The best performing currency last week was the CAD?!

The CAD was the best performing currency last week and it is has completely reversed its year to date performance from a negative to a positive gain since the Bank of Canada’s decision to keep rates on hold in mid-January. The CAD’s reversal of fortune can be attributed to firmer price of oil, stable equity markets, and to better economic performance with Canada’s biggest trading partner the USA. One prominent Canadian bank has gone so far as to proclaim that the worst is probably over for the CAD.

Looking at the daily chart of the CAD, there is good support around the 1.33 level and resistance around the 1.40 level. This trading range should contain future price action as long as the Canadian economy stabilizes, the price of oil continues to trade above the $30 range, and that the Bank of Canada remains on hold.

The stress factors that were driving the price action in the currency, bond, and equity markets from the start of the year have ebbed, for now. Those stresses were the volatility of the Chinese yuan, the fall in Chinese equity shares, the downward pressure on commodities, especially oil, and the fear that the US economy was showing signs of a recession. The fact that the CAD was the best performing currency last week speaks to this – the relief of anxiety over the stresses. On the opposite end of the spectrum, the ebbing of the collective stresses have been replaced by a new one – Brexit, "British exit", refers to the possibility of Britain's withdrawal from the 28-country bloc known as the European Union (EU), hence the 3.7% decline in the GBP last week.

The previous Friday, Prime Minister David Cameron had reached agreement with other EU leaders on changes to the U.K.’s relationship to the bloc. He laid out the key arguments he plans to use in his campaign, arguing that Britain is better off in terms of economic and national security within the EU, the destination for a significant portion of the U.K.’s exports. The GBP was actually buoyed by the agreement. However, the GBP quickly changed course and its losses accelerated after Boris Johnson, London’s mayor and one of the U.K.’s most prominent politicians, said he would campaign for Brexit. Johnson, a contender to become prime minister one day, is now the most high profile politician to back the “leave” campaign ahead of a referendum, now set for June 23.

How bad was the GBP’s fall last week? – it was down more than 500 pips, slicing through 30-year generational support at the 1.40 level. Since 1986, the GBP has experienced only 3-4 periods below $1.40. Was the move warranted? Frankly, no one is certain what Brexit would mean for the UK and Eurozone economies (after all, it’s never happened before), so because of this uncertainty traders tend to sell first and ask questions later. Last week’s losses have left the GBP technically oversold, and we should expect some sort of relief rally – although more selling would not be unusual.

Brexit would most certainly lead to Scotexit - Scotland exiting the United Kingdom. For the rest of Europe, the threat of Brexit has also opened up a Pandora’s box of fears about EU itself. If Britain did leave the EU it would open up the door to other EU countries which are unhappy with the current union. Little wonder then that euro has been drifting lower along with the GBP as investors grow increasingly wary of the whole region. Hyperbole you say! Then why did this weekend’s G20 warn against an exit from the EU?

Gold Wins by Default

The Japanese Yen was the biggest winner last week, surging despite negative fundamentals like the 0.4% decline in preliminary Japanese GDP for the fourth quarter. Despite all the gloom and doom, the Japanese yen has not only held its own against the strong US dollar, but posted a superb rally. How is this possible? Well, the Yen simply maximized its traditional safe-haven status, and global financial instability drove investors away from risk assets towards safer waters like the Japanese currency. The recent rush to safe assets will not last indefinitely however, and weak fundamentals will not fade away for this island country. Losers last week include, the Swiss Franc which experienced a retracement from the previous week’s gains.

On of this week’s major themes is the fact that an increasing number of central banks are employing negative rates – Europe, Denmark, Sweden, Switzerland and now Japan. What does it mean? And who’s next?

Well, negative rates signal slight desperation on the part of central banks. It suggests that traditional policy options were not effective and that new drastic measures are needed. Rates below zero also mean that there is minimal expectation of inflation and little to no anticipation of near-term economic rebound. How well negative interest rates have worked in the past is debatable, but most economists think they've had some success in Europe. Lowering rates has helped stem the appreciation of the Swedish and Swiss currencies and significantly pushed down the value of the Euro against the Dollar, which was a nice boost for exporters in the Euro Zone.

Well, negative rates signal slight desperation on the part of central banks. It suggests that traditional policy options were not effective and that new drastic measures are needed. Rates below zero also mean that there is minimal expectation of inflation and little to no anticipation of near-term economic rebound. How well negative interest rates have worked in the past is debatable, but most economists think they've had some success in Europe. Lowering rates has helped stem the appreciation of the Swedish and Swiss currencies and significantly pushed down the value of the Euro.

As for who is next, The Bank of Canada is the most likely of the major central banks to opt for negative rates this year, claims Marc Chandler, head of FX Markets Strategy at BBH. "I am not saying the Bank of Canada will, but that is the most likely candidate of those that are not there yet…” Canada's current overnight rate is already very low and the BOC has prepared markets for the possibility of negative rates by alluding to how they might work as a policy tool. Back in December, Stephen Poloz said the lower bound for the policy interest rate was around minus 0.5%. The bank will update its rate target on March 9.

In the US, it remains an open question whether the Fed will adopt negative rates in this environment. They seem to be enjoying a stronger economy than most, but everyone’s eyes will be on the data in coming weeks to see if it will warrant a drastic policy shift at the FOMC meeting in March. A change in economic circumstances could put negative rates “on the table” in the U.S., but unless the economy weakens significantly many analysts expect Fed policymakers to slowly raise rates, and not cut them. “I do not see this as anything but very low risk in the U.S." states Chandler.

In theory, rates below zero should reduce borrowing costs for companies and households, driving demand for loans. In practice however, a bank charging customers to hold their money, may cause cash to go under the mattress, or perhaps somewhere shinier...

It seems that the threat of negative rates across the globe has made Gold one of this year’s best investments. Negative rates, in simple terms, means that depositing cash will leave investors with less than when they started, making traditional assets such as gold more appealing. “Leave a million dollars with a bank, and in a year, you get only something like $990,000 back,” said Marc Faber, publisher of the Gloom, Boom & Doom Report. “I would rather want to own some solid currency, in other words gold.” All in all, when you have negative rates, something with a 0% yield becomes a high-yield asset and is therefore a nice place to park your money

Diminishing Returns

The carry trade continued to unwind last week. The Japanese yen, Swiss franc, and the euro have been used as funding currencies, due to their low or negative interest rates, were at the head of the pack. Market participants bought those currencies last week in order to exit their trades. The unwinding of the carry trade caused excessive volatility in financial markets. However, signs of stabilization in the equity markets were apparent in Friday’s price action. This was also reflected in the currency markets as the funding currency stopped rising and actually fell on Friday – perhaps signalling that the carry trade unwind had run its course, for now. We will know for sure as the new week opens and markets in most of Asia reopen after being closed for most of last week due to holidays.

It has been an extraordinary start to 2016. For the first couple of weeks the market’s anxiety revolved around the declines in the stock market and currency of China. It quickly changed to the oversupply of crude and its falling price. Then the market’s obsession turned to fears that the US economy was entering a recession. Before that obsession faded, along came the obsession of third party risk and troubled banks.

The financial sector is down about 15% year to date but Deutsche Bank is down more than 35% due to potential issues with its derivatives portfolio and its capital structure. Deutsche responded to the investor’s loss of confidence with a plan to back $5.4B in debt. The plan is so desperate it will even start buying back debt that was issued less than six weeks ago. Where have we seen this before? You got it – Lehman Brother in 2008. I guess we should have seen this coming back in June 2015 when the bank’s co-CEO, Anshu Jain and Jürgen Fitschen, abruptly resigned. We are not suggesting that this is 2008 all over again. However, sentiment has definitely changed since the Fed’s December rate hike as evidenced by the unwinding of carry trades.

Last week, Fed Chair Janet Yellen delivered a relatively upbeat assessment to the Senate Banking Committee. “A lot has happened” since December, when the Fed talked about raising rates 4 times in 2016 to kick off three years of sequential rate hikes, Yellen acknowledged. When asked about the risk of a recession, she responded that anything is possible but “expansions don’t die of old age.” She made clear that Fed officials were still debating when, not whether, they should raise rates again. She went on to play down the possibility that the Fed would seek to provide new stimulus by imposing negative interest rates. However, she refused to take negative interest rates off the table.

What we have here is a difference of opinion between the market and the central bank. The Fed expects the economy to continue to perform while it administers additional interest rate hikes; while investors expect the slowdown in the global economy will force the Fed to change course. The market is currently pricing in about an 8% chance that the Fed will lower rates by the end of 2016, compared with a 4% chance it will raise them, according to overnight-indexed swaps data compiled by Bloomberg.

Gold’s 16.76% rise year to date seems to reflect investors’ angst that central banks are out of ammo. The popular finance blog, Zero Hedge, recently put out a missive promoting that notion. They suggested that 8 years of monetary easing comprised of 637 collective rate cuts, $12.3 trillion in global quantitative easing, and with $8.3tn of global government debt currently yielding 0% or less

have been a “quantitative failure.” They insist that central banks have failed to revive the global economy and that every new measure yields less and less. They may be correct but we don’t think that central banks will stop. They continue to tell us that they have more tools in their tool box and we don’t doubt them – in fact, Ben Bernanke once talked about dropping money out of a helicopter. One thing that we are sure of is that every new tool used by central banks will lead to a corresponding move higher in the price of gold. Why you ask? – because Gold is the only currency that central bank can’t debase (create out of thin air).

Five and Counting

At the end of last week’s blog post, we mentioned that the central banks of Japan, New Zealand, and the USA would deliver policy announcements. We went on to say that no moves were expected by all three banks but if there was to be a move it would come from the Reserve Bank of New Zealand. On this count, we were half correct. There was a surprise move but it came from Japan not New Zealand, more on that later.

The big surprise of the week was the Bank of Japan adopting negative interest rates. The BOJ will charge 0.1% on any cash left on deposit with the bank. The yen responded with a loss of almost 2% on the week. This move shocked the markets because only a week ago Bank of Japan Governor, Haruhiko Kuroda, told an audience at the Davos World Economic Forum that he would not adopt negative interest rates. The bank’s policymakers, who voted 5-4 to approve the measure, took great pains to say the rate cut was based on global conditions and not the Japanese economy itself. It makes you wonder what the BOJ has seen that has changed their minds so quickly. It also makes you wonder why the Fed’s policymakers are not seeing the same thing.

The BOJ’s latest move makes it five and counting – i.e. five central banks that currently have a negative interest rate policy. The others are the ECB (-0.3%), Denmark (-0.65%), Switzerland (-0.75) and Sweden (-1.1%). We are emphasizing “and counting” because we believe that eventually other western central banks, including the US Fed, will have no choice but to adopt negative interest rates.

There were some changes in last Wednesday’s FOMC statement. The FOMC removed the line about the economy “expanding at a moderate pace” and replaced it with “growth slowed late last year”. They warned that market based measures of inflation compensation “declined further” and that inflation is expected to “remain low in the near term, in part because of further declines in energy prices.” The FOMC also explicitly said they were closely monitoring global economic and financial developments. These were nice dovish additions but we thought that the dropping of “risks being balanced” and the reference to being “reasonably confident” about inflation returning to 2% was more telling.

The changes to the FOMC statement reinforced what the market had already discounted – that the Fed's four rate hikes, as laid out in December’s dot-plot, are a fantasy. Before all the market turmoil in January, the fed funds futures were pricing in just two rate increases by year-end. The market is currently pricing in a single hike this year and traders see a 16% chance that the Fed will raise rates at its March meeting, down from 51 percent at the start of this year.

Looking ahead, it will be another busy week in the currency markets. The first trading week in February will see the release of Chinese PMI, UK PMI, RBA Rate Decision, German Labor Report, NZ Labor Report, BoE Rate Decision & Quarterly Report, US Non-Farm Payrolls, and the Canadian Employment Report.