This post examines the factors driving FX markets and previews this week’s Fed and BoJ decisions. The main points are:
• Calmer market conditions, driven by a continuation of the factors I discussed here, mean that G10 and EM FX volatilty has fallen thereby further raising the attractiveness of FX carry trades. This seems likely to continue near-term given likely limited Fed policy changes on Wednesday and a potentially more dovish BoJ on Thursday.
• The most attractive dollar-funded carry trades remain in INR, TRY, and BRL (plus NZD and AUD in G10) although the biggest recent movers have been the medium-carry ZAR and RUB. Overlapping this has been the support for commodity currencies have been supported by price bounces.
• The Fed’s cautious risk-management approach seems likely to continue on Wednesday with only limited changes to the March text – perhaps marginally less worry about international risks balanced by marginally greater concerns about US data. Limited further hints about a potential June rate hike seem less likely (but not impossible).
• The Feds’s likely continued dovishness reflects: (i) there’s no press conference to flesh out the change of text and hence calibrate market reactions (ii) the Fed will likely not want to disturb the better, but fragile, market developments which have supported loosning of financal conditions by sending a strong signal about a potential June Fed hike; (iii) while better Chinese data will soothe Fed concerns about international developments it’s premature to set them aside; (iv) softer US data, with Q1 GDP likely weaker than the underwhelming Q4 outturn, could be starting to worry the Fed even though the labour market remains strong; (v) the Fed’s call that the recent inflation uptick was temporary looks prescient and survey inflation expectations remain low, although inflation breakevens have bounced.
• Such continued dovishness seems likely to result in limited near-term USD weakness, with EURUSD potentially rising above 1.14, especially should the Fed raise it’s concerns about inflation expectations (not my central case).
• The odds are finely balanced for further BoJ action on Thurdsay. Continued weak domestic demand and inflation argue for action to finally escape the mire. But BoJ disagreements/public dissent, the need to avoid FX manipulation accusations ( JPY is the most undervaued major currency) and the limited impacts of previous easings suggest that more of the same isn’t appropriate.
• The rumoured shift to an ECB-like response of further (limited) QE expansion plus TLTRO-type scheme to offset the impact of rate cuts on Japanese banks seems likely to have limited medium-term impacts on the Yen but could cause knee-jerk near-term JPY weakness given stretched JPY long positions. But the market has already priced action, raising the bar for the BoJ to suprise positively and likely leading to JPY spiking on the BoJ disappointing elevated expectations. Overall, Japanese fiscal easing needs to share more of the policy burden.
• The potential EUR strength associated with likely continued Fed dovishness and fresh BoJ easing could increase ECB concerns.
• GBP has bounced on a fall in Brexit odds, despite weak labour market and retail sales data providing further evidence of Brexit uncertainties having real impacts, supported by market BoE pricing becoming a little less extreme. These developments seems unlikely to extend unless the “remain” camp obtain a truly-decisive poll lead: without that market concerns seem likely to again rise as the 23 June referendum approaches. Moreover, while 3-month and longer GBP implied vols have fallen, shorter-tenor vols are rising as are GBP risk-reversals.
• Last week’s ECB and Riksbank meetings were in line with my expectations, with the market doubtful about the Riksbank’s ability to contain SEK strength. So I maintain my medium term short EURSEK view.
Calmer market conditions encourage FX carry trades
A month ago I detailed how a combination of Fed dovishness (greater focus on international issues and willingness to let inflation run hot), decreasing concerns over China’s devaluation risk, signs of global macro data bottoming out and abounce in oil and other commodity prices had increased the attractiveness of carry trades. And, as I anticipated, those factors have continued supporting the FX market, with both G10 and EM 3m FX implied volatility consequently recently falling back (see Chart: G10 vol is lower if the Brexit-driven uptick in GBP volatility is excluded).
And the second chart above illustrates that this has been associated with some fairly-healthy carry-volatility ratios (Sharpe ratios) across a range of EM currencies, with the most attractive USD-funded carry trades being INR, TRY, and BRL long positions (TRY and INR switch places for EUR- and JPY-funded trades) And the EM Sharpe ratios have tended to rise a little over the past month. While USD-funded NZD and AUD carry trades are less attractive in absolute terms, the lure of AAA-rated bonds and greater liquidity may well compensate and help account for their recent resilience (alongside commodity price bounces).
The FX impact over the past months is, however, most apparent for the medium carry ZAR and RUB, with the higher-carry INR and TRY actually little changed over the past month (see Chart below). That can again reflect the overlapping factor of the commodity price bounce. But, as I mentioned a month ago, the other caveat is that while carry/vol ratios have risen they remain below previous peaks (see second Chart). So carry trades need to be enetered cautiously, considering country-specific factors. But the recent rises in equities and subdued VIX suggest that overall it’s likely to remain relevant over the coming months if it’s not disturbed by adverse data, Brexit or the Fed turning susprisingly hawkish. But on the latter there’s room for optimism and potential further BoJ dovishness may provide a tailwind (see below).
No China Crisis: data have surprisingly spiked (if you believe them)
Indeed, of the previously-discussed drivers of lower volatility, the most notable has been the surprisingly-good recent Chinese data. While obviously Chinese data always needs to be treated with a pinch of salt, the largely across-the-board recent improvement following previous policy easing gives room for greater optimism and to believe the authorities when they say that they’ve no intention of devaluing the Yuan or letting the economy crash.
Specifically the 15 April China data deluge revealed GDP in line with expectations (6.7% y/y) but with monthly data on industrial production, fixed asset investment, total social financing, retail sales and FDI all exceeding market expectations. That buttressed the first reported rise in Chinese FX reserves for five months, following the sharp fall over since mid-2014, and the sharp bounce in Chinese export volumes (to 11.5% y/y from -25.2%). Indeed, the IMF raised their China 2016 GDP forecast to 6.50% up from 6.30%. That said, the continued debt build-up, with total social financing growing close to 15% y/y and hence having a smaller bang for the buck on activity, raises longer-term concerns. But for now the immediate stresses appear to have subsided.
But the dollar’s post-Fed weakness has also helps reduce the pressures for a Yuan devaluation. While the yuan has appreciated against the dollar, it has depreciated on a TWI basis (CFETS RMB index, see chart above). Indeed, the extent of the TWI fall is strething the credibility of the Chinese authorities’ commitment to a stable Yuan. But markets don’t seem to be focussing on this at present, instead concentrating on the apparent improvement of Chinese maro data and the stabilisation of Chinese FX reserves. And as I dicussed here, there seems to have been the informal agreement at the Shanghai G20 meeting to allow for USD weakness to take the pressure off the Chinese authorities (plus hopefully a greater focus on fiscal policy), which benefits both the US and the global economy.
Fed faces mixed evidence: continued risk-management suggests limited signalling about a potential June hike
Given the improved Chinese situation, the on Wednesday the Fed seems likely to recognise (implicitly) that the international risks have diminished somewhat relative to their 16th March meeting and Yellen’s very dovish 29 March speech to the New York Economic Club. That said, the weak global growth situation remains fragile, so it’s premature for the Fed to completely stop worrying about international risks only six weeks after they suprised with their dovishness on this front. Moreover, And the Fed will likely not want to rock the boat and reverse the global benefits of it’s 2016 dovishness: weaker dollar helping US exporters, reduces the pressure for a yuan devaluation and helps loosen financial conditions (also helped by the associated contained Treasury yields, equity price rises and narrower credit spreads – with the H2 2015 tightening being reversed in recent months see Chart).
For now, such arguments seem likely to dominate some FOMC members’ concerns that the market is underpricing the path of rate hikes (Fed fund futures only imply a 20% chance of a June hike and 66% chance of a hike by end-2016, although the latter has risen in recent weeks) or asset price bubbles (Esther George, who voted for a March rate rise). So the Fed seems unlikely to completely step away from its March language that on international risks “global economic and financial developments continue to pose risks“. Rather some limited watering down of the text seems possible e.g. “while there are tentative signs of improvement in the global economic and financial situation, the committtee will continue to monitor developments closely“. In other words, the Fed will likely remain in cautious risk-management mode.
That likelihood is reinforced by recent weak US data. The chart below illustrates the recent pattern of US data releases disappointing alongside improving international data, especially in China. Within that, industrial surveys have been stronger than “hard” official data. For example both of the US ISM’s have bounced, including notable improvements in the new export orders components. But Tuesday’s weaker-than-expected durable goods data follows disappointing retail sales, industrial production and trade data. Moreover, consumer condidence has fallen back in both Tuesday’s Conference Board survey and the University of Michigan meaure (see Chart).
So Yellen’s March press conference view that “growth appears to have picked up from the modest pace seen in the fourth quarter of last year…Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will continue to expand at a moderate pace” seems likely to be revised in a more dovish direction. Indeed, market expectations are for Thursday’s GDP release to report only 0.6% q/q (annualied) Q1 growth, with estimates as low as 0.3%, down from the already sub-trend pace of 1.4% in Q4.
The Fed also faces mixed news on inflation and inflation expectations. The Fed’s March call that the recent pickup in inflation was temporary (driven by more erratic factors) looks prescient. Core CPI fell back to 2.2% y/y in March and on Friday the core PCE deflator is expected to decline to 1.5% y/y from 1.7%. Moreover, survey-based meaures of households’ inflation expectations remain low (see Chart). On the other hand, US 5y5y inflation breakevens have bouced somewhat, being closely correlated with both the rise in oil prices (see Chart) and the dollar’s depreciation, in contrast to the fresh decline in euro area breakevens (see here). But Yellen has tended to be sceptical about such market based measures. So I expect a repeat of the sentence “In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal“. Indeed, the risks seem slighty skewed to a marginal upgrade of such concerns.
Such continued dovishness seems likely to result in limited near-term USD weakness, with EURUSD potentially rising towards 1.14 or above. The latter is more likely should the Fed raise it’s concerns about inflation expectations, although that’s not my central case.
Increased pricing of BoJ action: limited medium-term Yen impact if domestic-focussed, spike on disappointment
The situation appears finely balanced ahead of Thursday’s BoJ policy meeting. I’ve previously been sceptical about whether the BoJ would ease further and, if it does, whether that would significantly weaken the Yen (see here) given:
• The BoJ appears divided on further easing measures: the January move to -0.1% rates (for a limited subset of bank deposits) was only agreed by a 5-4 vote and recent minutes reveal intense debates on the appropriateness of negative rates (with one member preferring a reversal were it not for associated confusion).
• Japanese public opinion has turned against further rate cuts, given their adverse impacts on pension funds and banks.
• The lack of impact of BoJ’s January move to negative rates on JPY, with markets interpreting the decision to only apply negative rates to a small portion of deposits as a sign of BoJ weakness, buttressed by similar recent ECB and Riksbank experiences.
• The constraints imposed on BoJ easing by the G20 commitment to avoid FX manipulation (competitive devaluations), especially since JPY remains fundamentally the most undervalued major currency (see Chart). Japan hosting the 26-27 May G7 summit reinforces this coinstraint.
• The BoJ’s typical approach of waiting a reasonable time to assess existing measures before undertaking new ones: the proximity to the 29 January easing reduces the chances of a fresh BoJ bazooka on Thursday.
But the Japanese macro situation shows few signs of improvement. The latest disappointment was the Japanese manufacturing PMI falling sharply to only 48 in April, the worst of the major economies (see Chart above). The recent Tankan survey also disappointed and industrial production is struggling to gain meaningful momentum (falling 5.2% m/m in February!). And of course inflation remains disappointingly-low, with the preferred CPI ex food and energy measure recording only 0.8% y/y in February but other meaures closer to or at zero (see Chart below). The BoJ clearly isn’t meeting it’s mandate.
Several supplementary findings add to that concern. First, Japanese wage growth also remains very low (see Chart above), with the recent disappointing Shunto wage negotiation giving little hope for an uptick despite low unemployment. So there are definite questions about the domestic sources of inflation and the likelihood of second-round effects from low inflation. Second, Japanese inflation breakevens are remain at very-low levels (see Chart below), with the end-January BoJ easing having little apparent impact. Indeed, these figures make the Euro Area situation seem quite mild by comparison. So the risks of a low-inflation mentality becomming entrenched, leading to second round effects which make the BoJ’s task of returning inflation to target make difficult, are clearly growing.
So it’s unsurprising that Governor Kuroda has consistently maintained that BoJ remains ready to further expand monetary policy if risks threaten the achievement of its 2% inflation target. But he’s been growing increasingly concerned about the Yen’s 2016 appreciation: given limited domestic sources of inflationary pressure it’s worying if import prices also start falling. Of course, a one-off JPY levels shift should only temporarily impact inflation , if inflation expectations are ancored. And some context is in order: while the Yen’s recent rise has been relatively sharp (with Kuroda describing it as “excessive”), it’s actually only taken it back to around it’s 2014 levels and it remains substantially below the 2010-12 range (see Chart). Moreover, as mentioned above, JPY is the most undervalued major currency on a real effective basis.
But Kuroda upped the ante in his 19 April WSJ interview by noting that “If excessive appreciation continues, that could affect not just actual inflation, but even the trend in inflation through its impact on business confidence, business activity, and even through inflation expectations”. That said, a couple of days earlier he commented that the excessive Yen appreciation had eased. And a Bloomberg survey shows that only just over half of analysts (23 out of 41) are expected the BoJ to act, with most of those anticipating increased ETF purchases but only 8 anticipting further rate cuts.
But Friday’s Bloomberg story that BoJ is considering lending to banks at negative rates, in order to shield Japanese banks’ profitability from the impacts of a further rate cut (see here) caused the sharpest JPY fall (USDJPY rise) in nearly two months (although it’s since partly reversed on a higher market risk aversion). Worries about the adverse impacts of BoJ policy is certainly apposite given the substantial underperformance of Japanese bank equities (still down over 20% since start-2016 despite their recent bunce, see Chart above) which has driven overall Nikkei underperformamce.
This rumoured policy action sounds similar to the ECB’s TLTRO II scheme. But the ECB experience is that such a domestic shift in policy, does little to weaken the currency. So unless the BoJ announces something extremely aggressive (and surprising) over and above that, I’m not expecting a significant medium-term impact on JPY.
An initial knee-jerk JPY fall is, however, possible on a BoJ easing. JPY long positions are at record highs (see Chart below) and hence vulnerable to a position squeeze on the BoJ surpising the market. And USDJPY is substantially weaker than implied by 10-year Trasury-JGB yields on risk-aversion driven support (see seconf chart), which could decline on BoJ action. So USDJPY could potentially rise above 114 range near-term on a BoJ surprise. That said, the bar for the BoJ susprising the market has been raised by the TLTRO-like potential policy innovation already being at least partly priced. So another bazooka is likely required to halt/reverse JPY strength, but that seems unlikely given that Kuroda ruled out helicopter money in his recent WSJ interview.
The elevated easing expectations generated by Kuroda’s comments and the Bloomberg story also mean, however, that JPY will likely spike sharply should the BoJ disappoint by e.g. continuing it’s previous cautious “assess then act” approach to further easing. Such Yen strength would be reinforced by the likely spike in market risk aversion on a BoJ disappointment, in addition to more traditional policy expectations effects.
Overall, trading the Yen around the BoJ is pretty hazardous given the wide range of potential outcomes and likely volatility.
Moreover, Japanese policy probably needs to shift more towards fiscal easing to support growth, reducing the reliance on monetary easing which seems to be losing it’s impact (see here). Abe has yet to decide whether to delay the proposed 2017 consumption tax hike but recently alluded to fiscal support to deal with the effects of the recent earthquake. But Bloomberg reports that a growing number of BoJ board members are arguing for fiscal easing (see here). Such a policy shift would also be Yen-supportive.
Sterling: temporary Brexit relief but further weak macro data will conncern MPC
The other interesting FX market development has been GBP’s rebound over the past fortnight against all of the G10 (see Chart), although that only partly unwinds the post-November weakness. That’s reflected reduced odds of Brexit (see second Chart), helped by President Obama’s reality check on trade negotiation, plus the more supportive risk environment.
As such, BoE rate hike expectations have shifted to slightly less ludicrously far into the future – to “only” 28 months away, versus over 50 months at end-February. And that’s provided GBP with some support – with the close medium-term correlation between GBPUSD and 2-year relative swap rates (see here) supplemented by stronger recent links for EURGBP. Sterling’s bouce may also have reflected a short-position squeeze (see Chart above on CFTC positioning).
Moreover, GBP implied volatilities (relative to the rest of the G10) at 3-months and longer tenors have fallen reasonably-significantly from their mid-April record highs (see Chart above). The fall in the 3-month measure is unsurprising given that that’s now outside the EU referendum date (only 2 months away!), but the fall in longer-tenor vols is more notable. Conversely, it’s also notable that 2-month implied vols have risen to record highs. And the Scottish referendum experience indicates that shorter-tenor volatilities are likely to spike as 23 June approaches. Indeed, the recent disproportionate impact on longer-tenor vols indiating that the Scottish referendum related record highs will likely be exceeded.
Sterling risk reversals have also moved to indicate slightly less GBP downside at 3-month and 6-month tenors, but again shorter tenor have started pricing GBP downside. So it’s more a question of the changing window rather that markets stopping worrying about GBP downsides. Indeed, longer-tenor GBPJPY and GBPUSD risk reversals have moved significantly less than EURGBP ones.
The interesting thing is that the above FX developments have occurred despite weak labour market and retail sales data providing further evidence of Brexit uncertainties having real impacts (see Charts below). And Wednesday’s GDP release likely to show a slowdown from the 0.6% q/q Q4 figure (see here) although we’ll have to wait a few weeks for the intersting expenditure breakdown and current account data (we just get the services-production split on Wednesday)
Overall, the recent comparative GBP strength seems unlikely to extend unless the “remain” camp obtain a truly-decisive poll lead (see here). Rather, market nerves about Brexit seem likely to grow again as the 23 June referendum date approaches. So I remain biased to further GBP weakness over the next two months, especially against SEK, CAD and JPY (although GBPJPY could also bounce near-term on BoJ actions) plus potential EM carry destinations (see above). And the likely relief rally on a “remain” vote will probably be constrained by growing signs of weakness in the UK economy, due to the impacts of Brexit uncertainties. They will likely take time to be resolve, as delayed investment and hiring decisions hopefully come back on stream.
ECB and Riksbank as Expected, maintain short EURSEK view
Last week’s ECB and Riksbank meetings were in line with my expectations, with the market doubtful about the Riksbank’s ability to contain SEK strength. So I maintain my medium term short EURSEK view.