March 1, 2016 11:46 am
Author — Nick Korzhenevsky, the senior analyst at AMarkets Company. The anchorman of a TV program «Economics. Day rates».
- The market is underestimating Fed’s willingness to hike.
- The USD is to rise as expectations reverse, TRY and BRL to suffer.
- Brexit and the GBP is now the main story of the G10 currencies.
The markets are entering March in an environment of heightened uncertainty, which now seems to be normal. Volatility remains elevated, albeit lower than it was in January. Most major pairs are trading in wide ranges, with the exception of the British Pound.
The main theme of recent weeks is surely the prospective FOMC’s “hawkish pause”. It is the expectations of a delayed rate hike that traders are betting on. Fed funds futures suggest that the target rate is to remain in the current range of 0.25-0.5% through all of 2016. December contracts imply a nearly 50% probability of a Fed pause for the rest of the year. However, this is where we clearly see asymmetric risks.
Probability of another Fed rate rise in 2016. Source: CME.
The Fed’s reaction function has clearly changed, reflecting structural adjustments within the U.S. economy. Major shifts in employment patterns and housing preferences have occurred after the mortgage crisis of 2008. And it is now the FOMC’s task to combat any inflation risks stemming from the wage growth. The U.S. economy is also expanding steadily. Admittedly, this is happening at a much slower than what it used to be before that very same crisis. But this is due to lower potential output, and the Fed knows it very well.
Another argument often cited today is the weakness of incoming data on the U.S. economy. While the numbers are softer than a few quarters ago, we don’t necessarily see outright weakness. Most of incoming information is evidence of moving to the maturing stage of the business cycle. This means there should be two usual pillars of growth. The first one is the capital expenditures that companies undertake in the face of rising labour prices (i.e. wages). The other is growing demand in the real estate market, as households feel they are more in a position to make large purchases, and front-load those purchases while the rates are still relatively low.
Quantitative analysis also shows that the onset of the recession should be expected at least a year from now. There are early signs of stress (wider spreads, less liquidity, higher volatility), but all of that should be manageable for now. And from the balance of risks viewpoint, the economy is ready for higher rates. They, of course, can not go all the way up to 5%+ where they were last seen under Bernanke. But a 2.5% area seems plausible, given inflation and GDP trends.
The major conclusion here is that there are clear upside risks for the U.S. dollar. We believe that the market is underestimating the Fed’s readiness to act. The FOMC will now need to postpone the second hike and is not going to act in March in order to avoid excessive market stress. Yet we do not rule out another 25 b.p. move in June, and the greatest odds are for a move in September. Neither economic, nor political agenda should be an obstacle for a hike in the second half of 2016, and the USD price activity should evolve accordingly.
That, in turn, is a great risk for EM currencies. For now, though, they have finally found some footing as commodities have stabilized and Fed hikes are priced out. We still expect to see some further strength in the RUB and MXN, as both currencies seem to be underpriced from a medium-term perspective.
There also could be select buying of “what’s cheap”, in a fashion similar to May 2008. Back then many EM assets have seen heavy buying, despite the fact that Bear Stearns had already collapsed and spreads had widened accordingly. At the same time, we’re looking for entry points to re-sell TRY and BRL as fundamentals here are eroded, and they look to be a better way to trade on renewed EM stress later in the year. Relative value trades (long RUBTRY, long MXNBRL) are also worth a look.
Our conviction to sell the yuan has also got stronger. A CNY devaluation looks to be the most becoming tool given China’s inflation (or rather deflation) outlook. The country is trapped in a deflationary spiral, and some currency depreciation is actually desirable. It would help the exporters and stabilize the “old economy”, simultaneously being a pro-inflationary measure and putting some upside pressure on the prices. The only question with CNY weakness is timing. We think that the PBoC will be very dogmatic when it comes to FX adjustments. The central bank is probably going to allow yuan weakness only when the USD is generally strong again. And that brings us right back to the issue of rate hikes and market expectations, already discussed above.
EURUSD: time to go short again
Recently the euro was busy completing its corrective move. EURUSD managed to go up all the way up to 1.1378. While this wasn’t our base-case scenario, this leap higher didn’t just come out of the blue either. The general assumption for any price activity today is heightened volatility. And the surge of euro into the 1.14 area should be viewed in this context.
Fundamentally EURUSD remains a sell. We do not believe that the Fed is going to stay on hold through 2016. But what is also important, we think the ECB will act aggressively on its March 10th meeting. Most recent inflation data suggest that the deflationary pressure remains in full force, and economic activity is not as brisk. All of this warrants further stimulus from the ECB. The options for Mario Draghi are to lower the deposit rate, to extend the QE, or to do both. The latter, of course, would be the most efficient policy action, and our central expectation. But there is risk that board might not be willing to go that far.
Should the council proceed with lowering the deposit rate, it will be cut by another 0.1% to -0.4%. It is of an utmost importance that the ECB might introduce a tiered system, similar to one established in Japan. This would be an interesting development, as it would signal the presence of a hidden coalition, probably formed in Davos. If QE is modified, it should be expanded by another 10 bln eur per month. We do not expect an amendment to the program’s term.
Either move would be negative for the EURUSD given current market sentiment. The positioning in the euro is far from December extremes, and the cumulative dollar long is also relatively mild. From a technical viewpoint, EURUSD has finally shown some weakness by breaking below 1.095 at the end of February. This shapes and important weekly and monthly closings, signaling potential for further declines. The magnitude of the downside depends on what the ECB does exactly. But we conservatively expect EURUSD to at least re-test 1.05 area over the course of March-April. The worst-case scenario, in our view, would be another month of volatile trading sideways.
GBPUSD: it’s all about Brexit
The pound has fallen under pressure after Brexit speculations surfaced. The reason why traders are finally paying attention to the issue is the fact that the date of the referendum has been set. The Brits will vote for their EU membership on the 23rd of June. Latest polls are skewed towards staying in the union, but it’s a close call.
As it was the case with Greece in 2011-2012, the market, in our view, is still underestimating the significance of the issue and its implications. It is quite probable that in the end the Brits will vote to leave the EU. Even if avoided in a last-minute-miracle Hollywood style, the fear of this event is going to be affecting the markets for the next 4 months. Any pound trader should consider the risk of the polls leaning in favor of a negative outcome at some point.
While the first reaction has been pound-negative, this should be re-evaluated going forward. It is expected that GBPUSD remains pressurized, but sterling should regain footing on the crosses. Naturally, EURGBP is the primary candidate for a reversal. Back at the end of the 90’s the euro firmed against the pound. It was speculated that Britain would lose its financial supremacy in Europe because it hadn’t joined the currency union. The idea was that all the banks and trading would move to Frankfurt, and London would slowly die. Life has proven these theories wrong.
This time around the speculation is similar. It’s feared that Britain would lose access to European financial markets and become less competitive, but there are good ground to doubt this. An alternative would be the U.K. actually gaining advantage by distancing itself from weaker continental counterparts. If one recalls the recent developments regarding, for example, Deutsche Bank, it is easy to make the case why real money would prefer the good old safety of London.
From a technical perspective, GBPUSD has demonstrated weakness, and is now on its way to 1.35. It remains to be seen if this area of support is penetrated as this is actually the lowest rate since the 1990 and a strong support. Still, shorting GBPUSD looks to be the first choice for someone who firmly believes that Brexit is unanimously negative for the sterling.
Yet it is EURGBP that stands out as an interesting opportunity. We expect the 0.8 to hold as a major resistance. The market should reassess the implications of a potential Brexit and realize this would dramatically damage the rest of Europe as well. One also shouldn’t forget about general euro fragility. We are looking for entry points to short EURGBP as it tests the 0.8 area, expecting it to revert back to 0.72.