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.