August 1, 2017 11:32 am
Author — Nick Korzhenevsky, senior analyst with AMarkets Company. The anchorman of a TV program “Economics. Day rates”.
- All major central banks are now firmly in normalizing mode, with the notable exception of the Bank of Japan.
- Political premia is moving to the forefront, as monetary policies are converging and QE is put to rest.
- Global growth looks solid, but structurally represents a typical late stage of the economic cycle.
- The euro remains underpriced from the balance of payments view, but looks expensive short-term as yield differentials are not catching up with FX.
Being a central banker is a tough job these days. They are finding themselves in a peculiar situation: potential growth is low, and so even if policies are fully normalized, interest rates are going to be much lower than they were before the onset of the 2008 crisis. However, it is not clear why one would normalize policy when inflationary pressures are absent. If you only look at growth and prices, really, the rates should stay close to where they currently are.
But then, of course, there is the matter of financial stability. Nearly ten years of ultra-low yields have created the perfect environment for bubbles. And as economic growth recovers, excessive speculations might occur. What is even worse, the whole sovereign debt market is at risk of behaving like a bubble once excess liquidity starts dropping.
And that’s where a serious conflict emerges. On the one hand, you really want to raise rates preemptively, in order to be ahead of the curve, gain some ammunition before the next recession hits, and, of course, contain inflationary risks. On the other hand, you might end up fighting windmills, doing significant damage to the debt market along the way. And that’s the dilemma that central bankers are facing, with heavy tail risks on both sides.
This is exactly why central bankers hint at the upcoming policy tightening one day, and then try to play down the importance of their own words the very next day. It has been the pattern for over two months now, and the markets are nearly used to it. They now need to process the information, see through all this noise, and figure out what is likeliest outcome. We feel that the path of least resistance is to keep on selling the USD. This should be the general trend for the second half of 2017, as there’s plenty of room for surprises from the ECB, but hardly any for the Fed.
To put it differently, Mario Draghi is using the best of his skills to explain that there will be no more QE, but no tightening is warranted for now. This is the very game of words explained above. But in practice that means one had better get ready for ECB tightening, as sooner or later it is going to hit. This is how the market is likely to interpret the words of the president eventually. Especially if there is a reason to believe that the general situation is normalizing. Which looks to be exactly the case for Europe.
Growth numbers have consistently surprised on the upside, and the momentum is spreading from the core to the peripheral countries of the eurozone. While inflationary pressure is literally absent, the dogmatic ECB still needs to be focused on further price developments, as credit flows faster and labor markets get tighter. The governing council will try to avoid the policy mistake of 2011, when under then-president Jean-Clause Trichet the rates were raised twice only to be lowered next, as the Greek crisis hit. But they will also be keeping in mind that current policy is much looser, liquidity is ample, and, importantly, risks for PIIGS countries look to be quite low.
This is actually the second pillar of significant support for the EUR. Monetary policies are synchronizing, but political risks are diverging wildly. They are diminishing for Europe, taking nearly all European currencies higher. As far as the euro itself is concerned, a fairly rapid spread compression has been in place for over 3 months, with 10-year Italian bonos now yielding only 1 p.p. above Germany’s bunds. This is reminiscent of the 2012-2014 episode. Back then Mario Draghi gave his “whatever it takes” speech that reversed selling in peripheral debt markets and triggered persistent spread tightening. The process lasted for the entire two-year period, and helped propel the euro higher.
We are not going to go deep into the current political matters of the continent. When things are good, it’s just too boring of an exercise. Most major elections are now behind us, with the French delivering an investor-friendly outcome. There is, of course, the German vote ahead, but Angela Markel is leading by such a wide margin that it would be absurd to worry about her victory, at least for the time being. In this context, the above-mentioned example of spread compression is the process of pricing out political tail-risks, and a vote of confidence in the euro.
On the other hand, the politics has been depressing for the dollar. Well over half-a-year into his term, Donald Trump has hardly achieved anything. There’s very little progress on any of the items on his agenda. Literally, none of the goals have been attained. A lively discussion on the healthcare bill is taking place as we write this piece, with a procedural victory scored by the republicans. But that was a very close call of 51 to 50 in favor of the new set of proposals, and a lot of battling remains ahead.
Importantly, there is not only a divide between the Republicans and the Democrats, but also a clear split within the Republican party. The gap has grown so wide that markets are now openly questioning Washington’s capacity to reach a deal on anything. It is a crucial question, as the Congress is soon to start debating the budget and the debt ceiling. All the decisions have to be made before mid-October, otherwise the U.S. risks defaulting on its obligations. Within an incapable political setting, this now seems to be a viable, albeit still a very remote possibility.
Certainly, this is no good for the dollar. Investors have been actively dumping all the so-called “Trump trades”, with the greenback selling off hard. Another key consideration: the fact that Washington is almost paralyzed means that no significant fiscal stimulus is coming. This, in turn, implies that the Fed will not rush to raise rates. The FOMC instead will focus on unwinding the QE and watching the early effects of their actions, with sparse rate increases along the way. As we wrote earlier, the speed of the “exit” from stimulus is very low, and will do nothing to support the USD during the early stages.
There is also a fundamental side of things supporting a higher euro and a lower dollar. The global economy is growing at a decent pace, but lately all the improvements have come out of China and Europe. While the former was (sort of) predictable, the latter did come as a surprise. It is important to stress the fact that the EU has been doing better on a relative basis. Investors are now used to relatively fast GDP growth in the US, and recently they have been mostly disappointed by the hard data coming out of the States. It is the other way around with the eurozone: numbers are consistently beating expectations and suggest that growth is accelerating. Rewind a few paragraphs back, and it is clear that economic perspectives are likely to make markets believe the ECB is to hike soon.
A better global picture also lends support to the industrial commodities segment. Copper has made it through 6000 and is trading firmly above that level (USD6300/tonn at the moment of writing). Oil has also seen some buying and is currently above the $50 for Brent (USD51.9/barrel as of right now). This, in turn, has helped commodity currencies, where CAD stands out as a particularly strong unit. It is a very interesting thing to watch. Just a couple of short months ago the country was facing a financial disaster as Home Capital Group ran out of capital. The company has been given an injection of liquidity, and the story has quickly gone off radars. However, underlying cracks in the local financial system remain.
The surge of the Canadian dollar is absolutely due to the recent rate increase delivered by the Bank of Canada. We believe they will act again this year, and hike by at least 25 b.p. The move and the shift of expectations have triggered a wave of CAD buying – and some forced short-covering. This, together with higher oil prices, has taken the currency to 2-year highs. The price movements will be discussed below. But it is worth noting that we now view the loonie as that very bird in the coalmine that will provide you with early warning signs. Once CAD reaches its top and stops responding to positive surprises, we would generally become very cautious about taking on additional risks elsewhere.
EURUSD: now requires a corrective move
We sell EURUSD at 1.176, stop-loss at 1.184, taking profits at 1.141/1.122, will establish long positions at those levels.
Having said all the good stuff about the fundamentals of the euro, we need now add some negativity on its near-term perspectives. First of all, the pair has got well above the levels that would be consistent with yield spreads. Whatever you consider to be the driver – government, interbank, or swap rates, 2-year or 10-year – any measure now warrants a significant pull-back. Our use of the approach says that EURUSD is highly likely to drop to at least 1.145 before reverting back up. And this is a rather conservative estimate based on the narrowest spreads, i.e. on a pan-European average versus the U.S. If we only take Germany vs. the States, the expected drop comes in at 4-5 full figures, which would bring the pair to 1.13 area.
Technical and wave analysis both paint a very similar picture. Under the first method, we are witnessing a test of the higher limit of a nearly three-year range, and if this is to be a text-book move, the first test has to fail. A 200-day moving average is also near, currently hovering just below 1.18. Most fast indicators are heavily overbought. The wave approach says this is the end to a classic 3rd wave stretching from the onset of the year. A corrective 4th wave is often messy, and it’s unlikely to be a smooth drop lower. Yet we turn into sellers on spikes until a decent corrective move is in place. Again, we judge 1.141 to be the most nearest and most conservative of the near-term targets. A weekly close above 1.18 or an intraday test of 1.184 would force us to review the tactics.
To note, our longer-term view is outright bullish, and we would become buyers again in the 1.12-1.14 area, with medium-term targets around 1.214-1.26.
USDCAD: stellar performance, and also a very clean technical move
We take profits in USDCAD, will sell again at 1.265, stop-loss at 1.277, taking profit at 1.161.
Last month we point out that the Canadian dollar looked underpriced and had some catching up to do. Well, the unit was very quick to return to its fair-value. The current run down in USDCAD might have a little more to go, as the next meaningful target lies very close to 1.23. However, the move has been very directional, and those tend to reverse abruptly. It seems wise to close the position at least partially and reestablish shorts higher. Regardless of how far the move goes now, it is likely to correct to 1.262-1.269 area.
Longer-term fundamental idea remains in place for now. Namely, it is the normalization of the monetary policy in Canada, on the back of higher oil prices and faster growth elsewhere. The fact that China is doing well is also important, as the country is a significant source of capital flows going into North America. We would buy into any CAD weakness, and go short USDCAD again around 1.265, with targets hanging quite low. Ideally, the move should stretch to 1.16-1.17 area by the end of the year. Just like it is the case with EURUSD, here we also observe a combination of several analysis methods all pointing in one direction: slightly higher short-term, significantly lower afterwards.
USDJPY: temporarily serves at the litmus test for the dollar
We again stopped-out on our short-JPY positions, will reconsider USDJPY longs at 108.35, CHFJPY longs at 113.8.
Last month we also saw significant negative momentum reemerge in the yen. However, USDJPY proved stuck in a wide range between 108.3 – 114.3. We still believe that the Japanese currency will ultimately go lower, as the Bank of Japan remains the sole liquidity provider for the global markets. BoJ is the only central bank to continue QE in 2018 in sizeable amounts, and this should reinforce carry trades on the back of slightlty higher rates elsewhere. As usual, it has come on the back of a healthy world economy.
The risks for USDJPY and CHFJPY are now slowly turning skewed to the downside. Whether they materialize or not depends on the broad dollar strength. We believe that for now both units are to stay capped. What is really important is that dollar-yen provides a confirmation for the two trades mentioned above – EURUSD and USDCAD. As these pairs correct their recent moves, USDJPY should stay below 112.50. And once the dollar starts sliding again, it ideally should drop to 108.3 versus the Japanese counterpart. In other words, the yen itself is hardly currently a story, and, therefore, USDJPY can be used to trace the general dollar trend.
Copper: the patient seems to be quite healthy
We buy copper at market, will add at 6220, stop-loss at 5980, taking profits at 7310.
Market veterans often refer to this asset as Dr. Copper, as the metal is often indicative of how well the global economy is going. Of course, its role has been falling over the years, as the services sector has overtaken other GDP components. Yet copper is still a very important leading indicator. And currently it is screaming that the global economy is doing well. Apparently, the business cycle has still some way to go before entering the contraction phase, and this should serve as a meaningful input when analyzing markets in general. Other commodities and commodity currencies should hold up well, if our interpretation of the signal proves correct.
Copper itself now looks as an attractive asset to trade. Prices have posted a clear break higher, nearly a year-long consolidation is now over. Furthermore, the move looks to be quite ambitious. It aims at least 6866, and, more likely, at 7270 as the ultimate target. We believe it is still not too late to enter long positions in copper, and are buying at the market, willing to add to the position should prices pull back to 6220. One should keep in mind that this is purely a strategic play, with expected holding period of around 6 to 8 months.
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.