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).

Don't say we didn't warn you...

Over Promised and Under -Delivered

Sometimes our crystal ball is a little less murky. In last week's blog post, we essentially laid it all out for you. We stated: "One has to wonder if this week's ECB meeting will be the catalyst for the change in trend. With the market currently priced for perfection, i.e. an ECB move, there is scope for disappointment. "That is exactly what transpired - in the lead up to the ECB policy meeting ECB President, Mario Draghi, went out of his way to express his sense of urgency to do something big. Trial balloons were even launched about a two-tier deposit rate scheme, but it was not to be. Draghi simply overpromised and under-delivered, causing a massive short squeeze in the Euro. Was this his intention? Probably not. According to a Reuters article, Draghi's public stance of urgency ahead of the meeting was his way of trying to pressure the more conservative members of Governing Council to take bigger action. In the end, he was rebuffed. Hence, you see the under-delivery.

 In last weeks blog we stated: "our Spidey senses tingle when everything seems to be a foregone conclusion... with the majority of the market leaning the same way, it is entirely possible for a correction to ensue resulting from either disappointing ECB action or Fed hike uncertainty due to Friday's U.S. jobs report" And what a correction it induced! The Euro squeezed higher by 4 big figures moving from around the 1.0550 level ahead of the ECB announcement to over the 1.0950 level by the end of the trading day. That was the biggest gain in the Euro in more than six years.

Please don't mistake the market's reaction to the ECB move - the move was a reaction due to market positioning  not to the ECB move itself. The bottom line is that the ECB did make a move to ease monetary policy once more. Specifically, they made four moves. First, they cut the deposit rate by 10 basis points from -.0.20 to -0.30. Second, they extended by six months the end date of the current QE program from September 2016 to March 2017. Next, they broadened the range of securities that can be bought to include regional bonds. Finally, they stated that they intended to reinvest maturing bonds similar to the Bank of England and the Fed. Needless to say, policy divergence between the ECB and the rest of the central banks is alive and well.

The market was so convinced of an ECB move that the Swiss franc ended up the big loser in pre-ECB trading. CHF was sold aggressively in anticipation of matching move by the Swiss National Bank (SNB), whose next meeting is scheduled for December 10. Since the ECB didn't go full throttle, the pressure is off the SNB at this week's policy meeting. This has allowed the CHF to be last week's best performing currency with a gain of 3.37%. Meanwhile, the yen squeaked by the USD to finish in last place last week as the ECB disappointment led to a correction as market players shed the safety of the USD and yen. With the holiday season upon us and a light calendar for the U.S. in the week ahead, we suspect the correction will endure at least until the Fed meeting on December 16th.

IMF Adds China’s Yuan to World’s Top Currencies

In our blog post from November 16, we discussed the possibility of the IMF including the Chinese Yuan into the IMF's Special Drawing Rights (SDR) basket of currencies, which includes the USD, GBP, EUR and JOY. On November 30th, the IMF made their decision and the CNY is officially in.

Mover over euro! The CNY is mainly replacing part of the euro's role in the SDR. This is an important milestone in the integration of the Chinese economy into the global financial system. With this, China becomes more exposed to the risks associated with capital flows - particularly those flows associated with money leaving the country, but the following benefits will remain:

1. Increase in trade settlement in Chinese Yuan
2. Global Central Bank will increase their exposure in Yuan.
3. Reconfirm the importance of Chinese economy in context to world trade.
4. Strengthening the political prowess of China on world stage.

   




 




 

 

 





 


  

The next best performer... RBNZ and the Haka interest rate cut!

The best performing currency last week was the euro – why? Didn’t you hear everything is resolved?! Sorry, we couldn’t resist, but the situation is actually far from it. The only reason the euro went up is because the Greek government managed to pass the legislation that the Eurozone demanded before any negotiations of a third bailout package. As a reward for doing what was dictated, Greece received a €7bn bridge loan. Unfortunately, the Greek government received very little of the loan as it was quickly directed towards repaying debts to the ECB and IMF.

The next best performer was the NZD. The Reserve Bank of New Zealand cut interest rates by 25bp last week for the second time in a row due to softening economic outlook and inflation. The RBNZ said that further easing seems likely and a further drop in the currency is necessary, which would normally be a negative for the currency. However, the NZD rallied hard because the RBNZ dropped the reference to the NZD being "over-valued" or "unjustifiably high" in its announcement. Meanwhile, the AUD was the worst performer last week as it fell to fresh multi-year lows due to the sharp slowdown in Chinese manufacturing activity. As for last week’s dual winners the USD and GBP, they took a break after their spectacular gains in the month of July to quietly correct and work off their overextended gains.

The peso has been trading in a negative territory since mid-July due to the rout in commodities. The domestic economy is growing at a slow pace however the jobless rate fell to 4.41% in June. Thus, there is another factor at play here. The peso happens to be one of the most liquid currencies in the sphere of emerging markets. Thus, if investors fear problems in EM they will sell the peso regardless of their view of the Mexican economy itself. That is what is currently happening as investors fear monetary tightening by the US Federal Reserve. The worry is that a rise in interest rates in the U.S. will cause the debt servicing to rise on the roughly $4.5 trillion dollars in EM loans. Complicating the matter is that most of the EM countries rely on commodity exports and/or Chinese growth, thus they are getting hit by a double whammy – decreasing export revenues and increasing debt servicing costs.

Having said this, according to Citi there is another factor at play in the peso’s weakness. Citi’s research shows that the foreign exchange flows handled by the bank on behalf of its clients flow into real money accounts, leveraged accounts, corporates, and banks. Its latest date shows that USDMXN transactions flows into the first three categories has been neutral over the year, but flows by banks has been strongly negative. So what does this mean? It means that the Mexican people themselves are responsible as they are converting their pesos into USD and depositing them in USD accounts at their banks. Hmmm, they must know something that the rest of us don’t.

The key events for this upcoming week are the FOMC rate decision and Q2 GDP report. While we are not looking for the Fed to raise interest rates in July, most economists expect the first interest rate hike in 8 years at the September FOMC meeting. Also, remember that Chair Yellen indicated at her semi-annual testimony on Capitol Hill that her preference was to start raising rates earlier so that monetary policy can be tightened at a more gradual pace going forward. All we can say about this is we wonder if she will be able to pull the trigger if China keeps slowing, world trade volume drops for a 7th month in a row, and oil fall below the March low of $42.

The US Fed Decision and Commodity Currencies

The currencies of commodity-exporting nations including Australia, New Zealand, Canada, Brazil and Indonesia are near the lowest in at least 4 years as the market braces for a Federal Reserve statement tomorrow that may indicate it is ready to raise interest rates – it’s not likely that the Fed will make actually make a move this week, but economists and analysts aren’t expecting anything more than indications that September is when we’ll see the first hike in rates in several years.

The market is hotly awaiting the post-meeting comments for hints of a rate increase and should that happen, then expect another surge in the USD and further downward pressure on currencies of the aforementioned nations. These nations are hoping that Fed Chairperson Janet Yellen will portray a cautious tone in her statement, which would pause a sell-off in AUD, NZD, CAD, BRL and IDR.
“Commodities are very much in the forefront of markets’ minds and commodity-linked currencies are definitely under pressure,” said Sam Tuck, a senior currency strategist at ANZ Bank New Zealand Ltd. in Auckland. “The majority in the market believes Yellen will remove patient” from the Fed’s pledge on interest-rate policy, he said.

New Zealand’s currency weakened last week after the whole milk price index fell almost 10% in a GlobalDairyTrade auction. The Aussie has been falling amid a decline in prices for iron ore and prospects for a further interest rate cut, with the Reserve Bank of Australia’s March 3 meeting minutes released yesterday reiterating an easing bias. And energy makes up the bulk of Canadian, Brazilian and Indonesian exports. Therefore, a sharp decline in energy, gold, dairy and metals combined with a mix of a strong dollar and a weakening Chinese economy plus looser monetary policy (except for Brazil where rates are still high) – what you get is a flood of commodity bears in full-force to claw down the value of commodity currencies.

Market strategist for IG feels that tomorrow's meeting has the possibility to be a boon for the disintegrating commodity sector. In a note from this past Monday morning, IG said that, "The Fed policy statement release may actually halt the USD bulls." The note further states that "Expectations are low for any major divergence from current language or action. The FOMC may even be a little more cautious about the current market and economic conditions. This would see a quick unwind in oversold markets: Oil and industrial metals would likely rise and a likely drop in the USD would transpire."

The Dust Has Settled

 

 

Canadian employment surged last month, as the economy added the most jobs in over seven months. The best part of this news is that employment came everywhere, which is exactly what policymakers like to see. Canada recorded a net gain of almost 59K jobs while analysts had been expecting a net gain of a 10K with the full- and part-time almost evenly split (31K and 28K respectively). The unemployment rate stayed the same at 6.8%. After experiencing dramatic declines last year due to plummeting commodity prices, employment in Canada finally looks to be trending higher. More good news is that manufacturing jobs outside the commodity sector buoyed the employment report.

 

According to Bloomberg, "Canada added six times as many jobs in May as economists predicted on the biggest manufacturing gain in four years -- the kind of progress the central bank says is needed to foster a

recovery from the shock of lower oil prices. The strength counters other recent setbacks – shrinking Q1 output, record trade deficits, slow inflation – and supports Bank of Canada Governor Stephen Poloz's view that momentum is shifting to non-energy companies as the oil industry cuts investment and jobs."

 

It’s important to note that some of gains in May were driven by self-employment, but paid employment was still up by a healthy positive 37K. CAD bulls would suggest that last week’s jobs figures is a sign that the Canadian economy is shrugging off any set-back from its first quarter. On the flipside, aside from the rate divergence argument, USD bulls will also lean on how erratic Canadian jobs report can be. If you’re someone who manages your company’s USDCAD exposure, it’s important to remember that ‘one’ headline print is not a trend, so do not look at one report in isolation.

 

In addition, while the labor market added jobs, consumer spending also rose. The Wall Street Journal reports that the retail sales figure came in at an annual pace of 3.1%, above the previous month's reading of 2.5%. After falling alongside the weakening labor market, consumer spending has recently begun to rise. Auto sales contributed the most to the consumer spending measure. The WSJ states, "The largest gain in dollar terms was a 1.5% increase, to C$10.24 billion, in auto-related goods, led by a 1.8% sales gain at new-car dealers. Excluding the auto component, Canadian retail sales rose 0.5% to C$32.22 billion."

However, despite that fact that the labor market and household spending are improving, productivity of the labor force is falling. In Q1, the productivity figure came in at a quarterly contraction of -0.1%, which is down from Q4 2014 revised reading of 0.3%, while also missing estimates for 0.2%. In recent months, the productivity measure has leveled off, seen below. As productivity declines, economic growth will continue to have trouble rebounding higher.

Canada's economy remains weak, but is steadily improving. Jobs are being added to non-energy related sectors which is aiding consumer spending measures. Increased jobs, however, are not translating to economic activity as much as it could, due to lower labor force productivity. Ultimately, the Canadian economy is improving, which should technically lead the loonie to higher ground in coming months.

 

 

From the Canada Mortgage and Housing Corporation, the trend measure of housing starts in Canada was 181,231 units in May compared to 179,524 in April, according to Canada Mortgage and Housing Corporation (CMHC). The trend is a six-month moving average of the monthly seasonally adjusted annual rates (SAAR) of housing starts. "The small increase in the trend was primarily driven by higher multiple starts in Ontario, the Atlantic region, and Québec. Despite month-to-month variation in multiple starts, CMHC expects builders will continue to focus on managing inventory of completed but unsold units — inventory that is still above historical average," said Bob Dugan, CMHC’s Chief Economist. "CMHC also forecasts slight moderation in housing starts in 2015 and 2016, reflecting a slowdown in housing market activity in oil-producing provinces that will partly be offset by increased activity in provinces that are seeing the positive impacts of low oil prices."

 

From a report for April, Statistics Canada demonstrates that contractors took out $7.8 billion worth of building permits in April, up 11.6% from the previous month and a second consecutive monthly advance. The gain in April stemmed from higher construction intentions in both the residential and non-residential sectors in Ontario.

In the non-residential sector, the value of permits rose 30.2% to $3.3 billion in April, following a 24.8% gain in March. Increases were posted in three provinces, led by Ontario, followed by Alberta and Newfoundland and Labrador. British Columbia and Quebec registered the largest declines in construction intentions for non-residential buildings. Construction intentions for residential buildings increased 1.2% to $4.5 billion, a third consecutive monthly advance. Gains were noted in Ontario, Quebec, Nova Scotia and Newfoundland and Labrador. The largest decrease occurred in British Columbia, which had posted a notable increase the previous month.

USD in Focus

 

　

Last week we mused that because the Swiss franc was able to nudge out the USD as the best weekly performer that it foreshadowed a brief pause in the USD rally. And that’s exactly what transpired; the USD corrected its strong two week rally with a four day losing streak until Friday’s strong U.S. jobs data arrested its decline. The outliers for the week were the euro, NZD, and the yen. The euro was the top performer last week as the long German bund and short euro hedge position reared its ugly head again (the last time it happened was late April and early May). The NZD sold off to a low dating back to August 2010 as the market is pricing in a 50% chance of an interest rate cut by the Reserve Bank of New Zealand on June 10. Meanwhile, the yen also reached a multi-year low dating back to November 2002 as the strong May U.S. nonfarm employment report caused the December Fed funds contract to fully price in one rate hike by the Fed this year.

 

Euro in Focus
 

The price action in the Euro was very volatile last week. It moved from a low of 1.0880 on Monday to a high of 1.1380 on Thursday, that’s a 5 euro move and it was all powered by the unwinding of the long German bund and short euro hedge trade. International holders of German bunds decided to sell their bonds and to buy back their euro hedges, which basically caused that massive short squeeze in which the euro rallied by five big figures.

More important is why the bonds are being sold. Two reasons, the first is that back to back Eurozone inflation of 0.0% for April and 0.3% for May demonstrate that deflationary pressures are easing, which in turn are causing investors to question whether the ECB will continue its newly minted QE program. The second reason is fear that the Greek crisis could unravel. Greece is refusing to maintain the status quo of pretend and extend – that is to say that they are not looking to have creditors loan them more bailout funds in order for them to service debt. The Greeks want debt relief. The trigger point last week was that Greece delayed a key debt payment to the International Monetary Fund due on Friday offering instead to bundle four payments due in June into a single 1.6 billion euro (£1.16 billion) lump sum which is now due on June 30. This might be a sign that Greece may be choosing to preserve what's left of its war chest if talks don't improve and default.

JPY in Focus

 

The other move that caught our eye last week was that of the JPYUSD to a multi-year low at the 125 level. The decline in the yen suggests that traders are once again speculating that the Japanese currency will continue lower and, indeed, the recent CFTC Commitment of Traders data shows a dramatic increase in bearish bets on the JPY (bullish JPYUSD positions). In the past two weeks, net yen shorts have risen to 86K from 22K. This week’s revision to Japan’s initial Q1 GDP estimate will be the key market moving event. Revisions have been consistently higher than the original estimate so if it also happens on this one it could pour cold water on those looking for more QE which could induce a period of short covering.