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ECU's Market Commentary

By Neil Staines on 14/05/15 | Category - Comment

"The future ain’t what it used to be”Yogi Berra

At the end of April, the release of the UK Q1 GDP data disappointed expectations. At just +0.3% q/q, it was the slowest pace of growth in 2 years. Yesterday, following the unemployment report for March / April, the Bank of England released their latest (forward looking) Quarterly Inflation Report (QIR). With much of Europe out for the Ascension Day holiday, today we take the opportunity to take a step back and assess the prospects for the UK’s economic momentum. Is the lower growth momentum in Q1 a bump in the road, or the start of a more sinister decline in activity?

In what could be described as a relief rally, GBP has appreciated across the board since the surprise majority win for the Conservative Party at last week’s General Election. While the clarity of fiscal trajectory and the removal of political uncertainty are clearly positive, the state of the UK’s finances remains weak. Interestingly, however, this relief rally has not applied to the interest rate markets where interest rate futures have rallied since the Election, nudging the first interest rate rise expectation back out into the second half of 2016.  

Yesterday’s QIR brought a mixed response from the market upon its release. Its initial headline was a reduction in the GDP forecasts for both 2015 and 2016, however, looking deeper into the report there were a number of positives. Firstly, despite the forecast reduction, the BoE stated that "growth remains solid” and subsequently that recent "surveys of household and business confidence, as well as other indicators of consumption and business investment, suggest that activity has been more robust than reported in the official data”.

"Prediction is very difficult, particularly if it is about the future”Niels Bohr

Furthermore, the BoE expect wage and productivity growth to pick up and that headline inflation is likely to pick up "notably” towards the end of 2015, as the impact of lower energy and food prices fall out of the annual data comparison.  Lastly, and perhaps most importantly, BoE Carney stressed that the "best collective view of the MPC is that the amount of slack in the economy has narrowed over the past 6 months and is now in the region of 0.5%”. It is expected that this ‘slack’ will disappear in less than 1 year and, as the MPC have previously stated (most notably by recent Chief Economist and Deputy Governor Charlie Bean), that rates would need to rise before slack has been completely eroded (stating that monetary policy takes circa 18 months to reach its full impact). There is a strong case for the prospect of interest rate rises coming sooner (perhaps significantly sooner) than the current market expectation of June 2016.

The employment report, also released yesterday, highlighted continued strong labour market gains with employment reaching new record high levels and the unemployment rate falling further to 5.5%. The breakdown of the report was also positive, with jobs growth driven by gains in full time employment. Perhaps most significantly, against the current very low inflation backdrop, were the further gains in wage growth.

The QIR stated that "absorption of remaining slack and pickup in productivity growth are expected to support wage growth in the period ahead”. April is overwhelmingly the most popular month for wage bargaining and thus the April wage data will be very significant in shaping expectations in this regard.

"It is not in the stars to hold our destiny, but in ourselves”William Shakespeare

As we move into Q2 and beyond, our central expectation is that growth momentum in the UK will resume. In the near term, household income is boosted by low inflation and political uncertainties holding back business investment and personal consumption being lifted. A rebound in activity in Q2, if accompanied by accelerating wage growth (given that we are approaching the equilibrium level of unemployment and the erosion of economic slack), would, in our view, lead to a (potentially significant) re-rating of interest rate expectations. With the central QIR projection showing a ‘notable’ rise in inflation at the end of the year, any ‘front loaded’ wage pressure will likely bring with it a realistic probability of a Q4 2015 lift-off.

Going forward, we remain bullish of the UK economy relative to both expectations and its peers. If, as we anticipate, the UK economic momentum is regained in Q2 and beyond, we see a strong case for ‘sooner’ rate hikes and a stronger backdrop for GBP.
By Neil Staines on 12/05/15 | Category - Comment

"Not satisfied, but more optimistic”Jeroen Dijsselbloem

As the Greek negotiations rumble on in the background, European Commisioner, Pierre Moscovici described the negotiations as having a "new spirit”, but the once taboo topic of a referendum appears to be a topic that is increasingly mentioned and likely increasingly mooted by both sides as the impasse continues. With no new developments on the political front and little data to confirm or deny a US Q2 economic recovery, fixed income and interest rate markets remain the core driver in FX.

The German 10 year Bund yield continued its dramatic assent this morning, jumping 8bps on the open to the European trading session. Against a backdrop of very significant bond purchases, the sell off in Bunds (rising yields) has been very aggressive and perhaps counter intuitive. The move has forced liquidation from a variety of real money and institutional holders of the securities and the position liquidation has undoubtedly driven wave after wave of EUR buying.

"Divergence between major economies likely to widen”Moody’s

We retain the view that economic and monetary differentiation between the US (and UK) and the eurozone will ultimately result in a lower EUR. Furthermore, while Q1 was a positive month for eurozone growth and confidence (inspired in no small part by the widely expected initiation of ECB QE) recent developments {a higher EUR, higher oil price and markedly tighter monetary conditions through higher eurozone yields} add further headwinds to eurozone growth prospects into Q2 and beyond. This comes at a time where we anticipate a resumption in the macroeconomic data in the US and the UK.

However, in the near term, heightened volatility and very poor liquidity continue to dominate the proceedings, at least until Bunds stabilise and the US economic data for Q2 begin to validate the theory of ‘transient’ or temporary weakness in Q1. Against the current backdrop, further position liquidation and EUR strength are a distinct possibility.

As interest rates are playing such a key role in FX at the current juncture it is worth taking a step back and looking at the prospects for monetary normalisation in the US and the UK.   

In the UK, the rate curve currently pricing the first interest rate rise by in Q2 2016 (May) and only one more (to 1.00%) by the end of 2016. Despite the fact that it was pricing in the first rise in H2 2016 as recently as a month ago, from our perspective this is too dovish. This morning’s outperformance in industrial production, while unlikely to have a significant upward impact on Q1 GDP is significant in highlighting the UK’s continued economic momentum going into Q2. The removal of the political uncertainty is also key for GBP strength going forward. The EU debate is too far away to dominate FX at this juncture.  

In the US, we may have run out of time for a June hike to be a realistic possibility, however, with the US rate curve currently pricing the first interest rate rise by in Q1 2016 (February) and two more (to just over 1.00%) by the end of 2016, there is plenty of scope for a move in expectations back to a sooner date for the first hike. There is now a growing expectation of a September hike, the rate move that is will be needed if this comes to fruition will likely support the USD from here, even if the terminal rate for interest rates is significantly lower than in previous cycles.

Furthermore, a 5.4% unemployment rate and 2.2% wage growth are enough to sustain consumer spending growth of over 4% per annum in nominal terms, and thus there is every reason to believe that the Q2 data will indeed be a good bit stronger than Q1.

"Timing of Fed rate liftoff to depend on the data”NY Fed, Bill Dudley

Tomorrow’s data is particularly pertinent in terms of US and UK rate views. Firstly, the Bank of England Quarterly Inflation report will be keenly watched as the market formulates its central expectation for both the timing and trajectory of rate liftoff, following the disappointing Q1 GDP data and now that election uncertainty is in the past. The core focus will be on any increase in the inflation forecasts and any reference to GBP. In addition to the Inflation Report, the UK employment report is likely to show further strength in employment gains that continue to bode well for future consumption. In conjunction with the Inflation Report, any pickup in earnings growth could be a further significant boost for the UK, for interest rate expectations and for GBP.

Secondly, US retail sales will also be keenly watched for signs that the US Q1 GDP disappointment (likely to be revised into negative territory following the disappointing rise in the trade deficit in March), was indeed transitory.
By Neil Staines on 06/05/15 | Category - Comment

"Shaken not Stirred”James Bond

Over recent trading sessions the backdrop for financial markets has become increasingly disjointed and illiquid, as uncertainties ranging from the strength of the US economic recovery and its implications for Fed monetary policy, the political uncertainty in the UK ahead of tomorrow’s General Election, and the ongoing yet increasingly serious Greek debt debacle, have shaken markets from Equities to Fixed Income and Foreign Exchange.

Perhaps the most extreme movements have been in Fixed Income markets, or Bonds. In the last 5 trading days, the sell off has driven up the yield on 10 year German bunds by an eye watering 42bps (from 0.16% to their highest level this year), despite the continued prospect of substantial purchases by the ECB and the Bundesbank under QE, likely to continue for a further 16 months. This move, exacerbated by illiquidity and an extreme positional bias, has forced position squaring not just in bonds, but also likely in Equities and FX, as risk aversion rises.  

On a relative basis, the move in 10 year German yields has sharply outperformed the rest of the curve, and other countries, with the equivalent US yields only having risen 35bps in the same period (UK +32bps). If you combine this with the fact that the absolute level of eurozone yields is so much lower (and thus the convexity substantially greater), it is clear that the impact of such a move will have important ramifications.

"He always did have an inflated opinion of himself”James Bond

In FX terms, while the 2 year spread has remained consistent with a stronger USD throughout, the movement in Bunds would likely have given a bid to the EUR in two main ways. Firstly, the movement in the 10 year yield differential makes EUR more attractive on a relative basis and secondly, and perhaps more significantly in the short term, many international investors had likely coupled a long Bund position with a short EUR hedge. Thus as the Bunds get squeezed, the hedges need to be unwound. For now, market focus remains on the German Bond.

"Thats a Smith and Wesson and you’ve had your six”James Bond

The ECB will likely discuss the haircut on Greek collateral at their meeting today. This is integral to the solvency and viability of the Greek banking sector (and at this stage, the country). In our view, the Greek situation is coming to a head and a Greek default is increasingly likely. If, as is most probable, this happens with Greece within the eurozone, then this is likely the worst possible outcome for the EUR. The Eurogroup meeting on May 11th will therefore undoubtedly be the next key date.

In the meantime, illiquidity in the bond and FX markets likely means that movements in either direction for EURUSD can be sharper and of greater magnitude.

"Why is it that people who can’t take advice always insist on giving it?”  James Bond

In the UK we are reaching a crescendo of the political uncertainty that has led up to the Elections over the preceding 6-8 weeks. All the most recent polls suggest a hung parliament, in which case the days following the election will continue to add to the heightened uncertainty as to what the next government looks like following an inconclusive result on Friday morning. While GBP has remained very resilient in the run up to the election, the next few days leave GBP acutely vulnerable.

In Australia, the RBA cut rates and despite this the currency strengthened. The policy statement referred to the likelihood of further AUD weakness, but as the market prices in this being the low point of the interest rate cycle, 2 year AUD rates are some 30bps above their end March low. More Chinese weakness remains the key barometer for further AUD weakness.

The other major event of the week is Friday’s US employment report. After the sharp disappointment of the March report, the April report will be acutely assessed for signs of a rebound in labour market activity into Q2. Following yesterday’s US trade data, which points to US Q1 GDP being revised down into negative territory, broader financial markets will be hoping for a strong rebound to maintain the US recovery story and to give financial markets just a quantum of solace.
By Neil Staines on 01/05/15 | Category - Comment

"You wouldn’t want to be starting from here!”

Many years ago, while lost on a country road, en route to a golf course in Ireland, some colleagues and I decided to seek directions from farmer in a nearby field. His response, in a strong southern Irish accent, was "well… you wouldn’t want to be starting from here.” This sentiment almost perfectly sums up financial markets at the current juncture.   

In the US, "here” is zero interest rates and a substantial holding of QE assets. A historically unprecedented level of monetary accommodation that when introduced was postulated as an emergency measure. "Here” is a slowdown in the US economic momentum that has exacerbated uncertainty about the timing of the removal of Fed accommodation. "Here” is a very heavily owned (at least on short term metrics) USD.

Over recent sessions there has been a sharp unwinding of USD longs, exacerbated by a very weak Q1 GDP release, which continued despite an FOMC statement which appeared more sanguine about the US economy.  

While the Fed noted the slower growth and jobs pace it continues to expect that the weakness is transitory. Indeed when we look at the detail of Q1 growth weakness, the negative impact from the oil price decline on oil investment was the most striking with spending in wells and mines down 48.7% in Q1. This is in addition to the negative impact on activity from the poor weather and the supply disruptions from the West coast port strikes suggest at least some transiency.

While the headline figures are clearly weak for Q1, the ‘background noise’ or the volatility within the data components and their interactions is much higher than normal. That in itself likely justifies the wait and see, data focus of the Fed. The question for the medium term, however, is what the rebound from Q1 looks like, whether the missed consumption, investment and activity is transferred into Q2 and how that feeds through into inflation and interest rate expectations.

"I dont know where i’m going from here, but I promise it won’t be boring”David Bowie

While it seems that all eyes have been on the US and the USD, at some point during this week, the core driver of major FX in the short term (in our view) transitioned from being driven by sentiment towards the US, to being driven by position unwinding in first European rates (the very sharp rally in 10 year bund yields is testament to this view), which itself transitioned into an unwinding of EUR funded carry trades, that is arguably ongoing.

In EUR terms "here” is a fractious, fragile economy with the monetary accommodation pedal pressed firmly to the floor. "Here” is a negative interest rate and a segregated fixed income market (most of which offers a negative yield). "Here” is an environment that has been increasingly supportive of EUR as a funding currency.  

"There are no rules here, we are trying to accomplish something”Thomas A. Edison

The UK (and GBP) rank behind US and the eurozone in terms of their dominance in driving market sentiment and activity at the moment. However, last night’s political party ‘Question Time’ came as a timely reminder of the uncertainties of the political landscape over the next days and weeks. GBP, having gained 6.4% from its lows against the USD over the past two weeks, may become increasingly vulnerable in the short term.

Taking a step back, however, any successful resolution to the the political uncertainty in the UK would likely see GBP well placed to gain ground against a number of major currencies. While the recent GDP release for Q1 disappointed, we continue to view the UK economic momentum as being stronger than the official data suggest. However, for the UK "here” is political uncertainty.

In the medium term, we continue to favour a stronger USD and a weaker EUR on the back of significant monetary and economic differentiation. However, in the near term, position unwinding and heightened uncertainty continue to dominate. Likewise we maintain our bullish view on GBP relative to expectations and its peers going forward, however, in the near term GBP remains vulnerable to political uncertainty (and, as this mornings data highlights, near term weakness in sentiment and activity data as this uncertainty plays out.)

In essence, we favour USD and GBP over EUR, but remain mindful of the possibility that "you wouldn’t want to be starting from here

By Neil Staines on 28/04/15 | Category - Comment

"He who tampers with the currency robs labor of its bread”Daniel Webster

Not so long ago, currencies were the last thing on central bankers minds. Global interest rate policy settings had broadly, uniformly, reached the lower bound and along with interest rate differentials (and the lack of a standout "buy” currency), volatility diminished to historic lows. Global investors has come to see central bank asset purchases as a green light to buy equities and bonds (while there was still a yield to be had) and currencies were left in trading ranges that would once perhaps have been thought of as spreads. That was then.

Strong data in the US, and perhaps the UK last year changed that perspective. If monetary policy in one country were to move towards normalisation (albeit at a historically pedestrian pace) and become increasingly accommodative in another then surely the transmission mechanism for this policy divergence would be predominantly in FX. As the US economic recovery started to prove more resilient and fractures in the eurozone began to re-emerge (along with the threat of deflation - arguably from a persistently strong currency and persistently weak domestic demand) the EURUSD decline gained pace. Throw in the resultant impact and implications of the removal of the CHF cap and currency volatility was seemingly back.

"Only reason rates are not higher is low rates abroad”Norges Bank, Oeystein Olsen

Last night’s comments from the Norges Bank Governor, Oeystein Olsen, that domestic monetary policy has been shaped by the policy of other central banks via its implications for the currency are a case in point that central bankers are increasing facing conflict between domestic economic requirements and the side effects of currency and asset values (or vice versa). Market chatter of ‘unconventional policies’ in China has also become increasingly audible of late - particularly in light of a more acute focus on equity market valuation and leverage. Currency volatility is likely to remain elevated over the medium term.

As a function of its dominant position in the global economy, and as a function of its lead in the global economic recovery, US monetary policy is arguably the most significant driver of global financial markets at the current juncture, and while (potentially) in the opposite direction to the concerns of the ‘easing’ central banks, the Fed’s concerns over currency and asset prices are an increasing focus.

"Fed implementing the ‘loosest tightening’ ever seen”Mohamed el Erian

At the centre of the Fed monetary policy debate has to be the transiency (or not) of the recent slowdown in the US economic data. It appears that the decline in the oil price has negatively impacted energy jobs and investment as well as damped inflation (and retail sales?), but there is little evidence so far to suggest that the falling petrol price (effective tax cut?) has boosted consumption in any meaningful sense. The US data has been disappointing.

While the market will pay attention to tomorrow’s Fed statement and assess the wording and inference as usual, the reality is that the weakness in the data has already pushed market rate hike expectations out so far they are unlikely to be affected. Markets are expecting no policy action and a dovish statement.

A number of commentators have heralded the end of the USD rally and the beginning of its demise. We continue to argue that rumours of the death of the USD are (significantly) exaggerated. We anticipate a resumption in the USD uptrend over coming weeks (though in the very short term the USD remains fragile), though it is more likely to be an improvement in the data than rhetoric from the Fed that drives it.

UK GDP data this morning offered a similar disappointing snapshot of the UK’s economic momentum. However, 2.4% y/y growth is only modestly below expectations and we would anticipate economic momentum is sufficient to maintain a rate rise in the UK in 2015. Again similar to that of the USD, the near term is likely a vulnerable period for GBP (exacerbated by the election in just over a week), however, the implications for the currency over the medium term remain positive from our perspective.
By Neil Staines on 23/04/15 | Category - Comment

"The longer the excuse, the less likely its the truth”Robert Half

Over recent weeks the US economic data has disappointed expectations. Throughout this, we have maintained the view that the recent ‘dip’ understates the current economic momentum in the US and that if you strip out the weather and seasonal negatives, as well as the supply disruptions and distortions due to such large moves in the oil price, the picture is far more rosy that the data currently suggests.

However, there is only so long that anyone can maintain the view that the data are wrong, without it becoming merely an excuse. In this respect the April US employment report is key. Unfortunately, we will have to wait until 8th May for its release.

"I never gave or took any excuse”Florence Nightingale

Our view on the UK is not dissimilar to our view of the US in that we feel economic momentum is stronger than the data (and certainly broader sentiment) suggests. However, in the UK (at least in the near term), the uncertainties are more political than economic.

Yesterdays release of the Bank of England MPC meeting minutes from April 8th and 9th was, in our view, significant. While we would stop short of describing the minutes as outright hawkish, they certainly removed the dovish bias that has been a theme for recent months. Indeed, the comment that "All MPC agreed next move in rates likely to be up” removed the uncertainty brought about by Chief Economist Andy Haldane who had previously spoke of the prospect of further rate cuts.

From our perspective, perhaps the most significant part of the report was the discussion of the relationship between inflation and GBP. The minutes highlighted the "risk of faster inflation pick up from GBP strength” and that the "GBP feed through to CPI may be faster than expected”. This more hawkish interpretation of inflation likely supports our view of UK rate expectation and GBP outperformance after a resolution to the General Election uncertainties. If economic momentum is maintained or even accelerates as we anticipate going into H2, then rate hike expectations could be moved significantly closer than their current 2016 liftoff timeline. The huge move lower in Gilts yesterday, overshadowing the move in Bunds, is perhaps indicative of the sensitivity of markets to such a possibility.

"He who cannot dance claims the floor is uneven”

Over recent weeks, it has been this stabilisation and, in some cases, upturn in the eurozone data metrics that has led to a stabilisation in the value of the EUR. At the same time there has been a moderation and downturn in the US data metrics. However, just as the market was getting comfortable with the concept of improving eurozone data, this mornings flash PMI estimates disappointed expectations, particularly in France and while the data across the region has shown signs of broad stabilisation, growth remains at very low levels and economic momentum remains fragile.

"Excuse me while I kiss the sky”Jimi Hendrix

Furthermore, we expect the US economic data to recover after a weak Q1 as the weather and supply disruption effects are unwound. On a relative basis, therefore, we expect that the economic surprise indices will turn back in favour of the US, at least relative to the eurozone. If we then consider the recent developments in the EURUSD rate, which has broadly ranged between 1.05 and 1.10, amid anecdotal and empirical evidence that long USD positioning has been significantly reduced, the performance of the EUR amid significant relative data outperformance has been singularly unimpressive. If, as we expect, the forthcoming data impetus shifts positively in the US and falls back in the eurozone, then we would expect the EUR to become vulnerable, and for the broad USD rise to reassert itself.   

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