Eyes on Yellen (and global macro)

As we are getting close to the FOMC statement release, we were reading some articles over the past couple of days to understand the recent spike in volatility. Whether it is coming from a ‘Brexit’ fear scenario, widening spreads between core and peripheral countries in the Eurozone (German 10Y Bund now trading negative at -0.5bps), disappointing news coming from US policymakers this evening or more probably from something that we don’t know, we came across some interesting data.

First of all, we would like to introduce an indicator that is getting more and more popular these days: Goldman’s Current Activity Indicator (CAI). This indicator gives a more accurate reflection of the nation’s GDP and can be used in near real-time due to its intra-month updates. It incorporates 56 indicators, and showed a 1-percent drop in May to 1.2% due to poor figures in the labor market and ISM manufacturing data (see chart below).

Chart 1. Goldman CAI (Source: Bloomberg)

The implied probability of a rate hike tonight is less than 2% according to the CME Group FedWatch, and stands only at 22.5% for the July meeting. If we have a look at the Fed Dot Plot’s function in Bloomberg, we can see that the implied FF rates curve has decreased (purple line) compare to where it was after the last FOMC meeting (red line), meaning that the market is very reluctant to a rate hike in the US.

Chart 2. US Feds Dot Plot vs. Implied FF rates (Source: Bloomberg)

June hike, why not?

Many people have tried to convince me of a ‘no June hike’ scenario, however we try to understand why it isn’t a good moment for Yellen to tighten. Oil (WTI CL1) recovered sharply from its mid-February lows ($26/bbl) and now trades slightly below $48 (decreasing the default rate of the US high-yield companies), the US Dollar has been very quiet over the past 18 months (therefore not hurting the US companies’ earnings), the SP500 index is still trading above 2000, the unemployment rate stands at 4.7% (at Full employment) and the Core CPI index came in at 2.1% YoY in April.

However, it seems that US policymakers may have some other issues in mind: is it Eurozone and its collapsing banking sector, Brexit fear (i.e. no action until the referendum is released), CNY series of devaluation or Japanese sluggish market (i.e. JPY strength)?

The negative yield storm

According to a Fitch analysis, the amount of global sovereign debt trading with negative yields surpassed 10tr USD in May, with now the German 10Y Bund trading at -0.5%bps. According to DB research (see chart below), the German 10Y yield is the ‘simple indicator of a broken financial system’ and joins the pessimism in the banks’ strategy department. It seems that there has never been so much pessimism concerning the market’s outlook (12 months) coming from the sell-side research; do the sell-side firms now agree with the smart money managers (Carl Icahn, Stan Druckenmiller, Geroge Soros..)?

Chart 3. German 10Y Bund yield (Source: DB)

10Y bund DB.jpg

ECB Bazooka

In addition, thanks to the ECB’s QE (and CSPP program), there are 16% of Europe’s IG Corporate Bonds’ yield trading in negative territory, which represents roughly 440bn Euros out of the outstanding 2.8tr Euros according to Tradeweb data. If this situation remains, sovereign bonds will trade even more negative in the coming months, bringing more investors in the US where the 10Y stands at 1.61% and the 30Y at 2.40%. If we look at the yield curve, we can see that the curve flattened over the past year can investors could expect potentially LT US rates to decrease to lower levels if the extreme MP divergence continues, which can increase the value of Gold to 1,300 USD per ounce.

Chart 4. US Yield Curve (Flattened over the past year)

USIYC.png

(Source: Bloomberg)

Poor European equities (and Banks)

However, it seems that the situation is still very poor for European equities, Eurostoxx 50 is down almost 10% since the beginning of June, led by the big banks trading at record lows (Deutsche Bank at €13.3 a share, Credit Suisse at €11.70 a share). The situation is clearly concerning when it comes to banks in Europe, and until we haven’t restructured and/or deleveraged these banks, systemic risk will endure, leaving equities flat (despite 80bn Euros of money printing each month). Maybe Yellen is concerned about the European banks?

Brexit?

Another issue that could explain a status quo tonight could be the rising fear of a Brexit scenario. According to the Brexit poll tracker, leave has gained ground over the closing stages, (with 47% of polls for ‘Brexit’ vs. 44% for ‘Bremain’). This new development sent back the pound to 1.41 against the US Dollar, and we could potentially see further Cable weakness toward 1.40 in the coming days ahead of the results. Many people see a Brexit scenario very probable, raising the financial and contagions risks and the longer-term impact on global growth. It didn’t stop the 10Y UK Gilt yield to crater (now trading at 1.12%, vs. 1.6% in May), however a Brexit surprise could continue to send the 5Y CDS to new highs (see below).

Figure 1.  FT’s Brexit poll tracker (Source: Financial Times)

Brexit.JPG

Chart 5. UK 5Y CDS (Source: Bloomberg)

5YCDSUK.JPG

CNY devaluation: a problem for US policymakers?

Eventually, another problem is the CNY devaluation we saw since the beginning of April. The Chinese Yuan now stands now at its highest level since February 2011 against the greenback (USDCNY trading at around 6.60). we are sure the Fed won’t mention it in its FOMC statement, but this could also be a reason for not tightening tonight.

Conclusion: a rate hike is still possible tonight

To conclude, we are a bit skeptical why the market is so reluctant for a rate hike this evening, and we still think there is a chance of a 25bps hike based on the current market situation. We don’t believe that a the terrible NFP print (38K in May) could change the US policymakers’ decision. Moreover, even though we saw a bit of volatility in the past week (VIX spiked to 22 yesterday), equities are still trading well above 2,000 (SP500 trading at 2,082 at the moment) and the market may not be in the same situation in July or September.

Gold: how far can the current trend go?

Since the beginning of the year, the commodity market has been regaining strength, and especially gold that has been up 23% since its mid-December low (slightly below 1,050 USD/ounce). As you can see it on the chart below, the recent spike in commodities can be explained by the dollar weakness we have seen over the past five months (DXY index in yellow line inverted vs. Gold in candlesticks). However, we are still convinced that Gold could continue to act as the ‘currency of the last resort’ (i.e. an insurance against the confidence on the monetary system) even if the US dollar is set to appreciate in the long term.

(Source: Bloomberg)

As gold is traded primarily in dollars, many studies have showed that a weaker dollar makes gold cheaper and increases the demand for gold, which in the end pushes the price of the commodity higher. Therefore, Gold and US dollar should be negatively correlated. If we use HS spread analysis function in Bloomberg, we can see that the 1-month (20 Business days) correlation between Gold and DXY index (using the US Dollar index as a proxy of the dollar even if it’s mainly weighed in Euros, pounds and Yen) has been negative for most of the time over the past five years. However, this correlation can sometimes break down and turn positive for a small period of time.

GoldHSDXY

(Source: Bloomberg)

The question now that we are asking ourselves is to know the positive correlation between US dollar and Gold can last longer than just a week or two.

The reason why we think Gold is set to appreciate in the long term is coming from a long fat tail risk list that gets very concerning. In it, we could find the following events:

  • Japanese crisis in the bond market
  • Banking crisis in China coming from a rise in NPLs and a housing market collapse
  • Corporate default rates soaring in the US high-yield market
  • European Banking crisis

If one of those ‘black swan’ events rises in terms of probability, we would then see a sort risk-aversion environment with more demand for safe haven assets, such as US Treasuries or US Dollars. At the moment, the 10-year and 30-year Treasury yields both trade at 1.74% and 2.57% respectively, and a sudden risk-off sentiment could push LT US yields close to zero.

Academic studies have shown that there exists a cointegrating relation between gold and US real interest rates. If we stick with the assumption that inflation will remain low (i.e. close to zero) in the medium term (2-year period) based on the market’s expectation and that Treasury yields start to crater ‘once again’, an interest for gold could be a good alternative.

Tactical view on XAUUSD

Based on the chart below, it looks like the 50 SMA (purple line) has been acting as a strong support, however the momentum could continue in the future. The next psychological level stands at 1,300 on the upside, any break out could lead towards 1,325 then 1,350. On the downside, we see a strong support zone between 1,220 and 1,250 and could be a good entry point for a long term investment. The risk is if the US Dollar starts to appreciate to quickly based on this week’s FOMC ‘hawkish’ minutes with the market now starting to price at least a couple of rate hikes for 2016. For those looking for a more ST investment, a good psychological support on the downside to set up your stop stands below 1,200.

TechAnalysisGold

(Source: Bloomberg)

How long with the Risk-ON?

It seems that the low volatility in the FX market in addition to a strong risk sentiment both brought back carry traders’ interests for the past couple of weeks.

If we have a look at the graph below, we can see that the AUDJPY broke it 96.00 resistance to trade at 96.50 on Friday afternoon (up 7% since March 1st at that time), before edging down a bit. At the same time, the equity market (S&P500 – red line) reached a new record high at 1,897.28 and is now trading 40 points lower.

AUDJPY-SP

(Source: Reuters)

Is the risk-on trend going to continue in the coming days?

Firstly, this week started with an agitated session in Asia despite the Shanghai Composite was closed for a market holiday. After it reached a lower March high of 15,164.39 on Friday, the Nikkei index was down 1.7% with USDJPY down 100 pips and finding support slightly above the 103.00 level on Monday UK/US trading sessions.

This morning, the US Dollar remained under pressure against most of the currencies, with the USD index trading back below the 80 level. Although the US March employment report came in line with expectations last Friday (192K vs con. 200K) and February’s job creation was increased 22K to 197K, demand for the greenback is still weak as traders and investors have been guided to look at a ‘wide range’ of variables. As you can see it on the chart, the index managed to find support around 79.75; a level that the market seem to consider as a buying opportunity.

USDX

(Source: Reuters)

Tomorrow, the Fed will release the minutes of the March FOMC meeting (18th-19th) and should give us more details on the ‘qualitative’ guidance.

Euro: The ECB policymakers’ threat of unconventional action didn’t manage to push the Euro to lower levels, and the single currency found support at the high of the support band 1.3640 – 1.3680. EURUSD soared 50 pips this morning and is now trading around 1.3800. It mainly came from a Dollar weakness, which pushed the single currency to the high of the 1.3300 – 1.3800 range as the Dollar index is heavily weighted towards the Euro (57.6%).

Sterling: After underperforming a bit last week, Cable (Purple bar) surged 100 pips this morning boosted from strong Feb Manufacturing (1.0% MoM vs. 0.3% exp.) and Industrial (0.9% MoM vs. 0.3% exp.) production data. The pair is now trading at 1.6750; the next resistance on the topside stands at 1.6770. The 2-year UK-US yield, one indicator that we like to watch quite a bit (orange line), is up 5 bps since Friday’s low of 0.219%.

CAbrr

(Source: Reuters)

Yen: As expected, the BoJ kept their monetary policy unchanged at the conclusion of its 2-day meeting despite a series of missed indicators (PMI, GDP, Industrial production…). According to BoJ policymakers, the Japanese economy can ‘swallow’ a sales tax hike that started on April 1st without adding more stimulus on the table. As a reminder, the BoJ 2014 Monetary Base Target stands at 270tr Yen (which was decided to be kept steady unanimously overnight) and was double after the central bank introduced its Quantitative Qualitative Monetary Easing (QQME) last year (April 4). However, the policymakers’ decision to increase the monetary base target will depend on the level of the inflation rate which has been constantly rising to higher levels (Overall Nationwide CPI printed at 1.5% in February).

USDJPY is one of the biggest movers, down 2% since Friday high of 104.12. The pair is now trading at 102.20, testing its support band of 102.00 – 102.20. The next support on the downside stands at 101.75.

USDJPY

 (Source: Reuters)