May 2, 2017 9:45 am
Author — Nick Korzhenevsky, senior analyst with AMarkets Company. The anchorman of a TV program “Economics. Day rates”.
- Canada is on the verge of a serious economic crisis with potentially global implications. The country is suddenly battling with two issues at once: the north-american trade and the bursting bubble in the real estate market.
- Upcoming ECB policy tightening still hasn’t been properly discounted. There might be more speculation on that once we get through the second round of France’s presidential election.
- Bank of Russia has sped up its interest rate cuts, yet the rouble is not showing sings of weakness immediately. We only expect some RUB depreciation when the cycle gets into its mature stage.
April has brought alarming uncertainty into global markets as politics is now spilling into economic matters. We believe the prominent story here is the Trump administration’s unexpected decision to slap a 20-percent tariff on Canadian lumber imports. Various sources report that Canada’s dairy and even energy sectors are on the negotiation table as well. In all fairness, Canada has been long criticized for its protectionist policies. The White House’s actions towards its northern neighbor are not economically senseless either. And yet it’s a clear signal of America’s newly belligerent stance on foreign trade, which means all other deals (with China, in particular) could just be temporary.
Not only is the U.S. trade conflict a terrible headache for Canada, it also happened at the worst time as the government is busy dealing with another major issue. Last week saw the de-facto collapse of Home Capital Group, Canada’s largest non-bank mortgage lender. Over the course of a single day, the company’s shares plunged almost 70% following the reports that it had taken out a $2 billion line of credit with an interest rate of 22.5%. The loan was secured from the Healthcare of Ontario Pension Plan. Those who were in the stock market during the financial crisis of 2008 should now be having a deja vu: ten years ago a U.S. company called New Century Financial faced similar issues, and eventually fell victim to the implosion of the mortgage market.
It would be too early to talk of a full-fledged crisis, but we do see a very, very serious risk for Canada here. There are challenges associated with foreign trade meaning that the real sector is under pressure, and simultaneously the Home Capital crisis puts an enormous strain on the financial sector. The systemic effects of those factors are not to be underestimated either. Continuing the 2008 comparison, it was the asset-backed commercial paper (ABCP) market in Canada that was the very first to collapse back then, and only after that did mortgage-backed securities segment freeze in the U.S. Moreover, the Canadian housing until very recent saw a lot of buying from the Chinese capital. As a result, the prices are currently clearly inflated. This altogether is an awfully fertile ground for very negative scenarios.
Canada’s troubles are rooted in the general imbalances accumulated over the past five years, and these are not unique. They are actually common for most developed countries that pursued zero or near-zero-interest-rate policies, not to mention quantitative easing programs. And yet this is only a taste of what could happen to a seemingly stable financial system. We still believe that ample liquidity and relatively low interest rates keep a full-fledged crisis out of the picture for now. Next year, however, that liquidity may start shrinking. And the global risk appetite might too.
By the way, as you are reading through these lines, the Fed is likely discussing what to do with its balance sheet. There’s already been some public statements made on the issue and the officials have to come up with a joint stance. If they really agree on cutting the size of the balance sheet, Janet Yellen will have to put that out for public discussion first. By tradition, this is likely to happen at the Fed’s Jackson Hole annual symposium in August, which attracts the world’s financial leaders and central bankers. Discussing the end of the quantitative easing program at the conference would bring things full circle as that’s exactly where Ben Bernanke announced it years ago.
We hasten to add that we don’t see any economic sense or need to shrink the central bank’s balance sheet. There is basically no inflation pressure, and the debt market is suffering from Donald Trump’s shaky ways of implementing a new fiscal policy anyway. The Fed’s assets amount to 23.7% of the GDP, which isn’t a critical level by any means. FOMC officials, however, seem to have a strong urge to get rid of some of the paper. If that does happen, every small step will have noticeable effect on the markets. According to our calculations, ending reinvestments alone could cause 10-year yields to go up by 0.2-0.3 p.p. immediately. A response this strong has to do with the fact that the money multiplier remains below 1. That implies the need to keep the balance sheet large.
The regulator probably takes comfort from the fact that there is significant excess liquidity. It has been staying above 2.5 trillion since 2015 and, perhaps, the FOMC believes that there’s a potential inflation threat here. In theory, an intra-balance-sheet “Operation Twist” is possible, when the central bank swaps its mortgage-backed securities for excess reserves. Sounds like a win-win: the Fed would dramatically reduce the risks of its portfolio (and, therefore, general systemic risk as well). And even after doing so, the liquidity would remain in surplus, yet the banks would be paying less to the “depositary of last resort.”
The problem is that the market equilibrium does not depend solely on stocks, but also on flows. Simply put, such seemingly “safe” approach would seriously shift market expectations and redirect capital flows. It’s still too early to predict just how strongly the market would react because we can only hypothesize about the alternatives. We note, however, that few plausible scenarios imply a rapid dollar strengthening. The main consequence of downsizing the Fed’s balance sheet is likely to be a sharp increase in volatility across all asset classes.
Therefore we are looking out for the FOMC’s rhetoric on the balance sheet. The rest is more or less clear: there will likely be a rate hike in June, and then one to follow in September or December. We may even be looking at three rate hikes by the end of 2017, but if the Fed really wants to start experimenting with its balance sheet, they need to hold off on raising rates too fast. That’s exactly what the current market expectations are, which is why even a clear signal of a June hike on Wednesday would not provide any significant support for the dollar.
EURUSD: waiting for the political risks to vanish
The euro continues its corrective move up. Without a doubt, the good news for the currency is the results of the first round of the French presidential election. As we have noted in the previous edition of this publication, the markets had priced in a possibility of Marie Le Pen winning the presidency. With the Brexit vote and Trump’s upset win, 2016 was too much of a shock for the investors not to be extra cautious this time around. And when the results turned out favorable, the euro rallied up. Moreover, the outcome of the first round being so accurately in line with the polls augurs well for the second round to go equally as smooth. The latest opinion polls show Emmanuel Macron at 58-60% against Marie Le Pen at 40-42%. The gap between the two candidates is quite large and, more importantly, stable. That’s another difference to the Brexit referendum when the margin of error was larger than the difference in votes.
As soon as the election is over with, investors should shift their focus to the ECB. Mario Draghi is now clearly hinting that the policy is to be changed in the future, of course noting that it’s still extra soft for now and there are no significant changes planned to be made any time soon. We, however, find those extra cautious remarks to be Draghi’s way of calming the markets. And as soon as Le Pen’s win is out of the picture, the ECB’s rhetoric should grow explicitly hawkish. We believe that EURUSD will continue its corrective rally up until August.
USDCAD: a one-two to the loonie
We buy EURCAD at 1.486, will add to the position at 1.472 targeting at least 1.508, stop-loss at 1.467.
The loonie is already under pressure due to the factors explained in the first part of this edition. The lumber war with the U.S. doesn’t have an immediate effect on Canada’s terms of trade, but it does negatively affect expectations due to possible taxes on Canadian oil. While we don’t think that Trump’s administration will go that far, there is actually nothing stopping the U.S. from removing a small portion of Canadian supplies from its market. Knowing how unpredictable the new White House is, the scenario can not be fully ruled out.
Then there’s Home (Without) Capital, as one blog puts it. Now this can actually affect Canadian capital flows immediately, as Chinese money might stop pouring in. This alone is an outright negative for the CAD. On top of that, we have yet to hear from the central bank on how they plan to deal with the newly-discovered challenges. The regulator may hold off on raising rates, which doesn’t work well for the loonie, ceteris paribus, either.
From a technical viewpoint, the CAD is looking weak against majority of currencies. USDCAD has broken key resistance at 1.3585 and is now moving towards the last bounding level at 1.383. If breached, the path would be cleared all the way to the 1.433 mark. However, we like to buy the EURCAD due to tactical considerations. Speculators may consider going long at 1.486 and adding to the position at 1.472, while more conservative traders should just wait for the latter entry point. The upside target lies at 1.508.
USDJPY: moving according to plan
We add USDJPY longs at 110.65 targeting 118.80/127.3, stop-loss at 107.8, reestablish CHFJPY longs at 111.1 targeting 118.2/123.1, stop-loss at 108.9.
The dollar did eventually go all the way down to 108.6 against the yen (with intraday minima below that), but then bounced back up sharply. The upside momentum is definitely there, and our bullish outlook for the cross remains in tact. The fundamental view is still that the dollar will strengthen against the yen regardless of whether the FOMC decides to simply proceed with interest rate increases or starts shrinking its balance sheet. The difference here would be the pace of the move up, but yield-hungry Japanese investors are unlikely to stop plowing money into the United States.
Moreover, next year the Bank of Japan may find itself as the world’s only central bank still “printing money”. When taken together with possible changes in the Fed’s quantitative policies, the target of 129 for USDJPY may seem too conservative. History has seen levels much higher than that. And looking back into the 1970s one can learn that the dollar was trading around 300 yen. During the first half of the 1980s, USDJPY hovered in the 200-250 range. We remain long the pair and view the current levels as strategically favorable entry points. We also rebuild long positions in CHFJPY. It’s worth noting that nearly all other yen crosses are flashing bullish signals, including EURJPY, GBPJPY.
USDRUB: a classic market trap
We buy USDRUB at 56.1, will add to the position at 54.6 targeting 61.7, stop-loss at 53.3.
For nearly a year now most professional (and not-so-professional) analysts have been expecting the Russian currency to drop 7-10%, pointing to both the balance of payments aspect and the country’s volatile real sector. Both arguments are fair, but are mostly true only when we speak of long-term equilibria. In reality, however, a market can remain out of balance for a long time. In the particular case of RUB, deviations are caused by large speculative inflows and supported by a generally strong current account.
Now, high nominal and real interest rates are precisely what speculators love. We have long said that any measures to weaken the rouble would not be too effective as long as there is such a strong attractor of foreign capital. The Bank of Russia, of course, recognizes that, and it has finally found some space to ease its policy. There was a clear shift in the rhetoric in March, and the key rate was cut by a whopping 50 b.p. in April. The central bank’s officials are surely guided by fundamental principles: they see stalled inflation and falling inflation expectations. But on the back of their mind, we’re sure, they would love to see the rouble weakening at least slightly.
Unfortunately, even a 50 bp cut is currently not capable of triggering outright currency weakness. The logic of foreign investment is buying rouble bonds and holding them until the rate cut cycle is mature. This way investors get a very high coupon yield, and a capital gain due to falling rates (in the bond market, prices and yields move inversely). Therefore, when the Bank of Russia completes policy loosening, global investors are likely to cash out. That’s when capital outflow might intensify a bit, which would naturally cause a 7-10% RUB depreciation. A good timing for that would be the second half of 2017. Any speculator holding a short rouble position has to be patient, and ready to cope with a large negative carry.
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.