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.

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.

The Big Tickle

All currencies rallied to the upside against the USD last week except for the euro after the Federal Reserve switched gears. The best performs were the commodity cousins, the aussie and kiwi, in the wake of the Fed’s indecision on an interest rate hike. The euro unwound its post-Fed rally the following day after European Central Bank policy makers noted risks to the global economy. Benoit Coeure, an ECB Executive Board member, said the Fed’s decision vindicates the ECB’s assessment of the uncertainties surrounding the global growth outlook while his colleague on the ECB board, Peter Praet, said in an interview with the NZZ newspaper that the ECB should be ready to act if economic shocks turn out to be long-lasting.

The big tickle for the week was the Fed’s policy shift. Most were probably not surprised that the Fed left rates unchanged at their FOMC meeting last week. That makes it 55 straight meetings without a change in interest rates. The surprise came in the Fed’s reasoning for its inaction – its concerns that developments in the global economy and markets could “restrain US economic activity somewhat”. This change emphasizes that global growth concerns are a real concern, which may cause a risk off environment to develop.

We guess we can call this move a “dovish hold”.

The Fed also released its dot plot plan after the meeting. The plot shows the projections of the 16 members of the Federal Open Market Committee (the rate-setting body within the Fed). Each dot represents a member’s view on where the fed funds rate should be at the end of the various calendar years shown. The latest plot reveals the number of policy makers who do not expect lift-off to happen in 2015 has risen from two to four. Thus, 13 of 17 Fed officials still expect a rate hike this year, which is down from 15 in the June plot. This is surprising considering the new wrinkle towards global growth uncertainty – if the Fed is now “officially” worried about the recent global growth uncertainty is it logical that two months of global data will be enough to alleviate that uncertainty so that they can raise interest rates at their December meeting?

There was yet another shocker in the dot plot. For the first time ever, one Fed policy maker is forecasting negative rates for this year and next (highlighted in red on the dot plot). During the post meeting press conference, Chair Yellen was asked about negative rates and she said that negative rates were not "something we seriously considered" at the current juncture. However, she didn't rule it out – “I don’t expect that we’re going to be in a path of providing additional accommodation. But if the outlook were to change in a way that most of my colleagues and I do not expect, and we found ourselves with a weak economy that needed additional stimulus, we would look at all of our available tools. And that would be something that we would evaluate in that kind of context.”

The implications from all of this are that other foreign central bankers may be forced into further action. With the Fed on hold, dovish central banks may want to ensure that the Fed’s inaction doesn't jeopardize their own domestic inflation targets – thereby setting off another round of monetary easing in the ongoing currency wars.

Why the Fed HAS to Consider the Global Economy

From CNBC found here.

Operating within an economic system where the foreign trade sector represents nearly one-third of demand and output, the Fed must carefully consider price and activity effects coming from the rest of the world. This year, for example, an estimated foreign trade deficit of more than $500 billion is expected to reduce America's economic growth by an entire percentage point. That is because the strong domestic demand – consisting of private consumption, residential investments, business capital outlays and public spending - is stimulating the purchases of foreign goods and services, while the weak economies in the rest of the world, and a strong dollar, are holding back American export sales.

External price effects on American inflation developments are equally strong and straightforward. Driven by a 13.3 percent decline in fuel costs, import prices in the year to August fell 11.4 percent. The non-fuel prices also declined 3 percent, marking their largest drop since October 2009. As a result of that, the headline index of consumer prices (CPI) rose only 0.2 percent in the twelve months to August. But, over the same period, price gains in sectors sheltered from international competition – approximated by the core CPI - edged up 1.8 percent, maintaining the rate of increase observed since the middle of last year.

That enormous difference between the headline and the core rates of inflation shows the strength of externally-induced effects on American costs and prices. And the U.S. inflation story does not end there. What was discussed so far are just the first-round external effects on the domestic price formation process. The second-round effects are arguably even stronger and more pervasive, because an open trading system and declining import prices exercise a vigorous restraint on the pricing power in a broad range of American industries. All this shows how America's foreign trade transactions directly impact the Fed's ability to fulfil its mandate of full employment and price stability.

Employment, in particular, is a difficult part of the mandate. Monetarists have often objected to that. They argue that the monetary policy can only provide an environment of price stability in which demand, output and employment creation can take place. But the mandate is still there, and employment is always a politically-charged issue. Consider, for example, the fact that the current labor market numbers are not as good as implied by the reported 5.1 percent unemployment rate.
Adding 6.5 million involuntary part-time workers (people working part-time because they cannot get a full-time job) and 1.8 million people who are marginally attached to the labor force (mainly people who quit looking for a job because they could not find one), gives an actual unemployment rate that is more than double the official 5.1 percent rate. That also means that the actual number of unemployed is 16.3 million, rather than the reported 8 million. The high numbers of America's long-term unemployed (people out of work for 27 months and over) are reflecting current labor market difficulties as well. These numbers have been increasing since last June to reach 2.2 million at the end of August, accounting for nearly one-third of the reported unemployment.

A similar note about America's soft labor markets is sounded by average hourly earnings; they were roughly unchanged over the three months to August. Now, let's bring back into discussion that 1 percentage point that our foreign trade deficit will knock off the growth of our domestic demand. Even the convinced free traders – of which I am one – have to admit that the immediate effect of that will be job losses in our import-competing industries. The long-term dynamic effects of free trade may well be positive for the world economy as a whole, but that is of little consolation to retrenched workers and bankrupt companies.

The Fed's critics, and American bankers threatening to begin laying people off if the Fed does not promptly oblige with higher interest rates, should understand that there is nothing the U.S. monetary authorities can do about Asians' unrelenting quest for export-led growth, and the European chaos of mean fiscal austerity policies and biblical refugee crises. There is also nothing the Fed can do about structural problems in U.S. labor markets. Only broad and active structural policies – e.g., better and more affordable education, labor force retraining and relocation – could make more people employable in an economy which, thanks to the Fed, is already pushing well above its physical limits to growth.

Foreign trade and labor market policies are the responsibilities of the federal government.
It is not up to the Fed to negotiate better market access to American companies in foreign countries, or to make sure through various G forums (G7, G20, etc.) and multilateral organizations, such as the IMF and the OECD, that economic policies are properly coordinated in order to ensure a fair and a more balanced international trade. And neither is it the Fed's fault that East Asia and the euro area are currently running trade surpluses of $700 billion and $320 billion, respectively, and acting as a huge drag on world economy – extracting that 1 percentage-point gift from the growth of the U.S. domestic demand.

The Fed just has to compose with all that, and to calibrate its policy in order to minimize the negative
effects on U.S. growth and employment of this extremely unbalanced situation in global trade flows. The sad part is that none of these vitally important issues for American economy and security are even mentioned, let alone debated, in the presidential primaries of either party – except for some rather folkloric utterances by Donald Trump, who keeps screaming "they are robbing us blind," and who would treat the Chinese president to a Big Mac instead of a glittering state dinner at the White House.

Somebody has to mind the store. It is easy to criticize the Fed for everything, especially if the Dow does not keep soaring. But the Fed's critics have to understand that economic growth, employment creation and a sound investment environment are a result of an entire policy mix - monetary, fiscal and structural (or regulatory) policies – that is supposed to guide an open economy toward an optimal utilization of its (physical) capital and labor resources.

Having missed the September deadline for the Fed's interest rate increase, the wise-guys are now taking what they call "a December liftoff" as an obvious certainty. Investors, as opposed to traders, should pay no attention to that. People confidently predicting a September rate hike have shown that they can't even read an open book that is called the Fed. The Fed will exercise its mandate as a function of events whose outcome is unknowable ex-ante. The Fed is watching these events like the rest of us. When the data begin signaling the desirability of a policy change, the Fed will adjust its instruments in a manner that will carefully prepare its next move.

So far, the Fed sees nothing that would warrant that kind of action.

Curve Ball - Central bank heads of the U.S and Canada were at the podium last week

Last week the central bank heads of the U.S. and Canada were at the podium – Federal Reserve Chair Janet Yellen spoke at the semi-annual testimony to the Senate banking committee in Washington while Bank of Canada Governor Stephen Poloz delivered a speech in London, Ontario about "reinventing central banking". Unlike Yellen’s testimony, Poloz threw us a curve ball. The market was leaning heavily for another interest rate cut by the Bank of Canada at its March 4th policy meeting (didn't happen). However, those hopes were dashed when Poloz said "the downside risk insurance from the interest rate cut (in January) buys us some time to see how the economy actually responds." The CAD soared as the odds of a 25 basis point cut next week were cut from 72% to 38%. Poloz had been expected to sound a "dovish" tone but his curve ball put the central bank in wait-and-see mode.

　

Meanwhile, Yellen’s testimony was interpreted as dovish by the market even though we thought that she clarified the path to the Fed’s first interest rate hike since the 2008 credit crisis. Since the January FOMC meeting the market had come to understand that once the FOMC dropped or diluted the word "patience" from its policy statement that it could expect the Fed to raise rates after two meetings. In her testimony, Yellen further clarified this notion by saying that a rate hike could occur at any meeting after the forward guidance changed. We personally see this as a bullish development, but the market has read it as a dovish development. Most media outlets conveyed that this meant that once the word "patience" was removed that the Fed would become data dependent – duh! When hasn’t the Fed been data dependent? There is nothing new here; it will come down to a change in forward guidance and the next opportunity for the Fed to do that will be on March 18th. Thus, once patience is dropped, the count down for a rate hike will begin.

 

 

The USD has already gained considerable ground against a broad cross-section of other currencies, propelled by relatively strong U.S. growth and the divergent direction of monetary policy guidance from the Fed and the policy outlook for many other central banks. Now that the Fed has laid down the framework for a rate hike all data will be scrutinized as to whether it is positive or negative for a rate hike. Therefore, the USD is vulnerable to poor economic data and will move higher on good economic data. We had our first test last Thursday with the January CPI reading. Media headlines proclaimed that deflation had come to America with consumer prices falling by 0.1%. The decline in prices was almost all due to falling gas prices.

So this begs the question – can the Fed raise interest rates in the face of falling prices? We believe Yellen has already answered this question and took the opportunity to reiterate her position on this in her testimony by stating that the inflation impact from falling energy prices was temporary. We suspect that the plot will have a few more twists and turns with a busy data week ahead with US ISM manufacturing PMI and the non-farm payroll data.

Allusion of Ever-Present Peril

Flippity-Flop

The highlight of last week was the release of the Fed minutes from the FOMC meeting on January 28th 2015

The FOMC statement from that meeting left a hawkish impression on the market, however, the minutes showed that Fed members were much more cautious, with many members saying they were inclined to stay at zero for longer. Members expressed concern that raising interest rates too soon could pour cold water on the U.S. economic recovery, and fretted over the impact of dropping "patient" from the central bank's rate guidance. Members also grappled with the weakness in international markets as well as worrying about falling inflation expectations in the U.S.

The flippity-flop in terms of the perception of the Fed’s first interest rate increase has had a hand in sidelining the USD as of late. The market will now look towards Fed Chair Janet Yellen’s testimony before Congress next week for insight into what the Fed is thinking. If Yellen comes across as hawkish then the market will expect a rate hike at the June meeting. However, if Yellen takes pains to explain the risks from a prolonged decline in inflation and the uncertainty in the international outlook then the uncertainty in the Fed’s first interest rate hike will continue to dog the USD.

Sword of Damocles

 

Finance ministers from the 19 countries comprising the Euro group has granted Greece a critical 4-month extension to its massive debt bailout so that officials can work out a longer term deal thereby prolonging the state of looming disaster for the shaky economic union. After trading many jabs and insults, it is safe to say that the easy parts of the negotiations are over. The deal won’t go into effect until the various national legislatures around Europe have approved it.

In some countries, particularly the Netherlands and Europe, this will be a tough sell. Understandably, some countries are frustrated at seeing their euros flow into a country whose economy never seems to improve.

The deal will mean that Greece will temporarily avoid going bankrupt as their financial lifeline is extended for 4 months. It should also mean that capital controls will not be needed and that Greek banks will have enough money to stock up their ATM’s. However, to get the money, the Greek government has one more hurdle to clear, which is to present a series of unspecified economic reforms measures that are deemed acceptable by creditors and rooted in Greece's previously enacted bailout agreement – something the government had promised not to do. Greece’s Prime Minister, Alexis Tsipras, now has to sell the Brussels deal and an eventual long-term agreement with the Eurozone not only to voters, but to Syriza's left wing and his junior coalition partner, the right-wing Independent Greeks.

These economic reforms should have been presented at the time of this writing. Notably, the Greek government will be the author of the reforms pursued, which has a rallying cry for the Syriza Party during Greek election campaigning. This represents a change from the past 5 years when Greece has relied on rescue money to avoid going bankrupt and was effectively ordered to enact a series of austerity measures by Berlin and Brussels.

USDCAD extends above 1.2600 as U.S. Fed maintains status quo

VBCE Daily Foreign Exchange Update for Thursday, Jan. 29th, 2015

USDCAD spot rate: 1.2605 - 1.2610 (AS AT 8:11AM PST)

RANGES:	Asia:	1.2512	to	1.2541
	Europe:	1.2514	to	1.2562
	North America:	1.2529	to	1.2613

Technical Support / Resistance:

S2	S1	R1	R2
1.2380	1.2503	1.2713	1.3063

Key Economic Data Releases:

-U.S. Fed interest rate decision: http://www.federalreserve.gov/newsevents/press/monetary/20150128a.htm
-U.S. initial jobless claims: 265k (exp. 300k)

-U.S. pending home sales: -3.7% (exp. 0.5%) y/y: 6.1% prev. 4.1%)

Key Event Calendar:

DATE	CANADA	U.S.A.
Jan. 30	GDP	GDP, consumer sentiment index

Yesterday, USDCAD traded from 1.2390 up to 1.2537, effectively erasing Tuesday’s move from 1.2502 down to 1.2380. The pairing was holding near 1.2455 when the 11:00am U.S. Fed announcement was made. A brief dip to 1.2430 was short-lived and followed by a move up to 1.2537. The Fed announcement was not as dovish as the market had anticipated given recent central bank activity in Japan, Europe, and Canada. Equity markets plunged as the Fed continues with its upbeat assessment of the U.S. economy and wait-and-see attitude towards interest rate “lift off”. Overnight, USDCAD eased marginally to 1.2512 before climbing to 1.2562. A pull-back this morning to 1.2529 has been followed by a surge to 1.2640 as oil falls below $44. Tomorrow, Canadian GDP is expected to be unchanged after a 0.3% rise previously. U.S. 4TH quarter GDP is expected to be 3.3% on an annualized basis, down from 5.0%. Currently, the TSX and the DJIA are down 0.84% and 0.26% respectively. EURCAD is up 1% trading between 1.4113 and 1.4282. GBPCAD is up 0.15% trading between 1.8933 and 1.9013. JPYCAD is unchanged trading between 0.01061 and 0.01067. Gold is down 1.40% trading between $1,263 and $1,286USD/oz, silver is down 4% trading between $17.11 and $18.03USD/oz, while oil is down 1%, trading between $43.71 and $44.94.

Sources: Reuters, Bloomberg, FXStreet, RBC Capital Markets, Bank of Canada, U.S. Federal Reserve, CNBC, Forexlive