ECU's Investment Blog
"Falling unemployment will herald ‘boom time’ for US”James Bullard
A lot has been written over recent days, espousing the view of a decline in US economic momentum, delays in the process of US monetary normalisation and the end of the USD rally in FX. Little has been mentioned about the possibility that the ‘slowing’ of GDP momentum that was mooted by Janet Yellen at last weeks FOMC press conference is a function of extreme weather conditions and the west coast port strikes. While we would likely refrain from using the term ‘boom’, we expect US economic momentum to bounce back strongly in Q2, leaving the door open for the start of monetary normalisation from the Fed in June, and a further (perhaps substantial) leg higher for the USD.
"See more volatility from differing monetary policies”Christine Lagarde
The recent ‘correction’ (and we still maintain the view that it is a correction and not, as many have suggested, the end of the rally) in the USD has been exacerbated by liquidity. Low liquidity has induced high volatility, or perhaps more correctly, a higher volatility of volatility. We maintain the view, as alluded to by IMF head Christine Lagarde, that divergent monetary policies are a key driver of volatility and that this dynamic has significantly further to play out in FX.
"Economic impact of a strong dollar is slight”James Bullard
Since its correction there has been much speculation about the impact of the rise in the value of the USD as a headwind to growth, and thus its importance in determining the timing of the initiation of monetary normalisation in the US. Furthermore, the recent strength of the USD was cited by many as the key factor behind the downward revision of the FOMC Summary of Economic projections, or ‘the dots’. We would argue that the level of concern over a rising USD at the Fed remains modest and that in many respects, particularly if it fosters a growth recovery in Europe and Japan (among others) the Fed would agree with Treasury Secretary Lew that "its good for the US; its good for the world”
"Stronger dollar the inevitable result of policy divergence”Benoit Coeure
In the world of FX, however, any individual currency is only one half of the story. We maintain the view that the USD will outperform over coming months and that there are a number of strong contenders in the ‘sell’ camp.
EUR remains a key area of political and economic fragility and thus likely remains high on the list. ECB Peter Praet stated this week that the current recovery in the eurozone is "cyclical and not structural” as he continues to push lawmakers for much needed structural reform across the region. We would argue that monetary easing, negative interest rates (and yields across a vast amount of the eurozone yield curve), the lack of a Greek resolution as well as political uncertainties surrounding several General Elections in the region will continue to weigh on the EUR.
Elsewhere, there is a negative case to be made for several other developed world currencies. In Japan, the start of the new Fiscal Year next week could herald a new wave of retail money into equity markets and fuel the higher Nikkei, lower JPY theme that seems to have lost some impetus of late. In Australia, concerns over the path of China growth momentum, alongside deteriorations in mining investment and terms of trade will also likely weigh on the AUD.
In the UK, the story is more mixed, and we maintain a cautious approach towards GBP as a function of the political uncertainty surrounding the General Election in 6 weeks time. This morning’s release of a Speech by BoE Ben Broadbent echoed our own sentiment however, as he played down the prospects of both deflation and a further rate cut in the UK as being extremely slim. After the election we envisage a strong bounceback in UK economic momentum, business investment and GBP as the BoE move towards monetary normalisation in the wake of the Fed. For now, however, at least as far as GBP is concerned, we wait patiently on the sidelines.
"Things are looking better - in fact they are looking downright good” John Williams
While it may be the third quarter in the UK, rather than the second quarter in the US, we are inclined to open our minds to the possibility (refreshing after such a long absence) of significant economic outperformance in the US (and ultimately the UK). Here comes the boom?
"There is no such thing as bad weather, only inappropriate clothing” Sir Ranulph Fiennes
Last week we commented on the USD price action following the March FOMC statement, asking whether it was a "tsunami in a teacup” for the USD, with the earthquake coming from the downwardly revised Summary of Economic Projections (SEP’s) or ‘dots’ from the Fed. Following on from the extreme gyrations of the USD last week, nervousness and uncertainty surrounding the USD, exacerbated by a significant underlying positional bias has seen the USD decline once more, back towards the spike highs of last week. Today we take a step back and look at whether the USD up trend is over or whether the current pullback is merely… a pullback.
Firstly, as we noted last week, it is perhaps important to assess the message from the Fed statement and the removal of the "patient” language. While perhaps overcompensated for by cautious inclusions, we view the removal of the forward guidance criteria as a positive for monetary flexibility, and mildly hawkish for Fed policy, which is now in its most acutely data dependent state since the start of the crisis.
"Expecting US growth to rebound in Q2”James Bullard
The cautious tone of the Fed in relation to economic momentum into Q1 2015, was likely a function of negative weather impacts (as was clear in the US retail sales data that showed physical sales dropping but online sales surging) and as a compensating balance to the hawkish development of the removal of forward guidance. We therefore expect that US economic growth momentum will bounce back in Q2, and that the progression of this throughout the quarter will be sufficient to warrant the start of (an albeit very gradual) Fed normalisation in June.
"Never invest emergency savings in the stock market”Suze Orman
Many have suggested that growth momentum has weakened (we maintain that this is likely transient) and that there is little sign of consumer price or wage inflation. If interest rates in the US were at 2.00%, then we would share the markets apathy for a rate rise. However, with the US expected to reach maximum employment by the end of the year, inflation suppressed by the (likely) transitory impact of lower oil prices, and the fact that monetary policy acts with a significant lag, if we are right about a re acceleration of US economic momentum (after the weather induced dip), then it is difficult to find an argument against monetary normalisation from what is ‘emergency monetary policy’. The US economy is not in a state of emergency.
Furthermore, any increase in inflation from here will make US real rates even more negative than they are currently, suggesting that monetary policy will become more accommodative. Further into emergency territory!
The other increasingly dominant factor on market expectations is the impact of the recent significant rise in the USD. We are not in the (admittedly growing) camp that view the moderation of US economic performance and Fed expectations are a function of USD strength or that there is a sudden concern from Fed officials that USD strength is going to topple growth. Far from it.
Nor are we in the camp (published by HSBC and others last week) that we have seen the high for the USD for this cycle.
"I never gave or took any excuse”Florence Nightingale
Blaming USD strength for the recent slowdown, while an easy excuse for corporate america (and likely to be widely used when earnings results out of the US begin next week), may well be increasingly in the headlines but we would argue that the impact on the US economy as a whole is modest and that the USD is less of a concern for the Fed than the markets currently fear.
The correction in the USD may well go on for further than we would have anticipated, however, we maintain that it is a correction and retain our bullish view on the USD (and GBP) for the year ahead.
Later in the week we will look at GBP and its likely reactions to up to and beyond the UK General Election at the start of May, as this morning’s inflation print of zero for February (for the first time on record - 1989) puts the UK and GBP back in the headlines.
"International developments to be taken into account”FOMC statement
On Monday we noted that the FOMC would be the highlight of the weeks’ events and that the sentiment of the statement would be key in determining the continuation (or otherwise) of recent trends in FX. The reaction of the USD, and to a lesser degree, the US interest rate curve to last night’s FOMC statement (and subsequent press conference) was substantive. EURUSD moved from a low earlier in the day below 1.0600, to a (contested) high at 1.1062. By the time the equity markets had opened in the UK, it was back below 1.0700, so was the rally, a positioning related anomaly, fuelled by a lack of liquidity (and algo’s), or is the change of inference for US monetary policy a game-changer for the underlying FX dynamic.
On Monday we outlined our central view that the term "patient” would be removed from the statement, however, we also stated that this was not likely the key risk from the statement itself and that the Fed would likely add a clear caveat, stating that there is no automatic implication of a rate hike in June.
The Fed did indeed add a caveat (both in the statement and more emphatically in the press conference) that the removal of the term "patient” did not mean that the Fed "would be impatient” and that the progression of monetary policy would remain data dependent. The earthquake from the Fed, however, came in the Summary of Economic Projections (SEP’s) or the dots, where near term growth momentum was brought into question (Yellen stated that the economy had more clearly slowed from the pace of the last few quarters) with a significantly lower path of interest rate projections.
While it was expected that the removal of the term "patient” would bring central market expectations for the first hike forward to June, the lowered ‘dots’ and weaker growth outlook pushed expectations back to September. Indeed, with the suggested terminal rate now reduced to around 3% in 2017, there was room for longer term rates to fall also. They duly obliged.
If the SEP’s were the earthquake, then the subsequent tsunami was in the FX markets. In major currencies, the most dominant trend, that of EURUSD, was interrupted sharply and significantly. The upmove, driven by positioning and a distinct lack of liquidity, was the biggest (in an upward direction) in 15 years. The question we need to ask now is: Was this just a storm (Tsunami) in a tea cup?
To sell or not to sell. That is the question
In order to answer that question we should perhaps take a step back from the price action and look at the fundamentals, or more specifically, the relative fundamentals.
In the US, while there may be some debate about the relative momentum of the economic recovery, there is little doubt that there is indeed a recovery. The OECD economic projections, released yesterday, predict that the US will be the fastest growing economy in G7, with growth of 3.1% this year. US monetary policy retains a firmly hawkish bias and while some may suggest that the urgency from the Fed has lessened, we would argue that the more dovish than expected statement is just as likely to have been an intentional (mis)emphasis from the Fed in order to counter over-exuberance in US interest rate market and perhaps more significantly, the USD.
In the UK, which according to the OECD will be the second fastest growing economy in G7 at 2.6% this year, the monetary bias is also hawkish. The backdrop in the UK, however, is muddied by the complexities and uncertainties of the General Election in 7 weeks time which, at least in the near term, overshadows the positive economic, fiscal and ultimately monetary progression that we expect to accelerate once the uncertainties of the General Election are removed. Yesterday’s Budget, however, added a number of positives, not least in the (politically independent) OBR revisions to unemployment (falling to 5.2% by the end of 2015) and growth (up to 2.5% this year). Furthermore, with employment in the UK at a record high and with public finances beating expectations, we feel that there is significant upside potential for GBP in the second half of this year.
"I will not take ‘but’ for an answer”Langston Hughes
In the eurozone, growth remains weak, the monetary policy bias remains dovish, the political backdrop remains fractious (at best), and despite a substantial decline in the value of the EUR, there is surprisingly little evidence to suggest any positive impact on exports. We have argued on a number of occasions that the biggest negative for the value of the EUR, a global reserve currency, is its negative deposit rate. This is likely to continue for a significant period.
Elsewhere, within the developed world, CHF, AUD, CAD and JPY have one or more of the weak growth, dovish monetary bias and negative deposit rate ailments that likely mean more protracted weakness in FX markets. At the risk of sounding like a broken record, and despite the fact that the spike correction last night was both severe and disquieting, the default position in FX likely remains short EURUSD (or indeed short EURGBP). Last nights’ storm, while in many respects a Tsunami, may well be viewed historically as a ‘Tsunami in a tea cup’.
"Asynchronous monetary policy may trigger market swings”Christine Lagarde
Last week we highlighted our view that the persistent EURUSD decline is the new default scenario in FX. This morning, EURUSD made a new low for the 13th consecutive daily trading session. As officials and commentators alike ascribe the EUR decline to monetary policy divergence, amid a firm commitment from the ECB to fulfil its pledge of EUR 60B asset purchases per month until at least September 2016, Wednesday’s monetary policy meeting (and specifically the accompanying statement) will likely be key for the continuation of this trend.
The vast majority of commentators have emphasised the importance of the inclusion or exclusion of one word from the Fed statement on Wednesday - "patient”. From our perspective, however, this is not likely the key risk from the statement itself.
Our central view is the the term "patient” will be removed from the March statement. However, while this is a hawkish development, we would expect that the Fed also include in the statement a clear caveat to its removal stating that there is no automatic implication of a rate hike in June, merely the option to tighten policy on a meeting-by-meeting basis from as early as June, should the data support this development.
"Some might say that we should never ponder”Oasis
Ultimately therefore the timing of the first Fed hike remains dependent on the data. Some may point to recent disappointing retail sales data - we would argue that the headline reading was dented by the poor weather and that underlying demand momentum, as suggested by the very strong online sales reading, remains strong. (Furthermore the recent data showed that household net wealth in the US rose USD 1.5 trillion in Q4).
Some may point to the lack of consumer price and wage inflation as a reason to wait-and-see. As we have argued before, if interest rates were currently at 2%, then we would concede; at zero, and with a substantial lag in the impact of monetary normalisation, we see the risks to higher (demand driven) inflation towards the end of 2015 and into 2016.
In essence we maintain the view that the Fed will remove the term "patient” (albeit suitably caveated) and ultimately that they move to a process of monetary normalisation at the June meeting. The one key risk that we would, however, highlight on Thursday is the possibility that the Fed mention the recent ascent of the USD. We would suggest this is a greater risk to a EURUSD correction that the inclusion or exclusion of the term "patient”.
"Cigarettes and alcohol”?Oasis
Elsewhere, market focus will return to the UK this Wednesday with the release of the latest employment report, BoE minutes and the pre-election Budget. Despite rising political concerns as we approach the general election on May 7th, GBP has remained relatively strong against all but the USD. This has been particularly pertinent given the more dovish tone to the rhetoric of BoE governor Carney of late and the resultant reaction in interest rate futures. We expect the employment report to retain a positive bias and with little expected from the Budget, GBP may retain its resilience (at least until the election uncertain looms near).
With little data in the eurozone this week it is likely that the fortunes of the EUR come as a result of (and in the opposing direction to) the fortunes of the USD (and to a lesser extent, GBP). We stand by our view of the EURUSD default scenario, however, new lows for a 14th or 15th consecutive day are likely a function of the expectations and subsequent reality of the Fed this week.
"Path forward will call for higher interest rates” Richard Fisher
On Friday, we made the case that there has been a regime shift in FX, where a persistent EURUSD decline is now the default scenario going forward. Recent sessions have only added to our conviction. We went on to highlight that this EURUSD decline is a function of underlying fundamental support for the USD, through growth and interest rate outperformance, and underlying fundamental economic and political weakness within the eurozone.
The February US employment report on Friday maintained the theme of extraordinary strength in employment gains, which continue to outperform both expectations and the rest of the world. With the monthly employment gain average approaching 300,000 per month, and the unemployment rate falling to 5.5% (a figure that was mooted by the FOMC as the equilibrium level only months ago), we increasingly feel that the extraordinary strength in US employment means that the extraordinary level of monetary accommodation can not be justified.
"It’s clear the US economy needs higher real interest rates”Jeffrey M Lacker
Many continue to argue that with little headline or wage inflation pressure in the US, there is no urgency to tighten monetary policy and thus the Fed should continue to sit on its hands. If rates in the US were currently at 2.0%, then we would have some sympathy with this view. As it stands, we do not. Monetary normalisation in the US, from the emergency setting of zero rates with employment growth at 2.4% and wage growth at 2.0%, is long overdue. Our central case remains that the Fed remove the "patient” language next week and that US interest rates begin their normalisation (albeit at a slow pace) in June.
In the words of the Fed’s Jeffrey M Lacker, the "Fed must set correct policy, even if it means a higher dollar”. In our view, current Fed policy is no longer correct. This probably continues to mean a stronger USD.
"May have to raise rates steeply if liftoff delayed”Richard Fisher
Next week’s FOMC meeting will also include the release of the quarterly update of the Summary of Economic Projections (SEP’s or‘ dots’). While the markets primary focus will likely be on searching the text of the statement for the word "patient”, we would argue that the persistent gap between the ‘dots’ and the market expectation of the rate hike path is just as significant as the Fed moves to monetary normalisation. Any upward move in the US yield curve to more closely reflect the central expectation of policymakers will likely be a further strong USD positive. (In this respect it is important to note the recent rise in USD vs. EM and the potential for a further and significant unwind of USD funded structures within EM).
"Talks about talks a complete waste of time”Jeroen Dijsselbloem
On the other side of the exchange rate, in the eurozone, the issues are becoming more concerning as divergences within the region grow, not just economically, but politically.
Greece’s detailed proposals submitted on Friday failed to match up to the provisional promises made a couple of weeks ago in order to secure a bailout extension and, as a result, Jeroen Dijsselbloem has made it clear that Greece will not receive this months (much needed) disbursement. Dijsselbloem, worryingly, also stated that it is "unclear if, when Greece will run out of cash”
The Greek debt talks resume tomorrow and ahead of this meeting there is finally something that all parties agree on - that there is no more time to lose! There have been some encouraging, if sporadic, signs of stabilisation in some areas of eurozone growth and confidence data, but there is a long way for the region to go if they are to overcome the political and growth concerns, until then the default position remains likely a weaker EUR.
Indeed, while in the US we have suggested that the situation is a case of ‘waiting for Go-’Dots’’, in the eurozone are they simply waiting for Godot?
"Common sense is not so common”Voltaire
Earlier in the week we suggested that, after a rangebound February, March would likely bring a return of "volatility, acute focus and, in many cases a resumption of some core trends.” This has been very apparent in EUR which has seen significant declines, despite the fact that US yields and EU/US spreads have not been indicative of further EUR weakness. In our view, there are two core reasons why a persistent EURUSD downtrend is the default (common sense?) scenario going forward. The first is a broad EUR negative.
In the much awaited ECB press conference yesterday, there were a number of focal points to what should have been a fairly uneventful meeting to provide further details of the execution of the previuosly announced ECB QE programme.
"Growth is now in Europe’s vocabulary”Matteo Renzi
The first important (if expected) announcement was in the revised ECB forecast that implied a higher growth trajectory when incorporating the impact of lower oil prices, a weaker EUR and actual QE. The forecasters now expect 1.5% GDP growth this year (from 1.0% previously) and +1.9% GDP growth in 2016 (from 1.5% previously). Indeed, with no substantive change to the asset purchase programme announced in January, Draghi’s opening remarks were notably more upbeat, stating that "we have already seen a number of positive effects from these monetary policy decisions”, not least in arresting the decline in inflation expectations.
Furthermore, although the ECB lowered its inflation forecast for 2015 to 0.0% y/y (from 0.7% y/y, again as expected), it raised the forecast for 2016, to 1.5% (from 1.3% previously). The knee jerk reaction in FX was to buy EUR. That, however, proved to be a short lived response as the press conference evolved. While growth of 1.5% and inflation rising, eventually, is a dramatic improvement from the current backdrop, relative to the US (and the UK), on both fronts, this remains a continued theme of divergence.
In a more dovish tone, Draghi made the clear indication of ECB intent to continue asset purchases beyond September 2016, should the actions fail to achieve a "sustained adjustment in the path of inflation” - This undermined the EUR.
"Common sense is shared unequally in Europe”Jean Claude Juncker
There is, however, one core driver of EUR weakness in our opinion. It is something that we have noted on several occasions over recent months and it remains pertinent today. The EUR has, over the last 16 years, established itself as an important and significant global reserve currency. Currently, that reserve currency comes with a 20bp charge for holding it (US QE weakened the USD and yet the Fed paid 25bps on excess reserves!). At the margin, this is likely enough to prevent purchases or, for reserve managers, an incentive to run reserves to minimum requirements at the very least. Over recent years the share of FX reserves denominated in EUR has fallen significantly from above 27% to around 24%, but management of these reserves is an ongoing process. If EUR is being sold at the margin, that ‘margin’ is nonetheless a huge number, given that global FX reserves are in the region of $1.4 trillion worth of EUR. That is not to mention the investment intentions and currency hedging requirements of institutions and individuals across the globe.
In addition to this theme, Draghi announced yesterday that QE purchases by the National Central Banks will begin on Monday 9th March. During the Q&A, Draghi also stated that "half of euro area debt is held outside of the euro area”, Total eurozone debt is also a very large number and if these overseas sellers do become significant sellers to the ECB, then the implication for the EUR is a further negative.
"Monetary policies must be forward looking” Janet Yellen
In the US, the dynamic is potentially the opposite to that in the eurozone, at the very least in terms of the monetary policy dynamic.
Over recent months, we have seen a clear regime shift develop in terms of US monetary policy. Not only has the Fed now prepared us for eventual monetary normalisation, signified in the first instance by the removal of the term "patient” from the Fed’s statement but, as Yellen clearly stated in her recent testimony, the "Fed will raise rates when reasonably confident on inflation”. From our perspective the recent shift of emphasis means that the Fed need a reason not to raise rates in June rather than a reason to raise rates. This argument holds true for USD strength.
In football parlance, the USD is starting the second leg of a Champions League semi-final with a convincing win from the first leg. In order to end up progressing to the final, the USD merely has to avoid a significant defeat (downside data miss). More significantly a draw (data in line with expectations) is sufficient for progression.
In the UK, the growth outlook has been boosted this week by the strong surveys of services, manufacturing and construction sector activity. With all three indices strongly in expansion they remain consistent with continued UK growth outperformance. We expect to see Q1 GDP growth around +0.8% q/q and somewhere above 3.0% for 2015 (up from 2.6% in 2014).
For the day the US employment report will be the most significant event and thus the most intense focus. As we suggest above, the bias remains for USD strength as data broadly in line with expectations is likely still a USD positive.