April 1, 2016 1:55 pm
Author — Nick Korzhenevsky, senior analyst with AMarkets Company. The anchorman of a TV program «Economics. Day rates».
- FOMC March decision was extremely dovish; speculation of an extended pause are now thriving.
- None of the major banks is effectively tightening (again): the Fed’s on hold, the ECB and Bank of Japan are easing aggressively.
- We consider this to be a temporary and a somewhat artificial situation, aimed to help China act on its currency problem.
- The USD is already cheap – but not too cheap – relative to rates, volatility levels also now look suppressed.
USD upside momentum has vanished following the Fed’s decision to play it safe. Janet Yellen, a now-distinguished monetary dove, managed to persuade the FOMC to take a softer approach. They now forecast just two interest-rate increases this year, while we expected they would go for three. To recall, in December Fed officials were calling for four hikes.
The sudden change in the Fed’s stance led to a massive dollar sell-off and a general risk-rally. This trend has all means to continue for a while as the shift in the regulator’s rhetoric is significant. Essentially we call this a sort of easing of the monetary policy. With interest rates close to zero, the Fed changing its tone has affected the entire spectrum of market rates. After the FOMC decision announcement, the yield on U.S. treasuries fell throughout the entire curve.
The “dot-plot” indicating Fed governors’ view on appropriate policy rates, end of period.
Quantitative easing (QE) is normally carried out to create a similar effect on bonds. That means it is difficult to draw a clear line between verbal interventions and actual monetary actions. In one of his research pieces former Fed chairman Ben Bernanke wrote that it is expectations that is the main tool in the environment of ultra-low rates. He made a bold statement that even quantitative easing — essentially money-printing — is more of a way to change market sentiment rather than an attempt to flood the economy with liquidity.
We now adjust our trading ideas as we had expected a more hawkish action from the Fed. Current market situation is somewhat reminiscent of the late 1998 to mid-1999’s. Back then the Fed also decided to temporarily loosen their monetary policy in response to developments in foreign markets, particularly those in emerging economies. However, monetary authorities soon reversed their course and surprised the market by resuming interest rate hikes by the end of that short two-year period.
There’s a good chance are looking at a similar picture today. The Fed’s behavior should support risk appetite, and this seems to be a sustainable equilibrium for a few months. Keep in mind that both the ECB and the Bank of Japan are also conducting loose policies, rapidly creating global liquidity. Now that Janet Yellen & Co are not in their way, risk trades can thrive. The question is, when do investors realize that the Fed is actually in the process of policy normalization, albeit a slower one? As soon as this is back on the table, the strong dollar idea should make a comeback. And in order to find the answer, it’s important to understand the reasoning behind the Fed’s latest decision. FOMC’s own explanation of the latest decision is based on two pillars. First, doubts remain that the inflation trend is sustainable and prices are now firmly on the rising path. Second, there is excessive uncertaintly – and, therefore, risks – on the side of emerging markets.
We do not share Fed’s inflation concern. Upside price pressures are structurally stable and are not likely to run out within the next year. The main component of price growth is health care. It accounts for 26% of the overall CPI increase over the past 12 months. Simultaneously it makes a large contribution to the GDP growth and employment (just like real estate did in 2005 and 2006), and a slowdown here can only be abrupt, and not something one will be able to forecast with high precision.
On top of that, the wages are growing, and although that has only been happening for a few months, the trend looks set. Keep in mind that aggregate incomes are going up in spite of general weakness within the oil sector and some slowdown in exporters’ earnings. We strongly believe that current inflation trends actually warranted a rate increase in March, let alone looser policy.
“Sticky” (low-frequency) inflation as an indicator of price pressures.
Source: Federal Reserve Bank of Atlanta
So it is the emerging markets that the Fed is probably concerned about. The only country that can impact the U.S. monetary policy is China due to the size of its economy and its interconnectedness with the States. And the core reason for the FOMC’s decision mostly likely lies here.
Frankly speaking, we see some suspicious coincidence in the fact that all major central banks have suddenly turned outright dovish. Just recall that the Bank of Japan took a U-turn and reversed the course of its monetary policy following WEF’s annual meeting in Davos. The bank introduced negative interest rates, although it had denied there was even a remote possibility of this just in December. The ECB then took steps they had publicly condemned just two meetings earlier. And now the Fed is taking a step back as well, despite there not being any reasons for that within the U.S. economy. Heads of all aforementioned central banks also held a closed-door meeting during the G20 Summit in Shanghai. The main issue here was likely the situation in China.
It is possible that largest central banks are trying to create milder environment allowing China to proceed with its financial reforms. The next big step here is the devaluation of the yuan. Should the CNY depreciate significantly, this alone would be sufficient for a large-scale sell-off in global markets. And if this happens when the Fed is tightening, the consequences could be far-reaching. Following that logic, the Fed resuming its rate hikes is now also a function of developments in China. We note that this lends fundamental support to our idea of a long position in the USDCNY (USDCNH).
Given the setting, we expect broad range trading to continue, with an inclination to sell the dollar into strength. This is primarily due to overly long positioning the market had built going into the Fed’s December rate increase. We shall view this USD weakness as transitionary, and point to the fact that the unit is already underpriced from a yield viewpoint. Two FOMC tightening moves in the second half of 2016 are surely out base-case scenario. Moreover, three rate increases still can not be ruled out, in our opinion. It sure is risky for the Fed to go against their own forecast, but the inflation picture suggests upside risks. Strategy-wise we stick to buying the dips in the dollar, and focus on crosses and EM currencies as tactical trades.
EURUSD: a range of disappointment
The main unit failed to break the 1.08 level, and technical analysis strongly suggests this killed the move down. Uber-dovish Fed opens the way for the shorts to be squeezed out of the market. A large net short position has been accumulated in EURUSD, which effectively guarantees that the pain trade occurs in April. It is worth noting that each policy decision by the ECB or the Fed triggered euro buying, regardless of whether it was “good” or “bad” for the currency. That is indicative of positioning pressures.
Changes to the Fed’s policy stance should keep EURUSD supported for now. The pair is likely to remain close to the upper limit of the 1.08—1.15 range. The resistance around the 1.145 area is almost certainly to be tested. Depending on general market conditions, the move can extend to August 2015 highs of above 1.16. Trading at these levels is likely to be highly volatile, rapid, and to lack corrective moves, in a fashion similar to that following recent central banks’ decisions. Nevertheless, rate differentials and broad money supply will support the USD in the longer-term. We are speculative buyers of EURUSD around 1.135, but still looking for entry points to establish strategic shorts. Levels above 1.16 look attractive.
GBPUSD, EURGBP: Brexit stress easing
The British pound remains on back foot ahead of the Brexit vote. All of the UK’s domestic policy seems to be focused on the referendum. As we anticipated, the market is now in the process of reevaluating potential consequences of exiting the EU. Sadly, the month of March provided traders with some rather unfortunate reasons for that. The Brussels attacks and the increasing terror threat made some of the investors think that weakening the links with Europe could be a positive for the UK. However, our assumptions on the EUR/GBP were certainly not based solely on the security issue. We still believe that the balance of risks for Britain is neutral, and the outcome of a possible Brexit is not unequivocally negative.
Technical picture for EURGPB remains mixed. The cross ended March basically unchanged, and a short-term consolidation is obvious. However, the pair is trad-ing above key support level of 0.7695. And given the excessive short in the EUR, we can not rule out yet another upward move, bringing the price to the 0.8 area. That’s where fundamental value turns expensive, and looking for reversal makes most sense. Long-term strategic EURGBP shorts can be established around that very 0.8, leveraged speculative positions should look for a confirmation of a downtrend under 0.77.
VIX: volatility is now too cheap
The shift in the Fed’s policy led to a drastic implied volatility drop across the markets. In fact, crude oil stands out as the only liquid segment where vols are still elevated. The opposite is now true for stocks, bonds, and many currencies. The VIX index, based on S&P500 options, is now a standard deviation lower than its last year’s mean.
Our models indicate that volatility should significantly increase in the second half of 2016. Fed’s first (and only) rate rise is enough for VIX to average 20-21 in 2016. While the target needs to be updated as inflation data comes in, a bounce back to the 18 mark is highly possible. That is also supported by volatility’s “clustering” nature, and specific characteristics of its price process.
USDRUB: the old trend isn’t back either
The Russian rouble has reached all of our targets, and is now overshooting. The whole universe of EM currencies benefits massively from the Fed’s decision to hold off on its expected rate hike, and the RUB was not an exception. Between March 16th, when Janet Yellen announced her decision, and the March 18th, which was the end of the week, Russian currency gained about 4%. At the time of writing, the USD/RUB pair is trading just above the 67 mark, which is the 2016 low.
Since we expect the Fed’s decisions to have a stable positive impact on market sentiment, we don’t rule out the possibility of a further move south. The next targets are 65.40 and 63.60. Technical analysis also suggests that the downtrend is not over yet. A minor intraday reversal and a move to the 70 area occurred on low volume, and quickly came to its end. This is yet another sign it’s too early to bet against the rouble.
One’s trading behavior now heavily depends on the investment horizon. Short-term speculative activity favors another leg down, into the 65 area. The key risks here are the potential devaluation of the Chinese yuan and the unclear outlook for oil prices. Long-term investors, on the contrary, may want to take a closer look at USD at its current prices and begin establishing a long position against the rouble. Should it strengthen to that very 65 mark, this would be a good opportunity to add to the USDRUB long. Starting in May, seasonal factors are going to start worsening quickly, putting pressure on the Russian currency. We anticipate the USD/RUB pair to return to the 73—76 range by August.