April 29, 2016 11:04 am
Author — Nick Korzhenevsky, senior analyst with AMarkets Company. The anchorman of a TV program “Economics. Day rates”.
- The risk appetite has stabilized following the Fed leaning to the dovish side.
- Data from China has been perceived as the evidence of a resilient economy while we see risks piling up.
- The market is expected to continue sideways trading for now, USD should remain somewhat pressurized.
- We sell any USDCAD rebounds as the unit catches up with oil.
The market keeps on going nowhere. Risk-appetite has generally stabilized supported by diminishing near-term risks. Above all, investors have been calmed by a much less hawkish Fed. The minutes of the March meeting stated that a speedy rate increase “would signal a sense of urgency they (governors) did not think was appropriate”. The FOMC has therefore implicitly committed to staying on hold in April and possibly June. The statement of the April meeting also hints at a pause for another meeting. However, the language has already been modified to prepare markets for a move in the second half of the year. The statement does not mention present global risks anymore, but the Fed is monitoring those closely. This is clearly an attempt to communicate greater willingness to hike. The governors are probably trying to force repricing of the June hike probability to about 50%. On the other hand, general economic environment does not warrant tightening just yet. We expect the FOMC is to include the “risks are broadly balanced” sentence into its June or July statement, then hike in at the next meeting (July or September, respectively), and repeat in December, after the presidential election.
The newsflow out of China has also helped soothe the markets. The batch of Q1 data has been generally better than expected. “Hard” indicators have all come out either meeting or exceeding consensus, which alleviated the worries of a major slow-down in the economy. Against this favorable macro background, we are greatly concerned by the credit dynamics. Loan creation in Q1 exceeded USD 1 trln which by itself carries enormous risks. It is indicative of the underlying weakness and dramatically deteriorating trends. To put this number in context, it is 9% of the entire annual GDP and nearly a third of the Q1 GDP (the growth rate of which is only 6.7%).
People’s Bank of China has already expressed concern with regard to the leverage employed by the banking system. To us this seems like a sign of a major economic trouble ahead. We expect a significant drop of the aggregate demand in the “old part” of the Chinese economy. The cause for this could be either systemic instability (the bad scenario) or simply less support provided by the PBoC in an effort to slowly sort the problem out (the good scenario). But either case is more of a story for H2 2016. For now, the market is concentrating on risk-friendly pieces of data.
The third, but not the least source of recent stability is the oil market. Crude has outperformed all other commodities and is closing the month above $40/b for both Brent and the WTI. Here, again, not all waters are clear. The rally from January lows has been explosive, while realized and implied volatility measures for crude oil remain stubbornly high (firmly above 40% for the month of April). The carry is also elevated, around 10% p.a. Therefore, the recent rally might be a deviation from a much lower mean. If we assume that the reason for the move up was, for example, massive short-covering, the price surge is exactly what was expected to happen.
Furthermove, current price levels are hardly supported by the fundamentals, as the market hasn’t balanced itself out just yet. The Doha talks were a complete failure, and the “freeze” speculation should start fading out slowly. Our sources are telling us that Russia is not ready to commit to any further talks, as it expects the market to approach equilibrium in H2 2016 without any intervention on the supply side. Therefore, it makes no sense to continue deliberations, as they become unnecessary. The only true reason for higher oil has been consistent pressure on North America crude production. This should eventually balance the market out. This statement will prove true if – and only if – the demand keeps on growing. Bearing in mind recent monetary developments in China, though, we can not rule out major issues on the demand side going forward. We expect oil to re-test mid-30s area as the Fed resumes tightening and China worries resurface.
In the EM space, all is quiet for now. The rouble is trading at this year’s highs supported by the very factors described above. TRY, BRL, MXN and all other usual victims are also feeling fine for now. Just like it is the case with oil, we expect broad risk appetite to reverse in 2H 2016, and renewed pressure on emerging markets’ assets to appear. The shorts here have been liquidated, and some modest longs have been already built. The market only needs a reason for a sell-off now. We also highlight recent developments with the CNY. People’s Bank of China is obviously using this current period of market stability to allow some yuan depreciation. This is quite logical given all the country’s internal imbalances and challenges. We remain committed to our long USDCNY (USDCNH) call.
EURUSD: building short-term upside potential, returning to the downtrend later.
EURUSD has been trading in a relatively narrow range. The unit has failed to break 1.1465 level, but we see a wave up as the likeliest development from here. There is still excessive short positioning that is normally washed out before a long-term downtrend resumes. There is also a large gap to fill above 1.15, so once prices get there the pace of the move should increase. Without any doubt, the euro will look expensive once it goes up, and it is already overpriced should we judge by rate differentials. However, in a shallow summer market it is all about speculative flows.
Fundamentally EURUSD is supported by repricing of the relative monetary policy expectations. The Fed has unexpectedly turned dovish in March, and now we are talking about the ultra-loose G4 monetary conditions. This is a temporary state of things and policy divergence should once again become a prominent market theme in H2 as U.S. growth accelerates and price pressures build. For now, though, it is senseless to fight the market. Significant shifts in the FOMC stance usually take 2-3 months to be fully priced in, and the process is not even in its mature stage yet.
Another major factor in favor of the EUR is apparent demand for cash. As the ECB takes interest rates lower into negative territory, economic agents prefer to withdraw a portion of their holdings from the banking system and convert it into physical money to be kept under the mattress. While this should not become a sustainable system-wide phenomenon, it does create immediate transactions demand for euros.
We expect the EURUSD to break the upside limit of the trading range in May, and re-visit 1.16-1.17 area.
GBPUSD: fear of Brexit materializing, money flowing out.
The pound has been largely trading on the expectations of a Brexit referendum outcome. So far polls suggest a very mixed picture, with about 40% of the voters supporting the exit, 40% against it, and 20% undecided. With very little deviations, this has been the result of most surveys conducted this year. It seems that the abovementioned 20% are to remain undecided until the very 23rd of June, when the referendum is set to be held. Political noise suggests that the “exit” result is quite realistic, and this is keeping sterling on the back foot.
Furthermore, real money seems to be concerned about the outcome as well. U.K. balance of payments has deteriorated dramatically, and the current account situation is only getting worse. The deficit registered in Q4 2015 hit 7% of GDP, and for the 2015 as a whole it stands at 5.2% of the GDP. It is the worst figure since the records began in 1948. This sort of data is typical for a weak emerging economy, but certainly not for a G7 member. The numbers clearly go against our theory that Brexit could actually help attract money to the U.K. Eventually this hypothesis can prove true, but the magnitude of current outflows forces us to withdraw any stronger pound call.
EURGBP has tested the 0.8 area and then retraced to mid-0.77’s, as expected. However, we do not see much potential for the pound to strengthen from here. The fundamental picture for the GBP is now not any better than that of the EUR, albeit for a different reason. Strategically one should now look into shorting GBPUSD as the recovery gets overstretched.
USDCAD: a short-term winner.
One of the natural beneficiares of a less-hawkish Fed is the Canadian dollar. It is directly supported by a stronger U.S. economy, and it gains with the oil. Technical picture suggests that the road to 1.23 is now clear. The only question is how to trade the pair tactically. We are looking for any rebounds (ideally into the 1.2830-1.2850 area) to establish shorts targeting 1.2320. This is where longer-term support is currently located. A 38.2% Fibonacci retracement also lies close. The pair has lagged oil in its move down, and the statistical relationship also suggests that 1.23 should be revisited (unless crude falls again).
Fundamentally the main driver here is, of course, repricing of the FOMC hiking cycle. Just like it is the case with oil, we are wary of the CAD longer-term. There are too many potential headwinds that are expected to manifest themselves in the second half of the year. One the Bank of Canada side, though, there is still scope for CAD support. Regulators have been extremely conservative with their view on the economy, and remain so, judging by the latest monetary policy meeting. Official forecasts of the Q1 GDP proved to be much lower than the private sector number, and general macro data surprises have been predominantly positive. The market is still expecting another rate cut by the BoC. And this is exactly what could lend additional strength to CAD as policy loosening is priced out.
Again, tactically speaking, May and June should be mostly about speculative ideas. Long the looney (short USDCAD) surely looks to be one of these. Vice versa, long-term investors should start looking for entry points to go long the pair around 1.23.
Analytical materials and comments reflect only personal views of their authors and can’t be considered as trading advices. AMarkets is not responsible for losses as the result of analytical materials usage.