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By Neil Staines on 23/10/14 | Category - Comment

"Europe is ‘Cinderella’ of global economy”Matteo Renzi

I’m not entirely sure what the specific point of reference the Italian PM was making in regard to Europe: that it has two ugly sisters? Unlikely. That it is putting in a lot of hard work sorting its own house out, without the benefits of going to the ball? Unlikely. That at midnight the carriage of European economic prosperity will turn into a pumpkin? Possibly!

It could be argued that the ‘pumpkin’ moment has already happened for the Eurozone as, over the past months, a sharp deterioration in economic momentum and, subsequently growth forecasts, for the region have brought a swathe of unconventional monetary easing measures from (fairy godmother?) Mario Draghi. Perhaps surprisingly, Germany has been at the heart of the growth revisions and after a very disappointing Q2 GDP outcome, recent forecast from the leading European Institutes suggests that growth in Germany is likely to have stagnated in Q3.

In that regard, this morning’s Eurozone PMI data was something of a welcome surprise. Despite further deterioration in French and German service sectors, the bounce (back into expansion) in German manufacturing activity and an unexpected improvement in the composite measure for the region as a whole is a rare positive of late.

Normally at this stage of the month, focus would be shifting towards the expectations and intimations for the ECB meeting at the start of next month. Indeed, the rumours that the ECB are debating the purchase of corporate bonds (although not as soon as November) should have heightened this shift. This month, however, there are two significant events that could not only shape the confidence and activity of the markets going forward, but potentially, could also influence the ECB.

Two ugly sisters?

The first of these is the release of the ECB’s Asset Quality Review (AQR) stress test results for the regions banks. Rumours and reports have suggested that somewhere between 8 and 11 banks will fall short of minimum capital requirements and will thus need to rely on capital raising or national government ‘top-ups’. This comes with the additional complication of being released on Sunday (26th October) when markets are closed and thus ‘gap risk’ on the market open in Asia on Sunday night is heightened.

Secondly, as the political debate within the Eurozone rages on, the EU have until next Wednesday (29th October) to reject the Budget plans of member states. While France has grabbed much of the headline space in this regard, it is also a potential banana skin for Italy, Austria, Slovenia, Malta and, (particularly in FX markets) for the region as a whole.

Likely Suitors?

Elsewhere, in the UK this morning retail sales data for September came in on the weak side of expectations with the annual (ex-Auto) rate of sales growth slowing to 3.1% y/y, from 4.4% y/y in August. In reality, however, this does not suggest any substantial weakness and may in part be explained by the weather (high street warnings about the mismatch between Jumpers in shop windows, yet t-shirt weather outside). Furthermore, yesterday’s release of the BoE monetary policy meeting for September was met with dovish market commentary. In our view, it was not so much dovish, as data focussed. Thus, if the data (economic momentum) does NOT moderate (or deteriorate) as expected and, with interest rate expectations already substantially pushed back, the upside potential for GBP, remains significant – at least in relation to the EUR.

In the US, despite the best efforts of the Fed to undermine confidence, the US data (economic momentum) remains robust. As a result (Bullard comments aside), the Fed should end its asset purchases (QE) in October as planned. Furthermore, following the volatility and capitulation in risk assets last week (and the subsequent sharp decline in US yields as investors fleeing equities and risk assets flooded to the safety of US Treasuries), markets have calmed somewhat. This relative calm has brought an uptick in US yields (and a widening of rate differentials with respect to the Eurozone) that should continue to support the USD.

In essence, we continue to favour USD and GBP against the EUR in FX markets, particularly now that rate expectations have been pushed back so far in the both the US and UK. There has been much commentary over the past weeks about the potential for a loss of economic momentum or even a sharp slowdown in the US and the UK. However, for now, with China data supporting the notion that its economy is slowing, not collapsing (soft landing not hard landing), we continue to view the US and UK economic momentum as sustainable. The first real test for this comes tomorrow with the first estimate of Q3 UK GDP and in our view with the rest of the market looking in one (weaker) direction and with interest rate hikes already pushed out to August 2015, the risks are perhaps skewed slightly to the upside for the pound.

By Neil Staines on 21/10/14 | Category - Comment

"There is increasing Nervosity in markets” - Ewald Nowotny

This morning I heard recent market activity being described as ‘Karate Kid’ trading (risk-on, risk-off). The lack of first tier data over recent sessions has only added to this theme, rendering equity markets and peripheral European bonds as the primary drivers of broad risk sentiment. In the short term at least, the correlations between the movements in risk assets and currency out (or under) performance are at best, unreliable.

"Recovery continues but uncertainty returns” Riksbank 7th Oct

Adding to the near term confusion of the markets is the inconsistency of official commentary, none more so than from the Fed. Over recent weeks, the data from the US has been broadly positive (particularly on employment measures, but PMI and sentiment data has also retained their strength). Despite this, the St Louis Fed President James Bullard’s commentary (especially if taken directly as a barometer for Fed sentiment) has gone off-piste significantly. On the 2nd of October, Bullard stated his view that the "Fed are behind schedule on raising rates as QE3 nears its end”, only to state on the 16thof October (albeit following a wobble in equity markets) that the "Fed should consider a delay in ending QE”! Notwithstanding an aura of uncertainty, we continue to believe the US economic recovery is intact and, while there are indeed risks to the US from a broader and more acute slowdown outside of the US, we still favour a gradual move towards US monetary normalisation, and ultimately, a further appreciation of the USD.

"Sputtering Europe holding back global economy” - James Bullard

Ironically, perhaps, in the current market dynamic, the EUR has found some stability in currency markets. To a significant degree, this is a function of interest rate spreads but, with Eurozone rates (at least for the core) locked in negative territory at the front of the curve, further weakness is less likely. However, nervousness (or nervosity!) in the global economy has driven safe haven flows and or reduced interest rate normalisation expectations in those economies with positive momentum (notably US and UK), and thus narrowed spreads. Ironically, given the weakness is most chronic in the eurozone, this has strengthened the EUR, but we see this as more of a temporary aberration, driven by market positioning factors, rather than any sustainable new development.



Reality Check

In the UK, this week has the potential to be a significant juncture, with data from fiscal (today’s public sector finance data), monetary (BoE October meeting minutes tomorrow) and economic (Retail sales Thursday and the first estimate of Q3 GDP on Friday) inputs. GBP has been caught in the crossfire over the on/off M&A backdrop, as well as enduring a sharp reversal in sentiment on the monetary normalisation front as the September inflation data disappointed. However, our central view of the UK economy remains positive and it is possible that, having pushed back the central expectation for interest rate hikes out to August 2015, that the market gets a more positive reality check from this week’s UK data.

Furthermore, the decline in oil prices since mid-June accelerated in October and, in many respects, added to the feeling of economic uncertainty and the debate over global deflationary pressures. However, as San Francisco Fed President John Williams stated recently, "Lower oil prices will have a short term effect on the inflation rate and a positive impact on US growth”.

The overnight release of China’s Q3 GDP data, which came out better than expected (with strength in industrial production and retail sales maintained), will likely calm nerves and fears of an imminent collapse in global growth, challenging views that there is something more sinister behind the scenes driving the recent dovish shift in (global) central bank rhetoric.

"EURUSD movements are linked to growth differences” - US Treasury Secretary, Jack Lew

Equity and bond markets will continue to drive sentiment in the near term and we certainly cannot rule out more ‘karate kid’ trading. However, we continue to view the current levels of both the USD and GBP as offering buying opportunities, particularly against the EUR. However, it may take a resurgence in US and UK interest rates or rate expectations, whether a function of reduced ‘nervosity’ (thus reduced safe haven demand for US Treasuries) or more a bullish economic backdrop driven by stronger data, before we can break out of recent trading ranges.

By Neil Staines on 16/10/14 | Category - Comment

"If I panic, everyone else panics”             Kobe Bryant

Over recent months we have raised questions of the risks of an overtly dovish bias at the Fed, despite the increasingly strong economic momentum. We have stressed on a number of occasions that while this Fed bias may be keeping long end interest rates subdued, it also risks undermining confidence in the economic recovery. After all if the Fed are continually stressing the downside risks, should we not be worried?

"…sinking like stones”                  - Don’t Panic, Coldplay

Yesterday, financial markets experienced some evidence of those downside risks, at least in the unwinding of positions in equity (and broader) markets. The Dow Jones index dropped by around 600 points from high to low in around half an hour only to regain its composure shortly afterwards. Equity market spill over into FX was, however, not a linear function. The impact of the seeming collapse of the AbbVie / Shire M&A saw a sharp decline in GBP against the USD, however, weaker than expected consumer data out of the US instigated a sharp unwinding of long USD positions against a number of currencies, most notably (and aggressively) against EUR, JPY and CAD.

"…we live in a beautiful world”                                - Don’t Panic, Coldpay

In reality, however, the US economic data was nowhere near bad enough to warrant the kind of sell off that we saw in US yields. In fact, with US 2 year yields reaching a low of less than 25bps, and 10 year yields falling below 1.87%, the balance of risks for US yields and the USD has likely shifted back to the topside.

Comments later in the session from US Treasury Secretary Jack Lew that "it is a mistake to look at hour-by-hour movements in markets to get a picture of where the core is” and that "US core economic growth is very strong” were clearly intended to calm the concerns of the market.

On Tuesday, we warned of the rising uncertainty in financial markets and argued for a correction in EURUSD as a function of lower US yields (making specific reference to the significant decline in the 2 year forward point spread over recent sessions), as the spread of deflation seemingly induced a wave of panic about growth prospects (despite a sharply lower oil price?) in the global economy. Falling equity markets continued to drive investors into the relative safety of Government securities (most notably US treasuries) driving yields sharply lower across the curve.

"There is nothing here to run from”                        - Don’t Panic, Coldplay

Following the clear out of positions in FX (and to a certain extent equity and bond markets), there is now a case to be made for a resumption of the broader trend. If equity markets continue to decline, which we feel is possible (albeit at a slower pace) then there is an increased likelihood of a continued unwinding of USD funded carry trades. In addition to this, we see no signs or rationale for US economic momentum to be materially affected by recent events, in fact, sharply lower bond yields and oil prices should be a significant economic positive.

In the Eurozone, the picture is perhaps not so rosy and if there is cause for concern globally then it should be most acutely felt in the Eurozone. News last night that Italian PM Renzi has proposed a Budget that will cause a jump in next year’s deficit "to within a whisker of breaching EU deficit rules” (FT), has accelerated an increased focus on risk premium in the Eurozone periphery. It is notable that peripheral yields are rising again this morning.

To complete the square (so to speak), Eurozone yield spreads at current levels are no longer supportive of a weaker EUR. However, recent moves in the US and UK (supported by the hawkish references of BoE Weale overnight) yields provide a starting point where the risks are increasingly biased to the hawkish side for Rates and the bullish side for USD and GBP.

"Here we go, here we go.”          - Don’t Panic, Coldplay

For today, the major focus is likely to be on the US equity market open, with data limited to weekly jobless claims data from the US. With reference to our point above (and on many previous occasions) that the Fed dovish bias was at risk of (has?) undermining confidence in the US recovery, it is also likely that the rhetoric of Fed speakers has greater influence on sentiment that would be the case in more rational, orderly markets – and there is perhaps a greater likelihood that near term rhetoric emphasises some of the positive aspects of US growth against a nervous equity market backdrop.

Volatility is likely to remain at elevated levels for the rest of the week, however, after urging caution earlier in the week, we feel that re-entry into long USD and GBP vs. EUR and perhaps AUD now offers greater risk reward. 

By Neil Staines on 14/10/14 | Category - Comment

"Patience is bitter, but its fruit is sweet”                              - Jean-Jaques Rousseau

This morning’s inflation data in the UK was keenly awaited as the market attempts to clarify its expectations amid an increasingly complicated global macroeconomic backdrop. The inflation data for September showed a greater than expected decline in both the core and headline readings and although there was an (anticipated) impact from recent energy price declines, there is also clear evidence that the deflationary haze that has gripped the eurozone is beginning to impact broader global price pressures.

In the short term, this has likely heavily impact GBP in FX markets, as interest rate expectations get pushed back (even) further and the years low at 1.5944 will be a key barometer of that. Indeed, we feel that there are a number of interesting dynamics making the evolution of financial market price developments more complex in the short-term, notably in FX.

If we take the USD as an example, our view remains that the backdrop for the USD in the medium term remains positive, particularly against the EUR, AUD where monetary policy and growth divergence as well as valuation arguments remain. However, in the short term, deleveraging in equity markets has also led to some deleveraging in FX. This risk-off backdrop has also driven up those currencies that are negatively correlated to risk appetite, such as the JPY (quite markedly against the USD from above 110, to below 107 this morning).

One of the most concerning developments over recent sessions has been the decline in US yields. At the long end of the curve, US 30 year yields fell below 3% last night for the first time since May 13 and 10 year yields are now at their lowest level since June 2013. Perhaps most importantly, the 2 year yield is at its lowest since June, and almost a full 25bps lower than it was at the time of the last FOMC meeting.

This decline in US yields, perhaps a function of risk aversion as equity declines drive money into the relative safety of the Treasury markets, have also driven spreads relative to other currencies, most notably the EUR, tighter. We were very audible in our suggestions that the widening of the EURUSD 2 year forward points (which went from 19bps in December 2013, to 233bps in September) should be indicative of a move lower in EURUSD. Since the middle of last week this spread has narrowed back to a low of just 165bps this morning. In and of itself, this would argue for a correction in EURUSD, or at least more of a two way market.

"Euro area must get its act together”     - Dijsselbloem

The overall macro picture in the Eurozone, however, continues to deteriorate. Inflation and growth remain too low and the downward revision to forecasts (most notable in Italy and Germany) highlight that there is no remedy to the ailments of the Eurozone in the short to medium term. This morning, saw a further sharp deterioration in the German ZEW assessment of current situation, and expectations, both back to 2012 lows. On a positive note, perhaps the increasing convergence of (negative) growth across the region will accelerate the structural reforms and accommodative monetary policy that the region so badly needs to avoid the prospect described by French Finance Minister yesterday that "Europe faces a Japanese scenario”.

"Endurance is patience concentrated”   - Thomas Carlyle  

However, outside of the near term we retain our view that the USD, and indeed GBP, will re-engage their outperformance. Economic momentum in the US remains significant and, while there may be a short pause for thought, as the threat of deflation pushes back timing expectations of monetary normalisation, economic and monetary divergence ultimately remains in tact.

In the UK, rate hike expectations, which centred around November when GBPUSD was up above 1.70, are now priced beyond the elections in May prompting GBPUSD to fall markedly. Further, the uncertainty surrounding the Scottish Referendum debate and the subsequent impact and implications on investment decisions and activity in the UK, have also weighed on GBP, helping to bring GBPUSD below 1.60. However, going forward, we expect the economic momentum in the UK to continue, and interest rate expectations to once again edge nearer. On that basis, we view any further near term declines in GBP (particularly against the EUR at the current juncture) as representing good value and providing a buying opportunity over the medium term.    

Sentiment will likely continue to be driven predominantly by equity markets over coming sessions and, with the start of the US reporting season today {Citigroup, JP Morgan and Intel}, this will likely become more acute. FX volatility will continue, and, while more complex in the near term, it is likely that clearer trends re-emerge before long.

By Neil Staines on 09/10/14 | Category - Comment

"If you want to make enemies, try to change something”            - Woodrow Wilson

On Tuesday we touched on the global economic backdrop as global growth forecasts moderate. Subsequently the IMF published their World Economic Outlook (WEO) entitled ‘Legacies, Clouds, Uncertainties’ highlighting the fact that sentiment at the IMF has clearly deteriorated since earlier in the year. Against this backdrop we also noted that "central bankers and policy makers remain under pressure to reinvigorate stale economic momentum and, where growth momentum exists, to be patient with monetary normalisation.” We also noted a likely "marked uptick in FX volatility and a greater focus on FX as an increasingly important asset class.”

Last night it was the turn of the Fed (albeit delayed from its point of reference) and the release of the minutes from the September FOMC meeting. The Fed duly referenced a ‘global slowdown’ as being among the risks to the US outlook, yet it was their heavy reference to the downside risks to growth from a stronger USD that made the headlines.

"…What this world is about”     - Under Pressure, Queen

We are acutely aware that central bankers are under intense scrutiny and heightened pressure, none more so than the Fed (as their actions likely have the greatest influence on the global economy). However, after seemingly going to great lengths to emphasise the importance of the economic data on the trajectory of monetary policy, the Fed, in our opinion, are increasingly at risk of undermining confidence in the US economic momentum - If beauty is in the eye of the beholder, the Fed are not being as complimentary as we feel they should be. US Q2 GDP rose 4.6% q/q annualised, the current pace of job creation is at its fastest since 2006, the unemployment rate stands at 5.9% (albeit after an initial weaker employment report for August – the last information at the disposal of the Fed for the September meeting) and the revised ‘dot plot’ from the Fed members themselves suggests an interest rate term structure significantly above that of the market.  Yet the tone of the minutes remains extremely cautious and uncertain.

Further, it is likely that the appreciation of the USD would have to go much, much further in order for it to have a meaningful impact on inflation or growth.

Over the past months we have seen a raft of central bank heads implicitly (or in some cases explicitly) provoking a weakening of their respective currencies on the basis of a divergence of domestic monetary policy path in relation to that of the US (ECB, RBA, BoC, BoJ, RBNZ,…). Taking this into consideration in conjunction with broad macroeconomic consensus and, in many cases, positioning, it is perhaps not surprising that the Fed should issue a cautionary tone so as to minimise the impact and implications of such divergent monetary policy on the USD.

"It’s not a normal condition to have interest rates at zero”         - Lloyd Blankfein

While the USD declined somewhat in response to the Fed, arguably the most notable move was in US interest rates with the 2 year yield plummeting (not a word we use lightly) from a high of 59bps the day after the FOMC policy meeting (and press conference) to a low of just 42bps this morning. This in itself is a significant justification for a weaker USD, and while it is possible that we see a further decline in the USD in the near term (as interest rate differentials and positioning adjusts), our views on the continued economic and monetary outperformance of the US, and thus the USD in all but the very short term remain unchanged.

A Viable Alternative?

In the UK, after a reasonable period of negative sentiment towards GBP, we expect the emphasis on UK economic (and monetary) outperformance to gradually return over coming days, weeks. The Bank of England meeting today is unlikely to offer any new information, however, survey data (especially in the dominant services sector) remained relatively unscathed throughout the uncertainties of the Scottish Referendum in September and as USD positioning is reduced after the Fed’s (over?) dovishness, we would expect GBP to emerge as a strong alternative to the USD in the ‘currencies I would like to BUY bracket’. After all, there is certainly not a shortage of options in the ‘currencies I would like to SELL’ category.

With limited data today, it is likely that sentiment, equities and US rates are the core drivers within FX as the markets digests the Fed. With industrial production from a number of Eurozone countries and the UK trade data the highlights for tomorrow, this theme will likely carry through to the weekend. Volatility may calm during this period, but opportunity remains

By Neil Staines on 07/10/14 | Category - Comment

"World economy needs bold moves to avoid ‘new mediocre’”   - Christine Lagarde

As global growth forecasts moderate, central bankers and policy makers remain under pressure to reinvigorate stale economic momentum and, where growth momentum exists, to be patient with monetary normalisation, at least while inflation pressures (at the consumer price and wage level) remain muted. At the current stage of the economic recovery (or not in some cases), with interest rates less viable as a near term policy tool, the battle ground for avoiding mediocrity, or worse, is likely the foreign exchange market. We are not suggesting that we are in an environment akin to a ‘currency war’, but we certainly see a marked uptick in FX volatility and a greater focus on FX as an increasingly important asset class in global macroeconomic developments.  

"Currency war is a zero sum game… everybody loses”   Guido Mantega, Brazil Finance Minister

In the Eurozone a lower currency remains the only viable policy tool (though German opposition from former and current Bundesbank heads is becoming increasingly audible – both in terms of currency devaluation and the use of non-standard measures such as the ABS purchase programme). In part, this is a function of the joint structure of the Eurozone and its regulations which restrict the fiscal channels. The alternative monetary channel has also likely reached its limit (at least in terms of interest rates) or is facing increasing opposition (ABS), thus a lower EUR exchange rate becomes a key (if informal) tool for the ECB

"Sputtering Europe holding back global economy”         James Bullard, St Louis Fed

An increasing number of commentators have highlighted recent currency movements (EURUSD specifically) as a counter argument to both Eurozone deflation risks and US economic growth outperformance – in essence arguing for reduced impetus for further EURUSD declines. While at some point we would concede that a lower EUR will reduce disinflationary pressures just as a higher USD may damp US economic outperformance, we do not yet view this as a strong argument for a turn in EURUSD at the current juncture. Recent underperformance of Eurozone inflation relative to expectations (as well as increasing concern expressed by the ECB and falling inflation swaps) and the resurgence of US labour market strength in September following a lull in August (in addition to maintained survey strength, particularly in the dominant service sector) continue to support this view.

"Fed behind schedule on raising rates as QE3 nears end”             James Bullard, St Louis Fed

This week’s release of the minutes from the September FOMC meeting will be closely watched. While the impact of the minutes would usually be damped by the fact that the September was accompanied by a press conference, the minutiae surrounding the inclusion of the "considerable time language” (particularly, as we pointed out following the Fed statement, as Yellen appeared to remove the meaning of "considerable”, by suggesting that it was entirely data dependent) will be keenly watched.

"Rate rises will come sooner and will be more rapid if economic improvements imply faster convergence on target unemployment and inflation.”  Janet Yellen

 

Yesterday, we saw a pick-up in USD volatility which began with a sharp correction in USDBRL after the first round of the general elections drove a wave of USD selling. With little on the economic calendar and likely an increased long USD positional bias, following the stronger than expected US September employment report, further USD longs were unwound overnight.

Adding to this dynamic, increasing uncertainty over official support for - and, perhaps more significantly, growing uncertainty over the detrimental economic implications of- further JPY weakness, has prompted another retreat from the 110 level in USDJPY.

To this point the USD rally has been significant as well as relatively orderly. Going forward, while we anticipate USD strength to continue, it will likely become a more selective process both in terms of timing and with reference to specific alternate currencies. Overall we view the current backdrop as a significant development in the increasing importance of foreign exchange as an asset class following an extended period of relative stability. It will not likely be all one direction from here, but significant opportunities remain. 

 

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