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).

Position Adjustment - Euro was the top performer last week, US keeps interest rates at its current level and this Friday's April US non-farm jobs report will be in focus

What a week! The euro was the top performer on the week with a gain of over 3% and at one point moved a whole four euros against the USD. Technically, the euro rally may have run its course giving up almost a full euro on Friday and after having met the 61.8% Fibonacci retracement and coming within a whisker of its 100-day moving average. The price action in the euro last week caused clients, with euro exposure to their business, to call us with questions about what was happening. The simplest explanation is positioning. The euro has been the most heavily shorted currency in the futures market for some time now, so when everyone in the boat is leaning one way and a big wave hits the boat the result is that the wave redistributes the weight (position adjustment). Thus, the big move in the euro was due to a short squeeze as speculators bought the euro in order to exit their short trade and not due to a fundamental change in the prospects in the Eurozone.

 

The catalyst for the move was a combination of a poor reading for Q1 GDP and the FOMC announcement. The US Federal Reserve, as expected, kept interest rates at its current level, but offered little hints on the timing of its first rate hike in nearly a decade. What the Fed did do was to remove all calendar references on a potential window for raising its benchmark Fed Funds Rate making very clear that rate decision will be a data driven. Furthermore, the Fed said it will take into account labor market conditions, inflationary pressures, and expectations of international financial developments when it decides on the timing of a rate increase.

 

 

The latest reading of Q1 US GDP came in at 0.2% which essentially demonstrates that the economy stagnated in Q1, or to sugar coat it, the economy grew very, very, very slowly. This was a huge deceleration from the Q4 2014 when real GDP gained 2.2%. Economists on average were anticipating growth of 1% in Q1. How bad was it? Well, if it wasn’t for the biggest inventory build in history, which grew by $121.9 billion and merely remained flat, US Q1 GDP would not be 0.2%, but would be -2.6%.

 

Just like a year ago, many economists and investors are pointing to snowy winter weather as the root of the weakness. Other factors holding back growth this time around may have included the strong USD, pressure on the energy sector from lower oil prices, and dock worker strikes on the West Coast that disrupted that flow of trade. All of these excuses are what the Fed calls "transitory factors". Therefore, as long as inflation keeps moving to the Fed’s target and that the economy sees further improvement in the labor market then the Fed will be looking for an opportunity to raise interest rates. Having said this, this Friday’s April non-farm jobs report will be in focus. A strong report will keep a June rate hike as a possibility. A weak report would not only rule out a June rate hike, but would put into question a move in September as well.

 

 

The technical condition of the US dollar index is on much firmer ground after last week’s price action. The index has found support near the 50% Fibonacci retracement, the 100-day moving average, and the shelf of support which was carved out from mid-January to the end of February.

 

Furthermore, the RSI has turned up, the MACD looks to be making a bottom, and the full stochastics have crossed and turned up. The technical foot print makes us wonder if the chart is forecasting a good jobs number and thus a turn in the economic data, which dovetails nicely with the Fed’s transitory factors and the beginning of warmer weather.

 

 

 

Up, Up and Away - USD was the top performer last week

 

 

 

The USD was the top performer last week thanks to Friday’s U.S. non-farm payroll and developments elsewhere. The global monetary easing parade continued last week with surprise interest rate cuts from the central banks of China, India and Poland. Not to be left out, the European Central Bank announced that it will begin buying bonds (QE) on March 9th. This reinforces the dominant factor behind USD strength, which is the divergent direction of monetary policy guidance from the Fed and the policy outlook for many other central banks.

 

However, the USD powered higher against a broad cross-section of other currencies after Friday’s non-farm payrolls report as market participants are convinced more than ever that the U.S. Federal Reserve will raise interest rates in June. The 1.5% fall in the Dow tells us that equity investors are also convinced that the Fed is going to hike rates and are expecting the Fed to drop the word "patience" from its forward guidance at the next FOMC meeting on March 18th.

But before we all take for granted that the Fed is going to hike rates in June let’s pretend that we are Fed economists. Any economist worth her pay will tell you the following: based on the relative strength of the U.S. economy the Fed is in a position to raise interest rates, but on the other hand. Oh yes, the famous other hand. To be fair that hand has been weighed down by multiple economic data points that have missed expectation since the beginning of February...

 

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.

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