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.

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.

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