Retracing the US Dollar Q4 rise…

An important topic that has been making the headline over the past few weeks is the new surge of the US Dollar (vis-à-vis the major currencies) in the last quarter of 2016. Since its Obama Rise peak that occurred in mid-March 2015 (after a 25% appreciation), the US Dollar has been ranging against most of the major currencies (except the British pound due to political uncertainty and post-Brexit effect in June, and more recently the Mexican peso). The main reason for that long period of stagnation, in my opinion, was a shift in expectations of monetary policy in the US. After the Fed stepped out of the Bond Market (on October 28th 2014), market’s participants have been mainly focusing on the short-end of the curve, questioning themselves if the Fed was going to start a tightening monetary policy cycle. We saw a hike in December 2015 (25bps), which was immediately halted due to the market sell-off that followed afterwards (13% drawdown in US equities, 20% in Europe and Japan…). Therefore, the implied probability of a second hike in 2016 crashed, which was confirmed by the 7 FOMC meetings that followed (i.e. status quo).

Then, interest in the US Dollar started to emerge again in Q4 2016; the greenback experienced a 8%+ appreciation between October 1st and its December high of 13.65 (28th) according to the DXY index (Chart 1). There are a number of explanations to that recent surge: market was gradually pricing in a rate hike for the December meeting, political uncertainty rising in Europe or Infinite QE in Japan to protect the yield curve. All these stories make sense to explain the Dollar appreciation, therefore let’s retrace the important events that occurred in the last quarter of 2016.

Chart 1. US Dollar index in 2015-2016 (Source: Bloomberg)

usdollarhis

  1. Higher inflation and a positive post-Trump effect

First of all, the rebound in oil prices relieved pressure on energy-related companies [that have been falling one by one, applying to Chapter 11 bankruptcy] and had a positive effect on expected inflation. The price of a barrel has doubled since its February’s low of $26 and is currently trading slightly below $54 (Chart 2, red line) and obviously relieved US policymakers’ inflation anxiety. The 5Y5Y inflation swap forward (Chart 2, white line) stands now at 2.42%, higher than the 1.80% recorded last June. As a consequence, US long-term yields followed the move and the 10-year Treasury yield surged from a low of 1.36% reached in July last year to 2.44% today. With the unemployment rate below 5% and a Q3 GDP growth of 3.5% (annual QoQ), it seems inflation had been the main concern of the Fed’s officials in order to start tightening [again].

Therefore, on December 14th, US policymakers decide to raise the federal funds rate by 25bps to 0.5%-0.75% [and the discount rate from 1% to 1.25%], repeating a gradual policy path plan with three potential hikes in 2017. Even though it was considered to be the most ‘priced in’ hike of any Fed meeting ever, it pushed the implied rates to the upside with the current OIS (Chart 3, purple line) trading almost 1 percent above the OIS at the September meeting (Chart 3, red line). This change in implied rates was reflected in the Dollar appreciation.

Chart 2. US inflation overlaid with Oil Prices and US 10-year yield (Source: Bloomberg)

inflationus

Chart 3. Fed’s dot plot and implied rates (Source: Bloomberg)

FedPlot.JPG

We were not very surprised when the Fed officials announced the rate hike, however we were wondering if we would have seen such optimism if equity markets ‘followed’ the global bond sell-off after the election (Trump effect). The positive US equity market reaction to Trump’s victory also comforted US policymakers for the December’s hike; we strongly believe that the decision would have been much harder if they had to deal with a sudden equity sell-off. Instead, the SP500 reached new record highs (2,277) last months.

One explanation of this development is based on investors’ expectation of an expansionary fiscal policy that will boost economic growth and inflation in the future, which are usually positive news for equities and negative news for bonds in theory (see Four Quadrants matrix – image 1).

Image 1. The ‘Four Quadrants’ framework (Source: Gavekal Research)

  Quandrant.png

   2. Political uncertainty rising in Europe, the rigger of many ‘forgotten’ problems

A popular trade that was running in the last quarter of 2016 was to be long the Italian-German 10-year spread ahead of the Italian referendum that occurred on December 4th. Market was pricing a potential rejection (55% chance), leading to an increase in political uncertainty in Europe, rising spreads between periphery and core and weakening the Euro.

If we look at Chart 4, we can see that the spike in the Italian 10-year yield (Chart 4, white line) could explain the Euro weakness (hence, USD strength). While the 10-year yield increased from 1.20% to 2.20% in two months (October and November), EURUSD (Chart 4, red line, inverted) went down 7 figures and reached a new low of 1.0350 post-referendum (59.1% of voters rejected the reform bill, which was followed immediately by PM Renzi’s resignation).

Even though yields have been decreasing over the past month (the 10-year now standing at 1.73%), political uncertainty could be the trigger of the two ‘delayed’  and ‘forgotten’ issues [or Black Swans] in Europe: the weak banking system and the Sovereign debt crisis. Not only Italy (in this case) cannot survive with higher yields (the country has 2.34 trillion EUR of outstanding debt – 132.6% of GDP – which needs to be rolled with low yields), but a sell-off in equities will increase the percentage of NPLs and potentially forced their banks to bail-in their depositors. The failure of Monte Paschi di Siena’s plan to raise 5-billion euros in capital from the market was ‘solved’ by a Nationalization (the bank’s third bailout). It was announced that the government will own at least 75% of the common equity after the bank is nationalized, a rescue that will cost the Italian government (i.e. taxpayers) about 6.6bn Euros according to the ECB (4.6bn Euros are needed to meet capital requirements and 2bn Euros to compensate the retail bondholders).

Therefore, We strongly believe that we will hear other similar stories in the year to come, as Italy is not the only country facing non-performing loans (NPLs) issues that affect the banking sector. Therefore, political uncertainty in Europe will weigh on the single currency and increase investors’ interest to the US Dollar.

Chart 4. Italian 10-year yield versus EURUSD (inv.) (Source: Bloomberg)

ItalyandEuro.JPG

   3. The weakness in the Japanese Yen

In Japan, the BoJ introduced the ‘Yield Control’ operation in order to stabilize the steepness of the JGB yield curve, offering to buy an unlimited amount of debt at fixed yields to prevent a significant surge in rates. This is kind of a puzzle, as Japan Officials cannot afford higher yields [as many indebted developed nations], however too-low yields impact revenues of the banking system and the pension / mutual funds.

We don’t think the particular surge in USDJPY was explained by this new ‘BoJ Operation’ and We prefer to say that the Yen depreciation was a result of a Risk-on effect post-US election result in addition to the recent spike in US yields. USDJPY (Chart 5, candlesticks) trades above 117 and equities (Chart 5, red line) are above the 19,000 level for the first time since September 2015; and you can see how the increase in US yields (Chart 5, blue line) is ‘responsible’ to the Yen weakness.

The question now is to know if the late Q4 Yen weakness will persist in early 2017, with USDJPY pair attracting more and more momentum investors looking to hit the 125 resistance. We know historically that the [positive] trend on the USDJPY can halt [and reverse] very quickly if investors are suddenly skeptical about the global macro situation (Fed delaying its 2017 hike path, China liquidity issues or rising yields in peripheral European countries). On the top of that, if market starts to price in inflation in 2017, will the BoJ be able to counter a JGB tantrum and keep the 10-year JGB yield at around 0%?

One important thing about this recent Yen weakness though is that it allows the Japanese government to buy time in order to implement new reforms and increase productivity. If you remember well, Abe stated in September 2015 his 20% increase in Japan GDP in the medium term (increase from 500tr to 600tr Yen in 5 years).

Chart 5. USDJPY, Nikkei 225 and US 10-year yield (Source: Bloomberg)

OverallJapan.JPG

   4. The Chinese Yuan devaluation

Another currency that has been making the headlines is the Chinese Yuan. Over the past year, the Chinese Yuan has shed roughly 7 percent of its value against the greenback (Chart 6, USDCNY in candlesticks). At the same FX reserves (Chart 6, blue line) have been shrinking; reserves plunged by $69.1bn to $3.05tr in November (most in 10 months), bringing the reduction in the stockpile to almost USD 1tr from a record $4 trillion reach in June 2014. As Horseman Capital noted in their article on China (Is China running out of money?), if FX reserves continue to plummet and the PBoC wants to maintain control of the exchange rate, Chinese officials will face some difficult choices. One option would be to raise interest rates (the benchmark one-year lending rate stands currently at 4.35%) in order to reduce outflows and attract interest in the Yuan (high interest rate differential vs. the other countries). This would have a negative effect on the country’s growth outlook, which is already concerning the developed economies due to the high levels of corporate debt and overheated property markets. Another option would be to reduce the holding of deposits by cutting the reserve requirement rate (RRR) which stands currently at 17%. We can see in Chart 7 that the Asset-Liabilities spread (represented by Foreign Currency Assets and Deposits from Other banks) has narrowed drastically over the past year, therefore cutting the reserve rates for banks could be a temporary solution for the PBoC. The problem of the second option is that it will continue to weaken the Chinese Yuan vis-à-vis the US Dollar, which could increase political tensions between US and China.

Interestingly, an asset that has [sort-of] tracked the USDCNY move this year is the Bitcoin (Chart 6, red line) , which raised from $400 in January last year to over $1,000 today. The cryptocurrency was described as the ‘good’ instrument to circumvent capital control in China in periods of large capital outflows like today. Like gold, Bitcoin is readily available in China and can be sold for foreign currencies without problems and therefore have attracted a lot of buyers over the past year.

Chart 6. USDCNY, Bitcoin and Chinese FX reserves (Source: Bloomberg)

Chart 7. PBoC Balance Sheet (Source: Horseman Capital)

PBoCBaS.JPG

To conclude, there are several factors explaining the US Dollar strength in the last quarter of 2016, and it looks like the trend should continue in early 2017 (extreme monetary policy divergence to persist in 2017, black swan events coming from Europe, difficulties of Chinese officials to deal with the capital outflows…). However its trend cannot persist indefinitely as we know that it will eventually have negative effect on the US economy in the long term. For instance, we know that a strong dollar hurts US companies’ earnings, which is already a problem if we look at the 12-month forward earnings (Chart 8, green line). In addition, if long-term interest rates increase persistently in the future (breaking through the 3-percent level seen in the 2013 taper tantrum), the US could face a budget crisis: how is the government going to fund its budget deficit [which is expected to grow over USD 1 trillion again under Trump presidency] if China and other central banks are liquidating US Paper at record pace?

Chart 8. SP500 overlaid with 12-month forward earnings (Source: Bloomberg)

ForwardEarnings.JPG

FX positioning ahead of the September FOMC meeting

As of today, most market participants are getting prepared [and positioned] for the FOMC meeting on September 20/21st in order to see if policymakers stick with their Jackson-Hole hints, therefore we think it is a good time to share our current FX positioning.

Fed’s meeting: hike or no-hike?

We think that one important point investors were trying to figure out the last Jackson Hole Summit last week was to know if US policymakers were considering starting [again] their monetary policy tightening cycle after a [almost] 1-year halt. If we look at the FedWatch Tool available in CME Group website, the probability of a 25bps rate hike in September stands now at 18% based on a 30-day Fed Fund futures price of 99.58 (current contract October 2016, implied rate is 42bps).

CME.png

(Source: CME Group)

In addition, if we look at the Eurodollar futures market, the December Contract trades at 99.08, meaning the market is pricing a 1% US Dollar rate by the end of the year. We can clearly notice that the market expects some action coming from US policymakers within the next few months. However, recent macroeconomic data have shown signs of deterioration in the US that could potentially put the rate hike on hold for another few months. Following last week disappointing manufacturing ISM data that came out at 49.4 below its expansion level (50), ISM Service dropped to 51.4, its lowest number since February 2010 and has been dramatically declining since mid-2015. We strongly believe that there are both important indicators to watch, especially when they are flirting with the expansion/recession 50-level. We can see in the chart below that the ISM manufacturing PMI (white line) tracks really ‘well’ the US Real GDP (Annual YoY, yellow line), and as equity markets tend to do poorly in periods of recession we can say that the ISM Manufacturing / Services can potentially predict sharp drawdowns in equities.

Chart 1. ISM – blue and white – and Real US GDP Annual YoY – yellow line (Source: Bloomberg)

ISM_US.JPG

Another disappointment came from the Job market with Non-Farm Payrolls dropping back below the 200K level (it came out at 151K for August vs. 180K expected) and slower earnings growth (average hourly earnings increased by 2.4% YoY in August, lower than the previous month’s annual pace of 2.7%).

This accumulation of poor macro figures halted the US Dollar gains we saw during the J-Hole Summit and it seems that the market is starting to become more reluctant to a rate hike in September. The Dollar Index (DXY) is trading back below 95 and the 10-year rate is on its way to hit its mid-August 1.50% support (currently trades at 1.54%). What is interesting to analyse is which currency will benefit most from this new Dollar Weakness episode.

FX positioning

USDJPY: After hitting a high of 104.32 on Friday, the pair is once again poised to retest its 100 psychological support in the next few days. This is clearly a nightmare for Abe and Kuroda as the Yen has strengthen by almost 20% since its high last June (125.85). If we have a look at the chart below, the trend looks clearly bearish at the moment and longs should consider putting a tight top at 105. we would stay short USDJPY as we don’t see any aggressive response from the BoJ until the next MP meeting on September 21st.

Chart 2. USDJPY candlesticks (Source: Bloomberg)

EURUSD: Another interesting move today is the EURUSD 100-SMA break out, the pair is currently trading at 1.1240 and remains on its one-year range 1.05 – 1.15. As a few articles pointed out recently, the ECB has been active in the market since March 2015 and has purchased over 1 trillion government and corporate bonds. The balance sheet total assets now totals 3.3 trillion Euros (versus 4 trillion EUR for the Fed), an indicator to watch as further easing announced by Draghi will tend to weigh on the Euro in the long run. The ECB meets in Frankfurt on Thursday and the market expect an extension of the asset purchases beyond March 2017 (by 6 to 9 months). We don’t see a further rate cut (to -0.5%) or a boost in the asset purchase program for the moment, therefore we don’t think we will see a lot of volatility in the coming days. we wouldn’t take an important position in the Euro, however we can see EURUSD trading above 1.13 by Thursday noon.

Chart 3. EURUSD and Fibonacci retracements (Source: Bloomberg)

Another important factor EU policymakers will have to deal with in the future is lower growth and inflation expectations. The 2017 GDP growth expectation decreased to 1.20% (vs. 1.70% in the beginning of the year) and the 5y/5y forward inflation expectation rate is still far below the 2-percent target (it stands currently at 1.66% according to FRED).

Sterling Pound: New Trend, New Friend? The currency that raised traders’ interest over the past couple of weeks has been the British pound as it was considered oversold according to many market participants. Cable is up 5% since its August low (1.2866) and is approaching its 1.35 resistance. We would try to short some as we think many traders will try to lock in their profit soon which could slow down the Pound appetite in the next few days. If 1.35 doesn’t hold, then it may be interesting to play to break out with a new target at 1.3600.

Chart 4. GBPUSD and its 1.35 resistance (Source: Bloomberg)

GBP.JPG

We would short some (GBPUSD) with a tight stop loss at 1.3520 and a target at 1.3350. No action expected from the BoE on September 15th, Carney is giving the UK markets some ‘digestion’ time after the recent action (rate cut + QE).

USDCHF: For the Swissie, our analysis stands close to the Yen’s one, and therefore we think the Swiss Franc strength could continue in the coming days. we like 0.96 as a first ‘shy’ target, and we would look at the 0.9550 level if the situation remains similar (poor macro and quiet vol) in the short term.

AUDUSD: Australia, as many other commodity countries (Canada, New Zealand), remains in a difficult situation as the deterioration of the terms of trade will tend to force RBA policymakers to move towards a ZIRP policy. However, lower rates will continue to inflate housing prices, which continue to grow at a two-digit rate. According to CoreLogic, house prices averaged 10-percent growth over the past year, with Sydney and Melbourne up 13% and 13.9%, respectively. Australian citizens are now leverage more than ever; the Household debt-to-GDP increased from 70% in the beginning of the century to 125% in Q4 2015 (see chart below). This is clearly unsustainable over the long-run, which obviously deprives policymakers to lower rates too ‘quickly’ to counter disinflation. As expected, the RBA left its cash rate steady at 1.50% today, which will play in favor of the Aussie in the next couple of weeks. One interesting point as well is that the Aussie didn’t react to an interest rate cut on August 2nd, something that Governor Glenn Stevens will have to study in case policymakers want to weaken the currency. There is still room on the upside for AUDUSD, first level stands at 0.7750.

Australia.png

(Source: Trading Economics)

Chinese Yuan: The Renminbi has been pretty shy over the past two month, USDCNH has been ranging between 6.62 and 6.72. The onshore – offshore spread is now close to zero as you can see it on the chart below (chart on the bottom). We don’t see any volatility rising in the next few weeks, therefore we wouldn’t build a position in that particular currency.

Chart 5. CNY – CNH spread analysis (Source: Bloomberg)

CNH spread.JPG

 To conclude, we think that we are going to see further dollar weakness ahead of the FOMC September meeting as practitioners will start to [re]consider a rate hike this time, especially if fundamentals keep being poor in the near future.

Ahead of the ECB and Fed meetings: watch the VIX

In this very quiet week, the SP500 is once again ‘playing’ with the 2,100 level and we strongly believe that it could be a perfect time to go short if you think about the upside / downside risk. There are many events coming up starting with the ECB meeting tomorrow and Non-Farm Payrolls on Friday. We guess we could see some volatility coming from these events which could impact equities and the FX market. As we wrote here, we saw that usually EURUSD tends to be positively correlated to sudden rise in volatility. Even though we expect the ECB to keep its rates steady (deposit at -0.4%, refi at 0% and marginal lending facility at 0.25%) with no increase in the current 80-billion-euro QE program, the market may react negatively during Draghi’s conference starting 1.30pm. Once again, the ECB could disappoint, leading to equities sell-off and some Euro appreciation. As you can see it in the chart below, EURUSD has entered in a bearish trend since May 3rd, decreasing by 5 figures until it hit its 200-SMA (yellow line) at 1.11. It has been trading within a 90-pip range over the past 3 days and we expect the currency pair to stay rangy today as well; however we would pay attention to the potential spike we can see tomorrow. The first strong resistance on the upside stands at 1.1250, a breakout could directly lead us towards the 1.1350 – 1.1400 range.

EURUSD

(Source: Bloomberg)

In addition, US non-farm payrolls could disappoint on Friday (Bloomberg survey at 160K) leading to another round of equity sell-off, sending the US 10-year yield back below 1.8% and pushing the Euro to higher levels. If we look back at the beginning-the-year sell-off in the chart below, the SP500 (candlesticks) fell by more than 200pts, the US 10-year (red line) crashed from 2.3% to 1.66% while the Euro (green line) surged by 7 figures to almost 1.14 against the greenback.

SPYields

(Source: Bloomberg)

Another reason to go short US equities at the moment could be a good strategy to hedge yourself against a volatility spike ahead of the FOMC meeting (June 14/15). If we look at the FedWatch Tool developed in the CME website, there is a 22.5% implied probability of a rate hike based on the CME 30-day Fed Funds futures prices.

FedWatch

(Source: CME Group)

However, the odds are higher based on the last few speeches delivered by US policymakers and of course a quiet market. In her 30-minute Q&A session with Greg Mankiw at Harvard on Friday, Fed Chairman Yellen said that the economy was continuing to improve and that a ‘rate hike in coming months may be appropriate’. In ouropinion, we think a June move is appropriate, especially if equities still trade above 2,000 until that meeting. In addition, if we look at the Eurodollar futures market, time deposits denominated in US dollars and held at banks outside of the United States, the June contract trades 99.28 (i.e. the implied rates is at 72bps). Eurodollar contracts are useful to look at as well as they are more liquid than Fed Funds futures.

The only reason we see no rate hike this meeting is if we experience another sharp sell off within the next couple of weeks.

Dollar pause: poor US fundamentals or overall disappointment on more global easing?

Since its high in mid-March last year, the US dollar has ‘stabilized’ vs. overall currencies; if we look at the US Dollar index (Source: Bloomberg, DXY index), it hit a high of 100.40 in March 13th then has been ranging between 92.50 and 100 over the past year. Now the question we have been asking ourselves is‘what is the main reason for this stagnation?’

USDIndex

(Source: Bloomberg) 

We strongly believe that one of the main reasons comes from looser-than-expected FOMC statements and a shift in expectations on more monetary policy tightening in the near future. If we look at the market, Fed Funds futures predict a much lower ST rates in the future compare to the Fed’s dot plot. Looking at the chart below, whereas the Fed officials see rates at around 1% and 2% by the end of 2016 and 2017 respectively, the market (Red line) predicts 50bps and 1%. It doesn’t necessarily mean that the market participants are right, but it looks to me that they are more ‘rational’ based on current market conditions and this spread between the Fed and the market may have created a dollar pause over the past year.

FedPlotvsMarket

(Source: Bloomberg)

The first reason that could explain why the Fed has been holding rates steady since last December would be the poor fundamentals we have seen lately (except for the unemployment rate currently at 4.9%). For instance, US GDP growth rate has been slowing over the past three quarters and came in at 1.4% for the last quarter of 2015 (vs. almost 4% in Q2). If we look at the latest core PCE deflator release (the inflation figure the Fed tracks), the index came in at 1.56% YoY in March, still far below the Fed’s ‘target’ of 2%. In addition, the economic data have been more than disappointing overall, which could explain the recent fly-to-quality and why yields are starting to plunge again (the 10Y YS yield trades currently at 1.8%, while the 30Y is at 2.66%).

Secondly, corporate profits have been plunging and printed a 7.8% fall in Q4 2015, the biggest decline since Q1 2011 (-9.2%) and the fourth decline in the last five quarters. If we look at chart below, we can see that the divergence between the S&P500 index and the 12-month forward earnings doesn’t work for too long and equities tend to be the one moving in general. You can see that in that case, equities are still overvalued based on this analysis and there is more potential downside coming in the future.

SPXFEPS

(Source: ZeroHedge)

The third and most important reason explaining this status quo – i.e. US dollar pause – would be the current global macro situation. Certainly, market participants have been recently disappointed by the recent news coming either from Japan (no additional QE see article) or the Eurozone and the loss of confidence in the ECB. On March 10th, Draghi announced the ECB Bazooka plan, where the officials decided to:

  • cut decrease the deposit refi and marginal lending rates to -0.4%, 0% and 0.25% respectively
  • Increase the QE from 60bn to 80bn Euros per month
  • Implement a four new target LTROs (TLTROs) each with maturity 4years
  • Include investment grade euro-denominated bonds issued by non-bank corporations clong the assets that are eligible for regular purchases

The effect on the market was minor; if we look at the chart below, the Euro increased in value against the greenback (green line) and the equity market stands at the same level since the announcement (Eurostoxx 50 index trading slightly below 3,000).

EUROstoxx

(Source: Bloomberg)

The sales-side research suggest that CBs should consider purchasing equities as well or taxing wealth (Deutsche Bank) as a intermediate step before implementing the Helicopter money strategy.

Despite a recent spike since the beginning of the year mainly driven by the recovery in oil prices (WTI spot increased from 26$ to 43$ per barrel), commodity prices are still trading at their lowest level since 1998 according to the Bloomberg BCOM index (see chart below). China’s (and other EM countries’) slowdown continue to weight on international finance putting a lot of export-driven countries into difficulty (or close to default). We personally believe that this situation will remain in the next 12 to 18 months as the emergence of a credit crisis in the EM market is not too far away.

CommodityPrices

(Source: Bloomberg)

Therefore, we think the global lack of easing will tend to stabilized the US dollar in the medium term; another rate hike from Yellen in one of the next two meetings is sort of priced in by the market, therefore only action from the rest of the world could start to bring interest into the US dollar. we would be careful of going short equities at the moment as USDJPY is very low and a response from the BoJ (more ETFs purchases) is kind of imminent if Kuroda wants to stop this current equity sell off and Yen purchases.

 

 

EURUSD and VIX

The chart below shows a quick analysis of EURUSD and VIX Index over the past six months. As you can see, the 20-day correlation between the two underlying assets has switched from a negative 80 in Mid-March to a positive 80.6% today. If you are a global macro trader, I personally believe that it is important to notice those changes between different asset classes, so you can see how a particular currency will react in case of a volatile day.

During the ‘Black Monday’ session this year (August 24th), the VIX Index soared above 40 and one of the surprising assets rallying was the Euro. On that day, EURUSD surged above the 1.17 level, up 350 pips in a few hours. Sell-side research started to call it the New Safe-Haven Currency, therefore reviewing its 3-month and 6-month to the upside.

Keep a small long EURUSD in your book ahead of the FOMC

In my opinion, I think it could be good to keep a long position on EURUSD ahead of the FOMC meeting this evening in case we see a bit of volatility.

Based on the macro situation in the US, a persistent moderate nominal growth and a poor core PCE deflator at 1% (Bloomberg PCE MBXYH Index), I think a no-hike scenario will make more sense. However, a 25bps is still in the game and wouldn’t have dramatic consequences for the market; but in that case, we could see a bit of equity sell-off, a higher VIX and therefore a higher EURUSD. An interesting level on the upside will be 1.1380; a break out could potentially bring EURUSD to 1.1450. On the downside, 1.1220 is the key level where I should potentially keep a safe stop.

CorrelEUR

(Source: Bloomberg)

Quick update on China ahead of the FOMC meeting…

Ahead of the FOMC meeting this week, I thought a quick update on China would be useful to review the major data on a global macro perspective.

Over the past few years, Chinese slowdown has massively impacted commodity prices, which are still ‘trying’ to find a bottom according to the late analysis I read. The chart below shows the historical moves of the Bloomberg Commodity Index (BCOM), a broadly diversified commodity price index (22 commodity futures in seven different sectors) that I like to watch quite a bit. As you can see it, the index has been trading below the 2009 lows since the beginning of the year and is now approaching the 2002 levels.

Commodity

(Source: Financial Times)

If we look at Iron Ore monthly prices for instance (see chart below), we can see that the commodity has lost more than three times its value since its high in February 2011. It fell from 187.18 (US Dollars per Dry Metric Ton) at that time to 56.40 (for the September 2015 Futures contract). There has been a few topics on the table that could have describe this drop – US rising rates and Dollar strength, Grexit fear, Oversupply issues – however the decrease in Chinese growth and productivity are the most important factors to the commodity market in general.

Iron Ore

(Source: indexmundi website)

How fast is China slowing?

First of all, if we look at the country’s annual growth rate over the past five years, China GDP decreased from approximately 12% in early 2010 to 7% in the last Q2 update. And looking at the major’s institution forecasts (IMF, World Bank, see below), it is more than likely that we are going to see lower and lower figures in the next few years, and therefore constantly weigh on export-driven economies. Based on the forecasts below, we are looking at a 5.5%-6% annual growth rate in 3 to 5 years.

ChinaGDP

(Source: knoema website)

Salaries increase in China, a secular change?

For decades, China has mostly been competitive based on its cheap labour and low-cost raw materials, and has been profitable based on its export-driven economy combined with an ‘undervalued’ exchange rate. However, with wages and transportation costs on the rise, the country’s economic projection has changed and I don’t know if the rest of the World is yet prepared for it. According to some financial analyst experts, compare to the mid-2000 levels, China needs twice the amount of Capital or Debt to create a 1-percent growth today.

Based on the International Labour Organization’s 2014 Wage report for the Asia Pacific published at the end of the first quarter of this year, Asia annual growth in real wages has been outperforming the global average over the past decade (6.0% vs. 2.0% in 2013). And East Asia (driven by China) reported at 7.1% increase in 2013, therefore indicating a growing consumer spending power. And between 1998 and 2010, the average annual growth rate of real wages were approximately 13.8% (Carsten A Holtz, 2014). Since 2010, real wages have grown by 9%, outperforming productivity which has grown by 6-7%, therefore reflecting negative signs about the economy.

Availability of a large pool of labour combined with low production costs have been one of the major pros of China, however the constant increase in labour costs will narrow the difference in manufacturing costs between China and a developed economy (such as the US) to a degree that is almost negligible.

As a result, no hike in September…

My view goes for a neutral FOMC statement this week, but no hikes from the Fed based on the weak current market’s conditions. If we look at it, we have more and more EM countries facing a currency crisis (Brazil, Russia, Malaysia…), low oil prices affecting highly leveraged US Shale oil companies, US debt ceiling ‘threat’ at the end of the month, China selling its USD FX reserves, US equities showing a sign of fatigue… These are all negative elements that the US policymakers will take into account at the September meeting (16th / 17th of September). The upside for currencies such as the Euro, the Swiss or the Sterling pound will be quite limited until the release of the FOMC Statement, however we could see some Dollar weakness in case of a status quo.

The ‘Obama’ Dollar Rises…

Over the past few weeks, I had several discussions with some friends of mine to try to understand and clarify the US Dollar ‘pause’ we have seen since the middle of March. A dovish stance from the Federal Reserve, which obviously led to a status quo at the June FOMC meeting, may have halted the Dollar bulls, but it seems to me that the market is getting more and more confident about this year’s lift-off.

Based on the forecasts made in June, the Fed Staff expect policymakers to raise the Fed funds rate to 35bps by the end of the fourth quarter of 2015, which implies a one quarter-point hike this year (chances of an initial move at the September meeting stand roughly at 60%).

Quick recap’ on the macro figures

Even though the unemployment rate hit a 7-year low at 5.3% in June (with a strong NFP at 223K) and Q2 GDP came in at 2.3% (above the 2% ‘target’, but still below Wall Street’s consensus estimate of 2.5%), the rest of the figures and the overall macro/geopolitical situation both don’t look quite good. US inflation has average 0% since the beginning of the year (0.1% YoY in June), consumer spending YoY declined for the third consecutive month and both business fixed investments and net exports stayed soft. On a broader scale, the commodity-meltdown continues as demand from China may slow even further on the back of a weak manufacturing activity (Chinese PMI fell to 47.8 in July, its two-year low). For instance, NYMEX WTI September futures are trading near levels not seen since March, with September contract at $46.30 per barrel.

In addition, even though the Economic and Financial Affairs Council (ECOFIN) approved a 7.1bn-euro bridge loan to Greece last month (July 17th) given through the EFSM so that the country could meet its short-term obligations including a 3.5bn-euro payment to the ECB on July 20, Athens has no money left. That is problematic as a second big 3.2bn-euro payment is coming on August 20 to the ECB and there are talks that they may miss it as the bailout timeline is ‘unrealistic’.

Chinese economic slowdown, low oil prices, deflation and Greek payments are all subjects that I try to follow closely as it is the topics I believe that US policymakers are watching as well. However, I think this time the Fed officials are quite ready for a lift-off in September, and now I have been questioning myself about the US Dollar rally.

The Dollar Rallies…

The chart below shows the three dollar rallies that occurred since the collapse of the Bretton Woods system. The first big one is the Reagan dollar rally in the early 80s, fueled by the tight monetary policy. As a result of the second oil shock in 1979, chairman Volker orchestrated a series of interest rate increases that took the federal funds target from 10 to nearly 20 percent. If the Euro had existed then, the single currency would have depreciated by roughly 60%. The rally was eventually halted in September 1985 by the Plaza Accord signed by five governments to depreciate the US Dollar in relation to the Japanese Yen and the Deutsche Mark.

The Clinton Dollar rally started in the mid 90s fueled by the US Tech bubble and capital inflows into the US equity market in addition to the US government running federal surpluses. This surge brought the Euro down to 0.8230 against the greenback and USDJPY was trading at a high of JPY135 at the end of the rally (late 2001).

The recent Obama rally has started in early July last year as a result of monetary policy diverge between the US and the rest of the World. The commodity meltdown will continue to weigh on commodity currencies and especially on the Dollar-Bloc (CAD, AUD and NZD), as Greece will continue to make the headlines until Bailout#3 is eventually agreed.

As you can see on the chart below, I added a downtrend line that was broken in the beginning of the year. The US Dollar index hit a high of 100.80 in mid-March before its March-May consolidation. It looks to me that the greenback is gradually recovering from its quick contraction.

DXY avec MA

Source: Reuters

Despite a low volatile market at the moment, I am convinced that the US Dollar will gain strength in the end of this second semester. I will try to add a currency-detailed article by the end of the week with my new levels on the main currency pairs.

Post FOMC Analysis, Dollar Flash Crashes…

This week has been full of macro events (four central banks meetings – BoJ, Norges Bank, SNB and the Fed), however all eyes were on the FOMC statement that came up yesterday. Dovish stance from Yellen in addition to 2015 forecasts revised on the downside created Dollar ‘Flash Crashes’, with the FX market completely out of control. The US Dollar index was trading around 100 yesterday morning, then went down from 99.50 to 98.00 after the FOMC, and eventually ‘flash-crashed’ after the US close. EURUSD (and Cable) soared by 400 pips (and 500 pips) to 1.1040 (and 1.5160 respectively), USDCHF down 4 figures as well down to 0.9620. The yen was less reactive (which clearly shows the declining Yen Pavlovian response the risk-off environment, USDJPY went down ‘only’ 200 pips to 119.30.

To review the FOMC statement briefly, the Committee revised down all 2015 forecasts since the previous Summary of Economic Projections (SEP) released on December 17 last year. The median dot plot for year end 2015 decreased from 1.125% to 0.625% (down by 50 pips). In addition, looking at the Fed’s dot plot for the year 2016 and 2017, we can see that the median dot for 2016 fell to 1.875% in March (vs. 2.5%) and decline to 3.125% from 3.625% for 2017.

FOMC DOT plot

 (Source: Fed’s website)

Furthermore, if we look at the table below which shows the advance release of the SEP, we can see that the central tendency for GDP this year was decreased to 2.3%-2.7% (from 2.3% – 2.7%), PCE inflation (the inflation measure watched by the Fed as the PCE index covers a wide range of household spending) went down to 0.6% – 0.8%, compared to 1.0% – 1.6% three months ago.

FED Forecasts

(Source: Federal Reserve’s website)

While the Dollar has been recovering all day (especially during Asia, USD index now trades back at 99.40, with EURUSD back down to 1.0660, USDCHF up to 0.9910, Cable down to 1.4740 and USDJPY at 120.80), the market is still a bit ‘stress’ with all core bond yields trading to lower levels (See appendix, Bund at 19bps, US 10Y at 1.95% or UK Gilt at 1.52%) and peripheral EZ bonds trading higher than yesterday’s levels.

As a result, the equity market (S&P500) is back on track after a quick 70-point bear consolidation as I was looking for (see tweet @LFXYvan on Feb 26). If we look at the chart below, we can see that the 100 SMA has acted as a sort of support where the market found some potential buyers-on-dips. Over the past few months, it looks like if the 100 SMA didn’t hold, the 200 SMA was doing the rest of the job (except in mid-October).

SP500

(Source: FXCM)

Even though the equity has lost a bit of ‘power’ since the Fed stepped out of the bond market at the end of October last year (the bear consolidation are becoming more and more recurrent), I still believe there is some potential room on the upside based on yesterday’s comments and readjustments.

I am curious to know how the US policymakers will play the rate hike within the next few months (will there be one in June?), as even if the job market has continued to show some strong figures with a NFP report at 295K in February and an unemployment rate at 5.5% (close to full employment according to economists), there has been a lots a disappointing macro figures. See list below with all the misses in just the past month…

Misses US

 (Source: ZeroHedge)

Earlier today, the SNB left its deposit rate negative at -0.75% and jawboned a bit about the recent CHF appreciation. EURCHF is trading at 1.0550, down 2.5 figures in the past month and potentially ‘hurting’ the Swiss economy (Swiss is also part of the ‘Currency War’ party). Norway unexpectedly left its interest rates unchanged and signalled in its report that another cut was planned to protect the Norwegian economy from the plunge in oil prices. The NOK rocketed against the greenback earlier today, down from 8.37 to 8.07 on this hawkish surprise. As a reminder, Oil (and gas) generate more than 20% of Norway’s output, and the country may be in difficulty if this low-oil-price era persists. Norway may have to ‘tap’ into their sovereign wealth funds – Government Pension Fund Global – (approx. $850bn) in order to support their annual budgets this year. However, the maximum that the government could spend from oil revenue is 4% of the fund (by law).

Otherwise, no surprise from Japan and the BoJ stood firm on Tuesday, leaving its monetary policy unchanged (80tr Yen of asset purchases annually, mostly JGBs), even though policymakers acknowledged that prices might start falling in the coming months. Consumer prices in Japan rose 2.4% YoY in January, the same as the previous two months and down from 3.7% in April last year.

 Appendix: Bonds yields…

BBG

 (Source: Bloomberg)

January 2015: A Rough Start

The past month has been quite eventful in the financial market and I am sure that some of the decisions (if not all) surprised many of us. After the SNB announce on January 15th, the ECB took over and unveiled a €60bn monthly QE (not open-ended) through September 2016; so 19 months at €60bn equals €1.14tr. The ECB, which has already been buying private assets such as covered bonds (a safe form of debt issued by banks) and ABS, will add an additional €50bn worth of public debt (bonds of national government and European institutions) to its current program starting in March this year. The purchases of these securities (in the secondary market) will be based on the Eurosystem NCB’s shares in the ECB’s capital.
In addition, President Draghi also added that the ECB will remove the 10bp spread on the TLTROs, and the interest rate applied will be equal to the rate on the Eurosystem’s MRO (5bp).

We saw on Friday that EZ preliminary inflation fell by 0.6% in January after a -0.2% print in December, the largest decline since July 2009 when prices also fell 0.6% following GFC.

The ECB decision(s) sent the Euro to newest lows last week, down to 1.1120 (11-year lows) against the greenback and below the 0.75 level (0.7440) against the pound. But more importantly, it sent a bigger amount of government debt in the negative territory (yields). According to JP Morgan, there is currently (approximately) €1.5tr of Euro area government bond with longer than 1-year maturity trading at negative yields over time, and a ‘mind-blowing’ €3.6tr of global government bond debt (nearly a fifth of the total) with negative yields as the chat below shows us. For instance, the entire 10-year Swiss curve is  now negative.

Global NIRP(Source: JPMorgan)

Another interesting topic is of course the 3 consecutive rate cuts (in 10 days) by the Danish Central Bank, that lowered it deposit rate to a record low of -0.5% to defend its peg and keep the Danish kroner (DKK) close to 7.46 per Euro (ERM II since 1999). EURDKK went down below 7.43; we will see this week how much policymakers spent in January in order to counter a DKK appreciation (some reports estimated that the central bank had to sell more than DKK 100bn). As a consequence (of the NIRP policy), a local bank – Nordea Kredit – is now offering a mortgage with a negative interest rate.
I believe the Danish krone is a currency to watch (in addition to the CHF) this month if the situation in Greece deteriorates.

A Weak Swiss Franc…
Since the SNB surprise, the Swiss has remained weak against the major currencies, with USDCHF up 7 figures  (trading currently at 0.93) and EURCHF up from parity to 1.0550. Analysts slashed their forecast for this year and are now predicting a recession (-0.5% according to the KOF Swiss Economic Institute). I like the chart below which shows the 12-month Probability of the top 10 countries to fall into recession in the coming months according to Bloomberg economist surveys.

Probarecession(Source: Bloomberg)

Japan and JPY still under threat over the long-run
In Japan, the 10-year JGB yield rose by 9bp in the last 10 days and is now trading at 29bps. USDJPY tumbled below 117 overnight on Grexit comments and Chinese manufacturing PMI contraction in January (49.8 vs. 50.2 expected), breaking its 117.25 support and extending its trading range to 116 – 118.75. ‘Buyers on dips’ reversed the trend and the pair is now trading at 117.60.
If we look at the long-run perspective in Japan, late macro indicators showed us that Abe’s government will have to do more. Real wages are still declining and fell the most in almost 5 years and the economy has now entered in a triple-dip recession (0.5% contraction QoQ in Q3). On the top of that, inflation has been weakening for the past 8 months as energy prices (mainly weak crude oil) weight on Japanese core inflation rate.
In addition, we saw that Japan plans a record budget deficit for next fiscal year (starting April 1st 2015) to support the economy. FinMin Taro Aso reported that government minister and the ruling coalition parties approved a 96.34tr Yen budget proposal for FY2015/2016. And I believe that we haven’t reached the peak yet, as Japan’s aging population (i.e. increasing social security spending) will ‘force’ the government to print larger and larger deficits. The IMF predicts that the country’s debt-to-GDP ratio will increase to 245% in 2015. It clearly shows that the USDJPY trend is not over yet, and there is further JPY weakness (and USD strength) to come.

On the other side of the Pacific Ocean, the US economy cooled in the fourth quarter. After the 5-percent Q3 print, GDP expanded at a 2.6% annual pace in the fourth quarter (first estimate). Net exports was the largest detractor from Q4 GDP (-1.02%) as imports grew faster than exports. King Dollar continues to benefit from the global weakness with the USD index trading slightly below 95. The equity market still handles the Fed’s withdrawal from the Bond Market with the S&P500 trading around 2,000 (looks like it is out of energy though), while US Treasury yields are compressing to new lows. The 10-year and the 30-year yields are trading at 1.67% and 2.25% respectively (which is quite concerning), and it seems the trend is not over yet. In regards to the inflation rate (that plummeted to 0.8% in December), the Fed delivered a hawkish statement last Wednesday (‘strong jobs gains’, ‘solid pace’ for economy), however dropping the entire ‘considerable time’ sentence and adding ‘inflation is anticipating to decline further in the near term’. The implied rate of the December 2015 Fed Funds futures contract is trading 30bps lower at 41 bps, while the December 2016 implied rate decreased by 60bps to 1.05bps in the past 6 weeks.

An important topic to follow this month will be developments in Greece which are moving very fast since the election on Sunday (January 25) and Syriza’s victory. ECB council Member Erkki Liikanen said over the week end that Greece needs to negotiate a deal before February 28th (when the Greek support program EFSF expires after the 2-month extension approved in December).

Quick thoughts ahead of the Fed’s minutes…

Last month (October 8th), while many investors were quite confident on the US Dollar strength momentum, the minutes of the FOMC’s September 16-17 policy meeting clearly showed us a message from US policymakers.

If you ask me if we see a stronger dollar in the LT against most of the currencies, we would answer yes and without any doubt. we think the Fed is comfortable with a Dollar appreciation, however we strongly believe they want the process to be slow and gradual. Despite strong recent fundamentals (another NFP above the 200K level in October for the 9th consecutive time, an annual 3.5% first Q3 GDP estimate, ISM Manufacturing PMI still above 50, Housing Start fluctuating around 1mio for the past year…), global economic issues will weigh on US policymakers this time.

Let’s start with the first issue: the decline in oil prices. December Crude Oil WTI futures contract (CLZ14) is down $30 since end-of-June’s high, now trading below the $75 level. While we mentioned in one of our previous article that the decline in oil prices will be problematic for a lot of OPEC countries (see article Oil Breakeven Prices), it is now entering into critical levels even for the US. We heard and read that low oil prices could be seen as a stimulus for consumers, however it is now at levels hurting US shale production. According to some experts, most shale oil fields breakeven is seen between $70 and $75 per barrel (see chart below from Barclays Research).

ShaleBreakeven

(Source: Barclays)

 As a reminder, the US, now producing around 8.5 million barrels per day (8.65mio in August 2014 according to the Energy Information Administration), was expected to surpass Russia within the next 10 years and grow its production by 35% to approximately 11.5mio barrels per day (see chart below from the Wall Street Journal).

OilProduction

(Source: Wall Street Journal)

Therefore, if prices continue to fell, the party could end earlier than expected. In addition, lower oil prices will add pressure on inflation expectations and the 2-percent target that the Fed is watching desperately. Important figure to watch tomorrow, CPI inflation is expected to remain steady at 1.7% in November. Any print below that would create a bit of US Dollar weakness as traders will start to lose credibility on the quantitative definition of ‘considerable time’.

Speaking of disinflationary pressures, let me go to the second issue: Dollar strength. Back in the minutes, Fed officials mentioned that they saw ‘rising dollar as a risk to exports and growth’. At that time, the USD index was trading at a 4-year high above the 86 level, and up 8.5% approximately since July low of 79.78. Today, the index is trading at even higher levels (87.60), thanks to the BoJ and the Yen development and EM meltdown. We saw that September US trade balance printed its biggest deficit since April at $43bn (vs. $40.2bn consensus), up from $40bn the previous month, due to a decline in exports (down 1.5%). In our opinion, ‘Dollar strength’ will be one of the topics tonight, therefore we could see some dollar weakness after the release. In addition, Dollar strength will also weigh on inflation expectations in the US (we don’t think the inflation effect of dollar appreciation is negligible, especially couple with lower oil prices).

Therefore, we see a bit of disappointment this evening, and we will encourage some of the US Dollar bulls to cut some of their long positions. The Euro and especially the British pound could recover from their recent losses, technical resistances are seen at 1.2670 and 1.5800 respectively.