September 1, 2017 10:24 am
Author — Nick Korzhenevsky, senior analyst with AMarkets Company. The anchorman of a TV program “Economics. Day rates”.
- U.S. budget and debt-ceiling debates are going to take the stage in September. We assign a 50% chance of a government shutdown.
- Central banks are questioning econometric concepts describing the relationship between employment and inflation, but are not tweaking their policies just yet.
- EURUSD is in the area of a short-term overshoot, likely topping out around 1.21-1.22.
- Cryptocurrencies, including bitcoin, are the new bubble; the sole question is where it bursts.
The month of August was largely a non-event. Yes, we did get a few notable market moves, including the run-up of the EURUSD and the fireworks in the cryptocurrencies area. But in terms of incoming fundamental information the month was nearly empty. The Jackson Hole symposium was an eagerly-awaited event, and if you are an academic economist, you probably enjoyed it greatly. Really big questions were asked, and the central bankers are now openly admitting they are struck by how low inflation is. The problem is now postulated and well-defined, but there were no answers as to what to do with it.
Practitioners wanted to hear Janet Yellen and Mario Draghi elaborate on what implications this would bear for monetary policies. And we’ve got a muted response. The chairwoman’s speech combined with the July’s meeting minutes does explain the thinking within the Fed, though. Committee members are now openly questioning the validity of the current framework used to forecast inflation trends and inflationary pressure. Today this is mostly analyzed in the Phillips curve context. The idea is that the lower unemployment goes, the faster wages rise. And labor market is deemed to be the only source of persistent inflation pressures on the policy-relevant horizon (other sources are usually treated as a one-off event, and referred to as “transitory”).
The importance of this trade-off should not be underestimated. Remember, the Fed has a dual mandate: it aims to keep unemployment as low as possible while containing inflation at the rate of 2% per annum. So when the FOMC publicly states that the relationship between prices and labor market is not playing out the way it used to, it implicitly doubts the validity of its own objectives. The discussion on the phenomenon of stubbornly low inflation is just starting, but it may evolve into a very serious debate on how the Fed should run monetary policy in general.
The admittance is striking, and we believe the Fed has already switched to an alternative reaction function. As the relationship between prices and employment is now broken (at least temporarily), the governors are paying much more attention to financial stability. And they are apparently finding a reason to be concerned here. As the FOMC was raising rates during the current cycle, financial conditions have not always responded in a usual fashion.
The committee is also watching the markets, and just like all of us are witnessing the bubbles ballooning is some segments. The outstanding example here are the cryptocurrencies, into which the money has piled only simply because a) there’s a new asset-class available for investment and b) there is too much cash still sitting on the sidelines. If you want to know what a central banker thinks about the bitcoin, you may need to wait until January, when Ben Bernanke is scheduled to give a speech on the topic. But either way, we have a classic bubble at our hands, and Janet Yellen is surely willing to remove some of the excessive cash from the system, as it has started going where it was never meant to. One important outtake from her most recent appearance is that the Fed is surely willing to proceed with policy normalization, and may speed up balance sheet unwinding should conditions warrant that. The “lowflation” considerations will be largely ignored at this stage. They will only be important again when the policy is defined as “neutral”.
The only other speaker of importance at the Jackson Hole conference was Mario Draghi. The ECB president is, of course, puzzled by the same problem of persistently low inflation, but, unlike Janet Yellen, he is trying to find compelling explanations as to why this is a temporary phenomenon and sooner or later things are going to return to normal. The list of possible causes for this is quite long, so we will just skip it. The bottom line here is that the next step for Europe is also tightening the monetary policy. We are likely to get first information on the schedule as soon as this month, and the whole plan is likely to be presented in October. According to our base-case scenario, the QE will have been fully wound down by the end of H1 2018.
So from a practitioner’s viewpoint, the Fed and the ECB chiefs have by large confirmed what the market had already learned. Furthermore, these paths of policy changes have been mostly discounted. At the moment of writing EURUSD is trading close to 1.2, and any support from rate differential or broader monetary conditions has long been gone. The other source of euro’s recent strength is also nearly exhausted. As we pointed out last month, the intra-EMU spread compression has been a significant driver. It has served as an indicator of political stability in the European Union, while things in Washington are falling apart. But now markets are at the point where further spread compression is highly likely. First, relative yields are now at their historically normal levels. Second, a large portion of this normalization has stemmed from the ECB buying, which is to be concluded soon.
But it takes two to tango. EURUSD is not only the reflection of developments in Europe, but is also dependent on what is happening in the U.S. Unfortunately, it’s this same old story of a harsh political gridlock. Important deadlines are approaching fast, yet the political landscape is only getting uglier. Given how difficult it is for Donald Trump to negotiate, it is nearly a certainty that all the fiscal decisions will be last-minute. The treasury has already said that government spending can carry on through the end of September, and then the debt-ceiling limit will be reached.
We are confident that the treasury will have to invoke emergency measures. Our estimates show that there is currently a 50% probability of a partial government shutdown. Subjectively, one can say that the chances of a political crisis are much larger, as nothing has gone smoothly after Donald Trump checked into the White House. If the parties manage to achieve some sort of consensus before mid-October, the episode will be quickly forgotten, as occurrences of this sort happen quite often. But if there’s no decision, markets might go into a full-crisis mode. Failure to raise the debt ceiling would force government spending cuts of 3-3.5% of the U.S. GDP. This would create risks of a recession, and this surely has not been discounted.
September is likely going to be another difficult month for the dollar, as the market keeps on pricing in political challenges related to the budget and debt-ceiling debate. This is exactly why we think EURUSD might go a bit higher before it reverses. And we sincerely hope that at the time of writing the October edition of this publication there will be at least some clarity on the fiscal deal. Given the level of optimism currently present in the risk-related assets, a sell-off of a very large magnitude is slowly becoming a real risk, and an unfriendly jump in volatility in then nearly warranted.
EURUSD: flying high in thin air
We are to go long EURUSD at 1.158-1.161 targeting 1.2425, stop-loss at 1.1335.
One of the few important lessons of August: euro has proven it can stage a come-back. The speed of recovery has been impressive, and further downside is likely to be corrective. Having said that, we note that the stage is set for a move down. Massive stop-loss orders in the 1.2 area have been taken out, barriers have been triggered, and now the path lower is clear. We still believe that EURUSD should lose a few big figures before it can resume the uptrend.
Accounting for the divergence in EURUSD and the rates markets, the corrective move has to take euro down to around 1.16. This level is justified by current rate differentials, and our proprietary models tell us that the longer end of the treasury curve should move 10-15 bps higher. This warrants a weaker common currency, at least temporarily. However, once EURUSD falls back into 1.16 area, it will worth considering to restore long positions. 1.24 now looks like a realistic target for the remainder of 2017.
GBPUSD: the move up is over, time to complete the long-term move down
We sell GBPUSD at 1.288; closing out ½ of the position at 1.272, stop-loss at 1.2955, closing out the other ½ at 1.172, stop-loss at 1.306.
Unlike the euro, pound sterling is just not that sterling anymore. GBP has been repeatedly failing to move meaningfully higher. The currency is pressurized by both fundamentals and speculative flows. As far as the former is concerned, the whole Brexit mess is of an utmost importance when analyzing the pound. It’s been five months of putting together a comprehensive plan of the divorce with the E.U., and British politicians have just started realizing how difficult the matter is. Brussels is watching this with joy.
The other critical factor is the monetary policy. Bank of England has its arms pinned to its sides. Retail prices have fully adjusted to pound’s devaluation, inflation pressure has receded, while general uncertainty remains high. Under these circumstances any speculations on eventual tightening are ruled out. And as a result, lower targets for the sterling are now becoming more probable. The next important support for GBPUSD comes in at 1.27-1.272. If broken, the downside spans all the way to 1.17. In the worst case scenario, one should remember there’s also the good old 1.02 target. We now also revise our forecasts for EURGBP and only expect a corrective move there as well. The cross has risen from 0.83 to 0.93, and after a short-term move down the parity should be its next aim.
NZDUSD: a very technical sell
We sell NZDUSD at 0.72 targeting 0.687, stop-loss at 0.7255.
The trade idea in NZDUSD is very simple: it is a good mix of weak fundamentals and weak technicals. The latter is particularly interesting, as we see a clear “head-and-shoulders” pattern here. The “shoulder” part has, of course, been rapidly traded down, and it’s too late to try catching this part of the signal. However, there’s the potential related to the “head” part, which would be preceded by a correction. The ultimate target then is 0.6853.
On the fundamental side all the factors influencing the dollar are going to be at play. It is both the general volatility that is likely to emerge in September, and our expectations of higher dollar yields. Yet on the side of the kiwi things don’t look good. Macroeconomic data has been unusually weak given the global context, and there is quite a bit of uncertainty heading into the general elections. It is scheduled for the end of the month. And before investors get a clear understanding of New Zealand’s fiscal policy, the NZD is likely to remain under pressure. In recent weeks kiwi has consistently underperformed other liquid currencies. In August it even managed to weaken against the GBP. And there’s nothing on the horizon that could alter this.
COPPER: going up smoothly, but also needs to correct
We’re staying long copper, will take profits at 7310, and then restore the position at 6780.
In the previous edition of this publication we pointed at copper as an asset that has some great upside potential, and a clean technical setup. Well, this sure has not changed in August. The move up is steady, accompanied by shallow intraday corrections. There is a significant probability that the 7310 target will be reached without any sell-offs on the way. Furthermore, the rally now looks too good to simply halt once the 7000 level is breached.
From the wave analysis viewpoint, we might be into the first wave of the move higher. This means that the rally is still young, but it also makes it difficult to assess ultimate targets. The picture is to become clearer once we watch the price activity around 6780. However, even a conservative estimate now gives 8490 as the likeliest aim. Just like it is with the kiwi, there is a confluence of fundamental and speculative factors, and unlike it is with the kiwi, here they are a source of strong upward momentum.
Bitcoin: in an advanced bubble stage, already showing signs of hysteria
We stay as far away from the cryptocurrencies as possible; our judgment is that it is a frontier market with exceptionally high risks.
The cryptocurrencies segment has become a mania. We have tried to avoid commenting or forecasting anything in this market, but it has become impossible to ignore the elephant in the room. So what can we say on these assets? We are witnessing a classic bubble. It would always appear in the early stages of a market that is just emerging. This is just how it works, and the only valuable information one can extract from the price dynamics here is that cryptocurrencies do have some global intrinsic value and will likely stay with us for some time as an asset class.
However, from a purely financial point of view, cryptocurrencies are not suitable for directional trading. They are markets of extremely low information efficiency, where strong linear one-way moves make up for the most of trading activity. The trend seems (and we mean “seems”) to be well-defined, accompanying fluctuations fit very well into simple technical models. But this hides the greatest threat: the “corrective” move will be just as one-sided and brutal. Observers will surely call it a burst of a bubble. And forecasting when this happens is exceptionally challenging. The bottom line: currently the very few market participants who can make money on the Bitcoin are arbitrageurs and video card producers. As it is the case in any episode of a “gold rush”, only those supplying shovels earn a stable income.
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.