Yellen will likely find it difficult to calm the sum of the markets fears: fixed income rally and JPY strength to extend

Fed Chair Yellen’s semi-annual testimony occurs at a time of considerable uncertainty about the global economy and substantial financial market volatility.  Oil price and equity price falls, particularly bank stocks, have dominated recent moves as global government bonds have fallen up to 60bp since end-2016 (with 10 year JGBs turning notably negative) and the dollar has weakened despite dovish words/actions by the BoJ and the ECB as risk aversion effects have dominated policy expectations in driving FX movements.
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Moroever, investors are increasingly questioning whether the Fed make a mistake by hiking in December, with US recession expectations seemingly growing by the day (with commentators focussing on yield curve slopes adjusted for the extraordinary policy measures e.g. here). Yet the January Fed statement was less dovish than markets had hoped for.  So Yellen’s testimony will be closely watched to see the extent to which she backs away from the four interest rate hikes indicated by the December dot plot. By contrast, market FOMC rate expectations have repriced sharply over the past six weeks such that no hike is priced in for 2016. That’s certainly a challenge to Fed orthodoxy which sees inflation picking up with a tightnening labour market and waning headwinds from previous oil price falls (Yellen focussed on price level effect in December) and the previous USD appreciation.

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Yellen to be dovish but could disappoint elevated market expectations

Overall I expect Yellen’s comments to echo the dovish ones of Stanley Fischer and Bill Dudley reasonably closely, recognising that there’e been a deterioration in the international environment, a tightening of US financial conditions and some dimming of US growth prospects (as indicated by weak ISM surveys).  But financial market seem to have pretty elevated expectations/hopes for the extent of her dovishness: only a reasonably large policy volte face would constitute a dovish surprise that would provide significant market support.
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Rather, unfortunately, the risks seems skewed to Yellen being a little less dovish than the market expects, thereby failing to make a major inroad into market risk aversion and hence interrupt the recent market themes of government bond market rallies, dollar weakness and equity selloffs.  Specifically, it’s probably still too early for Yellen to start dropping strong hints about interest rate cuts just yet or preparedness to follow the ECB, BoJ etc into negative rates (while obviously not ruling it out, mirroring the Bank of England last week), she will likely continue to stress data dependency and it’s also not impossible that she could:
(i) not yet be ready to go as far as the September statement in playing up the dangers from the international environment (“Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term“) given that they then ended up subsequently doing a volte face and may well want to avoid repeating that loop.  In other words market hopes that she moves significantly beyond the January statement “The Committee is closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook” could well be dashed;
(ii) not definitively take a March (or indeed a June or 2016)  hike off the table – the Fed seems unlikely to move in line with market pricing for a while yet (they’ll need much more evidence that something dramatically different is going on, even if the evidence increasingly points that way) .
(iii) highlight the continued steady US labour market progress, with the unemployment rate having a 4-handle for the first time since February 2008 and signs of earnings growth finally ticking up (albeit erratically). The Fed has been steadfast in assuming that the Phillips curve will eventually kick in although there’s not much evidence of this in unemployment-inflation space (which is why I’d have preferred them to have not moved in December) and the deflationary emenating from China could yet stall the recent small core PCE deflator uptick;

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(iv) see some positive for the US within the financial market turbulence e.g. dollar depreciation supporting exporters/manufacturing, lower yields supporting investment  and oil price falls supporting consumers’ real incomes.
(v) downweight the importance of the sharp decline in US 5y5y breakevens which has coincided with the renewed oil price falls and has been sharper than even the fall in EA breakeens.  But the New York fed model tends to ascribes it to risk premia effects, although you’ve got to question how much weight to put on such models.  And Monday’s reported fall in the New York Fed survey measure of household inflation expectations (see here) should start raising concerns.
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Even a dovish Yellen probably can’t calm all markets’ (justifyable) fears

Moreover, it’s also debateable about whether even a very dovish Yellen will be able to calm markets near term (although it would help at the margin), given that market worries encompass a wide range of substantive issues:
(i) Concerns that G10 Central bank policy becoming ineffective.  Markets have brushed aside recent ECB dovish hints and BoJ rate cuts (because the latter only apply to a small subset of deposits, if at all) as both EUR and JPY have soared on the risk-off environment (see below).  But more generally markets are concerned that the impact of QE and rates cuts on asset prices is both waning (decreasing returns) and there’s little sign of their effects being felt in inflation (althoigh obviously the counterfactual would likely have been much worse).
(ii) Worries about the sources of global demand, in an environment of falling trade volumes and concerns about growth prosects in most regions of the world and deflationary pressures emanating from China and AxJ. Certainly G4 macro data have surprised negatively, although the US situation isn’t yet as bad as early-2015.
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(iii) Concerns about the extent of the China slowdown and the PBOC’s temptation to engineer a sharp CNY devaluation given rapidly-shrinking reserves.  The remaining $3.23 tn reserves may at face value sound like a lot but IMF-suggested adequate can be as high as $2.7tn (depending on assumptions) and reserves have fallen by nearly $0.3tn over the past three months so at this run-rate it could only be six months before they fall below that level and the market really starts questioning the policy;
(iii) excess capacity problems in much of AxJ after their investment/borrowing boom, leading to more generalised deflationary pressures (adding that originating in China) and vulnerabilities to USD appreciation given that much of the debt was dollar denominated;
(iv) evidence of a more general EME slowdown e.g. the travails in Brazil and Russia (see here);
(v) excess supply capacity in the oil market, notwithstanding the hoped-for Russia-Saudi deal which seems to have halted the oil price decline, with the IEA raising its estimate of surplus oil supply on Tuesday.
(vi) worries about European banks, as concern about credit markets has seeped into equities (even if the latest moves probably represent overshoots).
(vii) Concerns about the European project – with UK Brexit uncertainties likely to persist/grow over the coming months (see here), which would likely hurt the EA as well as the UK – plus renewed widening of periphery-Bund spreads on political uncertainties (see here).

Such concerns will likely take at least several months to abate – helped eiether by growth surprisingly picking up or, more likely, by further central bank dovishness (the ECB will likely have to cut the deposit rate by at least 15bp and perhaps expand QE further to have a substantive impact).  But they could well also widen because of their own dynamics (e.g. further months of weak Chinese macro data and/or sharply falling reserves) or because central banks are judged to be not be up to the task of turning the situation around (or the PBOC does another policy fumble rather than tbe focus shifting to fiscal measures and structural reform).

Bond markets: likely further fixed income rallies

The net impact is that the recent high demand for fixed income assets, as a safe haven from the volatility/uncertainty of equities is likely to continue.  The up to 60bp fall in government bond yields since end-2015 seems likely to extend in a continued uncertain market environment.

FX markets dominated by risk aversion effects: higher vols and USD weakness

As mentioned above, the risk-off market enviroment of recent weeks has been characterised by USD (and GBP weakness) alongside EUR and JPY strength – with EURUSD rising to within a hairs breath of 1.13 (the highest since October 2015, see here) while USDJPY has fallen below 115 (the weakest since October 2014).  Those sharp moves have caught some high-profile investors on the hop (see e.g. here), although I cautioned in December that USD was vulnerable to a China-induced spike in risk aversion (see here).

But it’s notable that the FX moves haven’t reflected their usual driver of relative swap rate movements (policy expectations). That’s most apparent for USDJPY,  where indeed 2y swap rates suggest small upward pressure, but there’s also a gap for EURUSD (although US 2y swaps have actually fallen by more than EA ones despite the ECB’s renewed dovisness).

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Rather there’s again been strong links with the equity price falls discussed above, particularly for JPY.  But my previous conclusion that the ECB will be relieved that the EUR has risen by less than implied by EA equity price falls (see here).  But the net effect has been for G10 FX volatility to rise broadly in parallel with equity market volatility (VIX), with indeed FX implied volatilty rising to the highest since February 2015.

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And given that Yellen seems unlikely to be able to calm the sum of markets’ fears, such risk-avererse trading seems likely to continue near-term, with safe havens like JPY continuing strengthening while risky currencies continue underperforming. I discussed here how Brexit-related uncertainties will likely weigh on GBP in the coming months (with markets being sceptical about opinion polls and the MPC happy to see GBP fall back to help generate inflation and support exports/manufacturing).  And the recent sharp GBPJPY fall seems like a prime example of strong risk aversion effects at work. So the risks seem weighted to further GBPJPY downsides in the near-term (unless the market decides that it’s over-egged recent concerns).     

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Of course, GBP isn’t the only “risky” currency at present.  Indeed much of the EM, especially in AxJ with excess capacity and commodity exporters, remain exposed in current conditions.  For example, the recent rises in JPYKRW and JPYRUB seem to have room to extend further should, as seems likely, recent stressed market conditions continue.

Japanese authorities worry, but BoJ options shrinking and JPY still looks “cheap” (USD doesn’t look significantly “expensive”)

The potential major constraint on JPY upside in continued stressed market conditions, of course, is potential BoJ action.  Indeed, PM Abe was on the wires overnight saying that he was “closely watching markets” (though it was up to the BoJ to decide monetary policy). And such concerns about the impact of BoJ policy easing stalling will be exacerbated by the sharp fall in Japanese equities, with Nikkei banking stocks vying with EA bank equities for the largest recent falls.

While BoJ governor Kuroda has recently been arguing that the BoJ is prepared to do more, such arguments are undermined by the recent rate cut only being voted for by a narrow 5-4 majority.  Moreover, the tiered interest rate system substantially reduces the impact of the negative rates policy: its’s far from shocking and aweing the market. And further extending QQE will likely run into problems of the BoJ owning a large share of the JGB market (already at around a third but set to rise to around a half in the coming months).

Finally, valuations don’t seem to represent a major barrier to further JPY upside.  Judging whether a currency is “cheap” or “expensive” is notoriously difficult, but rather than getting into complicated modelling a well-trusted approach is to examine real effective exchange rates relative to long-term averages (as computed by the IMF).  And on this metric JPY looks the “cheapest” of the major currencies (currently lying nearly 30% below it’s long-term averages).  Interetingly, SEK is the second cheapest – and that combined with Sweden’s strong growth dynamics and house price inflation suggests SEK upside in the medium term (but the near-term risks seem skewed to the Riksbank neverthless cutting again tomorrow on CPIF inflation concerns). Conversely, CNY looks the most “expensive”, hence the pressure on the PBOC to devalue.  But GBP also looks expensive, reinforcing the downsides discussed above (although the latest data are for November).

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It’s also notable that USD looks only slightly expensive on this metric: given the uncertainties anything less than 10% on them classifies as “not clear”.  And that suggests  that valuations shouldn’t act as a major barrier to eventual further USD upside should the current period of abate or the Fed end up actually raising interest rates in 2016 rather than being “one and done”.  But that remains a bif “if” at the moment – hence why Yellen’s testimony will be so watched by market.

Stretched JPY upside positioning could start biting

One potential constraint on further JPY upside, however, is that positoning is starting to look a bit stretched.  CFTC data show JPY longs at the highest share of open interest since 2012 (although it only took a small knock after the BoJ action which had such a temporary impact on JPY). And GBP downside positioning is also starting to look crowded.  But my prior is that in the near-term the macro-financial developments will trump those crowded trade concerns although traders will likely take much-needed profits at opportune moments.  Conversely EUR short positions continue to be squeezed, which could add further to the recent EUR upside dynamics.

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