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).

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.

Keep Calm and Have a Fortune Cookie

The last week we saw the Chinese government force the devaluation of their currency by 4.4% in an effort to inject life into their economy after their recent market crash. This started a frenzy of protest on Main St. and Wall St. alike. Both sides of the political aisle in the U.S. claimed this currency manipulation by the Chinese will further weaken U.S. exports. Although it's relieving to see bipartisan action, we would like to highlight this event and others that our readers and clients should also focus on in world markets.

Chinese devaluing their currency, effectively making their products more affordable to the rest of the world, was a foregone conclusion with the recent strength of the US dollar. In March, the Euro hit an all-time high against the Yuan at 0.15274 due to the Yuan's peg to the strong US Dollar. The Eurozone is virtually the same in importance to Chinese exports as the U.S. market. The PBoC devaluation in China to protect their exports has a similar effect to low interest rates and the bond buy-back (quantitative easing) in major markets.

The declining economies in Europe and Japan have caused both central banks to print money and embark on massive bond buying programs. This helped jump start both economies and also devalued their respective currencies. Japan saw over 3% GDP growth but also saw some of the lowest levels in their currency since 2007, closing at less than 124 JPY per US dollar Friday, August 14. This made Japanese exports even more attractive, and lucky enough for Japan, global commodities are so low their cheap currency didn’t hamper growth. Look for Japanese intervention to increase the value of their currency if commodity prices rebound. Virtually the same can be said for the Eurozone.

Funny enough, the move in the Chinese currency caused such speculation that it would hurt U.S. exports, the top performing major currency last week was the EUR, gaining 1.34% over the USD hitting over 1.1150. This month-long high for the Euro and increase in strength for the GBP and CHF was likely aided by the multi-billion dollar deal approved by the Greek parliament to finalize their bailout. Even though the EU only grew 0.3% this quarter (projected 0.4%), the perceived stabilization of the region was enough to convince the market of its relative strength.

With a pending rate decision in the U.S. in September, low commodity prices and shaky global markets, be on the lookout for more government intervention by regions globally. Closer to home, take a look at the article below for some signals coming this week of what might happen in September.

Hints of a Fed Rate Hike Could Come This Week

Today’s release offers one of the early estimates of the macro trend in August. Although the data is focused on the New York Fed’s region within the U.S., the report is the first of several regional updates on manufacturing activity from the Fed banks. As usual, this data will set the tone for expectations for the monthly figures that will follow in the weeks ahead.

In addition, today’s report will be widely read as the first clue of the week for assessing the potential that Yellen & Co. will begin raising interest rates in September for the first time since 2006. The odds that tighter policy is set to begin with next months’ Federal Open Market Committee meeting draw fresh support in last week’s optimistic news on retail sales and industrial output for July. More of the same is expected for the initial peek at August’s profile.

According to consensus forecast from www.econoday.com, the NY Fed Index is on track for a modest rise to 4.75 for this month. If the calculation holds, the benchmark will tick up to its highest level since March. In turn, the news will offer the throng of analysts another reason to think that we'll see a rate hike next month.

Last week’s key economic updates – industrial production and retail sales – delivered positive news. In both cases, strong gains for July marked a turnaround from disappointing comparisons through most of the first half of the year. Are the encouraging numbers a sign that the macro trend is poised to deliver stronger growth in the second half of the year? Those of you in manufacturing know the answer just by looking at your order pipeline.

The view from the perspective of home builders is certainly optimistic these days. In the July update, the mood was clearly resilient. The National Association of Home Builders/Wells Fargo Housing Market Index (HMI) remained unchanged at 60 in July, sticking to the highest reading in nearly a decade. “The fact that builder confidence has returned to levels not seen since 2005 shows that housing continues to improve at a steady pace,” NAHB’s chairman Tom Woods said last month. “As we head into the second half of 2015, we should expect a continued recovery of the housing market.”

The bullish narrative is projected to remain intact in today’s release for August. At www.briefing.com, the consensus estimate sees HMI rising fractionally to 61, which would mark another multi-year high. In that case, we’ll have another clue for expecting upbeat news in tomorrow’s report on residential housing construction.

Puzzled?

Earlier this month we speculated that the Bank of Canada could cut interest rates after the negative April GDP print; and in last week’s blog post we said that we would be shocked if the BOC didn’t cut because of the string of negative data point after the disappointing April GDP report. Faced with a firestorm of recession talk, the BOC had no choice but to cut interest rates by 25bp to 0.5%. The CAD was promptly sold hard to six years lows. The price action far exceeded our expectations especially after the BOC raised the possibility of QE, if necessary, indicating that this move may not be the end of its easing campaign.

Bank of Canada Governor Stephen Poloz refrained from using the R word by stating that "real GDP is now projected to have contracted modestly in the first half of the year." The BOC also lowered its 2015 growth forecast from 1.9% to 1.1%. For 2016, it expects the economy to grow by 2.3% versus a previous forecast of 2.5%. The economy is not expected to return to full capacity until 2017. As for inflation, the underlying estimate is now 1.5% instead of 1.7%. As you might imagine, the decline in the price of crude oil was the major culprit in the adjusted forecasts.

In the press conference after the policy announcement, Governor Poloz said two things that really
stand out and didn’t seem to receive enough press. He mentioned that he was puzzled that the weaker CAD failed to improve non-energy exports. This statement struck a chord with us because two other countries have had that similar experience. The weak yen has not caused a surge in Japanese exports. Similarly, the weak euro has also not caused an increase in exports as evidenced in the recent Eurozone May trade figures which showed that exports fell 1.5%. We are not sure why this would be puzzling – after all, central banks are engaged in a currency war and no country can gain an advantage if all central banks are counter acting other bank’s moves with matching simulative monetary policy measures.

The other thing that Poloz said was that he expected the Canadian economy to be less in sync with that of the U.S. Are the economic cycles of the two nations that much out of sync? Many economists certainly think so – according to a recent survey in the Wall Street Journal, 82% of economists expect a Fed hike in September. If that is the case, the CAD is in for way more downside that anyone currently expects.

Still the One

With Greece and the Chinese stock market off the front pages, safe haven flows subsided and the monetary divergence theme reasserted itself as the driving force in the currency markets. Last week, the GBP was the top performer as positive economic data, including accelerating employment earnings, and a chorus of Bank of England members sounding more hawkish about a rate hike. This caused the timing of a UK rate hike to move from Q2 2016 to Q1. Having said this, the U.S. is still the one. No, we are not referring to the 70s soft rock ballad by Orleans but rather the only major central bank that is on course to raise interest rates in 2015. Federal Reserve Chairwomen Janet Yellen was on Capitol Hill last week and she stuck with her script by reaffirming that the central bank was on track to raise interest rates this year. If you remember, this is the very same driving force that prevailed in January of this year as the rate hikers were the top performers while the rest of the countries were moving in the opposite direction.

Apart from the central banks of the US and UK, the other major central banks have either a neutral bias or are in easing mode. The ECB left its policy unchanged at last week’s meeting and reaffirmed that the conditions of low inflation remain. Thus, its policy of bond purchase will remain in place. The Bank of Japan also had its meeting last week and it adjusted its inflation forecast – it no longer expects to hit its inflation target until after 2018 which means that it may need to apply more stimuli in meetings to come.

China reported a slew of key economic indicators last week, including Q2 GDP. It announced that its quarterly GDP came in right on target at 7%, like it always does. However, this time the chorus of investors responding with disbelief was louder than ever. No one believes their data anymore. Leaving this aside, China will probably need to administer more stimulus but more importantly their economy is not growing like it was, which is putting tremendous pressure on commodity prices and the economies of the countries that produce them – Australia, New Zealand, and Canada. Australia was the best performer of the countries in easing mode mainly because their next central bank meeting isn’t until the beginning of August. New Zealand was the worst performer because their next central bank meeting is next Wednesday; and after last week’s disastrous dairy auction, the odds have increased dramatically that the RBNZ will cut rates by 50 bps instead of 25 bps.

Tony Valente
Fred Maurer