The British Economy’s Grooving

From Europe the news is improving
The British economy’s grooving
And there’s no mistaking
That Germany’s making
An effort to keep things there moving

It’s been something of a mixed bag in the FX markets overnight as the dollar has fallen against its G10 peers but rallied vs. many emerging currencies. This morning’s data from Germany and the UK has shown continued improvement in those nations although across the rest of the Eurozone things are less robust. Starting with the euro, it has edged higher on the back of strong German Factory orders (+3.8% in June), which set the tone for euro strength, albeit not an overwhelming amount. UK IP was stronger than expected (+1.1%) and House Prices there rose more than expected (+0.9%), with both pieces of data adding to the picture that the UK is climbing to a level of sustainable growth. The pound has mirrored the euro, rallying a small amount, and both currencies have maintained a positive tone over the past several sessions. Meanwhile, Italy continues to be mired in recession, with the GDP having fallen 2.0% in the past 12 months. While that was better than the -2.2% expected, it still highlights just how big are the problems that remain.

The bigger movers in the G10 space have been AUD and NZD. Aussie seems to have been the beneficiary of the adage: sell the rumor, buy the news. The RBA cut rates 25bps last night, which was almost universally expected, but in the accompanying statement they indicated that there was little reason to expect further cuts in the near term. The market had been short AUD overall prior to the announcement so the rally is not that surprising. Meanwhile in New Zealand, the fears over the milk powder issues I mentioned yesterday seem to be abating as the government there has made a strong effort to downplay any long term impacts on the economy.

And what of the yen? It has been edging higher over the past several sessions as the market awaits the outcome of the debate on raising the consumption tax there in October. If you recall, the plan was to raise the national sales tax to 8% in October and 10% in October, 2014, but PM Abe and his crew are concerned that raising taxes in a still weak economic environment may derail the recovery. Of course with a debt/GDP ratio approaching 250%, the government needs to show that they are looking at the revenue side of the equation in addition to the spending side. The IMF has added pressure on the Japanese to implement the tax hike with a statement overnight (of course, the IMF’s only known solution to all problems is raising taxes), and there continues to be concern over the idea that the BOJ is monetizing Japanese debt. So what can one expect? The long term situation in Japan has not changed meaning the yen has much further to decline. The catalyst for the next leg is still most likely to be the revamped ‘third arrow’ of policy from the government. However, given how tenuous the situation remains with regards to the massive debt position, it is quite feasible that something else triggers the next sell-off there. I see no reason for USDJPY to trade below its recent lows of 97.65, but markets are perverse and if positioning is more heavily short yen than I think, that move could be larger. In the end, the yen will eventually weaken further, but for now it has legs for modest strength.

In the EMG universe, INR is noteworthy for having traded to yet another historic low, this time at 61.806 before bouncing on intervention stories. Traders and investors continue to be concerned over the massive C/A deficit and are fleeing the local stock markets. This currency has further to fall as the RBI will not have the firepower to do much more than smooth the decline. I am still looking for 65.00 before the end of the year. And in Brazil, we are once again seeing the dollar above 2.30. The central bank there is doing all it can to prevent a freefall, with rate hikes trying to fight increasing inflation and slow the currencies decline. But the market is not yet a believer in the preferred outcome and sellers of BRL continue to materialize everywhere. Remember last year when the central bank was fighting a ‘too strong’ BRL? They created all kinds of rules to prevent inward investment and a rising currency. I’ll bet they would be pretty happy with that issue right now! USDBRL is on its way to 2.50, with the central bank there simply slowing the trajectory. Mark my words.

This morning in the US we see the Merchandise Trade Balance (exp -$43.0B) but unless it is a big miss, I doubt it will matter much to the market. As I wrote yesterday, there seems to be very little that has people willing to get involved here. Without comments from a Fed personality, I expect we close the day within 0.2% of where currencies are right now.

Good luck
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Europe’s Thin Ice

The ice throughout Europe’s still thin
Can Angela Merkel yet win?
And what of Rajoy?
He’s no altar boy
While Silvio’s soon a has-been

The FX markets are remarkably dull this morning, with perhaps the most exciting movement that of the New Zealand Dollar which has fallen almost 1% on a story about China banning milk powder imports from Fonterra, the big dairy producer there. Otherwise, in the G10 space, things are little changed. Friday’s payroll data were mixed with the NFP number disappointing at +161K but the Unemployment Rate falling to 7.4%. However, given the buildup in expectations from the strong ADP number as well as the relatively stronger US data we had been seeing, it was no surprise to see the dollar fall in the wake of the number. Just not that far.

With regard to the major currencies, the weekend merely brought a rehash of the ongoing problems in Europe. In order of importance (at least in my opinion) these are: the upcoming German election; the fallout from the upholding of Berlusconi’s tax fraud conviction by the Italian Supreme Court; the ongoing inquiry into Spanish PM Rajoy and the PP’s slush fund; and Greece’s continuing struggle to reform itself to both satisfy its paymasters at the Troika and its long suffering population. The thing is that for now, market players are quite sanguine over the prospects of any of these becoming an issue. After all, it is the beginning of August and many, if not most, of the important players in Europe are on summer holiday. However, I feel it would be a mistake to dismiss these issues. After all, the flip-side to traders and politicians being on holiday is that markets are far less liquid during this time of year. And any news from one of these stories, or any other major surprise, can have a disproportionate impact on prices. So while it is hard to point to a cause for a large move in the near term, especially since we won’t be seeing important data for at least several weeks, it is not hard to see how a surprising piece of information could lead to an outsized move. And this, my friends, is why companies hedge their FX risks!

A brief look at Emerging markets shows that Chinese non-manufacturing PMI data was released marginally better than expected at 54.1 over the weekend. The pundits in China were quick to point out that the slowing growth story there is ending and China remains on track for 7.5% growth in 2013. Now on the one hand, I would say that a modest positive blip in a survey outcome is hardly the start of a trend and so further weakness may yet appear. On the other hand, we are talking about China, and quite frankly, they can print any number they choose as the official growth statistic. Who is going to call them out on it? Again, my concern remains that growth there is slowing a bit more rapidly than the government would like and my money is still on GDP much nearer 7% if not below when it is all tallied up at year end. I will say this, a stronger China number would normally lead to a positive performance by the AUD, but as we look this morning, the Aussie has traded to fresh 3 year lows and shows no signs of stopping. It seems to me the market is still betting on a further slowdown in China.

As you can see from the table below, there is very little data this week, with this morning’s non-mfg ISM likely the most interesting data point. However, I doubt any of this results in much movement.

Today ISM Non-Mfg 53.1
Tuesday Trade Balance -$43.0B
Thursday Initial Claims 336K
Continuing Claims 2945K

My best advice is make sure the current low volatility environment allows you to keep appropriate hedges in place while they’re cheap. Because when we get the next move, the price of hedging will surely increase.

Good luck
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Silvio’s Problems

In Italy, tremors anew
As Silvio’s problems just grew
His tax fraud is real
He’s got no appeal
We may soon bid Letta adieu

What then? Will the euro decline?
Or will traders say its just fine?
Depends if we see
A hiring spree
From Payrolls this morning ere nine

As we await this morning’s NFP data and the accompanying Unemployment Rate, markets are continuing their recent trends. Equities have been rallying strongly based on the continuation of the free money QE paradigm which was reinforced yesterday by both the BOE, which said nothing to change last month’s actions, and the ECB, where Signor Draghi claimed any rate rises were “unwarranted” as the ECB will be keeping rates low for an “extended period”. Treasuries are softer after more good US data has traders getting excited that the Fed’s tapering operation will begin in September, and the dollar is generally stronger on a combination of higher US yields and optimism that the US growth path is sustainably improving. Will all this continue? While I like the dollar higher and bonds lower, I remain concerned over the valuation in the equity markets.

A quick rundown of markets shows the following:

EUR – it has been rallying steadily for 3 weeks but appears to have lost its momentum. While data in the Eurozone has improved, it still lags that of both the US and UK. With Draghi promising no rate movements for an extended period and the market looking for the Fed to ‘taper’ QE, it feels like the euro is rolling over. We never made it to 1.34 on this move and it feels like a test of 1.30 is more likely soon.

JPY – The Fed meeting was the catalyst for the rebound from the 97.75 level and here we are pushing 100 as I type. The Nikkei rallied on the back of the weak yen and the yen remains weak on prospects for further US rate rises. The interest rate spread between JGB’s and Treasuries has widened again and that draws in Japanese buyers of dollars. A strong number this morning should see a break back above 100 and perhaps a test of the early July levels of 101.50.

GBP – The pound has been a bit more volatile than the euro, showing real strength since early July although giving some of it up in the past week. The economic data there has been improving (last night Nationwide House prices roles 0.8%, better than expected and Construction PMI jumped to 57.0, its highest since March, 2012) and Carney continues to have the market’s confidence that he will manage things for growth. I think the pound will outperform the euro but lag the dollar for now, assuming payrolls today confirms the recent USD trend.

BRL – Well, yesterday we traded through 2.30 for the first time since March, 2009, and while the central bank was actively in the market trying to prevent further weakness, the much weaker than expected Trade data (-$1.9 Billion, exp +$400Million), has caused concern amongst investors and added pressure on the currency. My crystal ball still sees 2.50 as a target, although I imagine the central bank will fight it all the way. (I wonder if FinMin Mantega is still worried about a currency war?)

INR – As I pointed out earlier this week, the Rupee has lost the confidence of the FX market. We are currently trading barely below the historic highs in USDINR and seem poised to break well beyond. Strong data this morning will simply add to the pressure on the Rupee and 65.00 is very much in play in the near term. The country cannot seem to address either its weakening growth or rising inflation issues, neither of which is going to support the currency.

Wednesday morning I suggested that the only certainty was that FX rates would move a lot through the end of the week. Even before the payroll report, let’s recap the movements thus far:

Wednesday Today % Change
EUR 1.3260 1.3205 -0.41%
JPY 97.75 99.85 2.15%
GBP 1.5205 1.5155 -0.33%
AUD 0.9030 0.8900 -1.44%
BRL 2.2825 2.3040 0.94%
MXN 12.7050 12.8450 1.10%
INR 60.374 61.095 1.19%

As you can see, we’ve already had good movement with more in store today.

Good luck and good weekend
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Inflation Concerns

The Fed is concerned if inflation
Remains too low then this great nation
Will have trouble growing
And so they’re foregoing
All thoughts that less money they’ll ration

in·fla·tion [in-fley-shuhn]

noun

1.
Economics . a persistent, substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currency (opposed to deflation ).

Sometimes I think it is useful to go back to the basics and remember what we discuss each day.  According to Dictionary.com, this is the definition of inflation, and I think it does a very good job of highlighting the two aspects of why inflation is seen as a problem.  Rising prices lead to the devaluation of money.  Now other than the fact that I buy things and see how prices change, I am no expert in inflation.  (If you want an expert in inflation, read my friend Mike Ashton’s blog E-piphany, http://mikeashton.wordpress.com or follow him on Twitter, @inflation_guy).  However, I have been giving it some thought lately since every economist will agree that high inflation reduces the value of a currency.  This value needs to be considered as both the value of the goods one can purchase with a given amount of money as well as the relative value of one currency vs. another.  Now mostly I write about the latter, relative values, but this morning I wanted to register my annoyance at Chairman Ben with regard to the first point.

Yesterday the Fed left policy completely unchanged and the accompanying statement modified the growth outlook from “moderate” to “modest”.  But it also said the following: “The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term.”  Now I understand that they measure inflation by the Core PCE Deflator, which is currently the lowest reading out there.  But I look at things a bit differently.  Consider what the Fed’s Financial Repression is doing for you these days.  If, after a lifetime of hard work, you save $1,000,000 as your nest egg, the idea was always that you could then earn a low risk interest rate in the long term of something around 5%-6%, which would generate $50-$60k of annual income without touching your principal.  Certainly not a fortune, but enough to help you live in retirement.  However, this option is no longer available to you with the Fed’s current activities.  In fact, you can only earn 2.5% nowadays in 10 year Treasuries, and less via CD’s and other savings instruments.  (I saw a bank offering 5-year CD’s at 1.01% yesterday!)  So despite all your hard work, the Fed has effectively cut the value of your savings in half, from $50k per year to $25k per year.  While the government may not measure inflation that way, I’m pretty confident this counts as a devaluation of your currency holdings.  A 50% reduction in purchasing power over the course of the past 5 years seems to me like inflation is pretty high, (something like 15% per year) regardless of how the Fed measures it.

You may ask how this impacts the FX markets.  Well, since the Fed is not the only central bank engaging in these policies, the relative value of the dollar has held up remarkably well vs. the other countries that are also engaged in Financial Repression.  But not every country is so engaged.  And if you look at Poland or Mexico or the Czech Republic, where central bank policies remain more standard, those currencies have outperformed the USD over the past year.  In the G10 space, it has been the Euro and the Danish Krone that have been best.  Of course the Danes track the euro and the ECB has only more recently begun its own efforts at Financial Repression, so it hasn’t yet built up the momentum or track record of the Fed.  The yen, on the other hand, has 20 years of experience at Financial Repression, and it has doubled down lately, leading to the weakest currency performance in the world over the past 12 months.

But on to more immediate concerns.  The BOE left policy completely on hold, as expected and there was no ensuing statement.  Next week, Governor Carney will release a report on the BOE’s analysis of other monetary tools, like forward guidance, which has obviously had an impact on their actions.  It has become increasingly clear that central bankers around the world have become enamored with the idea of forward guidance because it seems to help them without spending any actual money or adjusting their respective balance sheets.  Carney pioneered this idea at the Bank of Canada and it was taken up enthusiastically by Bernanke.  Now, Draghi and his ECB buddies are on board, as are the BOJ and SNB.  Even the RBA is toying with it through the discussions of scope for further rate cuts.  I wonder what they’ll do when this tool wanes in effectiveness.  Meanwhile, the ECB also left rates on hold, also as expected, and Draghi has not yet met with reporters so we don’t know what he will say.  But today’s data showed that Manufacturing PMI’s in Europe were generally stronger than expected as well as higher than last month.  In the UK, the number was actually quite robust at 54.6.  However, the euro has been unable to gain any traction this morning and is a bit softer, while the pound has responded positively to the data and bounced a bit.  Later this morning we get the ISM Manufacturing data here (exp 52.0) but first Initial Claims (345K).  And of course, tomorrow is payrolls, so I doubt today’s data will foster too much more activity.  Unless Draghi says something completely new, it appears that markets will remain more or less rangebound until tomorrow morning.

Good luck
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