Economists vs. Traders

Carnage on global stock and commodity markets last week had traders reaching for Alka-Seltzer to calm their nervous stomachs. And without a forthcoming cut in interest rates or reserve requirements by China on the weekend that had been speculated, it will be more of the same for the week ahead. The USD severely underperformed against the majors only managing to outpace the CAD and AUD. The risk aversion trade benefited the CHF with safe haven flows.

The other top performers were the EUR, NZD, and JPY. The NZD escaped the carnage of the other commodity currencies because it received a boost after a nearly 15% rise in last week’s GlobalDairyTrade auction. The EUR and JPY were up strongly for entirely different reason – short covering. With the negative interest rates of the ECB and zero rates with the BOJ, the EUR and JPY have been used as funding currencies to make bets in various investment arenas. With the downturn in global stock and commodity markets last week, traders have been selling their investment and paying back their loans causing them to have to purchase the EUR and JPY.

The USD may have been down against the majors but it was up against the emerging market currencies. Analysts at Deutsche Bank noted that 17 EM countries have seen their currencies depreciate by over 3% since China devalued CNY last Monday. Also weighing on the EM currencies is the possibility of the Fed raising interest rates at their September policy meeting. This would cause the debt servicing costs to rise for all of the EM. However, the release of the FOMC minutes last Wednesday paints a decisively different picture. The minutes highlighted concerns from Fed members with both the U.S. economy and the global economy, with particular focus on China. The comments from the Fed minutes on China are of particular interest because the meeting of the central bank actually took place back in July, before the China’s devaluation of CNY.

On the surface it appears that a September rate hike is viewed as less likely by market participants compared to prior to the minutes release. In other words, traders have responded and traded down to this perceived outcome. Fed funds futures, used by investors and traders to place bets on central bank policy, showed Friday that investors and traders see a 28% likelihood of a rate increase at the September 2015 meeting, according to data from the CME Group. It wasn’t that long ago that the odds were near 50%. Furthermore, noted currency analyst, Ashraf Laidi, points out that the 2-year breakeven inflation measures have tumbled to 7-month lows of 0.22% and the 5-year BE rates at 1.1%, is the lowest since August 2010. BE measure the difference between traders' expectations of the difference between nominal bonds and inflation-protected bonds. These measures are telling us that the collapse in oil prices is going to spur deflation across the globe.

The trader’s conclusion is that the Fed will not hike rates in September, which is at odds with what the economists are predicting. According to the latest Wall Street Journal survey of 60 business and academic economists, 82% of economists expect the first rate increase since 2006 at the September FOMC meeting. What should you believe – the survey of economist or the market based measures created by trader’s actions? Like a veteran market participant once told me – when’s the last time an economist made you money?

To Catch a Falling Knife

If you were surprised that the Yuan devaluation(s) didn’t give the USD a bit of a kick upward, you weren’t the only one. Economists will tell you that the devaluation should make the dollar at least

marginally more attractive given the implicit widening of policy divergence between the U.S. and the rest of the world. Instead, what you’re seeing is that the market is changing its perception of the policy divergence. As we’ve stated in weeks past, there is lack of hard evidence of the Fed's readiness to start rate normalization, and this has further greased the skids for the USD. The market has expressed its disillusionment by pushing the odds of a first rate hike out of the realm of September to December.

The dust hasn’t entirely settled after Friday’s massive sell-off in equities in part because the odds of a September rate hike fell from 45% to 24%. The odds of a hike in October fell from 50% to 32%. The likelihood of a December rate hike? That’s just one fragile catalyst away from pushing the first rate hike into 2016. And if the odds go into 2016, you may as well assume no imminent rate hikes as the U.S. Presidential election soap opera season kicks into high gear (without commentary from Jon Stewart, unfortunately).

The flavors of the day as traders run from the USD are (so far) the EUR and JPY. One could argue that the GBP should be included in the short list, but its move hasn’t been quite as significant. The rush into the EUR looks a bit overextended as the EUR trades close to its highest since the QE era began.