Macro Outlook for June 8, 2014
Correlation / Sensitivity Sheet for June 8, 2014:
AUD: Flat for the week. GDP was higher than expected for the first quarter and the China Non-Manuf PMI improved for May. Bearish forces are the Higher Chinese Yuan, and the RBA still wants to give time to see how the economy handles the mining slowdown and all the rate cuts. And RBA believes that inflation should remain contained, even with lower levels of the AUD. So it doesn’t see a need to move on rates. Don’t see anything here.
Equities are responding in a much more bullish manner to risk appetite rather than the typical commodity currencies like AUD and NZD, due to the perception that the central banks will move slowly on raising rates. The perception that there is a global dis inflationary wave that will keep a lid on inflation and the sub optimal growth keeping wage and price pressures contained.
NZD: Flat for the week after trying to initially sell off on the lower Fonterra dairy prices which have been consistently dropping. The bearish macro scenario is that the combination of the two rate hikes restraining current CPI of 1.5%, along with the drop in dairy prices to potentially delay further rate hikes. But NZD/USD has already dropped a few hundred pips from 0.8750 to 0.8450 to take into account this potential repricing of expectations. And given the current macro environment getting a 200 – 400 pip move in currencies seems to be around the maximum. Any further volatility would require a bigger global macro shift from a central bank, which the market does not believe will happen since it believes central banks around the world will be slow to raise rates (with the exception of the RBNZ). Bullish scenario for NZD are the continued rate hikes expected in the pipeline. Not doing anything here since the market is restrained either way. If NZD rises, it is restrained by the rate hikes cooling the economy and the high NZD hurting exports and the lower milk prices restraining economy.
CAD: Sold off for the week by -100 pips or so. Unemployment rate rose to 7.0%, which contrasts to 6.3% unemployment in the United States. Also the BoC said that the uptick in inflation is temporary, there is excess supply that will be absorbed gradually and that there are increased risks to economic growth. GDP for Q1 was at a very weak +1.2% y/y, and the Canadian Finance Minister said exports were not growing as quickly as desired. So a depreciation of the CAD would help with growth. The only two currencies that could potentially show weakness over coming months is the EUR and the CAD in my opinion. I would become highly interested in buying USD/CAD if it drops below 1.0800 barriers.
EUR: Flat for the week. Tripped downside stops below 1.3550 barriers in EUR/USD, then some short covering back into the range near 1.3640. The ECB delivered roughly what was expected with the deposit rate and refinance rate cut. The market tried to sell off on the news of the end to the SMP sterilization, and the LTRO, and Draghi said they can act swiftly if needed, and to intensify work of outright ABS buys, and that rates may stay low for longer than previously thought. EUR/USD tried to sell off further on that information flow, but the barrier protection at 1.3500 held for the time being. Macro model says not to try to short EUR/USD at the lows or after it breaks out lower, since there is not enough monetary policy divergence yet to warrant a further break lower, and there is still demand for EUR denominated equities and bonds that are propping the market.
One of the really important insights from last week in my opinion is the CPI reading which dropped to 0.5% from 0.7% y/y in May. That is a very important piece of information because what happened in May? The EUR dropped 200 – 300 pips. So my interpretation of the news is that even with a 300 pip drop in the EUR, inflation still dropped. Which is a very bearish signal from a global macro perspective. It would suggest that the EUR absolutely needs to depreciate another 1000 pips or more to help facilitate a re balancing towards higher growth and high inflation. The only obstacle in the way is the ECB, which has not yet done QE. They also do not want to go negative on the refinance rate as that would mean the average citizen having their money in the bank loses money every year. They do not want to go down that path so they only brought the deposit rate that banks pay to the ECB to go negative, which is nowhere near as effective in causing the EUR to depreciate, which is confirmed with the price action with the EUR/USD bouncing after trying to break out lower.
The current way the market is positioned in my opinion is that the recent drop in the EUR/USD has been mostly because the longs have been reducing exposure, and only a small ramp up of macro short positions. So there hasn’t been a very big macro short trades willing to short the lows, so they just wait for a rally to try to short EUR/USD. If the EUR/USD breaks lower, some tech traders jump in expecting it to continue, but they do not have the support of the bearish macro traders, so the move fizzles out and the EUR/USD bounces.
There has been a drop in crop prices the past month or so, and there is also intense competition in the Euro zone in the retail sectors and other sectors with low growth in demand, coupled with the still high level of the EUR, all helping to contribute to the drop in the CPI. I have also heard that some power prices may go lower as well. So a quadruple whammy of deflationary forces. Give these forces, the EUR is a short on rallies. It may decide to grind lower. The other bearish scenario for the EUR if the ECB does not QE, is when the central banks start hiking rates in 2015, and the market perceives the ECB will be on hold until 2016 or 2017. But that scenario is still many months away and may only inject gradual and light volatility, rather than huge volatility.
GBP: Overall flat for the week. Home price growth continues at a rapid pace, and the BoE is aware of it, but they do not want to use rate hikes to cool the housing market yet as they still believe there is spare capacity and that the economic expansion is still fragile. Not doing anything here.
JPY: Sold off -100 pips or so for the week as bonds fell for the week causing yields to jump. What happens to the JPY is currently very dependent on what happens with US bonds. If bonds go up, JPY goes up. If bonds go down, JPY goes down. USD/JPY upside and EUR/USD downside are both restrained because the market perceives the Fed is only going to hike rates gradually and still over a year away. So any natural USD bullishness is not really occurring.
There is another potential scenario in USD/JPY where it breaks out in one direction if the market gets caught short volatility. Plenty of option players have been selling and buying DNT option structures with barrier locations above 105.00 and below 100.00. That is not something I can predict or call right now.
Kuroda said that even when they start winding down the QE program (maybe in mid to late 2015 or 2016), the JPY will still probably not strengthen. I would agree with him. He is probably operating under the assumption that when the BoJ is winding down QE, other central banks will be hiking rates, so the JPY should not strengthen. I think there will be another wave of JPY weakness, just perhaps towards the end of 2014 or early 2015, with either more BoJ easing, or the changes to the GPIF pension fund, or the other central banks start hiking rates.
I would not chase JPY weakness because I do not yet believe bonds will collapse in price yet. I think bonds may make a run to the topside resistance again.
CHF: Only thing to note is that the CPI rose to +0.2%y/y in May from 0.0%. It is still a very low rate, so it will not yet worry the SNB. And there are deflationary forces in the Euro area, so the CPI in Switzerland will probably stay low. However, if the CPI does start consistently trending higher for any reason, the SNB may have to re evaluate their loose monetary policy or the 1.20 floor they have in EUR/CHF. Though it is still way too early as it is only one month or data. Just something to keep in mind since the 1.20 floor has been in effect for almost three years, and whenever they find a macro catalyst to remove it, or raise the floor, that could be a very good trade opportunity.
S&P: Rallies strongly for the week, helped by the combination of continued NFP job gains, but mostly the ECB rate cuts causing the new upsurge in equity prices. The market believes there is a decent progress on the economy and that the Fed will not need to speed up taper as there is still low inflation. Equities also seem to be getting a boost from the drop in bond yields from the beginning of the year.
So the emergence from the sever winter with better US data, and the lower yields of the past few months, and the ECB rate cuts, and the perceived reduction in Ukraine – Russia tensions, and the China issue not worrying the market has all led to higher equity prices. American wealth hit a record in the first quarter as home values and equity prices soared. So there can be a virtuous cycle of the higher equity prices and home prices wealth effect leading to continued bull markets.
The only bearish scenarios I can see are if the market believes there are general full valuations for equities and those profit takers come in to cap the market. Other scenario is if the market believes there will be a low growth and low inflation period with the Fed tapering and the market perceiving that all the central banks have exhausted their rate cut and QE measures. Other bearish scenarios include if China growth falls further, resurgence in Ukraine – Russia tensions.
Market volatility is low as the market is not pricing in a rapid rise in interest rates. So the market can continue to grind higher in the absence of risk aversion events. No one wants to chase top tick and no one wants to take profit as they fear the market can just keep grinding higher and may not retrace. I wouldn’t chase top tick either.
Overall, this is the year where stock pickers shine as individual stocks will have better reward/risk characteristics than a plain, vanilla long S&P position. The continued bullish case for equities is still attractive for foreign and domestic investors: The USD is still flat/weak, Fed still has 5-6 months of QE left, inflation still low and subdued, there seems to be an energy boom over the past few years, housing may have room to grow further as the unemployment rate drops, the wealth effect of rising home prices and higher equity prices, interest rates to rise only gradually in 2015.
Nikkei: Similar to S&P, and the rise helped slightly by JPY weakness. Market is operating under the assumption that the Japanese economy is recovering well from the sales tax hike. And that the BoJ will reach its inflation target on time without the need for further QE. Look for deviations from this scenario to the bullish and bearish side.
Bonds: Dropped a few days in the row earlier in the week on some profit taking before the ECB meeting. And also due to the rise in equities causing some money to shift out of bonds and into equities since bonds had risen so much and the yields may have been unattractive and the opportunity to lock in some capital gains in bonds became juicy.
I have a developed a macro theory to help me explain equity and bond movements. The theory is that the bond downside and equity upside can both be capping each other. The thinking is as follows: The more bonds drop, the more it limits equity upside due to the fact that the yields become attractive to the bond buyers and the higher yields can slow the economy. And the higher equities go, the less attractive the valuations are and the more money flows into bonds. And the higher the bonds go, the more it boosts equities and the economy. And if bonds go higher, the lower yields become and people may begrudgingly shift money into equities. So to summarize this in the macro model of intraday trading, I would not chase S&P top tick, not would I go short bonds at the bottom tick.
Some market participants buying US bonds on dips due to the relative yield theory with the Eurozone. If Spanish 10 year bonds are yielding 2.70%, and US 10 year bonds are yielding 2.60%, then some people go buy the US bonds since they can feel that there is less credit risk and they are still getting roughly the same yield. And some people say: Why go buy German 10 year bonds that yield 1.35% or French 10 year bonds that yield 1.70%, when I can buy US bonds yielding 2.60%? So that perception is what is also keeping US bonds bid on the dips.
Euro zone bonds are getting bid up dramatically and yields are plummeting because of the continued perception that there can be many years of very low inflation(or slight risk of deflation) and sluggish growth and the ECB rate cuts ant the potential for more QE.
Gold: Flat for the week. Gold had bullish sensitivity for the middle of the week to the end of the week as equities were rising, but Gold did not make fresh lows. Gold dropped from 1290 to 1240, I would firstly due to the rise in equities causing Gold to go down macro scenario. The theory is that people would much rather own equities that benefit from some form of capital appreciation and dividend income rather than own gold if there is low inflation and moderate growth and no more QE from the Fed.
Gold also fell due to a heavy dose of standard technical selling came in as Gold broke out lower. A lot of technical shorts have been piling into the Gold market, and I believe Gold may experience short covering rally.
Also with the Karachi terrorist attacks may cause a bid in Gold to encourage the short covering.
Crude: I keep thinking Crude will want to continue going higher, but some profit takers keep coming in to restrain the market. There is already a very heavy long position held by many money managers as they have gotten their fill and it is struggling to go higher. There are also still very high inventories on the Gulf Coast to fuel some bearish macro traders.
The bullish macro is from the continued drop in Cushing inventories. And the wild card is the removal of the export ban. I believe there is a growing awareness as US energy production increases, that the US can export some of its crude oil and more refined petroleum products. Though the timing can be highly uncertain, that is also propping up the market on the dips. Just waiting for now.
U.S. econ to strengthen or weaken?
How fast and how much will Fed taper?
Mediocre U.S. data and low inflation to cause Fed to delay further taper?
Mediocre U.S. data and low inflation to cause Fed to expand bond buying?
Fed to taper hard and fast, by 20bln?
Inflation to come back or remain subdued?
EUR to sell off to rebalance economy toward higher inflation and lower unemployment rate?
Japan growth and inflation to disappoint after sales tax hike? Will that cause the BoJ to do more QE? Will the JPY have to weaken further?
Any risk aversion scenarios on the horizon?