June 1, 2017 1:06 pm
Author — Nick Korzhenevsky, senior analyst with AMarkets Company. The anchorman of a TV program “Economics. Day rates”.
- The Fed will hike twice more this year and will likely begin shrinking its balance sheet as early as September.
- The risks of the Chinese debt bubble are slowly getting recognized by analysts, but are not yet discounted by the markets.
- The global growth remains stable with European economies continuing to show improvements, save for the United Kingdom.
The Federal Reserve continues to surprise. The minutes of its May meeting wound up way more interesting than we could have anticipated, with some extensive discussion about reducing the size of the balance sheet. And while the March minutes discussed that under the “New on financial markets and in open-market operations” section, the talk has now slid down to “The Committee’s actions on the monetary policy” — a step that implies unwinding QE is now moving from the realm of theory to that of practice. It’s safe to say that Fed officials have reached a consensus on how to proceed with shrinking the balance sheet.
As a matter of fact, the first explanation is already here. Each meeting, the Committee plans to define the volume of its monthly asset reduction, which will be done solely through reinvestment — without direct selling of securities. Simply put, say, the officials set the reduction volume to $10 billion a month. That means that if the portfolio brings in $20 billion of cash, $10 billion of that will be reinvested, while the other $10 billion will leave the financial system. Now, if the income for a given month totals $1 billion, $9 billion will simply roll over and the amount of withdrawn liquidity in the following month will total $19 billion. The volume of monthly asset reduction is set to be gradually increased.
And yes, liquidity is precisely what we’re talking about here (those who survived 2008 surely remember the term “liquidity crisis”). And while we formally speak of trading in treasury bonds with maturities of years, one should remember that the flip side of QE is the surge in commercial banks’ excess reserves at the Fed. We are confident that it will begin to decrease as the Fed shrinks its balance sheet. The real question is where the pain threshold lies for the markets.
We estimate that a drop in total assets below $3 trillion would be critical, while anything lower than $2.3 trillion is certainly enough to trigger a full-fledged crisis (the numbers are explained in detail in the previous edition of this publication). In fact, the reason why Janet Yellen & Co. are aiming to withdraw liquidity gradually is likely to be able to track the unusual growth in interbank rates and general volatility. This way they can jump in before the financial system can destabilize. That’s not a bad plan, but it does require mathematical precision in balance-sheet operations. However, no one can really predict what we’ll have to be dealing with. Even a balance of $4 billion could end up not being enough for the markets and there not being any issues at first wouldn’t mean that they can’t appear later. We also remind that the growth rates always end up being significantly lower than what the governors have been promising for the past four years, so it isn’t unreasonable to question the accuracy of their estimates.
Some may write such problem statement off as being too unscientific, but any problem has to be framed for a specific goal. What the Fed’s goal is and why it is rushing to unwind its balance sheet is not evident at all. This is a very serious fundamental change, not only in the U.S. monetary condition, but also in the global financial system. Yet it remains unclear why it has to be done now. Inflation levels in the U.S. remain low; on top of that, the March price report was so weak that the officials had to actually explain how a further policy tightening would even make sense. Sure, the labour market looks quite strong, but that is a question of rates which are still nowhere near the equilibrium.
We are slightly concerned about the U.S. money and credit multiplier. In a situation where the former remains less than 1, a reduction in the monetary base (aka a reduction of assets on the balance sheet) carries the potential for a drastic decrease in liquidity in the banking system. The implications of such move would be extremely difficult to quantify. We assume that we’ll see some risk aversion in the coming months, however, it will start with a number of selected assets rather than a total sell-off.
What’s more alarming is the outlook for 2018 and beyond. The ECB will have finished its QE program in December, the Bank of England already has. The People’s Bank of China is gently withdrawing liquidity in which they are about to be joined by the Fed. And while the main central banks were collectively increasing liquidity on average by 2% of the combined GDP from 2011 to 2017, they may start to reduce it starting 2018. This is a new reality and it’s best we start preparing for it now.
In the short-term, we see the following implications for the markets. First, the dollar is likely to remain under pressure right up until the balance sheet is effectively reduced. Big money will surely want to drop U.S. treasuries fearing that the shrinkage could lead to lower prices. This implies that some money will be driven out from the dollar and into other currencies, primarily high-yielding ones. We believe that the rouble, in particular, will be the main investment currency with the USDRUB cross testing the 50 mark, especially if the oil prices are on par. Meanwhile, the assets that have accumulated the most short positions will continue to grow against the greenback. EURUSD is the most vivid example here.
Secondly, one should keep in mind that a one-time drop in liquidity is not enough to really shake things up. That requires problems with real economic growth too, and there are none so far. Thus, equity and commodity markets can still take a leap forward. In this case good buys lie where the GDP dynamic still has the potential to surprise. Europe would be a good suit for conservative traders, while speculative ones should look into Russia. Oil is looking pretty attractive as well. And while the Vienna deal was met with a degree of skepticism, the excess of short positions and the balance between supply and demand can send Brent to the $62 mark.
In our view, all of the above will be the last happy moment for the global markets. Under the current circumstances, higher oil prices have the potential to destroy physical demand, while higher stock prices will push the Fed to speed up its policy normalization. That’s when it will be time to search for “crisis” ideas. But for now doing so would be premature.
Two more things deserve a special mention. First, China has had its credit rating downgraded by Moody’s. Analysts blame it on the country’s debt-inflated bubble. Its size is no surprise, but there’s now another unfortunate issue: the nominal debt is outgrowing the nominal GDP, whereas the stimulating effect is dying down. This dynamic does create risks but there need to be new factors for them to materialize. We believe that the trigger will come in the face of renewed capital outflow as soon as the Fed proceeds to reduce its balance sheet along with further increasing interest rates. But as long as all is quiet on the eastern front, the debt itself poses no threat.
Second is the disappointing data on the growth rate in the United Kingdom. The whole situation here is reminiscent of that of Russia in 2014–2016. First there was a devaluation that triggered a decline in incomes, which, in turn, caused a short recession as demand went south. There is, however, a significant difference: Britain is still dealing with its severe current-account deficit. That means the risks for the pound are still trending downward and our mid-term GBPUSD targets below 1.15 remain relevant.
EURUSD: an impulsive upward correction
We buy EURUSD on its way down to 1.11, will add to the position at 1.1010, stop-loss at 1.089, will lock in profits at 1.162.
The euro has regained some strength following a sluggish, three-month-long corrective move up. The upside momentum is now way more apparent and the cross has broken the key resistance at 1.10. From the fundamental viewpoint, that was possible thanks to the shifting expectations on the ECB’s next move and large speculators selling the dollar on the market. The long-term trend is still looking down but it’s unlikely to resume until the fall.
Tactically, we still view drawdowns as an opportunity to open new long positions. The above-mentioned 1.10 mark now acts as a support level and is exactly where the 38.2% retracement from the previous growth wave lies. There’s a number of targets that meet in the 1.162-1.169 area, and the growth movement is very likely to stop there as well. There are higher targets for an end of a full longer-term movement near the 1.22 mark. Those, however, are not very realistic, given the Fed’s plans to shrink its balance sheet and Greece being on the brink of a default.
EURCAD: where the technical meets the fundamental
We raise the EURCAD target to 1.575 and move the stop-loss to the entry point.
Nearly all crosses are showing good resistance and are looking up. EURGBP is moving towards 0.88-0.9, EURJPY is nearing 130, and even EURRUB is ready to test the lower end and make a full reversal. And yet it’s EURCAD that’s performing best according to the technical indicators. This is the cross that beautifully went through every target (specifically, 1.508) outlined in our previous review. Corrective sell-offs are poor, the move downs don’t progress, and their levels often drop. Fundamentally, nothing changed much for the euro-loonie pair either. Fueled by the ECB rhetoric, the European currency continues to grow while the Canadian dollar is suffering from volatility in the domestic market. We believe that the EUROCAD cross will enter the 1.576-1.59 corridor as early as June/July, and increase take-profit to the lower end of the range.
BRLRUB: two worlds going in opposite directions
We sell BRLRUB at 17.6 targeting 15.6, stop-loss order at 18.2.
Equally important was the revelation of just how vulnerable high-yielding currencies of developing countries are. The Brazilian real, which used to be a favorite direction for speculative money, became the latest example of that. BRL collapsed 10% overnight amidst corruption allegations against the country’s president Michel Temer. A surveillance video appeared to show Temer, who replaced impeached Dilma Rousseff last year, approving a bribe.
We are certainly not about to get bogged down in Brazil’s political squabbles. What we will say, though, is that there’s an clear trendline breakout and the macroeconomic background for a short position in BRL is generally favorable. The only problem is the high real and nominal interest rates, combined with the dollar potentially remaining weaker for a while. That makes going long in USDBRL no fun. Hence the idea to balance it out with a short in USDRUB. The Russian currency remains fundamentally valuable and offers crosses with high real and nominal returns. From the technical viewpoint, the BRLRUB has formed a head-and-shoulders pattern, where only the right shoulder is completed so far. Interestingly, the average rate for the pair over the past 8 years lies noticeably lower, at about 15 roubles to a real. That is the target for the full completion of the “head” as well.
We also lock in profits in CHFJPY, losses in USDJPY.
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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.