FED UP

The top spot this past week belonged to GBP which managed to rally over 1% on the week on a great retail sales report and favourable Brexit polls. Retail sales in the UK rose by 1.3% on the month in April, despite the cold weather and well above economists' average forecast of 0.5% growth. The GBP also received a boost by some polls indicating a shift toward the Remain camp.

The CAD will be on the radar this week as it has has fallen against its US counterpart for the past three weeks, matching its longest streak of the year. It is now at its worst level in a month and could move even lower as the Bank of Canada is expected to strike a more dovish tone in its policy meeting tomorrow due to the still-raging wildfire in Alberta that has disrupted oil production.

Until last week’s release of the minutes, markets were discounting extremely low odds on a US Federal Reserve interest rate increase in 2016, let alone a summer rate hike. The reason for this was due to the dovish tone of Fed Chair Janet Yellen’s speech shortly after the April FOMC meeting. In Fed speak; we can say that her dovish stance was transitory because last Wednesday’s release of the minutes from the April meeting suggested that policy makers thought that an interest rate increase would be appropriate in June if the economy continued to improve. Excuse us for being skeptical, but where have we heard this before. In plain English, I think the minutes were trying to tell us that the Fed’s decision will be data dependent – really, when hasn’t it been.

On the following day, NY Fed President William Dudley helped to cement the feeling that a summer rate hike was indeed in the cards. He said, “If I am convinced that my own forecast is sort of on track — then I think a tightening in the summer, the June, July timeframe is a reasonable expectation.” This notion was also echoed by Boston Fed President Eric Rosengren when he told the Financial Times that he was getting ready to back tighter monetary policy. Rosengren’s stance is interesting as he was one of the Fed doves last year.

After a number of false starts by the Fed we are hesitant to buy into the rate hike scenario. First of all, the June FOMC meeting is on June 14-15 – one week before the critical Brexit referendum vote on June 23. We doubt very highly that the Fed would raise interest rates before such a critical vote which has the potential to inflict significant market disruption if the UK were to vote to leave the EU. Secondly, the July FOMC meeting does not have a press conference afterward. It would seem very unlikely for the Fed to make a policy move without the benefit of a press conference after the meeting – especially since they like to paint their rate hikes with a dovish tint in order to minimize the damage to equity markets. And speaking of equity markets, everyone knows that deep down that’s what the Fed really cares about – with this in mind we present to you the working flow chart of the data dependent Fed, just kidding but not really sure.

Clarity

The commodity currencies – CAD, NZD and AUD – were the worst performers on the week. The CAD was hit by a combination of soft commodity prices, a disastrous trade report – the worst deficit on record - and an overdue correction in its recent rally.The RBA cut rates earlier this week and, in their most recent minutes, indicated a dovish view on the outlook for Australian inflation, implying further rate cuts were possible.  GBP was relatively quiet, the only item of note being the Leave side taking a small lead in the Brexit referendum slated for next month. The two sides – Remain and Leave – have swapped places either side of 50% for some time now, so the news was greeted with some indifference. Lastly, given the lack of any negative news out of Europe – a welcome change, no doubt, for the region’s politicians – the EUR traded largely unchanged on the week.

It appears that US investors now have a measure of clarity that had been lacking for far too long. Firstly, with the rather disappointing US employment stats released last Friday, it is now clear that the US economy has stalled for the present. What will recharge the increasingly moribund economy isn't obvious, given that just about everything that has been tried has failed. Fed funds futures are now pricing in just a 4% chance of a rate hike in June and only 44% in December. (This latter percentage will likely drop further) So no rate hike in June and, as we have mentioned before, the odds of a Fed hike after the June meeting, during the onset of the federal election season, were always slim at best. Now it's essentially zero, and Mr. Market can see with unexpected clarity that the US economy is in serious trouble. The employment numbers are a lagging indicator and they have finally caught up with the leading macro indicators.

Secondly, with the recent triumph of Donald Trump over the vast Republican field, a large degree of clarity has emerged in the presidential race. Despite Bernie Sander's quixotic bid for the Democrat nomination, the nomination of Hillary Clinton has never been in serious doubt, notwithstanding her numerous issues. Now investors can focus on the two candidates and begin assessing their worthiness for the job of president. There are fundamental differences between the two parties and, beginning now, market players can start placing their bets.

Finally, given the weakness in the US, it appears that global interest rate levels will remain low for quite some time into the future - yet another instance of clarity for investors.

BOJ Inaction

The surpise of the week was the lack of new policy moves by the Bank of Japan. The market’s reaction to the BOJ’s inaction was swift as the yen soared by over 2% on the day and more than 5% on the week. The BOJ did do something – it cut its economic forecasts, predicting growth of 1.2% instead of 1.5% for the fiscal year to March 2017. It also cut its inflation forecast for the fourth time in around a year, from 0.8% to 0.5%. A case can be made that the BOJ refrained from making any policy change because it wanted to see the results of its newly enacted policy of negative interest rates working through the economy. Or that the BOJ wanted to pressure the government for a fiscal policy solution rather than a monetary policy fix, consistent with G20 concerns about the over-dependence on monetary policy.

There may be another, more political, reason for the BOJ’s surprise inaction – they didn’t have permission to do so. Late Friday, the US Treasury put out a new “monitoring list” – it placed China, Japan, Germany, South Korea, and Taiwan on a new currency watch list, saying that their foreign exchange practices bear close monitoring to gauge if they provide an unfair trade advantage over America. The US has not named a single country as a currency manipulator since it did so to China in 1994 – so it would appear that the US is very serious about this now. Let’s not mince words here - this is a direct threat to the rest of the world that it not engage in any monetary policy (QE, NIRP, or ZIRP) that is tantamount to currency devaluation, without express written consent of the US government.

It would appear that the US government has decided it has had enough of the currency wars and it will no longer tolerate a high dollar as a headwind to US economic advancement. This may have signaled the end of the friendly currency wars, but we suspect that it will invite a response by China, Russia, and the rest of the emerging nations to seek an end to the USD reserve currency hegemony. You will hear more about the IMF’s SDR and gold in the not too distant future.

In last week’s blog we stated that if the Fed was able to craft a policy statement that adopted a more balanced outlook for the economy and inflation then it could further fuel the rally in the dollar index. Well, the Fed disappointed and the dollar took it on the chin. The index took out the recent swing bottom at 93.62 and the August 24, 2015 main bottom at 93.50 and the momentum indicators have rolled over. Another bearish sign - a death cross is about to form as the 100-day moving average is set to drop below the 200-day moving average.

The US didn’t help itself either – Q1 GDP slowed to 0.5%, the weakest pace in two years and lower than economists' expectation for 0.7%. Also, the Fed's preferred inflation barometer, the PCE index, rose just 0.8% in the 12 months ended in March, remaining below the Fed's 2% target. The combination of a stagnating economy

Prior to the FOMC meeting the CME Fed futures tool was pricing a 23% chance of a June rate hike. As of Friday, the probability of a June hike has dropped to 11%. The exclusion of the balance of risks statement by the Fed for the 3rd consecutive FOMC statement confirms the market’s view that the Fed will not be hiking rates at its next meeting in June. Furthermore, June is fraught with international considerations which could keep the Fed from hiking – UK referendum, the Spanish election, the possible impeachment of the President of Brazil, and the rekindling of tensions between the EU and Greece. So, given the Fed wishes to appear politically impartial, if there is no rate hike in June then it is difficult to envision the Fed hiking rates as the US moves closer to electing a new President in the fall. Thus, the market is skeptical that it will raise rates at all in 2016 – the probability of a December hike has dropped to 60% as of Friday from 71% just prior to the FOMC meeting.

Countermeasures

The CAD and the GBP were the top performers last week while the yen lagged. The CAD was right behind the GBP as oil and the rest of the commodity complex continued to perform well. Canadian domestic data also helped as March retail sales increased and inflation continued to firm. It also didn’t hurt that Bank of Canada Governor, Stephen Polz, did not express dismay about the recent strength in the domestic currency unlike other global central bankers.

The GBP proved to be resilient in the face of poor data as it recouped its losses from the previous couple of weeks. Economic data from the UK continues to be sluggish as evidenced by last week’s disappointing retail sales and employment data. In fact, this upcoming week’s release of GDP growth will probably show that growth has slowed down due the weight of uncertainty around Brexit. However, the latest polls show that the “stay” in the EU vote is gaining traction, so much so that the probability of Britain voting to leave the European Union dropped to 20%.

Yen strength over the past several weeks finally relented. Of course, it didn’t hurt that Japanese officials floated a trial balloon about negative interest rate loans. That’s right, this isn’t a typo - apparently the Bank of Japan is considering paying banks to make loans. The ECB also mentioned this as a possibility at its March policy meeting. The BOJ’s Stimulating Bank Lending Facility, which now offers loans at zero percent interest, would be the most likely vehicle for this option. The BOJ board next meets to set policy April 27-28 and it is desperate to deploy countermeasures to counter an appreciation in the yen, especially after being denied the use of currency intervention by the G7 and G20. The BOJ may decline to make a move at this meeting if the Fed does its work for it by being more hawkish at its policy meeting on April 27.

This week the US Federal Reserve will probably seek to convince all of us that it will raise interest rates this year. It will not raise rates at this meeting but it will try to convey that a second rate hike may come at its June meeting. This train of thought seems to dovetail nicely with the performance of the US dollar index. The index has carved out a bottom over the last couple of weeks and the momentum indicators are all aligned for more gains. So if the Fed is able to craft a policy statement that adopts a more balanced outlook for the economy and inflation then this could further fuel the rally in the dollar index.

In last week’s blog we mentioned that the commodity complex has been on a tear. It has now advanced for nine weeks since putting in a double bottom in early February. Under closer inspection, the commodity futures price index, the CRB, has broken out and has reached its highest level in five months. The momentum indicators are giving the all clear sign for additional gains. This tells us that central bankers are finally going to get what they have all desperately tried to achieve – inflation. That’s right folks; the inflation shock will probably be the story for the latter part of 2016. If inflation becomes entrenched, then the central bankers will be desperate to try to tame it – I guess this is what they mean when they say “be careful what you wish for”.

Doves vs. Hawks

The commodity currencies of Canada, Australia and New Zealand led the way higher in FX last week underpinned by firmer commodity prices and an improving China. The commodity futures price index, the CRB, has advanced for 8 weeks since putting in a double bottom in early February. China’s industrial output and retail sales surged in March urging greater confidence that China’s economy has stabilized and will avoid a hard landing. Of course, the better the Chinese economy performs the better the continued advance for commodity prices.

There were no less than eight Federal Reserve Presidents speaking last week. Some were doves, some were hawks, some were FOMC voting members, and some were not. One wanted a rate hike in April; others ruled out an April hike but favoured a June hike; and one (Lacker) was busy making a case for four rates hikes in 2016 – I kid you not. I don’t know about you, but methinks that continued pontification by US Fed members is starting to fall on deaf ears. I think the market is sensing this as well – US Fed fund futures is pricing in 2% chance of a rate hike at the April FOMC meeting, 13% for June, 28% for July, 36% for September, 40% for November, and 52% for December, 55% in February 2017. In other words, the market is pricing in no rate hike until 2017.

So with possible interest rate hikes being pushed out further in time, the USD continued to be shunned. U.S. economic reports didn’t help the dollar’s cause either. A horrible retail sales report and a disappointing inflation report undermined the US Fed’s interest rate hike expectations.

At the time of this writing, we learn that the world’s major oil producers failed to reach an agreement to freeze oil production at this weekend’s OPEC and non-OPEC meeting in Doha. No one should be surprised by this as, over a month ago, the Saudis stated that there would be no agreement without Iran’s participation. There was no way that Iran would agree to freeze production now that they have been allowed to sell oil again on the world market after agreeing to forgo their nuclear ambitions; and the Saudis knew this. The price of oil and the CAD have steadily gone up over the past two months on hopes of a deal.

我々は問題を抱えています - translates into: Tokyo we have a problem

The dominant theme in the currency market last week was the strong yen. What’s more, the upward movement in the yen flies in the face of the Bank of Japan’s NIRP (negative interest rate policy). When a central bank adopts NIRP, one of the effects should be a sharply weaker currency not a decisively stronger one.

This is a problem for Japan. A weak yen has been the key plank in “Abenomics” – Prime Minister Shinzo Abe’s turnaround plan for the Japanese economy. Japan has been plagued with deflation for over 30 years and a weaker yen is seen as the best hope. A weakening currency makes a nation's exports cheaper in other countries, and the theory is that expanding exports will boost the overall economy-- especially if that economy is stagnating or in recession.

This surge higher in the yen is leading to speculation about whether Japanese policymakers will intervene in the market. Intervention speculation is rooted in historical precedence because in previous similar situations the BOJ would aggressively intervene in the market by selling yen to weaken the currency.

However, it is unlikely that Japanese officials will directly intervene in the currency markets. They will most likely stick to verbal intervention with statements like “we are closely monitoring the currency”. The reason for this is twofold. Firstly, currency intervention is not very effective unless it is coordinated with other central banks. Secondly, intervention is frowned upon due to the consistent message from G7 and G20 meetings that countries should not seek a competitive advantage in the currency market. This is further complicated by the fact that Japan is hosting the next G-7 summit in May.

Yen strength is a real blow since it undermines the BOJ’s efforts to fight deflation. It also calls into question the credibility of not just the BOJ but that of all central bank in the market’s eyes. For instance, the euro had a simillar reaction to the last round of aggressive ECB policy action – it went up in the face of NIRP. The question being raised by the market is – what’s the point of continuing monetary polices of ZIRP, NIRP, and QE if a weaker currency is not achieved?

This type of talk is considered blasphemy to a central banker. We can be sure that the BOJ will promote an even more radical “whatever it takes” option to reflate the Japanese economy as soon as the next G7 meeting is out of the way – we can hardly wait.

Yellen Too Loud

The first trading day of the week was very lackluster with little to move the currency markets either way due to the Easter holiday break. This only helped to raise the anxiety level of traders as they waited for Tuesday’s speech at the Economic Club of New York by Fed Chair Janet Yellen. The question on everyone’s mind was did she mean to sound as dovish as she did in her post-FOMC press conference in mid-March, especially since various Fed presidents had taken a more hawkish tone since then. The answer is yes, she absolutely meant to sound dovish.

The third paragraph of her speech is very telling, it reads as follows: “In my remarks today, I will explain why the Committee anticipates that only gradual increases in the federal funds rate are likely to be warranted in coming years, emphasizing that this guidance should be understood as a forecast for the trajectory of policy rates that the Committee anticipates will prove to be appropriate to achieve its objectives, conditional on the outlook for real economic activity and inflation. Importantly, this forecast is not a plan set in stone that will be carried out regardless of economic developments. Instead, monetary policy will, as always, respond to the economy's twists and turns so as to promote, as best as we can in an uncertain economic environment, the employment and inflation goals assigned to us by the Congress." In other words, the Fed should proceed with caution and with a gradual approach in adjusting policy.

Ok, so Yellen stressed a “gradual approach” to Fed policy and, just in case the economy goes sideways or worse, the Fed is prepared to employ additional "money" printing (QE): "Even if the federal funds rate were to return to near zero, the FOMC would still have considerable scope to provide additional accommodation. In particular, we could use the approaches that we and other central banks successfully employed in the wake of the financial crisis to put additional downward pressure on long-term interest rates and so support the economy--specifically, forward guidance about the future path of the federal funds rate and increases in the size or duration of our holdings of long-term securities. While these tools may entail some risks and costs that do not apply to the federal funds rate, we used them effectively to strengthen the recovery from the Great Recession, and we would do so again if needed." Really, we are back to this again. How successful was QE anyway? Not very, considering QE1 was followed by QE2, Operation Twist, and QE3.

Here is another unsettling part of the speech: "The FOMC left the target range for the federal funds rate unchanged in January and March, in large part reflecting the changes in baseline conditions that I noted earlier. In particular, developments abroad imply that meeting our objectives for employment and inflation will likely require a somewhat lower path for the federal funds rate than was anticipated in December. Given the risks to the outlook, I consider it appropriate for the Committee to proceed cautiously in adjusting policy. This caution is especially warranted because, with the federal funds rate so low, the FOMC's ability to use conventional monetary policy to respond to economic disturbances is asymmetric." So what you’re telling us is that the Fed’s “data dependency” will now include data like Japanese inflation, European GDP, and Chinese PMI – you get the picture.

It appears that Janet Yellen is not only dovish but she is a lot more dovish than anyone previously thought. To illustrate this point, the ninth footnote in the text of her speech stated “uncertainty and greater downside risk” when the Fed’s policy rate is so close to zero “call for greater gradualism.”

At the time of this writing, fed funds futures traders have revised down the implied probability of a June rate hike to just 26%, and “only” a 66% chance of another rate hike at all this year.

In the currency trade, it’s no surprise the the USD took the brunt of Yellen’s dovishness as it lost ground to all the major currencies. During the past week, multi-month highs for the AUD, NZD, and CAD were recorded. The big question is will the gains in commodity currencies last – investors are seeing the spike highs and the natural inclination is to think of exhaustion followed by reversals.

In other parts around the world the yen is the best performing currency in Q1, which is surprising since the Bank of Japan decided to up the ante with the introduction of negative interest rates. The GBP was in last place which is not surprising as the currency is being weighed down by the uncertainty of Brexit. To underscore this point, the global manufacturing PMIs were released on Friday and the only one that missed its mark was from the UK where the PMI reading printed at 51 versus 51.2 forecast. By the way, the PMI for China surprised to the upside with manufacturing activity expanding for the first time in 8 months – does this mean Yellen will raise rates – sorry we’re confused.