The Chairman is having some trouble
Deflating his massive bond bubble
His stated intent
Is to circumvent
The market collapsing in rubble
The consequences of the recent market volatility are that it is very difficult to figure out what’s next. In the past three sessions we have gone from concern over the end of the world to an all clear signal. Yesterday started with serious concern as the Nikkei had tumbled further overnight and European markets were roiled. US data was certainly better than expected, with Initial Claims falling and, more importantly, Retail Sales showing more strength than expected, but it seems that it was a Fed planted article in the WSJ by Jon Hilsenrath that was able to turn sentiment. In it, he explained that any Fed reduction of QE would be verrrrrry gradual and anyway, even when they finally stop buying, there will still be no raising of short term rates for a long time thereafter. In fact, this morning there seemed to be more articles discussing the concerns over falling inflation in the US, or at least falling inflation expectations, than on anything else. And that would imply increasing the monthly purchases, not cutting them back. What I do know is that the Fed finds itself in a very uncomfortable position. It has followed a policy that has not directly addressed its targets (which in fairness are not directly addressable), but which has led to a significant distortion in price signals in asset markets. And any attempt to unwind this policy is going to result in very severe market responses. This, my friends, is why market volatility is high, and why it is likely to remain so for a while yet. The Fed is not done in its attempts to force the market to respond as it sees fit, and that process is inherently volatile.
So what does this mean for the FX markets? My thoughts go as follows:
1) EUR – This remains capped by virtue of its internal flaws, which are playing out every day. There remains no reconciliation over the need for a unified fiscal policy to complement the single currency and unified monetary policy. Throughout history, nations in trouble like Spain, Greece, etc have always been able to devalue their currency, suffer early consequences but simultaneously realign their labor productivity with global competitors and get their economies growing again. But this arrangement doesn’t allow for that, and so the tension of the German led core vs. the peripheral weak links is going to prevent substantive strength here. Despite trading at 1.33, I continue to believe we will see 1.25 before 1.35.
2) JPY – The recent strength in the yen is a consequence of the market correcting its massive move since last fall. The Abe – Kuroda plan of doubling the money supply is still going to have the desired effect of weakening the currency. To me, this remains a timing situation, with the Upper House election on July 21 a key date. Once that is past, and assuming Abe gains a strong majority there, as currently forecast by the polls, the Japanese will take the next steps toward aggressive fiscal policy and double down on their monetary policy actions leading to a much weaker yen. If you add in the idea that US rates are likely to move higher over the summer, it simply adds to the case for USDJPY to trade back above 100 before Labor Day, and still achieve my 110 target by year end.
3) GBP – The pound has seen less activity lately for two reasons, I believe. First, it has run into pretty strong resistance at the 1.56ish level, and needs another catalyst to take any further steps higher, and second, with so much ongoing in the euro and yen, traders’ propensity to be active in the pound, which is much less liquid than the big two, is diminished. There is no story crying out for a significant move here, and I don’t foresee one upcoming. While the recent trend has been higher, and the UK economy continues to perform modestly better, I expect that we are more likely to drift back toward 1.54 in the next weeks than rally further. When Mark Carney chairs his first MPC meeting in July, we can look for some fireworks.
4) Commodity currencies – Aussie continues to underperform on the weakness in commodity prices and the uninspiring Chinese economic picture. Growth forecasts in China continue to be downgraded, and monetary policy there seems to be tightening, which will lead to still weaker growth. (Last night the Chinese Finance Ministry had a 9-month bill auction with bids for less than 2/3 of the planned amount signaling there is a lack of available liquidity in the economy.) If Chinese GDP doesn’t pick up, Aussie has further to decline. CAD on the other hand has performed pretty well during the past month as it benefits from the better than expected US data that has been showing up. While we have been trading between 1.00/1.04 for the past six months, it appears that we are going to test parity again, implying further modest CAD strength.
5) EMG – For the past several years these currencies were traded en bloc as almost a single unit. Yield seekers were willing to buy into virtually any market if the nominal returns were high, regardless of the fundamentals underlying things. But these days, we have seen a pretty steady outflow of funds from these markets, with another $6.8 billion leaving EMG funds last week. These currencies are having to live on their own merits, which some can do much better than others. MXN has rebounded smartly from its weakest point on Tuesday, as has ZAR, while both BRL and INR have lagged that rebound a bit. During periods of increased volatility like we are seeing currently, history shows that these currencies will underperform. I see no reason for that to change. Eventually, investment will flow back to these nations and the currencies will strengthen again, but for now, a trend toward volatile weakness seems the most likely outcome.