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.

Who let the Kangaroos out?

Who let the kangaroos out? It was that type of week, a risk-on rally. The risk-on currencies are led by the commodity currencies of the AUD, NZD, and CAD as it was a banner week for this lot as funds poured into the high yielding currencies. The GBP was able to slip into that club last week as it traded higher, despite the weakness of U.K. data. The GBP demonstrated incredible resilience as it corrected its oversold condition as Brexit fears abated, for now. As you can imagine, during bouts of risk-on trading the low yielding currencies or funding currencies would be the laggards and that is exactly what transpired last week. The low funding currencies of the EUR, CHF, JPY, and USD were at the back of the pack.

The AUD had its best week since October, having gained over 300 pips on the week. It wasn’t purely driven by the risk-on condition of the market, positive Australian economic data also helped. The Australian economy grew 0.6% in Q4, as consumer spending, housing construction, and public sector expenditure offset a fall in company investment and profits and export prices. The growth rate, which equates to 3% year-on-year and 2.5% for 2015, came in at the high end of economists' estimates. A smaller January trade deficit (A$2.94 bln vs. A$3.2 bln consensus) and a rise in the service PMI (51.8 vs. 48.4) also helped to lift the AUD. The Aussie also received a helping hand from the Reserve Bank of Australia, which left rates steady as widely anticipated. However, the most impressive aspect of the AUD’s performance is that it happened despite continued weakness in the China's PMIs last week.

Technically, the AUD could extend its recent strength as the risk-on theme of the market continues to run its course considering that there are no major U.S. economic reports on the calendar in the upcoming week; and against the backdrop of potential central bank easing from the ECB (March 10th) and Bank of Japan (March 15th). This also applies to the other commodity currencies of the NZD and CAD – they could move even higher along with the risk-on rally. Having said that, the momentum indicators are starting to show signs of over extension and warn of a possible correction or change in trend. The potential turning point may come from the US Federal Reserve meeting on March 16th. The Fed is not expected to hike interest rates but there has been enough improvement in the jobs report for the Fed to maintain a hawkish bias. This, in turn, would have the potential of turning the risk-on rally into risk-off.

Annual Round-up

The CAD was the worst performing currency of 2015 as it lost over 16% on the year while making 11- year lows. The Canadian economy suffered a technical recession in the first half of the year. The Bank of Canada responded with two interest rate cuts early on which seemed to help the economy get back to at least flat growth. The biggest culprit, as you can pretty well guess, was the crash in the price of oil. Unfortunately, the price of oil has not bottomed yet. With the Iranian sanctions coming to an end, more oil will be added to the current supply glut, which is also increasing thanks to the mild winter season in North America due to the warm El Nino weather pattern. With oil currently trading around the $37 handle a fall to $20 could be in the cards. If the price of oil does fall further don’t be surprised if the Bank of Canada offers up more interest cuts and possibly unconventional policies such as negative rates and/or QE, if things really go downhill. As we have seen with other central banks, dovish monetary easing doesn’t necessarily translate into an increase in a country’s exports especially when the world is struggling with insufficient global demand – thus some central banks have been forced into the use of unconventional policy tools.

The USD powered ahead for the first three months of 2015 on the premise that the U.S. Federal Reserve was getting ready to raise interest rates while the rest of the world was just kicking off another round of monetary easing. While this monetary policy divergence was well telegraphed, and thus easy to prepare for, it was the unexpected moves that caused the most damage. The breaking of the Swiss franc/euro peg in January and the Chinese yuan devaluation in August caused market participants undue stress and reminded everyone that forex markets are not for the faint of heart. 

Come to think of it, the policy divergence theme was also full of false starts as the Fed tied any rate increases to economic improvement amid signs of an inconsistent recovery. The market was blindsided when the Fed downgraded its predictions for U.S. growth and inflation at the March FOMC meeting instead of raising interest rates for the first time since 2006, sparking a selloff in the USD. This sapped the momentum from the US dollar index as it peaked in March and fell prey to false starts after each of the next four meetings. The second last meeting of the year in October was the turning point for the USD as it gained strength in anticipation of a December rate hike. Unfortunately, the USD was side swiped once again after ECB President Mario Draghi under delivered at the ECB policy meeting. A massive short squeeze in the EUR/USD ensued, which temporarily put a dent in the divergence theme. This helped to temper the market’s reaction to the Fed’s rate hike in December.

There is no question that the USD was the top performer of 2015, led by the divergence in monetary policy between the Fed and the rest of the main central banks. Now that the Fed has its first rate hike under its belt it is looking to make four additional hikes in the year ahead. The Fed will have more hawks in the birdcage in 2016 so the case for monetary tightening and a higher USD can easily be made. However, the divergence case may have a short shelf life since we think that the global easing cycle is nearing an end. How this plays out remains to be seen as each of the other central banks and foreign governments will have their say as well. Let us take a brief look at the majors.

The Japanese yen was the best performing currency after the USD. The yen was sought after as a safe haven during geopolitical events such as the Paris terrorist attacks. It also remained strong because the Bank of Japan did not find the need to offer any new easing policies. At this point, the only way we see the BOJ adding to its easing bias is if the fallout of the Chinese slowdown takes a turn for the worse. As we will shortly see, this wild card will be in play for many of the world’s central banks.

The one thing we can say for sure about the National Bank of Switzerland is that they are not ready to throw in the towel on keeping their currency from appreciating. They may change the goal posts from time to time, like they did in early January, but they are not about to quit. The biggest threat to currency appreciation would be a slowdown in the Eurozone economy which would cause the ECB to act again. Thus, the central bank could go further into negative rates if the circumstances warrant it.

The UK economy was one of the best performing economies in the first half of 2015 which caused many to believe that the Bank of England would be the second major central bank to raise interest rates. However, the economy tailed off in the second half of the year as the commodity sector continued to crash causing the market to push out the BOE’s interest rate hike. The greatest risk to the GBP in 2016 is the threat of Brexit - "British exit". Brexit refers to the possibility of Britain's withdrawal from the European Union. Prime Minister Cameron has promised a referendum but no date has been set as of yet. Leaving the EU would have an enormous economic impact on the UK economy, thus Brexit is a black cloud over the future.

The euro was down about 10% for the year but was able to hold its March low prior to the December ECB meeting which caused it to move up on a classic short squeeze. The fact that the Eurozone continues to struggle after the great financial crisis of 2008 and the European Sovereign debt crisis of 2010 is not surprising and only reinforces the problems with a currency union. The biggest drawback of the union is that they only share a currency but not revenue and taxation policies. Be that as it may, the ECB has done what it can to stimulate growth and it will continue to do so in 2016, considering it was the last one to the global easing party. Geopolitical risks in the Ukraine and the Middle East will continue to be the black clouds over the Eurozone in 2016.

The AUD and NZD were down 10.72% and 12.35% respectively for the full 2015 year. However, those numbers are misleading because for the last 3 months of 2015, the NZD and AUD were the top performing currencies with gains of 6.76% and 3.87% respectively. These gains came despite continued commodity price pressures in Q4 2015. In the first nine months of the year, the two commodity currencies struggled due to the high USD and the slowdown in the Chinese economy. The central banks of both countries responded with interest rate cuts and good old fashioned jawboning. By the time the fourth quarter started, both banks made it abundantly clear that they were satisfied with their country’s economic progress signalling the end of monetary stimulus. Coupled with a bottoming of key commodity prices for each country in the month of December - dairy for New Zealand and iron ore for Australia – the way was cleared for a rally into year-end for both currencies. The key for each currency in 2016 will be the performance of the Chinese economy. If China continues to sputter than both currencies will suffer. On the other hand, if China begins to turn the corner then both currencies will finish 2016 on a positive note. In either case, the NZD should outperform its commodity brethren, the AUD, due to its greater exposure to the Chinese consumer in the form of soft commodities (food) rather than hard commodities which are more geared to the investment and infrastructure side of the Chinese economy.

So there you have it, a brief synopsis of each of the key currency majors that we follow. We have taken for granted that we have entered into the second phase of monetary policy divergence. This phase will be marked by interest rate hikes by the Fed while other central banks stand pat or extend easing. It will be interesting to see how long this divergence lasts, considering that on the surface; it would seem that we are closer to the end of the global easing cycle rather than the middle. Once the Fed hints that it is close to ending its course of rate hikes then and then will the USD crest and turn downward.

Australia reports strong jobs numbers!

After finishing in second place last week the AUD was able to supplant the USD, as it failed to maintain its lead in the week after the exceptionally strong U.S. jobs report which had helped fan expectations of a December Fed rate hike. Similar to last week, it was the jobs report that helped power up the performance of the domestic currency. Australia recorded the largest payroll increase since early 2012 as the economy added 59K jobs in October, beating expectations of 15K and a -1K decline in September. The unemployment rate dropped to 5.9% from 6.2% a month ago, marking the lowest level since May 2014, while the participation rate picked up to 65% from 64.9% in the prior month. The internals were also stellar as both full-time and part-time jobs rose last month with the former gaining 40K (following September upwardly revised 10K decline) and the latter adding 19K (compared with September's 10K increase). Just to put these numbers into perspective, the 59K October jobs gain would equate to over 800K new jobs in the U.S.; and just last week the market was cheering about the 271K increase.

Surprisingly, the GBP was able to match the AUD’s gain after last week’s disastrous Super Thursday performance which was outlined in detail in last week’s Dispatch. The labor market also played a role in relation to the domestic currency 1.21% gain as the unemployment rate fell unexpectedly to a fresh seven-year low of 5.3%. Meanwhile, employment rose by 177,000 over the quarter, meaning there are now 31.2m people in work, according to the Office for National Statistics. Comments made by Bank of England Governor Mark Carney encouraged speculation that the central bank could move on interest rates sooner than previously suggested. Carney told Bloomberg he believes the U.K. economy, which is forecast to grow at 2.7% this year, may soon have the right conditions for a rate rise.

The odd person out last week belonged to the CAD with a weekly decline of 0.15%. The main culprit was the 8% drop in the price of crude as prices fell toward the $40 handle. The decline this week came from fresh signs of increasing supply due to abundant supplies and slackening demand, especially in China. The IEA said global oil-demand growth will slow to 1.2 million barrels a day in 2016, after surging to 1.8 million barrels a day this year, a five-year high. Having said this, Friday’s tragic terrorist attack on Paris could further slow the global economy and demand for oil. Thus, weakening oil prices may exert even more downside pressure on the CAD to start the week on top of key reports due this week on inflation and retail sales.

Last Thursday, no less than six Federal Reserve policy members spoke. We won’t bore you with the details of each speech – the common take away was that the Fed is ready to raise interest rate if the data supports the move.

IMF Will Decide the Near-Term Future of the Yuan

Most market analysts have little doubt the that Chinese yuan will one day be part of the International Monetary Fund’s special drawing rights (SDR) at some point in the future, but very few believe that it will happen by the end of this month. On November 30th the IMF Managing Director Christin Lagarde will make a decision about the CNY becoming part of the SDR, which is a multilateral institution basket of currencies that include the USD, EUR, GBP and JPY. However, if the IMF surprises us all, the inclusion of the CNY into the SDR could be the spark that fires the yuan rocket in the years ahead as a global reserve currency, likely replacing the Japanese yen and Great Britain pound in the currency hungry emerging market central banks.
It was only a few months ago that several media outlet reports suggested that people inside the IMF were saying that the yuan was not yet equipped for prime time. However, more recently Ms. Lagarde stated, “The IMF staff assessed that the RMB [CNY] meets the requirements to be a ‘freely usable’ currency and…proposes that the Executive Board determine the RMB to be included in the SDR basket as a fifth currency, along with the British pound, euro, Japanese yen, and the U.S. dollar.” She added that the staff also found that Chinese authorities have addressed “all remaining operational issues identified in an initial staff analysis submitted to the Executive Board in July. I support the staff’s findings.” This is big news.

The decision to include the CNY into the SDR will not rest entirely on Ms. Lagarde. The market at large will have a say as well. Meanwhile, China is busy building up its local bond market with the hope that it will be seen by Asian institutional investors, emerging market central banks and big sovereign wealth funds as a safe haven alternative to U.S. Treasury bonds at some point in the near future.

In August, the Peoples Bank of China (PBoC) allowed the CNY to trade within a wider band, which resulted in a weaker yuan. The result was furious push-back from Western economies because they felt that it was a protectionist measure to manipulate its currency in order to save its export
manufacturers at a time when the economy is growing slower than it has in years. However, it’s important to keep in mind that the yuan at the time was the strongest in the region – stronger than the likes of South Korea, Taiwan and the Singapore Dollar. Moreover, the trading band actually gave the market more say to sell the CNY short and weaken it against the USD and EUR. In its history, this is the closest China has come to free-float the CNY. China still has a long road ahead, but its goal to become a reserve currency has gain momentum. However, the PBoC’s strict control on the flow of the yuan will continue to impede its progress and restrict it from becoming a basket currency, as all other currencies in the IMF’s SDR are determined by the market.

Ok CAD!

The CAD turned in another strong performance after leading the pack the previous week, however, caution is warranted after last Friday’s employment report. Like all currencies, the CAD has benefited from the US Fed’s dovish September hold. Another driver of the CAD’s advance has been the rebound in the economy. Back-to-back monthly GDP growth in June and July after five sequential months of negative or zero growth has help to cement expectations that the economy may have turned the corner and would not need any additional easing by the Bank of Canada. Of course, a discussion on the performance of the CAD would not be complete without any mention of the price of crude. Crude oil has managed to rally about 34% of its recent low in August and also managed to rise over the $50 level this past week before giving up some of its gains. Having said this, the way forward for Canada remains bumpy as evidenced by Friday’s jobs data. Canada added 12.1k jobs in the month of September, which was slightly better than expected. However, all of those gains were in part-time jobs since there was a loss of 61.9k full-time jobs, the largest amount since October 2011. That brings the loss in full-time jobs to 25K for Q3 alone. In addition, the unemployment rate rose to 7.1%, a 2-year high. This type of data warns that the rally in the CAD may sputter soon.

For the second consecutive week the USD has been the underperformer against the majors as the release of the FOMC minutes from the September meeting reinforced the dovish impression. The leaders of the pack, AUD and NZD, each managed to turn in a 4% increase on the week, powered by its own unique driver. The AUD surged higher after the Reserve Bank of Australia kept rates on hold as expected but it suggested that the bar was high for another rate cut this year. For the NZD, the story continued to be milk. Milk prices increased for the fourth auction in a row, fanning expectations that prices for New Zealand’s most important export have bottomed, which in turn takes the pressure off the Reserve Bank of New Zealand to ease again.

We had no less than six FOMC members speaking last week and even though all 6 members are considered doves, they all went out of their way to impress upon us that an interest rate hike is coming soon and that they really, really, really mean it this time. Oh really?! They’re not the only ones trying to sell us this line. Apparently 64% of the economists surveyed by the Wall Street Journal expect a hike in December. To be a little fair, some of these economists have wavered from their original position because back in August, 82% expected a hike in September. The survey also found that 23% expect the first hike will be delivered in March 2016; do we hear anyone for 2017? We wonder if any of these economists are also employed at the IMF because they just downgraded global growth to 3.1% this year from its previous forecast of 3.3%. By the way, it was the fourth time this year that they changed their forecast. Are you kidding me? Why do we even listen to these people? Apparently, we are not the only ones with this opinion. Joris Luyendijk of the Guardian wrote an eloquent piece on the science of economics, or rather the lack thereof, this weekend titled, “Don’t let the Nobel prize fool you, Economics is not a science.”

We have our doubts. We don’t see a hike at all this year or next, which falls in line with many forecasters and analysts. But hey… what do we know? We’re not going to let the fact that for the first time since 2009, all six major Fed regional activity surveys are in contraction territory. We’re also going to ignore the fact that 3-month bills sold at a yield of zero for the first time in history. That’s right, at last Monday’s Treasury auction investors decided to buy $21 billion in 3-month Treasury bills at a yield of zero. If that didn’t astonish you, demand was the strongest in over three months, as the bid-to-cover ratio, which is a widely used measure of demand, was the highest since late June, according to data from Jefferies. Don’t worry folks, interest rates can’t go much lower than zero, or can they?

The USD has been the worst performing currency since the Fed decided to leave interest rate on hold at its September policy meeting. This weakening in the USD combined with the global slowdown in growth and lower inflation due to lower commodity prices is starting to undermine the current quantitative easing (QE) programs of the ECB and the BOJ. What we mean by undermine is that the euro and yen are rising against the USD. This may cause these central banks along with other foreign central banks to ease policy even further causing the USD to rise again. If this transpires, then the Fed may have to respond in kind in order to keep the USD in check (The ECB and BOJ can’t have this, there is a currency war going on after all). Many of the bloggers in cyberspace that are calling for QE4 have it all wrong. The fact that we have had more than one QE program from the Fed only tells us that they have all failed. We think the Fed’s next move will be not a hike in rates or another QE program, but a cut in interest rates to negative. Don’t think it’s possible? Well, let’s consider that the Swiss national bank is at negative 0.75%, the ECB is at negative 0.20%, and Sweden and Denmark are also in negative territory. Also, remember the September dot plot, which showed that one FOMC member wanted negative rates at the end of 2015 and 2016. We’re guessing that was Minneapolis Fed chief Narayana Kocherlakota because in a speech last Thursday he made these following points that were summarized by Bloomberg:

 KOCHERLAKOTA SAYS FED SHOULD CONSIDER NEGATIVE RATES
 KOCHERLAKOTA: TAPERING ASSET PURCHASES LED TO SLOWER JOB GAINS
 KOCHERLAKOTA SAYS JOBS SLOWDOWN 'NOT SURPRISING' GIVEN POLICY
 KOCHERLAKOTA: TAPERING ASSET PURCHASES LED TO SLOWER JOB GAINS

We would be remised if we didn’t mention the China factor in all of this. China’s foreign exchange reserves fell another $43bn last month, suggesting continued intervention in the forex markets to support the renminbi. This was down from the $94bn they spent in August trying to shore up the renminbi after the August 11 devaluation. Should we expect the Chinese to continue to spend their reserves on stopping their currency from falling while their economy continues to sputter? Wouldn’t it help China’s economy if they allowed the currency to fall? We suspect that if the Chinese renminbi does fall it will force the Fed to react and that reaction may very well be in the form of negative interest rates.

US Federal Reserve Interest Rate Talk Again...

Honestly, after last week’s anticlimactic FOMC decision we thought
that we would get off this topic of interest rate hikes and move on to
other market drivers. Unfortunately, we demur as the issue has
come back, front and center, and is vying for top spot in the news
cycle along with the VW’s exhaust issues (food for thought: Chinese,
Indian or Korean automaker to buy Porsche from VW?). The USD was
able to pick itself up off the mat and finish at the top of the currency
heap last week. The week prior, the USD was down and out due to
the market’s perception of a dovish hold after the FOMC meeting.
Sound bites from several Fed officials and a speech by Chairperson
Yellen were able to transform the market’s perception from a dovish
hold to a hawkish hold. This policy stance is grounded in the fact that
most Committee members continue to project a policy rate increase
later this year, even though the conditions that led to a delay in a
September rate hike are likely to persist in the months ahead. Thus,
as long as U.S. policy normalisation remains on the table, the
divergence between the Fed and the continued monetary easing of
other central banks, especially the ECB and the BOJ, should continue
to cause the USD to trade with a strengthening bias.

The worst performers last week were the GBP and AUD. The GBP has
plainly run out of gas. The Bank of England is the only other central
bank besides the US Federal Reserve that is close to raising interest rates. There
wasn’t any key market moving data releases last week but there was
conflicting central bank commentary. Sir Jon Cunliffe asserted that
the UK’s economic outlook was ‘pretty strong’ and that the next interest rate related movement was likely to be an increase, however, fellow Monetary Policy Committee member Ben Broadbent stated that he wouldn’t be voting for higher borrowing costs anytime soon. Since the UK economy appears to have slowed in Q3, Broadbent’s comments carried more weight and helped the GBP fall by 2.5% last week. The focus for next week will be revisions to Q3 GDP and the PMI manufacturing report.
The other poor performer last week was the AUD. The AUD dropped below 70 cents intraday last week and is down about 20% over the last year primarily due to the China slowdown story and the slump in commodity prices. China is Australia’s biggest trading partner so any negative news about China’s economy tends to weigh on the AUD. Last week’s negative China news was the Caixin PMI, which showed that manufacturing activity contracting at the fastest pace since March 2009. The other driver of Aussie weakness last week was a report by ANZ Bank that suggested that the Reserve Bank of Australia may cut rates twice in 2016 taking the benchmark rate to 1.50%. If this were to happen, the next likely target on the monthly price chart would be around the 0.60 level last seen in late 2008.

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.

We have an Agreekment

Greece’s Bailout Deal Explained with a Euro-Parable

The following parable pretty much explains the bailout deal reached late Sunday night. This actually made the online rounds back in December 2011, but it still applies today and isn't that much of an exaggeration. Enjoy!

It’s a slow day in a little Greek Village. The rain is beating down and the streets are deserted. Times are tough. Everybody is in debt. Everybody lives on credit. On this particular day a rich German tourist is driving through the village. He stops at the local hotel and lays a €100 note on the desk, telling the hotel owner he wants to inspect the rooms upstairs in order to pick one to spend the night.

The owner gives him some keys and, as soon as the visitor has walked upstairs, the hotelier grabs the €100 note and runs next door to pay his debt to the butcher.

The butcher takes the €100 note and runs down the street to repay his debt to the pig farmer.

The pig farmer takes the €100 note and heads off to pay his bill at the supplier of feed and fuel.

The guy at the Farmers’ Co-op takes the €100 note and runs to pay his drinks bill at the local tavern.

The tavern owner slips the money along to the local bookie drinking at the bar, who has also been facing hard times and has had to offer him bets on the horses using.

The bookie then rushes to the hotel and pays off his room bill to the hotel owner (he drank too much one evening and couldn’t drive home) with the €100 note.

The hotel proprietor then places the €100 note back on the counter so the rich traveller will not suspect anything.

At that moment the traveller comes down the stairs, picks up the €100 note, states that the rooms are not satisfactory, pockets the money, and leaves town. No one produced anything. No one earned anything. However, the whole village is now out of debt and looking to the future with a lot more optimism.

And that, dear readers, is how the bailout package will work!

Yes, we finally have a deal in Greece, but by many accounts it is not materially different from the deal(s) Greece rejected over the past few weeks. The fallout from the Greek street has been swift. Now Prime Minister Tsipras has to get to work convincing the Greek people that as difficult and long as the path ahead may be, it’s the only way out.

If you would like to read the Euro Summit statement, you can find it here. Its main points include:

 A "significantly scaled up privatization program with improved governance."

 "Ambitious pension reforms" and measures to make the system more affordable.

 General deregulation and liberalization of Greece's market economy, with areas such as pharmacies being opened up to more competition.

 A "rigorous review" of modernizing the Greek labor market.

 Depoliticizing the Greek governing establishment — it's a common criticism that Greece's government is riddled with cronies from whichever administration is in office at the time.

 Amending or rolling back some legislation that has been passed in Syriza's first six months in power, much of which ran against previous bailout deals.

Margin Call

Currencies were under a lot of pressure for the first three days of last week as safe haven flows into the yen and USD dominated due the continued uncertainty in Greece and China. By Thursday, safe haven flows subsided and gradually reversed as the slew of Chinese government measures utilized to stop the equity markets from falling finally took hold. For now, this helped to stabilize the market and allowed currencies to rebound against the yen and USD. Stability continued to take hold on Friday as a sense of optimism over a potential Greek deal emerged. Thus, the only two currencies that moved by more or less than 0.50% for the week were the AUD and CAD.

It’s not surprising to us that the two outliers for the week were the AUD and CAD because it’s become apparent that the turmoil in the Chinese equity markets, and the slower economic growth in China in general, have weighed heavily on commodity prices. The fall in energy (oil for Canada) and industrial commodities (iron ore and copper for Australia) show no sign of abating as of yet and will continue to cast a long shadow on the respective currencies.


New Zealand may be spared the brunt of the fallout as agricultural commodities are more insulated from economic downturns in general since people still need to eat. Having said this, the fall in the two currencies last week was all about monetary policy. In Australia, on Tuesday keeping interest rates on hold at 2% for the second-straight month. However, the Aussie fell anyway after Reserve Bank governor Glenn Stevens said "further depreciation (in the currency) seems both likely and necessary, particularly given the significant declines in key commodity prices”.

Meanwhile in Canada, the key driver in CAD weakness was the cumulative soft economic data on top of the prior week’s negative GDP growth for April. Speculation has risen that the Bank of Canada will deliver a rate cut at tomorrow's policy meeting. Frankly, we would be surprised if they choose to wait until their September meeting given the string of disappointing data and the characterization of its surprise January rate cut by Bank of Canada governor Stephen Poloz as an “insurance policy”.

As we pen this blog, we feel a sense of exhaustion over thinking about the deal between Greece and the Eurozone. After the last couple of weeks we think that everyone, including ourselves, is suffering from crisis fatigue – not just about Greece but the 30% drop in the Shanghai Composite index over the last 3 weeks and 20% drop in oil, just to name a few. All of this is resurrecting fears of deflation or disinflation again, which may kick off a new monetary easing race by central bank; like it did in January of this year. Therefore, central banks look to ease policy further or to leave rates lower for longer.

Whatever happens in Greece is critical for the week ahead in markets, but what transpires in China will matter for many more months. Why? Because it renews fears of downside risks to global growth. We mentioned last week that China’s array of policy measures to arrest the fall in their stock market reeked of desperation. Unfortunately, last week they had to deploy even more measures before the stock market was able to stabilize. This stability will only last a short while because the reason behind the plunge in stock is margin calls. Investment bank, Goldman Sachs, notes that China’s margin debt is the highest in history of global equity market and stands at 12% of the free float market cap of imaginable stocks. So when equity prices began to fall about 4 weeks ago, it set off a wave of forced selling of shares due to margin calls. And with more than 90 million "retail" investors involved in the stock market, more downside is expected due to forced selling created by margin calls. The fear for all of us is that the stock market crash will dent Chinese consumer sentiment and derail whatever economic momentum China has left, which in turn could spread and derail the global economy.

Trouble in Oceania

The Swiss franc nudged the USD out of first place last week despite the news that Switzerland's economy shrank in Q1 by 0.2%, which may foreshadow a brief pause in the USD’s rally after strong advance since mid-May. A combination of month-end flows and a six point drop in Friday’s release of the May Chicago PMI, to contraction territory at 46.2, encouraged USD bulls to take profits ahead of this week’s busy economic calendar. The releases include a central bank meeting in Australia, the UK, and Europe as well as OPEC's semi-annual meeting. The key economic events are the monthly global PMI readings, Eurozone flash CPI, and the U.S. nonfarm payroll report.

The worst performing currencies last week came from the two main countries in Oceania, Australia and New Zealand as their currencies fell 2.7% and 2.38% respectively. Both economies are dealing with the reduced demand from China for their main export product, iron ore for Australia and milk for New Zealand. Both currencies are being pulled down against the USD by the divergence in monetary policy. 

The AUD was weighed down by Wednesday’s release of private capital expenditure which came in at -4.4% versus -2.3% that was expected. The data reveals that Australia’s transition away from a mining-dominated economy remains challenging and is still some time away. The capex data is the weakest in five years and supports the Reserve Bank of Australia's decision to cut the official cash rate in February and possibly at this week’s upcoming meeting.

The NZD fell to a five year low against the USD on Friday and has shed about 6.5% since mid-May as investors wagered that interest rates in New Zealand and in the U.S. were set on a diverging course. The catalyst for the move was the release of the ANZ Business Outlook Survey which fell to 15.7 in May from April's reading of 30.2. The survey showed that inflation expectations were at an all-time low of 1.6% in May, which is below the Reserve Bank of New Zealand's (RBNZ) 2% target midpoint. The string of poor data and dairy price indications has increased pressure on the RBNZ to cut rates. The central bank’s next meeting is on June 10th.

Is Deflation Scare Over?

　

The unexpected Tory victory in the UK general election catapulted the GBP to the top of the currency heap last week. The AUD was the second best performer helped by a shift in interest rate expectations to later in the year. The NZD was the only currency that shielded the USD by sliding into last place ahead of it. The latest employment and wage date; and the continued slump in dairy auction prices weighed heavily on the currency. Meanwhile, the closely watched U.S. employment and wage data did not offer a strong sign of a pick-up in the U.S. economy; helping extended the USD’s correction for a third week. The end result is that market watchers have pushed expectations of the Fed’s rate lift off from June to September.

The stunning victory by Prime Minister Cameron was shocking but it would have to take a back seat to the flash crash in the German bund market. Having fallen to just 0.05 % in mid-April, the benchmark 10-year German Bund yields shot as high as 0.78% intraday on Thursday, before easing again. This set off similar moves in the global bond market. Moves of this magnitude are extremely rare in government bond markets – rising yields can be a healthy development if the global economy is picking up speed, but it spells trouble ahead if they suddenly jump at a time of sluggish growth. Thus, the Deutsch Bund Kernschmelze (German bund meltdown) either signals that the threat of deflation has eased or that inflation is about to rise on top of a sluggish economy, which is characterised as stagflation.

Is the deflation scare over and are we now headed toward inflation? This may be the case, especially if we see what has transpired in the oil and copper market as of late. Since falling 60% between June and January to a six-year low of $45 a barrel, crude oil has posted a strong recovery gaining more than 30%. Copper is up close to 20% off its January lows which according to an old investor’s mantra means that the global economy is coming back to life – copper has a Ph.D. in economics because of its ability to predict turning points in the global economy. Because of copper's widespread use in most sectors of the economy, demand for copper is often viewed as a reliable leading indicator of economic health. If we are moving away from deflation and into inflation then we should expect central banks to rein in stimulus and start to raise interest rates.

The only problem is that the current macro-economic back-drop doesn’t support this scenario. Media reports of market participants within the fixed income arena are blaming the meltdown on the lack of liquidity. This topic is more complex than we care to explain here but in a nutshell the lack of liquidity at times reflects changes in structure of the fixed income market due to the involvement of central bank buying for their QE programs. This may explain the violence of the move but perhaps the change in sentiment may actually reflect a realization of a bonafide Eurozone recovery. Having said this, the bond meltdown may also be reflecting the tenuous situation in the Greek default negotiations. The pressure is mounting and even though Greece was able to scrape together enough funds to make Monday’s 767 Million euro payment to the IMF it does not have enough funds to get through to the end of the month.