Policy Divergence 2.0 increasingly priced but further limited FX action possible

This will be a key week for determining the strength of the ECB-Fed policy divergence theme (“divergence 2.0”) which has been increasingly occupying markets in recent weeks. While Thursday’s much-awaited ECB meeting tops the billing, it will be sandwiched by two high-profile appearances by Yellen (economic outlook speech on Wednesday, address to the congressional Joint Economic Committee on Thursday) and the week will be finished off nicely by Friday’s US payrolls data release (the US ISMs releases on Tuesday and Thursday will also be much-watched).

The policy divergence theme has become increasingly priced, in both spot and options spaces (see below), as the market has partially caught up with my view from a few weeks ago that a 20bp ECB deposit rate cut is a live option on Thursday (given the ECB’s strategy of keeping ahead of market expectations, Draghi’s record of over-delivering when the chips are down and deposit rate cuts having likely bigger euro impacts than QE extensions) and a December Fed rate hike has become increasingly priced. So there’s now a greater chance of policy disappointment, and associated potential reversals of recent EUR weakness and USD strength (with EURUSD again below 1.06 and DXY above 100 this morning, both of which have been strongly related to growing policy divergence expectations).

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But nevertheless several factors support further limited EURUSD downside seems likely this week, with 1.05 potentially being breached.
• First, the ECB policy decision will be importantly impacted by the ECB staff’s new forecasts – and there’s a good chance that these could be materially lower than in September given Draghi’s recent comments.
• Second, the 20bp ECB deposit rate cut I anticipate on Thursday isn’t completely priced (ECB-dated Eonia futures are pricing a 90% chance of a 15bp cut) and Draghi’s “we will do what we must to raise inflation as quickly as possible” speech laid out a provocative case for strong ECB action (see here), reinforced last week by the Reuters story of a wide variety of policy innovations being considered and the ECB FSR warning about risks from Asia.
• Third, Draghi may well also spring a surprise by unveiling measures to offset the impact of the deposit rate cut on banks’ margins e.g. more generous TLTRO terms or last week’s Reuters story on potential tiered deposit rates. I expect a 6-12 month QE extension in addition to the 20bp deposit rate cut, although the QE extensionby itself probably won’t have that much impact on the euro.
• Fourth, Draghi is expert at using dovish language to complement immediate policy actions – promising further action down the line if necessary – and will be keen to avoid the euro bouncing back on a disappointed market.  Moreover, it’s notable that the EUR TWI has fallen less than EURUSD (and the ECB pays more attention to the TWI) and that the nascent rise in EA inflation breakevens again seems to have stalled, despite the EUR fall (see Chart). The rumours of about municipal bond QE purchases could fit in the “we can do this if necessary: we’ve got ammunition left” category.

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• Fifth, Draghi, Praet and Constancio likely wouldn’t have ramped up their dovish rhetoric if they weren’t confident that they could get the Governing Council to agree to substantive measures. Recent comments indicate that Lautenschlager, Hansson, Jazbec and Rimsevics will be the toughest to convince, although unanimity could be sacrificed if necessary.
• Sixth, Yellen’s speeches and US data will likely see expectations of a December Fed rate hike rise a little further.  Yellen seems likely to reiterate the significant cumulative progress the US economy has made and the expectation for the Phillips curve to kick in to get inflation heading up (I’m still not completely convinced by the Phillips curve arguments but base effects will help support a rise in inflation over the next few months).  I’m not expecting her to express greater concern about USD strength than Fisher did, but that’s a risk to watch out for. On the data side, a payrolls number anywhere near last months’ stonking 271k rise (the market consensus is for 195k) or a further rise in average hourly earnings growth above last month’s 2.5% would almost-certainly see the market-implied probability rise closer to 80%. And recent steady US data could well continue with the ISM releases, although market attention will be on the impact of USD strength on manufacturing.
• Seventh, EURUSD downside may well gather momentum should the mid-March low of 1.0466 be breached (consistent with my 3m view of 1.02-1.04), although there may also be technical resistance around that level.  That said, technical factors (shor squeeze) could also potentially amplify EURUSD upside should Draghi disappoint.

Indeed, the temptation for investors to square positions and take profits around the uncertain outcomes needs to be taken seriously –  especially if investors worry that USD could suffer from “buy the rumour sell the fact” around the prospective Fed rate hike (such perceptions can be self-fulfilling). While the raw data around previous Fed tightening periods provide some such dynamics, in September I argued that digging deeper revealed some important caveats about the applicability to the current situation e.g. US-foreign rate differentials generally didn’t widen further after the previous Fed hikes (but seem likely to over the next few months) and USD weakness after the 2004 Fed rate hike seemed to reflect a combination ofoil-price rise induced US current account worries and USD’s funding currency status (neither of which are apparent now).

Interestingly, however, the USD TWI rise over the past 2 months is sharper than in the run-up to any of the four Fed pevious rate hike cycles (although on a longer view it looks less of an outlier as as it looks reasonably similar to the June 1999 Fed hike, and to a lesser extent the February 1994 one).  My preferred interpretation is that this reflects the prospective policy divergence this time around likely being substantially greater than in the Fed rate hike periods.  Indeed, 1994 is the only other time that US and European (Bundesbank) policy were moving in opposite directions.  But increasingly negative ECB deposit rates seem a different kettle of fish, with likely greater FX impacts, to the Bundesbank cutting from 5.75% to approach US rates from above.  While the recent unusual USD strength could also be consistent with a larger eventual disappointent-driven retracement, I prefer economics (ECB won’t want to disappoint) to such muchanical arguments.

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That said, USD long positions look more stretched than around previous Fed rate hike periods.  Indeed, the now-substantial EUR short positions argue against further large EUR falls, unless of course the ECB surprises more substantially than I expect.

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Policy divergence increasingly priced: options suggest biggest impact from ECB

As mentioned above, the ECB-Fed policy divergence story has been increasingly priced, in both spot markets are derivatives.
• ECB-dated Eonia futures are pricing a 90% chance of a 15bp ECB deposit rate cut (with a 10bp cut being fully priced in), up from virtually zero only a few weeks ago.
Fed funds futures are pricing around a 70% probability of the Fed starting lift-off on 16 December, up from around 30% prior to the Fed’s hawkish turn in October last month’s strong payrolls release.
• The two year Bund-Treasury spread has reached its widest level since 2006 as 2 year bund yields have fallen into record negative territory (-0.43% today, with ) at the same time that US treasury yields have spiked relatively sharply (2y Treasuries up 35bp since early October).

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• Alongside that, the EA-US 2-year swap spread has reached a record low and that’s been highly-correlated with EURUSD’s fall in recent weeks (see Chart above).  Indeed, EURUSD’s move below 1.06 in recent days equates to an 7.7% fall since mid-October and puts the mid-March (closing) low of 1.0496 in view. But, as noted above, the EUR TWI (which the ECB places more weight on) has been more resilient.
• And, as also noted above, the general USD appreciation in recent months (DXY or USD TWI) also seems strongly related to growing policy divergence expectations. The chart below illustrates that this reflects a steady rise in expectations of non-US policy easing and an erratic path for expectations of Fed tightening, with the sharp moves downgrade after the September hold (with the statement’s concern about EM weakness) and subsequent sharp upgrade after the October Fed statement (see here) notable.  And the risks seem skewed towards Yellen having some difficulty convincing markets that the Fed really is going to tighten only gradually in 2016 after a December rate hike: so a further pickup in US yields could eventuate, supporting USD.

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•That said, bond markets show signs of listening the Fed’s (new) message thus far: the chart above illustrates that the US yield curve has flattened notably since July with a further leg-down in the past couple of weeks.  By constrast, the EA yield curve slope has changed little since mid-year and so remains substantially steeper than in April (before Draghi’s ill-timed “get used to volatility” comment).  The ECB have previosuly been concerned about the slope of the yield curve (see here), so this represents a further argument for the ECB extending/expanding QE.
Implied FX volatilities have also moved to price December ECB easing and, to a lesser extent, December Fed liftoff. Specifically, 1 week FX volatilities involving the EUR have risen to historically-elevated levels and are generally a little higher than their 2 week and 1 month equivalents (see Chart).  So option markets are pricing a significant but decaying impact from this week’s ECB meeting (although volatility obviously doesn’t necessarily equate to EUR depreciation). By contrast, FX vols involving USD are generally less elevated, even for the 1-month coverign the aftermath of the Fed’s decision (EURUSD vol are the main exception, but that sems to reflect the ECB side of things).  This option market view that the Fed won’t significantly shake up the FX market is consistent with market participants regarding a December Fed rate hike as a done deal.

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Short-maturity option-implied correlations with EUR as the “independent” variable (e.g. correlation between EURGBP and EURJPY) have risen markedly. That’s particularly marked at the 1-week tenor, with implied correlations reached record highs of above 0.9. The equivalent 1-month implied correlation is less elevated (0.64). So options are pricing a substantial independent shock originating from the ECB over the next week which then dies down somewhat.
Implied correlations with USD as the “independent” variable e.g. correlation between GBPUSD and USDJPY) have also risen in recent weeks but are generally lower than those with the EUR as the independent currency across tenors. That said, the gap narrows if you consider only G3 currency interactions (LHS chart below), with the 1-month implied correlation between EURUSD and USDJPY currently lying close to 0.7. But overall option prices don’t seem to anticipate the Fed shaking up the FX market quite as much as the ECB.

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FX strategists less impressed by growing policy divergence theme

In contrast to the relatively sharp moves in asset price diagnostics of policy divergence, the consensus of FX strategists about future FX moves have changed relatively little in recent weeks and indeed continue to indicate relatively small FX moves in the next few months (I consider mean forecasts but the story is the same for medians). For EURUSD the limited downward revisions to the forecasts over the past month (with the mean Q1 ’15 forecast down to 1.06 from 1.09) contrasts with the much larger downward revisions alongside the sharp (expected) QE-induced EURUSD fall between September 2014 and March 2015.  Having followed the spot down, the average strategists decided (for a change) to stick to her guns despite the limited EURUSD bounceback. But the most notable development is the withdrawal of aggressive EURUSD downside forecasts (dotted lines) e.g. the lowest Q1 ’16 forecast is now 1.00 whereas someone was willing to stick their neck out with a 0.92 for three months. The downward revisions to mean USDJPY forecasts likely reflects the growing realisation that the BoJ was unlikely to act. I advocated EURJPY shorts as attractive a couple of months ago, given that the BoJ seemed likely to underperform ECB easing and that it usefully abstracts from Fed policy uncertainty and market risk appetite impacts. But here the highest USDJPY forecast has actually been little changed – one strategist is currently forecasting an aggressive 132 in Q1 ’16 (versus a Q1 ’16 high of 133 in July) – its the lower end of the distribution that’s shifted up.

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Market risk appetite little impacted: EUR carry trades could  flourish

I’ve previously argued (see here and here) that even if the policy divergence theme emerges a potential barrier to EUR weakness (USD strength) would be market risk appetite being negatively impacted by the Fed hike or ongoing China/EM concerns (outweighing the support from ECB easing).  Such a net adverse hit would tend to reverse the recent EUR-funded carry trades, putting upward pressure on the EUR.  Falls in EA equity prices could also add a further leg to EUR upside: previous FX hedges of EA equity exposures would now be excessive and hence need to unwound, (the earlier initial hedging of foreign purchases of EA equities means that that such inflows didn’t suppprt EUR).  So it’s interesting that the growing policy divergence expectations, which have seen FX volatilities rising (see above), has not been accompanied by a rise in equity market uncertainty: the VIX ticked up for a few days after the Paris terrorist attack but have since fallen back.  So there’s hope that market risk appetite may well be robust to the prospective December Fed hike, allowing EUR-funded carry trades to gather pace.  Here there may be non-linear impacts of increasingly-negative EA deposit rates and the impacts via both speculative flows and longer-term portfolio flows need to be considered (I’m in the process of looking into the EA and US ortfolio flows data).  Indeed, given how well its’s been flagged, it would be surprising if a small reduction in the degree of US policy accommodation sent shock waves through equity markets.  Moreover, Yellen will likely work hard to forestall a large upward shift in future rate hike expectations (although this will also reduce USD’s yield support per se).

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Watch Vulnerable EM and the EUR satellites’ reactions to ECB actions

The impacts of the Fed and ECB decisions will neverthless likely reverberate around global markets. The potential adverse impacts of the Fed hike on emerging market countries (and FX), particularly those with large USD-denominated funding needs, low FX reserves and a strong incentive to depreciate in order to escape deflationary trends emenating from China have been much discussed.  Indeed, the temporary pause to EM FX weakness after the Fed’s September no change decision and dovish policy statement as been replaced by renewed EM FX weakness as Fed rate hike expectations regained their footing.  While some argue that the end to the uncertainty about the Fed is a conterveiling force, I expect that effect to be pretty limited relative to the excess capacity, debt burden and competiviveness issues faced by many EM countries (which depreciation can provide salves for).

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Conversely, substantial further ECB easing will further up the ante for the EA satellite central banks who have been trying to keep up with ECB easing. Here the SNB and the Riksbank stand out (I anticipated the Riksbank’s October QE extension to June 2016 and shifting out rate rises by 6m here).  Both have continued to stress that that they’re prepared to react to nascent FX strength (generated by ECB easing expectations).  But the FX moves illustrate that the SNB have been substantially more successful in recent months: while EURSEK is down nearly 4% since August, EURCHF has been pretty flat (and indeed is up 5% since start-June). That reflects Swiss inflation being more consistently moribund (the worst performer in the G10, see Chart) and the greater SNB policy credibility (the relatively-small Swedish government bond market will prevent Riksbank QE getting anywhere close to ECB QE as a share of GDP and Riksbank QE is slated to end earlier even after the October extension).  So the Riksbank seems likely to blink first (Indeed, the SNB’s apparent committment to EURCHF stability or upside in effect makes short EURUSD a leveraged play on short EURUSD positions.  But investors may be reluctant to implement such trades with the SNB’s January abandonment of EURCHF floor at the back of their minds (the “leveraged play” argument was often made before the SNB shocked the market).

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The BoE’s MPC may also be looking a bit nervously across the Channel, given that EURUSD is hovering just above 0.70 (versus its 2015 low of 0.697) and trading closely with rate differentials and MPC became more concerned about the persistent impacts of previous GBP strength on inflation in the November Inflation Report.  I discuss here how such concerns, plus MPC suddenly abandoning their sanguine take on EMs (just as the Fed was getting more relaxed again) appear puzzling and could be convenient covers for trying to differentiate the UK situation from the US given the Fed’s prospective hikes.  The MPC seem uncomfortable with their “mini me” to the Fed, but their attempts to shake it off haven’t really been successful.  That said, Friday’s record negative contribution of UK net exports to GDP (-1.5pp out of the 0.5% quarterly growth) largely reflected very strong UK imports (+5.5% q/q) rather than weak exports (+0.9% q/q) and looks potentially erratic.  The more enduring factor may wel be the robust business investment outturn (+2.2% q/q) alomgside continued string cosumption (+0.8% q/q).  Moreover, aggressive ECB action could well be an overall net positive for the UK if it stimulates EA demand for UK exports (exports are more responsive to such demand factors han FX moves).

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