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.

June rate hike? What Yellen (and the Fed) faces…

I have to admit that by just looking at the government bond yields (see appendix), I am asking myself a lot of questions about the stability of the economy and the financial markets. However, one particular point that matters the most is the Fed’s June rate hike.

Therefore, this article aims to give an update on the four major risks that can lift-off the central bank’s monetary policy decision for later this year, which are the following topics:

  • China slowdown
  • Dollar strength
  • Oil prices
  • Grexit: Greece and all its 2015 payments
  1. China Slowdown

It is clear that commodity prices have dropped dramatically over the past year based on a lower than expected Chinese growth (i.e. global demand). If we look at the last figures, analysts expect China to grow by approximately 7% in 2015, down from the last 7.5% projection (in late 2014). Last week, we saw that the economic output grew 7% YoY in the three months of 2015, down from 7.3% in Q4 last year and now standing at its slowest rate in six years. What really concerns me is that I read several times the word ‘approximately’ in analysts predictions of China 2015 growth, this means that we could see an actual lower than 7% figure, especially in the middle of this geopolitical war.

In the housing market, it looks like the economy is experiencing a sort of ‘real’ correction: if we look at on of Chinese Housing Market ‘benchmark’ – China 70-city Home price change – the last report showed that house prices decreased 6.1% YoY in March, its eighth negative print in a row and the biggest drop in history.

It is hard to believe that after a 15tr USD increase in total Chinese Bank assets since September 2008, the economy is still struggling to achieve a healthy growth. The obvious response from Beijing officials was to cut its Reserve Requirements Ratio by 1% to 18.5% (last one was a 50bp cut in early February), ‘flooding the market’ with liquidity and participating – like the rest of the World – to this massive monetary stimulus.

What the PoBC cut a sort of ‘preparation’ to the Fed’s action?

Maybe I know too little about the Chinese economy (and history), but it is curious too see that some financial experts have a totally different interpretation of China.

For instance, in the last discussion that I had with a (very) experienced economist, I asked him ‘Where do you see the most interesting opportunities at the moment for medium term investments?’

He answered me: ‘Well, there are three countries you should invest in: China, China and China!’ He started his quick analysis about the massive internal migration of young new dwellers moving from rural to towns and cities (between 10 and 20 million each year according to NBS). Chinese major cities will host approximately 60% of the country’s total population (permanent urban residents) by 2020 (slightly above 50% now), therefore playing in favor of Chinese Fixed assets, companies’ valuation,… However, I was asking myself: ‘What about work conditions and salary increase? We learned from the last GFC that you can’t reach a sustainable economy with a divergence between median annual incomes and home prices. In addition, you can’t build a strong economy based on speculative stories and artificial growth (look at the Spanish situation now after the correction in the housing market).

Moreover, this scenario was based on a strong assumption that relations between China and the US remain stable (i.e. no pressure from the West to abolish the exchange rate peg). This is clearly not obvious, especially in this new (sort of) Cold War between East and West. If we look at the US Treasury website, we can see that China has reduced its US Treasuries by 50bn USD over the past year (its US holdings stand at 1.224Tr USD as of February). If this trend continues, pressure from US officials to drop the peg will be more and more a serious debate.

Besides that digression, it seems that we are going to see some downward revision in China, which will obviously be a persistent topic at the next FOMC statements.

  1. Dollar strength

The topic that I love to discuss is the Dollar strength. Described as the most crowded trade of the year, it is clear that a constant strengthening greenback will be problematic for the US economy, especially now that the Fed has stepped out of the bond market. Even though we saw a sharp reduction of the government’s deficit in the last two fiscal years (the annual US budget deficit fell from 1.1tr USD for FY12 to 483bn USD for FY2014 as you can see it in the chart below – equivalent to 2.8% of the country’s GDP), the US still runs large current account deficits (coming from consistent trade deficits) which forces them to rely on external funding.

USdeficit

(Source: WSJ)

A strong dollar wouldn’t help to ‘redress’ the balance of trade (i.e. exports are less competitive), and will obviously decline companies’ sales and reduce the economic output. Pessimist Atlanta Fed forecast a zero-percent growth for the first three months of this year, down from 1.9% in early February. The market is more bullish anticipating a 1.4% rise.

The July Fed Funds Futures implied rate is at 15bp, while September and December are trading at 21bp and 34.5bp respectively. From that perspective, I will opt for a September move (vs. June).

  1. Oil prices

As you know, oil prices fell sharply in the second half of last year, bringing to an end a four-year period of stability around $105 per barrel. If we look back at prices’ history since the early 80s, there has been four other relevant declines prior to this one:

  • Increase in oil supply and change in OPEC policy (1985-86)
  • US recessions after the S&L crisis in 1990-1
  • The Asian crisis of 1997
  • The Great Financial Crisis 2007 – 2008

Today, the causes of the Sharp Drop could be explained by multiple factors: a change in OPEC policy objectives (no intervention from Saudi Arabia in the last OPEC meeting on November 27th last year), increasing production (US Production of Crude Oil now stands above 9ml barrel/day, up from 5ml 7 years ago post GFC), receding geopolitical concerns about supply disruptions in the Middle East and between Russia and Ukraine, a sinking global demand and a US dollar appreciation. It is hard to define which of these factors was the most important, however I would say the expansion of oil output in North American due to the US Shale revolution (and Canada oil sands) and a declining global demand both weighed on oil prices.

Although low oil prices (and other commodities) is seen as a sort of stimulus for consumers by analysts, I am very confident that it is also the explanation of the late decrease in inflation expectations in all the Western countries. The table below shows you the Consumer Price Index of the major economies:

Country

March

July

US

-0.10%

2.00%

UK

-0.10%

0.40%

EZ

0.00%

1.60%

Japan

2.2% (February)

3.40%

Even the 5y/5y forward swap rate, what central banks watch as an indication of inflation expectations, has fallen to unprecedented sub-2 percent levels in the US, which is going to be problematic as Yellen and (most of) the Fed’s Board have considered that it is time for monetary policy tightening – the so-called neutrality.

In addition, low oil prices could also be a burden for all the high leveraged shale oil companies in the US. The chart below (source Bloomberg) gives us a quick idea of where oil prices have to stand so that shale companies are (at least) breakeven. According to the sell side research, breakeven prices for US shale oil are within the $60-$65 window. WTI May futures contract is still trading below those figures at a shy $56.

ShaleBreakeven

(Source: Bloomberg)

  1. Grexit and the contagion effect

With the 10-year yield now trading at 13% (and the 2Y at 29%), it is clear that the market is anticipating disappointing negotiations between the new Greek party and the Troika. There are lots of good articles that came out lately about Greek’s situation, but that could easily be summarize by the chart below. This clearly shows that there are going to be a lot of meetings with European officials before the Summer, and the Tsipras government will have to innovate its list of reforms in order to free up funds and service its short-term obligations.

GreeceInSHort

(Source: IMF)

What’s next then? Let’s assume Greece makes it way through the summer (the two 3bn+ payments to the ECB) without catching a cold, this is only the 2015 chart and there are plenty of more years to come. No borrowing from the financial market and an unstoppable increasing debt (see article Pocketful of Miracles). A situation that could only deteriorate in my opinion…

In the latest news, Bloomberg reported that the Greek government issued a legislative act yesterday that requires public sector entities to transfer idle cash reserves to Bank of Greece (i.e. capital controls) as the country is willing to serve its next €1bn debt obligations to the IMF next month.

To conclude, we may see a symbolic 25bp hike at the June FOMC meeting, however I am certain that we are far from the so-called long-run neutrality rate of 3.5%-4%. If the weak global macro environment persists in the medium term, we are constantly going to see downward revision in the Fed’s dot plot.

Appendix: Government bond yields

BondYields

Pocketful of Miracles…

It is sure that things are not easy negotiating with its ‘partners’ as time goes on. As Latin poet Publilius Syrus once said ‘A small debt produces a debtor; a large one, an enemy’. In this article, we are interested to see where the negotiations will go within the next few days.

First, let’s review quickly what is going on with Greek’s liabilities.

GreekDebt

(Source: Bloomberg)

The pie chart above shows us who ‘owns’ Greece’s public debt. According to the country’s Statistical Authority, Greece’s total public debt amounted €315.5bn  at the end of the third quarter of last year, which corresponds to roughly 180% as a share of the country’s GDP. As you can see it, the EFSF, the EZ temporary crisis-fighting fund, lent the country €141.8bn (which represents 45% of it) and the current weighted average maturity is 32.38 years with the last payment due in August 2053 according to the fund’s website. As you may have heard at the end of last year, the Board of Directors of the EFSF decided to grant Greece a two-month technical extension. The program will end on February 28th instead of December 31st last year. As a result, the remaining amount available (1.8bn Euros, which will raise the total amount to 143.6bn Euros) could still be disbursed to Greece (in need of assistance) until the end of this month.

Another major ‘creditor’ of Greek’s debt is the ECB, as a result of the Security Markets Programme (SMP), which currently owns about €27bn (i.e. represents 40% of the €67.5bn marketable debt outstanding). However, whereas EFSF loans where principal payments don’t start until 2023, Greek is set to pay 6.7bn Euros held to the ECB this summer (20 July: €3.5bn, 20 August: €3.2bn).

Eventually, the IMF is also an important creditor with 25 billion Euros according to the fund’s website, maturing currently. IMF loans in February and March are €3.5bn. As a reminder, the IMF’s policy is to never restructure its loan.

Therefore, if we add up the Greek Loan Facility (Bilateral Loans), the ECB holdings, the EFSF loans and the outstanding IMF credit, we get 246.7bn Euros, that is to say 78.2% of the total public debt. How convincing will the new Tsipras government be ‘against’ those figures?

It has been a rough start for Greece: the country’s news has been making the headlines since (and before) the election of the new government (January 25th). PM Tsipras has made it clear that Greek debt is unsustainable, condemning the country to a state of perpetual economic recession and deflation, and is trying to negotiate a write off with its debt creditors. In addition to that, he unveiled last Sunday plans to undo several austerity measures: gradually increasing the minimum wage, dropping the recent property tax and promised the retirement age wouldn’t be change (anymore).

However, this will be the tricky part of the deal – asking for a write off while easing austerity measures – as they don’t (or never) come together usually. Negotiate a debt write off, press for a relaxation of economic austerity, avoid a bank run, and on the top of that, maintain a political stability. It is interesting to see that investors are considering political risks once again after more than two years of main attention to the ECB and its programs and promises.

However, as many of you, we would agree that the market is underestimating the consequences of a Grexit clearly, not only the costs, but also contagion to other ‘weak’ peripheral economies (i.e. Portugal). What would happen to the Euro if the spread between peripheral and core yields (good sovereign risk indicator) starts to rise once again (like in early 2012)?

Quick view on EURUSD:

EURUSD broke its small resistance at 1.1350 yesterday after a quiet week, and seems on its way to retest the 1.1500 level. We saw earlier this morning that EZ grew by 0.3% in the last quarter of 2014, meaning that the 19-bloc economy grew by 0.9% during 2014, better than the 0.8% expected (see details in Appendix). However, Greek FinMin is making the headlines this morning: ‘Haircut preferable to loan extension’, which is obviously ‘capping the pair on the topside. A good entry level would be above 1.1460 (if it makes it up there), with a stop above for 1.1530 and a take profit at 1.1300. You can also play the bigger range, setting your stop above 1.1650 and take profit at 1.1200. However, we wouldn’t recommend to be too ‘greedy’ ahead of the Eurogroup meeting on Monday.

Otherwise, we stay strongly bearish on the Euro in the long term (vs. USD and GBP), as growth, monetary policy divergence, Grexit contagion, geopolitical tensions will clearly weigh on the single currency.

Appendix

EZGDP

(Source: EuroStat)

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).