBNZ also explicitly stated that further NZD depreciation would be appropriate.
Finally, Last night BoJ Governor Haruhiko Kuroda generated outright surprised in financial markets by adopting a negative interest rate strategy, just a week or so after publicly rejecting the idea. The announcement came shortly after the release of bigger than expected declines in industrial production and household spending as Japan continues to struggle internationally, with the external environment weighing heavily on exports and nationally as domestic demand remains fragile.
"We have guided missiles and misguided men” Dr Martin Luther King, Jr.
In reality, while the negative rate policy is intended to boost inflation towards target at a faster rate, we would consider the measure as likely to have a minimal long term effect. The negative rate applies to a proportion of excess reserves held by banks at the BoJ (only those that are not existing balances or regulatory capital, the ‘Policy Rate Balance’). While at the margin this will likely increase the desire of financial institutions that are liable to the Policy Rate Balance to increase lending, it is not clear that corporate Japan (who have been the biggest beneficiaries of the BoJ’s QQE policies through higher equity valuations and a sharply weaker JPY) will have the desire to increase borrowing given their current levels of profits and cash surpluses.
The BoJ also delayed (again) their timing for reaching the 2% inflation target to H1 FY2017. The key point as far as we are concerned is that while shocking the markets the BoJ are likely missing the point. In order to boost prices consumer demand must rise. QQE has achieved is likely made corporate balance sheets substantially stronger, but (so far at least) has done little to boost consumer appetite (or indeed sentiment).
Death, Taxes… and Volatility?
Overall therefore, we feel that in many respects, the Central Bank actions (or inactions) this week have done little if anything to change the underlying backdrop, or our view of the world. We continue to expect equity markets to decline (albeit now in some cases, from improved levels) and thus in FX continue to favour JPY and USD outperformance against a number of currencies; including GBP, AUD and NZD. However, one thing that this week’s meetings have also done is increase our convictions that global financial market volatility will continue to increase in 2016, perhaps substantially. This is a key risk for broad financial markets.
Capitulation (Latin: Capitulum): Refers to the bowing of one’s head in surrender at the end of battle. If you are lucky, your head doesn’t get chopped off!
Last week, financial markets witnessed events which some may (historically at least) refer to as capitulative (the most prominent of which in oil and equity markets). While it is not clear whether participants had their (metaphorical) heads cut off, the moves are particularly worthy of reflection and consideration. Were the resultant bounces temporary, position adjustments, or the start of a change of trend?
"I have always preferred the reflection of life than life itself” Francois Truffaut
On Thursday, following the capitulative lows and subsequent (surprising) dovish ‘commitment’ from Mario Draghi, we questioned the efficacy of the markets response to the ECB announcement. Statements from Japanese officials that they are watching markets closely led to increased speculation that the BoJ were also primed for further monetary activism, as soon as this week. We argued that the impact of increased expectations of easing from the ECB and BoJ will be "modest at best” and that after a weekend of ‘reflection’ a different theme may ensue this week...
The reality however is a little more complicated. We maintain the view that equity markets will continue on a moderate, but sustained, decline for some time to come. Oil is, however, a different story. It is hard to argue that oil is in any way overvalued and it is likely that the price decline has overwhelmed the impact of (what is a fairly modest) oversupply dynamic. My central view is that while equities remain vulnerable, oil is now likely to stabilise and begin to edge back up. However, due to the recently entrenched relationship between equity valuations and oil prices, the net result for both in this scenario is likely higher baseline volatility.
"You can’t invest in natural gas on a daily basis. It’s too volatile” T Boone Pickens
While the progression of the equity and oil prices (and their interrelationship) will continue to dominate for weeks and months to come, this week also brings a more intense focus back to the progression of global monetary policy. This week it is the turn of the Fed (Wednesday), the RBNZ (an hour later) and the BoJ (Friday).
Expectations from the Fed are very minimal, even the hawks see no substantive chance of action this week. However, close attention will be made to any mention or increased focus on recent equity declines, global risk sentiment or the USD. The most interesting event is likely to be the BoJ announcement on Friday.
Core market expectations for BoJ action are centred around April rather than this week - though we would argue that even in April the chances of further easing from the BoJ are minimal. The Japanese govt has ‘urged’ corporates - who have benefitted the most from QQE, through higher equity valuations, a weaker JPY and lower term interest rates - to help reflate the economy by boosting wages. The BoJ have explicitly stated that ‘Q1 wage increases’ are key to further policy consideration. The BoJ will certainly be hoping that the pay awards are greater than the 0.4% they have just given themselves.
"I exist as I am, that is enough” Walt Whitman
Our argument last week that QE (or QQE in the case of Japan) faces significantly diminished returns and that the likelihood of further action is small, is a view we still hold. In fact when you look at the notional size of stimulus already committed (Japan’s QQE balance sheet stands at around 80% GDP, compared to around 25% for both the Fed and ECB) the argument for inaction is even more compelling.
It is possible that Japanese equities rise and JPY falls immediately prior to the BoJ meeting as participants expecting further easing attempt to pre-position. We would view this as an opportunity for the recent themes of JPY strength and equity weakness to resume.
Overnight, China A shares fell over 6.4% to a 13 month low. With capital outflows and demand for cash before the Lunar New Year continuing to weigh on equities (despite recent massive injection of funds from the PBOC) downside pressure is likely to remain. Suspected intervention from the PBOC to prop up the yuan overnight (likely an attempt to deter speculation rather than maintain or support any nominal level) has tempered risk aversion from spreading this morning, however, we continue to expect those currencies with a negative correlation to risk (JPY and USD) to outperform those positively correlated (AUD, NZD, GBP) for now.
"A government that robs Peter to pay Paul can always depend on the support of Paul” George Bernard Shaw
On Tuesday we discussed the the current financial market backdrop and how sentiment towards equities and broader risk assets had become the dominant driver of activity and the main focus of attention. We also noted our view that "Monetary developments, while remaining the key driver of medium term trends, will likely play a secondary role in the short-term direction of markets” as "global central banks are reaching a period of enforced inactivity or at least of significantly reduced activism.” In this regard, yesterday’s developments are very significant.
Yesterday was the one year anniversary of the ECB’s original QE programme and while the markets had little or no expectation of any further action (or indications), Draghi surprised markets with the clear statement that with "downside risks” increasing, it will be "necessary to review and possibly reconsider our monetary policy stance at our next meeting" (March 10th).
Looking back, since January 2015 the ‘actual’ impact of the ECB’s QE programme has been very modest. While the exchange rate is clearly lower and, as we have argued before, this is likely the most effective boost to the region (although not an official policy target), it has had very little effect on its main target - to lower bond yields (10y Bund yields are broadly unchanged) and to narrow peripheral bond spreads (if anything modestly wider). Measured in this respect, one may wonder why the ECB appear to believe that further monetary stimulus (bond purchases?) is still the answer. Furthermore, we would question the efficacy markets response to such an announcement.
"Who’s watching the watchmen?” Juvenal
Reserve Bank of India Governor, Dr Raghuram Rajan, suggested in Davos yesterday that "Monetary stimulus has run its course” and that we "need to look at structural reforms for developed markets” as "we do not seem to have succeeded through really low rates”. These are all statements that we would agree with. Further QE, in an attempt to stabilise or even reverse equity market declines and deflationary forces will likely have increasingly diminishing returns. We would raise the proposition that further QE may in fact even be a negative for equities and risk asset going forward.
"Never trust sheep” Ryan Styles
In the Asian session, Nikkei reported that the Bank of Japan is said to weigh more easing, likely via bond purchases, as falling oil prices undermine inflation. China’s Li vowed to "look after” stock investors and intervene as needed as well as denying any intent to devalue the yuan. Market participants duly bought equities.
Ultimately, while the ‘learned’ reaction of equities to the prospect of further monetary stimulus has driven a relief rally, we would argue that the likelihood of any significant further action from the ECB (or BoJ for that matter) is small and that its impact (beyond the very near term) will be modest at best.
The impact and implications of oil against this backdrop is becoming increasingly complex. At these levels relatively small price changes in absolute terms are substantial in percentage terms. While we would argue that equities are expensive relative to a number of forward looking metrics, oil is not… In fact it could be argued (though we are not suggesting this is likely) that global central banks would be better off buying oil than buying bonds!
"Have no fear of perfection - you’ll never reach it” Salvador Dali
As the US returns from its long weekend, market participants could be forgiven for forgetting that it is merely the third week of the year. While the first couple of weeks have been largely driven by sentiment and risk aversion, as yuan depreciation and capital outflows have tested the conviction of global economic prosperity forecasts, market sentiment this week will likely also be shaped by a raft of economic data and two significant central bank meetings.
While new data potentially adds a further level of complexity to the current investment backdrop, it is likely that equities will remain on centre stage. Thus the data should be evaluated (at least in the first instance) with respect to its implications for equity market sentiment ahead of economic differentiation. In FX, this likely means that a currency’s correlation to risk and risk assets remains key.
"Smoking is one of the leading causes of statistics” Fletcher Knebel
The data got underway in earnest overnight with the release of China's Q4 GDP statistics and accompanying retail sales, industrial production and investment data. While all of the metrics modestly disappointed market expectations, the result was not as scary for global indices as might have been expected and thus a relief rally has ensued this morning with the price action suggesting a case of ‘sell the rumour, buy the fact’. Additionally, given the likely positioning (especially of shorter term macro accounts) the fact that this data generated a distinct lack of appetite to follow through with any meaningful wave of new selling, suggested that the market was ripe for a (short term) oversold correction.
While markets have thus successfully navigated the first round of the week’s data (which now include a stronger than expected German ZEW survey), there are plenty of potential pitfalls as the week progresses. Tomorrow brings the UK unemployment report for November, US inflation data for December and the Bank of Canada rate decision. Thursday brings an ECB meeting and subsequent press conference. Friday brings Japanese and European PMI data, UK retail sales and US leading indicators. All amid further US corporate earnings’ releases.
"If you are first you are first. If you are second you are nothing” Bill Shankly
Monetary policy developments, while remaining the key driver of medium term trends, will likely play a secondary role in the short term direction of financial markets. With the exception of the Bank of Canada (more below), global central banks are (as we have discussed recently) reaching a period of enforced inactivity or at least of significantly reduced activism. This is either a function of operational limitations (BoJ), or lack of consensus (ECB). In essence, this likely adds to the fragility of the equity backdrop as the artificial asset inflation of ever easier monetary policy is no longer there… at least for now. ECU Global Macro Team member Stephen Jen sums it up perfectly by suggesting that central bank ‘puts’ are still there, but that their strike prices have been [significantly] lowered. Overall therefore, equity markets can continue to fall (in an orderly fashion) much further before any monetary intervention is even considered.
In the UK, monetary normalisation expectations were dealt a blow by the comments of the newest member of the Bank of England’s MPC, Gertjan Vlieghe, when he stated that the "UK outlook does not yet justify a rate increase” amid "no convincing evidence of upward pay pressure”. However he maintained the hawkish bias of the committee in stating that "on balance of probabilities the next rate move is up”.
"Take it easy”The Eagles
In contrast, our expectations are for the Bank of Canada to ease policy by 25bps at its scheduled monetary policy meeting tomorrow, as the economy’s fragilities continue to be exposed by a lower oil price and continued oversupply in oil and commodity markets. BoC governor Poloz has recently noted that while Canada’s exchange rate is not a panacea, that the "exchange rate is the most important adjustment facilitator”. CAD should thus continue to underperform in the short term. However, if the economic recovery in the US continues, it is hard to believe that the country with the biggest land border to the US will be too far behind in the recovery. Indeed, the significant currency adjustment has already resulted in the highest level of US imports of used autos from Canada in over 13 years last month. Any sign of prolonged stability, let alone recovery in the oil price should provide a backdrop of significant value in the CAD.
Ultimately, both economic data and monetary policy considerations will have an increased impact on broad financial markets this week. Regardless of these, however, it would be imprudent to ignore equities and equity market sentiment just yet.
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