Tomorrow Bernanke returns
To Congress to air his concerns
‘Bout growth that’s still slow
Though rates remain low
But Congress, it just never learns
The dollar is softer this morning against most currencies as a combination of diminishing expectations for the US taper and further actions by emerging market countries to protect their weakening currencies has led to more dollar selling. I find it instructive that despite a weak global growth profile, with most emerging markets underperforming their previous expectations, we are seeing them raise rates to protect their currencies. This points to two facts: first, the Fed remains the unquestioned driver of global monetary policy; and second, the “animal spirits” that are necessary to rekindle economic growth remain trapped under a global blanket of excess debt and regulation.
As to the first point, that is why the market remains on tenterhooks ahead of tomorrow’s Bernanke testimony to the House Financial Services Committee. Given the surprising comments about tapering from last month, and the extraordinary effort to walk back those comments since then, market participants are not sure what to expect. It is clear that the FOMC is pretty well divided on the QE process, with loud voices discussing both ending it and expanding it. Given the equity market’s extreme valuations, which are based almost entirely on the fact that there is so much liquidity in the system, the consequences of Bernanke’s words can be great. But it is not just equity markets that have been impacted. Emerging market assets had outperformed for many months as the excess liquidity searched for a home with higher returns than Treasuries. It was not that long ago that Brazil’s FinMin Mantega used the term ‘currency war’ to describe the Fed’s activities as he was trying to prevent excess BRL strength. Twelve months later he is trying to prevent excess BRL weakness as the change in market sentiment has resulted in the wholesale disposal of many EM currencies. Last night it was India’s turn to raise rates, by 200bps, in order to drain liquidity and bolster the currency, which had fallen to a record low last week. This, despite Indian growth near 5%, its lowest in more than a decade and far below its target of 7.5%-8.0%. Brazil has already raised rates 3 times in the past months and of course, China has been forcing the overnight on-shore interest rates higher via liquidity draining activities. All of this is simply a result of the discussion of the idea that the Fed may change its policy which led to a virtual stampede out of these currencies and back to more liquid instruments.
With regard to the second point, it remains evident in the overall slow growth globally, with the IMF having reduced its global GDP forecasts for 2013 and 2014 four times already this year, and global data showing no signs of a strong rebound anywhere around the world. The one constant globally has been the increase in sovereign debt as slow growth reduces national tax receipts and adds pressure to the fiscal situations in countries around the world. The G8 countries average 98% of GDP as their debt ratios! Having read the Reinhart and Rogoff book, “This Time is Different”, which pointed out that GDP growth slows once the debt/GDP ratio reaches 90%, it is hard not to accept their observation. The fact that the average level of debt amongst this group of nations is above that level bodes ill for the timing of any substantive global recovery.
So what does all this mean for the FX markets? Well, we remain in a situation where comments by Bernanke remain the market’s dominant force, followed by the words of Draghi, Kuroda and Carney (not necessarily in that order). Data plays a secondary impact and then other influences like war and global unrest are only minor players in the game of FX. For instance, UK CPI rose a less than expected to 2.9% but the pound didn’t really respond. This seems to be related to the fact that tomorrow the minutes of the last MPC meeting will be released and traders are waiting to see what transpired under Carney’s first meeting. Verbal guidance has become the final tool in central bankers’ toolkits, and it appears that all the major central bankers are using it aggressively. So with new information due tomorrow, traders won’t risk positions today. German ZEW numbers were released at a worse than expected 36.3, down from last month, and yet the euro rallied. We also saw the weakest auto sales numbers in 20 years in Europe this morning. So here it was clearly not the data driving things, but arguably a continuation of position adjustments ahead of tomorrow’s Bernanke testimony. After all, traders are still net long dollars, according to the CFTC data, in response to the first tapering talk. Fear is increasing that Bernanke will be even more aggressive in dispelling any notion of a taper any time soon, which would put the dollar back on its heels. So bad EU data will not have the same impact. However, weak US data will encourage a further USD sell-off. So keep an eye on this morning’s CPI (exp 0.3%, 0.2% core), IP (0.2%) and Capacity utilization (77.7%). If these point to less robust US growth, look for the euro to rally further and a general dollar decline. However, if the data is strong, I would not expect dollar strength, just a lack of weakness.
It is always difficult to manage risk in market situations where comments are the key drivers rather than macro data. Alas, that is where we find ourselves for now. Longer term, I don’t think there have been any significant changes, but in the immediate future, market response will be all about Bernanke (and Draghi et al.).