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.

Enough already - Get on with it!

The stabilization of Chinese markets during this last week has helped to lower volatility and ease safe haven flows into the USD and Japanese yen. The AUD was the best performing currency last week powered higher by better than expected employment data. The month of August saw 17K new jobs created, the unemployment rate easing to 6.2% from 6.3%, and with July job growth revised up. The Aussie also received some help from higher copper and iron ore prices. Surprisingly, the NZD was able to eke out a gain of 0.58% on the week despite a cut in interest rates of a quarter point to 2.75% by the central bank. The yen was the worst performer thanks to China’s stabilization, poor data, and political jawboning. Japan’s machine tool orders fell 3.6% on the month and producer prices fell by 3.6%. Prime Minister Abe’s economic advisor, Kozo Yamamoto, created a firestorm when he said that the Bank of Japan should expand its monetary easing program by at least 10 trillion yen at its October 30th policy meeting. Yamamoto said reaching the bank’s 2% inflation target in the first half of the fiscal year beginning April 2016 is an "absolute imperative".

All eyes will be on the Federal Reserve this week as they decide whether to increase interest rates for the first time in 9 years at its September 17th policy meeting. Last week, Fed Chair Yellen’s favorite jobs indicator, the US JOLTS data, showed a large jump in total job opening though hires lagged behind (for sixth month). However, the state of the U.S. economy hasn’t been the focal point for a rate hike since early August. The Fed was edging closer towards a hike at their September meeting before China devalued their currency, which caused equity markets around the world to destabilize spurring wild volatility and tightening of financial market conditions.

Well, we’re finally here. The stage has been set. The issues for and against a rate hike have been debated ad nauseam. The uncertainty of all of this has become unbearable – enough already and get on with it! Whatever the decision is, it will most certainly cause volatility to ramp up. A hike will deepen the fear of a global deflationary spiral caused by a stronger USD and/or a Chinese hard landing. Standing pat will keep the threat of such a hike ongoing into each subsequent meeting in October and December.

The U.S. dollar index has limped into the end of the week. Its technical condition is tenuous at best with the momentum indicators all pointing lower while it sits just about its 200-day moving average. It looks set to continue its sell off until the FOMC decision.

You’ve probably asked yourself what’s the big deal about a quarter point hike in interest rates when the fed funds rate is near between 0 and 25 bps. Well, if the Fed hikes by 25 bps then interest rates have effectively gone up by 100%. This alone has the ability to cause ripple effects across the derivative world of interest rate contracts which in turn has the ability to cause interbank credit risk. This is why the TED (TED spread definition) spread has been moving higher since China's devaluation. According to Head of Global Investment Research for Alhambra Investment Partners, Jeffrey Snider, the TED spread is now where it was in the weeks just following the flash crash of May 2010 and equal to October 2011, after the SNB pegged the CHF to the euro and the Fed reproduced dollar swaps globally.

The Greatest Show on Earth

Wow, what a volatile week in the markets! Black Monday 2015 kicked off violent moves in stocks and currencies. Stock markets managed to recover all of its losses and even finished the week higher in some cases. Unfortunately, that can’t be said about the currency markets as the yen and the USD outperformed the rest of the field as panic caused wild swings in currencies. The Americans pointed the figure at the Chinese for the cause of the sell off – the Chinese government failed attempt to support their equity markets followed by an unexpected devaluation of their currency. The Chinese retort was that stocks have moved sideways since the US Fed stopped QE in November and that the speculation around the Fed’s next move finally hit caused a panic. Who’s right? We happen to think that both sides are correct. Volatility always occurs at the end of a trend and the beginning of a new one. Market participants are nervous because of the two powerful and opposing threats to growth and stability – the risk of a deflationary slump if China buckles and the emerging market crisis turns systemic; versus the risk that central banks could fall behind the curve and leave too much stimulus in their own economies.

We think that most of you are by now familiar with the market turbulence caused by the threat of an interest rate hike by the U.S. Federal Reserve. The prospect of the Fed’s first rate hike since 2006 has fuelled growing fear of renewed volatility in emerging economies’ currency, bond, and stock markets. The concern is that rising interest rates will lead to a rising USD which will wreak havoc among emerging markets’ governments, financial institutions, corporations, and even households because they all have borrowed trillions of USDs and rising interest rates and a rising USD will cause debt servicing costs to rise.

Now imagine the pressure on currencies of oil producing countries. Most of these countries peg their local currency to the USD and plummeting oil prices are straining government budgets. Earlier this month, Kazakhstan decided to give up its peg and switched to a free float. This move caused Kazakhstan’s tenge to plunge a record 23% in one day, but it freed it from burning through its reserves in order to prop up its currency. Kazakhstan’s Prime Minister Karim Massimov told Bloomberg that in the new era of low oil prices “most of the oil-producing countries will go into the free-floating regime, including Saudi Arabia and the United Arab Emirates.” Indeed, expectations have grown after Fitch cut Saudi Arabia’s outlook to negative from stable last Friday. Fitch noted that the twin fiscal shocks of lower oil prices and increased spending under new Saudi King Salman bin Abdulaziz al-Saud will cause the budget deficit to widen to 14.4% of GDP this year. The budget is sure to rise on news that Saudi Arabia invaded Yemen on Friday.

With government budgets of emerging markets and oil producers under stress, these countries have had to rely on the selling of their reserves mainly by way of selling US Treasury’s. Speaking of selling Treasury’s, according to Societé Generale SA, the central bank of China has likely sold somewhere on the order of $100 billion in US Treasury’s in the past two weeks alone in open FX operations in order to slow down the fall of the yuan after it devalued its currency earlier in the month.

On the surface, this seems harmless. But in reality, it is a major headache for the USD and the U.S. with multiple ramifications. First, if these countries are selling US Treasury’s then they are not buying. This begs the question of who will step in to fund U.S. deficits? Second, the selling alone could cause yields to increase. If yields break above the trend line on the chart of 10-Year US Treasury yield it would signal that major central bank selling is overwhelming the buyers. This would cause the Fed to ease. Ironic isn’t it? A Fed rate hike would increase the stress on emerging market and oil producing countries, which in turn would cause them to tap their reserves by selling US Treasury’s, causing bond yields to rise and triggering a monetary policy reversal by the Fed, possibly in the form of QE4.

We Are Asking Too Much of the Federal Reserve

A well written article is making the rounds in the blogosphere of financial and political pages alike by Robert Kuttner who is co-founder and co-editor of ‘The American Prospect'. It’s worth a read and re-printed below.

There has been obsessive chatter about whether the Federal Reserve will, or should, raise interest rates this fall. At the Fed's annual end-of-summer gabfest at Jackson Hole, Wyoming, the issue was topic A. Advocates of a rate hike make the following claims:
Very low rates were necessary when the economy was deep in recession. Now, with growth up and unemployment down, the near-zero rates are creating speculative bubbles. They are not really stimulating the economy much, as corporations put cash into stock buybacks and bankers park spare money at the Fed itself. So, let's get on with a more normal borrowing rate.

Opponents of a rate hike counter that the economy is a lot weaker than it looks. Wages are going nowhere. A lot of the jobs that have pushed down the nominal employment rate are lousy jobs. China's economy has just hit a big wall, which will slow down global growth.

Raising rates will increase consumer and business costs across the economy – everything from home mortgages to credit cards to construction loans. There will come a time to raise rates, but we are not there yet. If anything, the Fed should find new ways to get money out into the real economy.

The Fed is famous for raising rates prematurely, seeing ghosts of inflation. But there is no inflation on the horizon -- the bigger worry is deflation. In fact, the inflation rate is well below the Fed's own target of two percent. And the Fed is the only game in town. On balance, I think the opponents of a rate hike have the better argument. But consider for a moment that last assumption -- that the Fed is the only game in town.

The larger issue, which is getting submerged in the great debate about raising rates, is that the Fed should not be the only game in town.

Normally, in a soft economy, the government would be using fiscal as well as monetary policy. But because of the obsession with deficit reduction -- unfortunately shared by the Obama Administration (remember the Bowles-Simpson Commission?) – fiscal stimulus today is off the table; worse, deficit-reduction is contractionary. In plain English, prolonged deficit-cutting slows down growth.