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Merkel Poised to Win 4th Term as Chancellor
While polls show Angela Merkel’s Christian Democratic Union (CDU) party heading the German Election with a 16% lead over follower Martin Schulz’s Social Democrat (SPD) party amid a televised debate the latter “failed”, German police dealt with an increased number of election-related crime against the far-right Alternative for Germany (AfD) party. Polls show that AfD will come comfortably around 10% as the party attracted more supporters from anti-extremists and anti-nationalists, the same as opinion polls give to Die Linke, while the FDP and Grune are given 9.5% and 8.2% respectively.
Potential Coalitions and Parties representations
Despite Merkel’s CDU is likely to win the elections and most of the seats in the Bundestag, she will have to form a coalition with another party, as done before with its Bavarian Sister (CSU), as the probability of falling short is high. The polls suggest a Grand Coalition; the current government, is in play. The question remains, will CDU and CSU team up with FDP if necessary, or decide to go for a “Jamaica Coalition” with the Greens? Another option is a CDU-FDP government as this would overpass the threshold target for a majority. The only risk for Merkel would be an SPD-Left-Green coalition, led by Martin Schulz.
In the current Bundestag system of 631 seats CDU and CSU represent 309 seats, followed by SPD’s 193 seats, Die Linke’s 64, and the Green Party’s 63 seats.
For the best part of 2017 political jitters, geopolitical tensions in the North Korean Peninsula and the recent raise in Digital Currencies brought economic prosperity and stability in the Eurozone as Dollar weekened. While Macron and Merkel agreed to fix the Eurozone as Euro is still holding strong, without having finalised any details on how, investors believe the chances to normalise monetary union deficiencies and to reform Eurozone are great. With Merkel in the lead, stability and prosperity are believed to continue not only in Germany, as the electorate desire, but also in Europe, since Europe is leading investor sentiment to be more bullish about Eurozone.
On an accelerating German economy pressure is still on. Top of the issues faced by the current, and future coalition, are immigration, genre and economic inequality. According to Reuters immigrant population has hit a new record high with new waves coming from the Middle East and Africa. More than a million migrants were allowed in the country after Merkel’s decision to open the borders, a reason AfD popularity was boosted. With more women working in worse conditions than men, and earning up to four times less than men, genre and economic inequality has risen, government figures show. In addition, economic inequality expanded as a result of ineffective income redistribution and structural changes in the labor market. A solution for greater genre and economic inequality is calling for Merkel and the new Coalition.
August NFP Special Report
A more important than usual report came out on the 4th of August as doubts over a rate hike increased following a slowdown in inflation. Along with the Fed’s approach to reducing the $4.5 trillion balance sheet, July’s job figures did matter the most to the central bank and investors.
The figures for July’s NFP resurfaced very positively as consensus expectations was for a 183K increase in employment change while the actual jobs created reached a figure of 209K. The unemployment rate was little changed to 4.3%, and the number of Total Nonfarm Payrolls up from 146.41M to 146.62M, a monthly growth of 1.71%.
The actual report showed an increase mainly in Leisure and Hospitality (+62K), Education and Health Services (+54K), and Professional and Business Services (+49K), while Manufacturing (+16K), Financial Activities (+6K), Wholesale Trade (+6), Construction (+6K) and Government (+4K) realised a smaller appreciation. The following table illustrates the Employment Change by Industry:
US Change in Nonfarm Payrolls is at a current level of 209.00K, down from 231.00K last month and down from 291.00K one year ago. This is a change of -9.52% from last month and -28.18% from one year ago. Despite the number of employed people hit a new high of 153.5 million wages remained unchanged. In fact, we should pay attention to the following numbers and events for the upcoming jobs report:
1. Unemployment Rate fell from 4.4% to 4.3%.
2. Participation Rate raised from 60.1% to 60.2%
3. ADP jobs growth fell to 178K from 187K expected while BLS report filed an increase from 182K to 209K
4. Euro hit a fresh 2 ½ year high against Dollar after last week’s Symposium at Jackson Hole
Now, let’s take a closer look at those key five points…
1. Lower unemployment rates: Despite the small decline in the unemployment rate to 4.3%, the lowest since May 2001 which was also reached in July, most jobs added in the workforce came from low income sectors and strongly the ones of the part-time basis. This gained 349K, while full time fell by 54K.
These individuals, who would have preferred full-time employment, were working part time because their hours had been cut back or because they were unable to find a full-time job – so a falling rate means that more people are employed but they work much less hours and earn less, hence the increase in the participation rate too. Note the average weekly hours remained unchanged to 34.5 hours per week.
2. Increased participation rate: The participation rate was little changed over the month but is up by 0.4% percentage point over the year. 1.6 million people were marginally attached to the labor force, 321K lower than a year earlier. Discouraged workers, a subset of the marginally attached who believed that no jobs were available for them, numbered 536K while employed persons saw a raise of 345K
3. June’s ADP jobs growth came in for 178K, worse than 187K expected: The ADP report hinted a possible above expectations jobs report as the 9K increase increased the prospects of a positive NFP report however this shouldn’t have been the case as over the last 12-Month period ADP private payroll growth averaged above 200K. This estimated was the first in a while that came out expected below 200K, and NFP showed amazing results. Investors have been losing confidence over ADP reports as the divergence between ADP and BLS widens further. June’s report was also revised from 222K to 231K, however May’s was revised down from 152K to 145K.
4. Debt ceiling sends Euro to the roof: Despite both Yellen and Draghi did disappoint investors last Friday as they did not touch monetary policy Euro broke the last high of 1.1913 technical resistance. Fears over debt ceiling as well as over Harvey hurricane and a possible weakening of the US economy took the pair to its highest levels last seen in January 2015. The move occurred after a 3-Week consolidation and could be the beginning of the next wave up in Euro’s rally. Looking at the monthly chart, things become a little clearer.
A closing word…
Remember that sharp spikes occur across many currency pairs, with a lower impact than the spikes on EURUSD due to weaker volatility. For example, opportunities may arise on USDJPY, USDCHF, Gold etc., depending always on your risk appetite. In addition, the price normally retraces back to normal levels by the end of the day, so, investors may look to take advantage of the market once the market have started settling down.
Any opinions, news, research, analyses, prices or other information contained on this email or linked to from this email are provided as general market commentary and do not constitute investment advice. FXPRIMUS does not accept liability for any loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance on such information.
I’d like to discuss my general expectations for what’s likely to happen in the FX markets this year. Much depends on how the Trump presidency and the Chinese economy work out. In general, I expect the dollar to continue to gain and for the yen and pound to weaken further.
We’ve seen the dollar soar after the presidential election as market participants expect the incoming Trump administration to cut taxes and boost infrastructure spending. Alas, those expectations ignore the way the US government actually works: the president submits a budget but Congress has to pass it. The Republican Party has been willing to pass tax cuts but is generally less enthusiastic about increased spending. In fact, the current plan among Congressional Republicans is to shrink the government’s budget, not expand it. The gap between what Trump is looking for and what Congress is planning currently totals many trillions of dollars. The wrangling over US fiscal policy is likely to be the main risk to the dollar in 2017.
Nevertheless, I still expect the dollar to strengthen further. There’s likely to be some fiscal boost, if not everything that Trump hopes for. Moreover, in December the Fed boosted its interest rate forecasts without even assuming a more expansive fiscal policy. Thus the monetary policy divergence that’s kept the dollar rising for several years now is likely to continue into 2017, albeit with perhaps more volatility as US politics weighs on the outlook.
The outlook for the yen is to a large degree the mirror image of that for the dollar. Not only has the Bank of Japan pushed short-term rates into negative territory, but it’s also capped long-term 10-year rates at zero. So even if rising US Treasury yields exert an upward pull on long rates elsewhere in the world, they won’t have the same impact on Japan. The widening yield gap between Japan and the rest of the world should keep the yen on a depreciating trend during 2016. On top of that, the Trump administration’s focus on countries that run significant trade surpluses with the US is likely to be to Japan’s detriment, as it runs the fourth-largest surplus of any single country.
The outlook for the euro is particularly clouded. I expect the currency to be weak in the beginning of the year as the market worries about political risk. Elections in the Netherlands in March and France in April and May are likely to keep the specter of euro disintegration haunting the market. In addition, the Italian banking crisis is another centrifugal force for the currency union to deal with.
However, I expect the elections to pass without much lasting impact and the pro-EU establishment parties to continue to govern. In particular, I don’t expect the National Front to come to power in France. That should mean less political tension in the Eurozone after May, just in time for people to start worrying about Britain again.
After plunging in the wake of the Brexit vote, the pound has had a respite recently as the British economy has proven more resilient than the pundits expected. Moreover, Britain has benefited through the contrast with Europe: the challenges Britain faces are now well known, while the impact of politics on Europe is more difficult to assess. That’s caused some selling of EUR/GBP. But by the late spring, concerns about European politics should be waning just as the wrangling between Britain and the EU over Brexit begins in earnest. At that point, the full impact of this historic move is likely to hit the markets and the pound is likely to suffer another leg down, in my view.
The commodity currencies: AUD, NZD, CAD
The outlook for AUD and NZD is tied to China, and the outlook for China isn’t that great, in my humble opinion. The Chinese government has been using every monetary and fiscal technique in the book to boost growth, but 2017 is likely to be the year that the book ends and the economy has to face reality. Moreover, Trump’s plans for revamping the global trade system are aimed squarely at China, which will compound an already difficult situation.
AUD is likely to be the main victim of slower Chinese growth. China takes 32% of the country’s exports and developing Asia overall takes 48%. A slowdown in China’s growth, particularly in its property sector, will hit Australia’s commodity exports. Moreover, the global supply of iron ore is set to increase (and the price fall) as new mines in other countries start producing.
NZD is less vulnerable to a Chinese slowdown than AUD is. China only takes 18% of the country’s exports (Australia takes 17%, the US takes 12%) and most of those exports are agricultural products, not building materials. If the economy slows, people might not buy a new house but they will still have to eat. Moreover, milk prices have been rising recently, in contrast to iron ore & coal.
CAD is vulnerable to a downturn in oil prices, but the correlation seems to be waning recently. On the other hand, unlike AUD, Canada is leveraged to an accelerating economy: 73% of Canadian exports go to the US, which I expect will continue to enjoy fairly robust growth in 2017. And the Trump administration has said that they don’t have a problem with Canada’s trade patterns, so NAFTA renegotiation is not a significant threat. If the USD continues to rally because of a strong US economy, Canada should be a major beneficiary. That ought to help the CAD outperform the other commodity currencies.
The Bank of Japan (BoJ) today surprised the markets with yet another tweak of their monetary policy. As expected, it focused on the shape of the Japanese Government Bond (JGB) yield curve, but it contained enough new and unexpected aspects to provide several surprises.
First, a short history of BoJ policy. They introduced “Quantitative and Qualitative Monetary Easing”, or QQE, in April 2013. When that didn’t work, they introduced “QQE with Negative Interest Rates” in January of this year. Now that they see negative interest rates actually harm the economy, they’ve switched to “QQE with Yield Curve Control.”
There are two major components of this new program:
Yield curve control: At the short end of the yield curve, BoJ has kept the benchmark rate for part of bank reserves unchanged at -0.1%.
At the long end, will target 10-year Japanese Govt Bond (JGB) yields at around current levels of 0%. They’ll buy bonds if yields start to move up, or they will lend money for up to 10 years at a fixed rate if yields start to move much lower. I’ve never heard of anything like that before. Their longest operations up to now were 1 year. The ECB’s long-term refinancing operations are 3 years.
Anchoring the 10-year yield at 0% has two effects. First off, they’re guaranteeing that if the banks (or anyone else) buy 10-year bonds at this level, they won’t lose money. Secondly, by preventing 10-year yields from going below zero, the yields of longer-term bonds should stay positive. That will help the profitability of insurance companies and pension funds, which need longer-term assets to match their long-term liabilities.
In any case, cutting the interest rate on bank reserves further into negative territory would have hurt bank profits, so this is better than the alternative, as far as the banks are concerned.
- Inflation-overshooting commitment: This is even more radical, in my view. Before, they were pledging to get inflation back up to 2% by a certain time. They never met that target, so they just kept pushing it out further and further. Now they’ve scrapped the target date and instead pledged to keep expand the monetary base until inflation is stable above the 2% target. In other words, they’ve committed to overshoot their inflation target. This is the only central bank in the world (that I know of) that has taken such a radical step.
They also said they will cut interest rates further if necessary
The moves seem aimed at reducing the harmful side effects from the negative rate policy, which was hurting bank profitability and could make them less willing to lend
Japanese stocks rose as banks & insurers are seen as benefiting from the moves. That’s the white line in this graph. USD/JPY, the yellow line, moved up almost in lockstep with the stock market. That seems to have been the path by which the BoJ’s moves affected the currency market.
But the graph shows, once the Tokyo stock market closed, the yen began strengthening again. That’s because these moves won’t directly impact the currency. It’s an indirect impact: by making banks and insurance companies more profitable, they won’t need to hedge their overseas investments so much and they may be more willing to take risks. But on the other hand, by making Japanese bonds more attractive, the BoJ could be discouraging them from investing abroad. So the impact on the currency isn’t that clear.
Meanwhile, the JGB yield curve steepened somewhat as 10-year yields, which had been below zero, moved up to around zero %. Rates at the longer end moved up as well, which may have been as much the BoJ’s intention as anything else.
All told, I believe that the BoJ’s pledge to keep policy loose not only until they achieve their inflation target but until they overshoot their target on a sustainable level is the most radical thing I’ve heard from a central bank. I think in the long term, that should work to weaken the yen, because it promises that they will just keep trying and trying. But in the short term, I’d say a lot depends on what the Fed decides tonight.
Today I’d like to discuss what impact the dramatic and largely unexpected Brexit vote will have on the world. But before I do, I’d like to discuss an event that happened almost 20 years ago: the Russian bond market default. The connection may not be immediately relevant, but I think it explains a good deal of why we are now entering into one of the most dangerous periods I’ve seen for the markets.
You may remember that Russia defaulted on its bonds back in 1998. At that time, one of the favorite investments for hedge fund was to borrow money in the low-interest-rate yen and invest it in high-yielding Russian bonds. When the Russian bond market collapsed and their assets suddenly plunged in value, all these hedge funds rushed to close out their positions and repay their liabilities. The result was an enormous rally in the yen – up something like 4 yen a day every day for a week.
The reason the Brexit vote reminded me of that event was this: it was completely understandable in retrospect, but completely unforeseen in advance. I don’t remember anyone warning that a collapse in Russian bonds would affect Japan. Yet it did, very much so. Now that we know why it did, we can see the cause and effect and we feel that we should have been able to forecast it. But certainly nobody did at the time.
Now we are hearing a lot of predictions and forecasts for what will happen after Brexit. That’s only natural; we all have to make plans for the future, and so we all want to have an idea of what the future is going to be like. Unfortunately, it’s inherently unknowable. The one thing we can be certain about the future is that it’s unlikely to be the way anyone imagined. As Daniel Kahneman said in Thinking, Fast and Slow (a book that every investor should read – twice),
…our tendency to construct and believe coherent narratives of the past makes it difficult for us to accept the limits of our forecasting ability. Everything makes sense in hindsight…And we cannot suppress the powerful intuition that what makes sense in hindsight today was predictable yesterday. The illusion that we understand the past fosters overconfidence in our ability to predict the future.i
I’d like to list some of the effects we’ve already seen from the Brexit vote. The disintegration of the Conservative Party leadership might have been foreseeable, even though PM Cameron had pledged ahead of time not to resign, but the Labour Party too? Boris Johnson out of the running for PM? Perhaps the gating of the UK commercial property funds was foreseeable, but who predicted that Brexit would accelerate the collapse of Italian banks? (I’m not even sure what the connection there is myself – it seems to be based on the expectation that the ECB will have to keep rates lower for longer, and that’s a particularly difficult environment for the troubled Italian banks.)
In fact, one of the consequences of the vote so far seems to be the absolute reverse of what everyone predicted. Most pundits – myself included, again – expected Brexit to be the first domino in a chain that would see voters in at least France and the Netherlands pushing for their own referendum. But so far the impact seems to be the exact opposite: voters in Spain strengthened the pro-European center-right party, while polls in Denmark, Finland and Sweden have shown increased support for staying in the EU. Perhaps people are seeing the problems that the UK is suddenly confronting by voting to leave and re-evaluating whether it’s worth it. Could it be that the ultimate impact of the Brexit vote could be greater Eurozone integration? Perhaps the Italian banking crisis will be the impetus. Seems hard to imagine, but not impossible.
The impact isn’t just in Europe. For example, during the recent FOMC meeting, participants said they thought it would be “prudent” to wait for the result of the referendum “in order to assess the consequences of the vote for global financial market conditions and the U.S. economic outlook.” Now that they know the result, how much longer will they wait? Brexit has sent the yen up sharply and thereby destabilized Japanese markets. Investment decisions on hold globally, economic activity lower, oil prices fall…what will be the impact on the Middle East?
In short, the implications of this event for investments are both global and unknowable. Money is flowing out of Britain (or it would, if the property funds would allow redemptions); where will it go to? If people sell their Belgravia flat, will they buy one in Vancouver instead? If they bail out of gilts, will we see the US long bond trade with a 1-handle, and US mortgage rates fall further? Will my house in Phoenix increase in value because of discontent in Sunderland?
Nonetheless, we have to make decisions based on our incomplete knowledge. Even doing nothing, even keeping our money in cash, is a decision. Cash in which currency?
We know that uncertainty has increased and that it’s likely to last some time. In that context, the typical trades in the FX market are to buy dollars; buy the safe-haven JPY and CHF; and sell the main currency affected, GBP. High-beta currencies such as AUD and SEK are also likely to be hit. Of course, these currencies have already moved a considerable amount. But just because they are cheap or expensive doesn’t mean they can’t get cheaper or more expensive.
The best plan at such times is to remember the wise words of Howard Marks, of Oaktree Capital: “You can’t predict. You can prepare.”
Fed and SNB lower their real interest rate forecasts: are we all turning Japanese?
Four major central bank meetings in 24 hours and no change in policy at any of them. The Chinese philosopher Lao Tzu summed it up when he said, “By doing nothing, everything is done.”
Yet as spectators at a soccer match well know, no score doesn’t mean no action. What emerged from two of these meetings was the conclusion that real interest rates – interest rates minus the rate of inflation -- would stay lower for longer than expected.
In the US, the FOMC lowered its forecast for end-2018 interest rates by around 50 bps to 2.46% on average from 2.95% (2.38% from 3.00%, using the median). Yet the forecast for inflation was left unchanged for both 2017 and 2018. That means lower real interest rates. The Swiss National Bank reached the same place but from the other direction. It kept its rates the same while predicting a slightly higher inflation rate – make that, less deflation – for 2016 and a slightly higher inflation rate for 2017. That too means lower real rates.
What was particularly significant for the Fed was the change in their forecast for the longer-run level of the Fed funds rate. Their median forecast for that fell 25 bps in March and another 25 bps this time as well. That’s a huge move, considering that this is their forecast for the long-run equilibrium level of rates – the rate over several economic cycles. It’s particularly significant given that there was no change in their forecast for the long-run rate of growth or inflation. They are now saying that for a given growth and inflation combination, interest rates will probably be lower than they were before. Note that their forecast of a future long-run Fed funds rate of 3% is only slightly more than half the actual long-run average, which is 5.73% (from 1954 to end-2007).
The Fed’s downgrade of this longer-term rate coincides with an important break in the market’s expectations for inflation. Until recently, the market’s inflation expectations were closely correlated with the current price of oil. But in late April, the two started to diverge significantly, with inflation expectations headed lower even while oil prices headed higher. Perhaps the market thinks that higher oil prices are only temporary (as do I); perhaps they see energy prices having less impact on inflation over time. Whichever, this change in inflation expectations is worrisome for the Fed, as Chair Yellen admitted: “we can’t take the stability of longer-run inflation expectations for granted,” she said at the press conference.
Note that this is also the week that 10-year German Bund yields went negative, suggesting that in Europe too, investors see little prospect of inflation any time soon. (Rates of course are also affected by the presence of a major non-profit-seeking buyer, namely the ECB.) We haven’t quite reached that point in either the US or the UK, however.
Is Japan’s experience a harbinger of things to come? There, overnight rates have been 50 bps or less since 1995, yet inflation has only exceeded 1% when the government raised the consumption tax. It could be that we are going to see global conversion to the Japanese norm, at least among the advanced economies.
What does this mean for currencies? In the near term, probably a weaker dollar as the “monetary policy divergence theme” fades even further from view. It is bullish for emerging market currencies as the reduced likelihood of any Fed tightening improves the outlook for those economies. It improves the outlook for carry trades; within the G10, that means NZD and AUD, the currencies with the highest interest rates, may benefit, while in EM, RUB, TRY and ZAR have the highest rates.
I would recommend caution with carry trades right now and also with EM currencies in general. That’s because these trades don’t perform well when during a risk-off environment, and next Thursday is the Brexit vote – which could turn out to be a serious, serious risk-off event.
Speaking of which, the statement following the Bank of England meeting today laid out the Monetary Policy Committee’s expectations for what would happen to sterling if the country votes to leave the EU. “On the evidence of the recent behaviour of the foreign exchange market, it appears increasingly likely that, were the UK to vote to leave the EU, sterling’s exchange rate would fall further, perhaps sharply,” the MPC predicted. “This would be consistent with changes to the fundamentals underpinning the exchange rate, including worsening terms of trade, lower productivity, and higher risk premia.” Note that by saying the fall would be “consistent with changes to the fundamentals,” they are in effect ruling out intervening in the FX market to counter any such decline. We could see some major volatility if the country votes Leave.
Oil prices likely to remain volatile
Oil prices were collapsing earlier this year, but they’ve since rebounded nearly 60% from their February lows. Is the price going to keep rising?
Personally, I don’t think so. I think the price is likely to fall back down towards the recent lows, although probably not that low again.
But in any case, I expect the oil price to remain quite volatile as economics, technology, geopolitics and finance combine to provide an unstable supply and demand picture for crude.
Behind the recent rally has been a remarkable turnaround in speculative positions. So far this year, hedge funds and other investors have more than doubled their net long position in oil futures and options. It’s now approaching the record set in June 2014, when it looked like ISIS fighters might take over Iraq.
As you can see, not only were investors accumulating long positions, but they also closed out over half of the record short positions that they held. It was this short-covering really that pushed oil prices up.
The question is, what will cause investors to continue to close out these short positions or to buy more contracts? This is where it gets difficult.
True, there has been some decline in global production. That’s because of several disruptions to supply, such as malfunctions at a Venezuelan export terminal and a pipeline bombing in Nigeria. And there’s been some hope that OPEC and the major non-OPEC countries would agree at their meeting in Doha on April 17th to at least freeze production, if not cut it back.
At the same time, demand out of China and India has been strong, with both countries importing near record amounts of crude and products in February.
But there’s one big problem overhanging the market: the global inventory overhang. The whole world could stop pumping oil for a week and that would only bring inventories back to their normal level. And we all know that’s just not going to happen. On the contrary, the US Government’s Energy Information Administration expects that global inventories will continue to rise this year and even next year.
Aside from supply and demand, there’s another factor coming into play: the refinancing of America’s shale oil producers. As I mentioned, the oil market is the intersection of economics, technology, geopolitics and finance. Economics determines the demand for oil. Technology increases oil companies’ ability to find and develop oil reserves. Geopolitics can interrupt oil supplies, as it is now in Nigeria, or increase supplies, like with Iran.
The impact of finance is a bit less obvious. It’s most important with the US shale oil companies, which depend on bank loans for finance. Banks reset oil companies’ credit facilities twice a year. They determine how much the companies can borrow based on the value of the companies’ oil reserves. If the price of oil is high, the banks lend them more money; if the price is low, the banks cut back their loans. Many of these agreements are coming up for renewal in April. If oil prices fall further, then much of the US shale oil production may be shut down, causing a big spike up in prices. And if the loans get rolled over, then production can continue unabated, which might push prices down.
So there’s a lot that might move the price of oil in the near future: speculative positioning, the Doha meeting, Asian demand, US shale oil refinancing…The direction of prices isn’t clear by any means.
But what is clear is that the volatility of oil is likely to remain high as these many cross-currents intersect to push the price around. That’s why I think oil is an attractive market for investors looking for volatility.
What to expect from the upcoming central bank meetings: ECB, BoJ, Fed
Webinar held on 3 March on www.fxstreet.com The recording can be accessed at: http://www.fxstreet.com/webinars/sessions/what-to-expect-from-the-upcoming-central-bank-meetings-ecb-boj-fed-20160303/
Hello everyone! This is Marshall Gittler, head of investment research here at FXPRIMUS.
Today I’m going to be discussing the upcoming central bank meetings We’ve got three biggies in the next two weeks: the ECB on the 10th (Thursday), the Bank of Japan on the 15th (next Tuesday), and Fed on the 16th. In addition, the Bank of Canada and RBNZ both meet on Wednesday, March 9th (Thursday in NZ). There’s also going to be a Bank of England meeting on March 17th, but that is likely to have relatively little market impact now that all the Monetary Policy Committee members are voting the same way.
So there’s going to be a lot of central bank activity in the near future. And as we all know, the markets are being totally dominated by the central banks nowadays.
So what can we expect from these meetings? Well, let’s first see what the general world conditions are.
The main things to notice are:
- Growth in most countries is stagnant at best, slowing at worst
- EM countries in particular are slowing sharply
- Global trade is falling
- Inflation is still well below target almost everywhere
- Financial markets are volatile (although not as volatile as they were back in January)
I’d like to take the fourth point, sluggish inflation. It’s true that inflation has picked up in many countries, but it’s still well below the central bank’s official target in most of them. We can see here that in the US, it’s moving back towards target, but the EU and Japan are nearly in deflation! So it’s hard to see how those two are going to hit their targets without further action. That’s why I think we might see further action from some central banks.
But…how do lower interest rates help an economy? In theory, they should boost lending. But you can see here that bank lending hasn’t picked up very much outside the US even though interest rates are at record low levels. That’s because companies don’t borrow just because money is cheap, they borrow it because they think they can invest that money profitably. Why should they bother building a new factory if they don’t think they can make money with it? This is the other problem that central banks face: lowering interest rates hasn’t worked in one of the main ways it’s supposed to.
So if lowering interest rates doesn’t encourage borrowing, what does it to? It weakens the exchange rate. That’s one way that central banks can help their economies out. But of course a country’s exchange rate will fall only if other countries don’t lower their rates too. If everyone lowers their interest rates, then relative interest rates remain the same and nobody wins – they just wind up in the same situation but with everyone worse off.
Furthermore, negative interest rates have started to have the opposite effect. You can see here in this graph of bank stocks relative to their home markets how bank stocks have underperformed the overall stock market recently. That’s because investors worry about negative interest rates eating into banks’ profits. That might force them to charge more for loans! So it may be that the interest rates tool is no longer as effective as it was.
Now let’s discuss the central bank meetings in the order in which they’ll occur:
The ECB is the one where expectations are the highest. At their last meeting, ECB President Draghi gave a big hint that they would increase their market assistance. He said that Eurozone inflation dynamics were weaker than expected that it may be “necessary to review and possibly reconsider our monetary policy stance at our next meeting in early March, when the new staff macroeconomic projections become available which will also cover the year 2018.”
The point about the ECB staff’s economic forecasts is quite significant. The forecasts that they have now only go out to 2017. At their next meeting, the staff will make forecasts out to 2018. These are really important for the ECB. As you can see, the ECB is forecasting that growth will recover and that inflation will move back towards the target over the next two years. But if they revise down their inflation forecast for this year and next and forecast that it’ll take three years to get back to their target, they’ll have to take some further action.
As you can see in the graplh below, inflation expectations – the blue line – haven’t been affected at all by the ECB’s actions, and instead have basically followed the oil price, the yellow line. And in fact recently inflation expectations have continued to fall even as oil prices have stabilized. So with oil remaining at extremely low levels, the ECB has to do something lest a deflationary mindset get established.
Now, we all know that they can’t really do anything. For example, the Bank of Japan has kept its short-term rates at 50 bps or less for the last 20 years, yet they’re still struggling with deflation So I’m not sure that central banks have the tools to create inflation right now. But they can’t admit that. No central banker can stand up and say, “well, really we’re powerless to do anything about it.” The former BoJ Gov. Shirakawa effectively said that, and he was forced out of his job early to make way for Gov. Kuroda, who promised to do more.
So the ECB will have to take some steps even if they don’t really think that the steps will make any difference. That’s because of the role that confidence plays in the markets.They have to appear confident even if they’re not.
The question then isn’t whether they’ll do anything. The question is what they’re likely to do, and more importantly, whether it will be enough to impress the markets.
For example, they did increase their stimulus in December. They lowered the deposit rate by 10 bps further into negative territory, and extended the length of time the bond purchases were scheduled to run by six months, as well as some other small measures. But Draghi had built up expectations so high ahead of that event that the small increase was a disappointment to the market, and this is what happened: EUR/USD jumped 4 cents in one day!
So the key point is that this time, they know they’ll have to do something really big, or else the market will once again be disappointed. And a second disappointment after such strong suggestions in January would be really really disappointing for the market. It would send the euro up sharply and stock markets down sharply. And they can’t risk that. Financial conditions in the Eurozone have already been tightening over the last few months, whereas in the US they’re actually looser despite the fact that the Fed hiked rates in December.
So what can they do? They need to make a big impression on the market. Just changing one thing probably wouldn’t be enough. That’s why I expect them to reveal several new measures. Among these, I’d expect to see the following:
- A further cut in the deposit rate. They’ve lowered it by 10 bps increments each time, maybe they’ll try 15 bps this time.
- The introduction of a tiered deposit rate, like in Japan. That will be necessary to prevent the negative interest rates from pinching bank profits.
- Raising the monthly bond purchases
- Extending the minimum duration of the bond purchases
- More miscellaneous measures
I don’t want to get into the question of whether these issues would be effective in boosting economic activity and raising inflation. That’s not what matters for us. The issue for the FX market is whether it’s enough to boost market confidence. I think these measures would demonstrate to the market that the ECB is seriously worried about the downside risks to inflation and to the economy and is going to take, as Mr. Draghi said on another subject, “whatever steps are necessary” to fight them. That should probably boost Eurozone stocks and weaken the euro, as happened when they first cut rates into negative territory.
BANK OF JAPAN
Now, the next meeting is the Bank of Japan the following week. It’s a lot harder to predict what they will do at that meeting. On the one hand, Japan’s inflation isn’t going anywhere. The BoJ even invented a new measure of inflation, one that excludes fresh foods, energy and the effect of tax hikes, in order to make it easier to meet its inflation goal, but that measure too turned down in January.
To make matters worse, inflation expectations are falling. The % of people who expect inflation to be higher next year is falling – that’s the graph on the left – and market-based inflation expectation measures show that the market expects no inflation for the next five years. So there is reason for the BoJ to act again.
On the other hand, we saw earlier how Japanese bank stocks basically collapsed following the move to negative interest rates. That’s the yellow line in this graph. Furthermore, the BoJ board only voted 5-4 in favor of going to negative rates. That’s a very close vote, which doesn’t inspire much confidence in such a radical move.
One of the four people who voted against negative rates – Ms. Shirai – will be leaving the BoJ board on March 31st, and another, Mr. Ishida, will be leaving on June 29th. BoJ board members serve 5-year terms so both of them were appointed before Mr. Abe came into office. If I were Mr. Kuroda, I’d wait until Mr. Abe had replaced these folks with more sympathetic board members before taking action again, rather than risk having the vote go against me. So I think they’ll wait at least until April, after Ms. Shirai leaves, and probably until July before changing rates, unless something big happens. That would suggest the yen is likely to strengthen further after the upcoming BoJ meeting.
After that, it’s a lot to do with the general global risk environment. I still believe that Japanese investors have more money to put offshore and that those capital flows are likely to weaken the yen further, but risk aversion may interfere.
Finally, there’s the Fed meeting the next day. I don’t think anyone expects them to raise rates at this meeting. Nonetheless, I think the market is underestimating the likelihood of another rate rise.
This graph shows the FOMC’s forecasts for the Fed funds rate over time, taken from the materials that they publish every quarter, vs the market expectations as derived from the Fed funds futures. As you can see, there’s a huge gap. The FOMC is assuming at least 3 more rate hikes this year, while the market is only pricing in about a 50-50 chance of even one more. (Note: the probability has increased somewhat since the webinar.) But does the Committee really need to hold off so much?
They have a dual mandate: they have to aim for price stability, which they define as a 2% rise in the core personal consumption expenditure, and full employment, which they estimate to be a 4.9% unemployment rate. As you can see, they’re pretty close to reaching both those targets.
So why didn’t they move in January? They explained that they are “closely monitoring global economic and financial developments and assessing their implications for the labor market and inflation, and for the balance of risks to the outlook.” Note that they said “global economic and financial developments,” not just “domestic economic and financial developments.” So apparently a lot depends on whether global growth recovers and markets around the world stabilize. You can see here from this graph of the implied volatility of various instruments that volatility is still pretty high, but it’s coming down. If that continues, I think they’ll still plan on hiking later this year.
The important thing will be to see the dot plot. This is the dot plot from the December FOMC meeting. Each dot represents the forecasts of a member of the Committee for the Fed funds rate at the end of each year. You can see from this the distribution of forecasts on the Committee. This is where I got the average weighted forecast that I used in the earlier graph. I think if the Committee is still forecasting at least two rate hikes this year, the market will have to adjust its rate expectations upwards. That is likely to strengthen the dollar. If on the other hand the Committee capitulates to the market’s view and forecasts only one hike this year, then I think the dollar will weaken.
In any event, many of the US economic indicators are starting to come in better than expected. The mood in the US is improving. Against this background, I wouldn’t be surprised to see some further downward revision to the Committee’s forecasts, but I don’t think they’re likely to change that much. I expect that the market will be surprised on this account and the dollar will strengthen after the FOMC meeting.
This is Marshall Gittler, head of investment research at FXPRIMUS. Get more market insights on our education pages and turn your trading ideas into action with FXPRIMUS, The Safest Place To Trade.
Brexit – the question of whether the UK will leave the European Union – is on everyone’s mind nowadays, after UK PM David Cameron called a referendum for June 23rd. Will they or won’t they? That’s not necessarily the right question, at least not for now. The proper question for the FX market is, might they? And the answer to that one is a definite “maybe.” So long as it’s “maybe” and not “no,” I think the pound is likely to be under pressure.
Fears of a Brexit have made the pound the worst performing major currency over the last week, even worse than the Argentinian Peso, the habitual resident in the FX basement. Of course, at some point it may mean revert – markets tend to overshoot in one direction then overshoot in the other – but I’m not sure it’s overshot to the downside quite yet.
At the end of the day I don’t think the British public will vote to leave the EU, but the market has to price in the chance that they might, and if that chance increases, then the risk premium associated with British assets and with the pound should increase too. That means a weaker pound.
The problem is that I don’t see things getting better rapidly on the Continent, and therefore I think the risk of higher poll numbers for the “out” vote may increase. In particular, the refugee issue is heating up again and is likely to get even warmer along with the weather as more people decide to leave their shattered homes. Immigration is one of the main concerns of those British who are dissatisfied with the EU. PM Cameron’s modest renegotiation of the UK’s status within the EU will probably fail to mollify these folks.
We can take some lead from the Scottish referendum on independence that was held in September 2014. While in the end the vote went against independence, it was noticeable that support for leaving rose as time went on, while declared support for staying in fell. In the event the vote to stay in was higher than the polls had suggested, but so too was the vote for leaving, as the “I don’t knows” made up their minds. The latest polls show some 46% want to remain in and 38% want to leave, but that’s almost exactly where we were with the Scottish referendum four months before it took place (48% “no” vs 35% “yes”) and it tightened up considerably after that.
Investors who want to take a position on the possibility that the UK leaves should do so by selling GBP/USD or, even better, GBP/JPY. That’s because if something with such wide-ranging and unpredictable implications does actually happen, the safe-haven JPY is likely to appreciate overall. It might also be worth considering buying gold in GBP terms, because gold too could benefit.
On the other hand, I think EUR would also be negatively affected in case of a vote to exit, although obviously not as much as GBP. That’s because not only would a vote to leave the EU be a leap into the unknown for the UK, it would also be a leap into the unknown for the EU itself, too. All sorts of questions arise, such as what will the people in Catalonia or the Basque region do? How would this affect the chances of anti-EUR parties, such as the National Front in France? Etc. Looking at the difference between the 6M risk reversals (which now include the referendum period) and the 3M risk reversals (which don’t encompass that event), it’s clear that the GBP options market is already concerned about the referendum while the EUR options market isn’t. That suggests the issue could put downward pressure on the EUR over the coming months as investors begin to think through the impact of a Brexit vote on other currencies besides GBP.
The year started out pretty badly, with the S&P 500 index down nearly 11% at one point. But since then it’s recovered about 40% of its losses in just five business days. Are we seeing a return of risk-seeking?
Certainly, many of the factors that were weighing on the market earlier in the year have stopped or even reversed. Foremost of these is China, where the authorities offered more measures to support the economy and boosted the currency. The fact that lending soared in January was also significant as it holds out the promise of a stable economy – although one wonders if prolonging a debt-fuelled expansion is really in the country’s best interest over the longer term. A slight rise in inflation there in January is also positive.
Meanwhile, in Europe, ECB President Draghi has reassured the markets that the ECB will do more in March, and even Bank of England uber-hawk Ian McCafferty has turned into a dove. Recent comments by (most) Fed officials give the impression too that they’re in no rush to hike any time soon, either.
The impact has already been felt in the bellwether commodity sector, where prices of many growth-sensitive commodities have risen slightly or at least stabilized after a prolonged period of declines. Brent for example is 25% off its recent lows, while copper is up 5.7% from the bottom.
Against this background, FX traders may want to put on some carry trades, taking advantage of the low interest rates among the buyers of commodities and the higher interest rates among the sellers. Going long ZAR, MXN, NZD or AUD and financing it with the safe-haven JPY or CHF, or the low-interest-rate EUR would seem to be one way to take advantage of this trend, if you think it’s likely to persist.TRY has the highest deposit rates among the readily available currencies, but given the geopolitical problems surrounding Turkey, its currency is likely to be subject to other forces. RUB is a strong oil playthat also has high rates; market participants who expect that oil will even stabilize should consider that currency too.
The Bank of Japan: Propping open Pandora’s box
The Bank of Japan’s introduction of negative interest rates is one of the most significant events to hit the FX market recently. By taking this action, the BoJ has basically said that its bond-buying operations have reached their limit and they need to find other ways to support the economy. The likely channel is through the exchange rate: by depressing interest rates across the yield curve and (one hopes) raising inflation, the BoJ is aiming to lower real interest rates. This won’t benefit companies that much, because they can already borrow at extraordinarily low rates, so the aim must be to push down the yen by making overseas investment more attractive and at the same time implicitly guaranteeing Japanese investors that the authorities will prevent the yen from strengthening.
Looking away from the yen, how might this move affect other countries? There are two ways: through trade and through policy. On the trade front, countries that compete with Japan are not likely to give up without a fight. I would expect to see other trading countries, such as South Korea, allow their currencies to weaken, too.
The big question will be whether or how China responds. If China responds by letting its currency weaken too, then that could set off a repeat of the round of risk aversion that we saw last August. Note that China has changed its way of managing the CNY and is now managing it against a basket of currencies, rather than just against the dollar, so it may move to offset a weaker yen. On the other hand, the country’s exports to Japan are relatively low compared to its imports from Japan, so it may decide to let the move slide as a wash.
The policy implications may be even more important. Simply put, now that two major central banks have instituted negative rates, the policy is no longer experimental but rather is a “standard policy tool.” Thus the BoJ has in effect validated it for other central banks. This had an immediate impact on the UK, where the market is now pricing in more of a chance of a cut this year. Sweden, Denmark and Switzerland, which all have negative rates now, may be emboldened to lower them further. It may also help ECB President Draghi to overcome opposition on the ECB Governing Council to lowering rates further into negative territory. (Note that the BoJ specifically said it would buy bonds at yields below its deposit rate, contrary to ECB policy.)
The BoJ said it “will cut the interest rate further into negative territory if judged as necessary.” And if other central banks cut in response to Japan, and then it cuts again, and then they follow again…it looks like the currency war is in full swing. The loser of this war – and hence the strongest currency -- is likely to be the dollar, as the Fed will probably at least keep rates steady if not hike further.
Special report: Today’s US nonfarm payrolls report for January
1330 GMT: US nonfarm payrolls (Jan) Today will be spent waiting for the US nonfarm payrolls report, the big indicator of the month. Strong employment data should encourage the Fed to keep hiking while any weakness might convince them to stand pat for longer. The market is looking for a relatively robust rise in payrolls of 190k, but after the stronger-than-expected ADP report of 205k, some people may have upped their forecasts. That would be a bit below the recent trend (229k a month over the last six months) but that would be quite reasonable after the enormous December (292k) and October (307k) increases. The market will also pay attention to any revisions to those earlier strong figures.
To be really supportive of the dollar, the figure would also have to show a rise in earnings and a rise in the participation rate, which are announced at the same time.
The reason is, the Fed wants to see a healthy job market. One part of that is that demand for labor should be rising and therefore the cost of labor should be rising. This has been happening; the rate of growth in earnings has accelerated from an average of 2.0% yoy in 2014 to 2.2% in 2015, and it was 2.5% yoy in December. However, the market is forecasting that the rate of growth in average earnings fell back to 2.2% yoy in January. That could be a negative for the dollar.
Another aspect of a healthy labor market should be more people coming off the unemployment rolls and into the work force. That would mean a continued rise in the participation rate. The participation rate hit a bottom of 62.4 in September and has since crept up to 62.6. That’s still low but at least the trend is upwards. No forecast is available for this indicator.
The unemployment rate is expected to stay at 5.0%. Only an extreme NFP number would be likely to change that.
It will be interesting to see how the market reacts to the data. On one hand there could be some relief if the data is weak, as it would discourage the Fed from hiking again any time soon. That could help risk-sensitive assets, such as the AUD and stock markets. On the other hand, more weak US data just adds to the evidence that the Fed shouldn't have hiked in December in the first place! One expects that the dollar would weaken in case of a miss or strengthen in case of a beat.
However, it’s not always like that. This graph shows how EUR/USD moved in the hour following the NFP the last six times that it missed its forecast. Curiously, the dollar strengthened three times and weakened three times.
On the other hand, the dollar gained for at least the first 30 minutes when it beat expectations. So it seems to me that its movement has more to do with the market’s view on the dollar than with what the number is. In today’s case, the market seems to be negative about the dollar for the moment, so unless it’s a pretty strong beat, the dollar could move lower.
13:30 - Canada – Unemployment rate and employment Change (Jan) At the same time, Canada releases its employment data for January as well. The market expects the unemployment rate to stay at 7.1% and for the economy to add 6k jobs, down from 22.8k in December. As the Canadian economy is increasingly affected by the weak oil price, there is a danger that unemployment may tick higher and job gains lower.
The Delphic Fed
The Fed’s January statement has replaced “Forward Guidance” with Delphic commentary that investors can interpret in line with their own biases. Some market participants believed that the Committee was still hawkish, because they did not rule out another rate hike in March (hence the fall in stocks). At the same time, those so disposed could interpret several key changes in the statement as dovish (hence the fall in bond yields). It’s as if they are now taking lessons in market communication from former Fed Chairman Alan Greenspan, who once told a senator that “if you understand me, I must have misspoke.”
They no longer say that they are “reasonably confident” that inflation will rise back to its target, but they did not say they think it won’t rise back to the target. They also removed the sentence about the risks to economic activity and the labor market being balanced, but they didn’t explain which way they do see the risks tipping. And they said they are “closely monitoring” global economic and financial developments, effectively a euphemism for China, oil and stock prices. “Closely monitoring” is a catchphrase for the Fed, much like the ECB saying it is “vigilant” the month before it takes some policy action. “Closely monitoring” means they’re worried about some issue that may affect policy, but it allows them to remain vague about what they intend to do about it. So at the end of the day investors are probably more confused than ever about the FOMC’s intentions.
There may be a reason for this ambiguity: it could be because the Committee isn’t sure what’s going on, either. The Fed is notoriously poor at forecasting the economy and the current mixed bag of indicators doesn’t make it any easier, especially if you start off by ruling out forecasting a downturn. A study by researchers at the San Francisco Fed showed that since 2007, the FOMC has been “persistently too optimistic about future U.S. economic growth.”[i] The previous year’s most recent annualized quarterly growth rate accounts for 62% of the variance in the FOMC’s forecasts even though there is little correlation between the quarterly growth rate at the end of one year and the actual growth rate over the next year, according to this study. In other words, despite the dozens and dozens of PhD economists at the Fed slogging away at forecasting the economy, the group responsible for steering the world’s largest economy basically makes policy using the rule of thumb that the future will be pretty much like the recent past.
In fact, it seems that the market is better at forecasting what the FOMC will do than the FOMC itself is! Note how much higher the Committee’s forecasts for rates at the end of 2015 were than the market’s.
The bottom line is that whether they hike again in March depends on the data, as usual. We now look to Fed Chair Yellen’s testimony to Congress on Feb. 10th for some clarity, but I doubt if we will get clarity then either, because I doubt if she has any clarity to give. This is only realistic, because in fact the economic signs are indeed mixed at the moment.
Is this ambiguity good or bad for the dollar? I believe that as long as they don’t rule out further rate hikes or change their forecasts, it should be dollar-positive in that the Fed remains more hawkish than the market. Moreover, the monetary policy divergence theme remains intact on the ECB’s side, if not the Fed’s. Nonetheless, that is all in the price already and so should not be much of a factor for the dollar’s future direction. We’ll have to see how the dots fall in March.
[i] Lansing, Kevin and Benjamin Pyle. 2015. “Persistent Overoptimism about Economic Growth.” FRBSF Economic Letter 2015-03. Available on the web at http://www.frbsf.org/economic-research/publications/economic-letter/2015/february/economic-growth-projections-optimism-federal-reserve/
Facing the same problems, central banks decide to wait and see
Both the ECB and the Bank of Canada remained on hold this week, but they both showed a bias for easing. The common point from their analysis was how both economies are being buffeted by the crisis in emerging markets and the collapse of oil prices. ECB President Draghi listed “uncertainty about emerging market economies’ growth prospects” and “volatility in financial and commodity markets” as two of the biggest factors causing heightened uncertainty, while BoC Gov. Poloz was more specific in mentioning “recent developments in China.” Of course falling oil prices hit the two areas in opposite ways: Draghi noted that lower oil prices should help consumers and companies, while Poloz said the BoC Governing Council focused its discussions on the implications of oil for the Canadian economy – one assumes not on how beneficial these implications would be.
One other notable difference is that the fall in oil prices has recently had a different impact on Canadian inflation than on Eurozone inflation. In past years, higher oil prices have meant higher inflation in Canada as they boosted the Canadian economy, while lower prices naturally meant lower energy costs and lower inflation – just like in Europe. But recently, the collapse in oil prices has been enough to send the currency plunging, and that has pushed up the price of imports, including food. The result is that Canadian inflation has actually been rising recently (watch Friday’s CI for December).
This creates somewhat of a policy dilemma for Canada. On the one hand, the economy is slowing and lower rates may be necessary to support business. On the other hand, that would probably weaken the currency further and push inflation up more (although at 1.4% it still has some way to go before it breaks out of the 1%-3% target range). My guess is that they will probably stand pat for some time further while they wait to see what kind of fiscal plan the new government comes up with. Meanwhile though I expect the market to do their work for them by continuing to weaken their currency as oil prices fall.
In the Eurozone I don’t see any such dilemma. So far the ECB’s QE program seems to be boosting bank lending without causing any harm to the average individual, as retail bank deposits have yet to go negative. Oil prices are now far below what the ECB staff assumed when they made their forecasts in December, and the International Energy Agency Tuesday warned that the market “could drown in oversupply” as Iran resumes supplying world markets. It’s quite likely that they will have to lower their 2016 inflation forecast of 1.0% at the March meeting, and probably the 1.6% forecast for 2017 too. Can they assume that oil prices recover by 2018? Nobody can assume anything nowadays. Draghi himself said that “the credibility of the ECB would be harmed if we weren’t ready to revise the monetary policy stance.” Of course, he also hinted that there would be more of a move in December than there actually was, but it will be hard to ignore yet another round of cuts in the inflation forecast within the time horizon of the ECB’s monetary policy. Further easing from the ECB should reaffirm and reinforce the “monetary policy divergence” theme that has been pushing EUR/USD down for some time.
Next week there are two more central bank meetings: the Fed on Wednesday and the Bank of Japan on Friday. The Fed is likely to stand pat, as not enough time nor data has gone by since the last meeting to conclude that further tightening is warranted. The Bank of Japan though faces a dilemma, though the opposite one from Canada’s: its currency is strengthening even while inflation is slowing. They too may choose to stand and wait at this meeting, but I think eventually they will have to take further action to prevent the safe-haven yen from becoming a danger to themselves.
How Did Pundits Do in 2015? Not Very Well, As Usual
This first comment of the year is always the most fun one for me. I’m going to compare what the market was forecasting for 2015 with what actually happened. The result, as usual, was that the pundits did poorly. Flipping a coin would have resulted in a pretty similar result and only cost you whatever the coin was worth.
For “market forecast,” I’m using the median consensus forecast from Bloomberg on 31 December 2014.
To start with, here’s a graph comparing what the market forecast the spot return would be for each of 31 major currencies against the dollar (the Y axis) vs what the spot return actually was (the X axis). (Spot return is just the change in the price of the currency.) If the market forecast was exactly correct, then the dot would fall on the yellow line.
The results were not particularly inspiring. The market only got the direction against the dollar of 17 of the 31 currencies correct or 55%. This about what one would expect by flipping a coin.
The biggest errors were BRL (expected: -1.7%%; actual: -33%), ZAR (+0.6% vs -25%), COP (+2.6% vs -25%), RUB (+16.5% vs -20%), MXN (+9.3% vs -14%) and TRY (-0.6% vs -20%). Clearly the market underestimated the decline in commodity prices, particularly oil, and the sell-off in EM currencies, not to mention the political turmoil in Turkey. What this suggests is that the slowdown in China and the sharp fall in oil prices were major surprises to the FX market.
Also note that almost all the currencies are either on or above the yellow line, meaning that they either met or were weaker than the market consensus. Only CHF (which abandoned its peg vs EUR) and JPY performed better than expected. That shows how the market underestimated the dollar’s rally in general.
If we look at total return (spot return plus interest income), the picture is even worse. In this case, the market got only 13 of 30 currencies correct, or 43%. Apparently the errors in forecasting interest were added onto the errors in forecasting currency rates, rather than cancelling each other out.
RUB was the major outlier; the market expected a total return of 45% but in fact it lost 8.5%. Many of the other commodity currencies also did much worse than expected on a total return basis.
One interesting point: ARS had the worst spot return (-35%) but the best total return (13%) of any of the currencies. It happened in 2013 as well that ARS was both the worst-performing and best-performing major currency in the world at the same time.
This analysis could be depressing for retail investors. You might think, if the highly paid experts working at the big investment banks who spend all their time thinking about FX can’t do any better than flipping a coin, how on earth can you? But I look at it the other way. This analysis suggests that even an amateur has a fighting chance against the experts, because the experts (and I include myself in this group) don’t really know for sure what will happen, either!
When will be the Fed’s next move?
Now that the Fed has started its process of “normalizing” interest rates, the question the market is focusing on is: when will be the Fed’s next move? I expect that there will be a period of waiting and watching while the FOMC members assess whether inflation is going to reach their target. If they decide it is, then they will tighten further and USD will appreciate; if not, then we may have reached almost the maximum for “policy divergence” and USD could weaken. But while they are waiting and watching, the dollar is likely to trade in a range.
Fed Chair Yellen spelled out in broad terms the conditions necessary for further tightening in her opening remarks at the press conference following the recent FOMC meeting. She said that “the process of normalizing interest rates is likely to proceed gradually, although future policy actions will obviously depend on how the economy evolves.” In other words, we are not to expect a rate hike at each meeting, as happened in the 2004 tightening cycle; each meeting is “live,” i.e. they will have to make a fresh decision at each meeting.
Under the Fed’s dual mandate, it is required to pursue “maximum employment” and “stable prices.” The former they define as 4.8% to 5.0%, which means that with the unemployment rate currently at 5.0%, they’ve met their goal. The latter they define as “inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures.” They’re not there yet by any means. That means progress on inflation will determine whether they hike or not. Inflation data may therefore supplant the monthly nonfarm payrolls as the key indicator for the markets.
With inflation taking the spotlight, the monthly personal consumption expenditure (PCE) deflator, the Fed’s main target, becomes an even more important indicator than before. The figure for November, which was released Wednesday, showed the overall deflator rising 0.4% yoy – a welcome acceleration from +0.2% yoy in October but still close to zero -- while the core index, which excludes volatile food and energy costs, remained at 1.3%, well below the 2% target.
While their target is defined as the PCE, the market assumes they look more at core PCE. The recent movements of this indicator are not encouraging. The three-month change annualized hit the target earlier this year, but has since declined and is now bouncing around 1.2% -- exactly where the yoy rate of change is.
Given the relatively stable inflation rate, I would expect a period of stability on the FOMC too. I don’t see much chance of another rate hike at the January meeting; I think the earliest would be the next meeting after that, in March. That means we may be in for a period of range trading on the dollar, at least against the major currencies.
I still believe that the Committee wants to raise rates further in order to normalize their monetary policy, but they need to move within the context of their mandate. That means they will be watching the inflation numbers carefully – and so should we.
South African Rand: stay away!
There’s been a lot of attention focused on the commodity currencies recently as commodity prices dive. I took a look at the South African Rand (ZAR) to see how it behaves relative to various commodities, stock market indices and interest-rate spreads and found out the following:
- 1) The strongest correlation is clearly with stock markets, notably the MSCI Emerging Market stock market index but also the S&P 500. As such, it appears that ZAR is a typical growth-sensitive EM currency.
- 2) It is more sensitive to movements in industrial metals than precious metals, even though the latter are a much bigger share of the country’s export basket. That probably ties in with metals as an indicator of global growth
- 3) The spread between official interest rates in the US and South Africa is little use in determining the exchange rate. On the contrary, the two-year spread actually works in reverse: that is, ZAR tends to weaken against the USD when the spread widens. That suggests that the causality runs the other way, i.e. the spread is driven by the FX rate rather than the FX rate being influenced by the spread. Note though that I only looked at nominal interest rate differentials. Other research found that real interest rate differentials (that is, after adjusting for inflation and default risk) are a significant determinant of the exchange rate.
The one thing that these sorts of studies don’t pick up is politics. Emerging markets have been described as "those countries where politics matter at least as much as economics for market outcomes,” and that certainly holds true for ZAR. (RUB and MXN are also EM currencies, but they are more closely correlated with oil than ZAR is.) For example, we saw barely a ripple in CAD recently when the Liberal Party ousted the Conservatives after nine years in office. On the other hand, on Wednesday USD/ZAR jumped after the well-respected Finance Minister was replaced, reportedly in part because of his opposition to a transaction involving a friend of the PM. ZAR is now at a record low.
My conclusion from this analysis is that when the commodity currencies are weak, ZAR is likely to be particularly weak. That’s because of second-round effects of commodity prices on local politics: low tax revenues and falling employment in the mining sector are likely to increase political instability. That’s why even though ZAR offers relatively high interest rates, I would not recommend carry trades using it at the moment.
Thinking about the direction of currencies in 2016, we have to start with the question: what will be the main themes likely to persist throughout the year? The past year was dominated by fears about global growth, particularly China; the decline in commodity prices, particularly oil; and the dénouement of policy divergence between the US and the rest of the world, particularly the EU.
The global economy doesn’t hit a reset button on 1 January and so I expect these trends to continue at least into the first half of the year and probably longer. Specifically, I expect Chinese growth to slow further as the government continues its multi-year effort to restructure the economy. That means the price of commodities used for capital investment, such as iron ore and copper, are likely to remain under pressure for longer than those for day-to-day use, such as oil. The oil-sensitive currencies (CAD, NOK, MXN, RUB) may therefore recover vis-à-vis the AUD, CLP and ZAR.
One side-effect is that EM countries, particularly China and the oil producers, may continue to run down their FX reserves. Their sale of US bonds should keep US interest rates well above those of other countries and support the dollar.
Slower Chinese growth and weak commodity prices also imply no quick return to inflation. The ECB and BoJ are therefore likely to ease further. I expect the BoJ to follow the lead of the ECB and SNB and to lower rates into negative territory for the first time in that country. That would probably propel USD/JPY higher still.
At the same time, the FOMC thinks rates will rise much more quickly than the market does. Assuming the Committee is even only half correct, that means further monetary policy divergence and a lower EUR/USD.
As for new trends, watch the refugee crisis in Europe. This issue will add to the pressure on the EUR as the institutional foundations of the EU starts to crumble: first the Shengen Agreement, then the debt limits, and then what? Furthermore, political disarray and high levels of immigration on the continent increase the possibility that the UK votes for a Brexit – another big uncertainty for the market, and one that is liable to weigh on the pound.
The US would seem to be an island of stability in this uncertain world. However, the impact of higher US rates and the Presidential election in November is likely to add to the global uncertainty. Still, the economics and the politics favor the dollar in 2016, in my view.
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