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.