From the Brown Brothers Harriman Global Currency Strategy Team
– We update our views on the main big picture drives for financial market:
(1) Fed tapering
(2) The stabilization of the Chinese economy
(3) The cyclical recovery in Europe
(4) The increase in Japanese purchases of foreign bonds
– Upcoming events promise to inject fresh volatility, including the decision on Japanese retail sales tax, German national elections and unresolved problems in the EU periphery
– Markets received some insights into the imminent measures effecting FX to be announced by the Indian government.
Price action: The dollar is broadly stronger against majors and emerging markets. EUR/USD is below 1.33 and GBP/USD gave up the 1.55 level. USD/JPY is testing the 97.0 level which proved to offer strong resistance late last week. In the EM space, ZAR and PHP are the losing the most, though no new ground has been made against the dollar. The MSCI Asia Pacific index closed flat, balanced by 2.4% gains in China and 0.7% loss in the Nikkei. Equity markets started to sell off towards the end of the London morning with Eurostoxx down 0.5% and the Dax losing 1.0%. S&P futures are down 0.5%.
- We continue to identify four main macro issues shaping the investment climate: The tapering anticipation in the US; the stabilization of the Chinese economy; a cyclical recovery in Europe; and the long awaited Japanese purchases of foreign bonds. Last week’ news, and the anticipated data stream this week, are expected to either reinforce these issues, or at least not challenge them. For the purposes here, though, let’s just update the four current themes:
1. Fed Tapering: The only voting FOMC member to speak last week was Evans, who while seen as a dove, towed what appears to be the party line, which is that tapering next month has not been ruled out. Bullard speaks this week. Recall that after dissenting in June because he did not think the Fed was showed proper concern with falling prices, Bullard gave up his dissent in July as the FOMC statement was expanded to reflect his point.
There is a full slate of high frequency economic reports, including both inflation measures, retail sales, industrial production, and the first regional surveys for the current month (Philadelphia Fed survey). However, none will change participants’ expectations for the Fed; for that, much will depend on the next batch of jobs data. Judging from media reports, the focus on next month’s budget issues has increased. To some this issue is rivaling the Fed tapering story. The US 10-year yields have largely been confined to a 2.46%-2.66% range since early July. A break of this range will be noteworthy, though this week’s data calendar makes it unlikely.
2. China Stabilizing: The recent string of official data lends more support to our understanding that the China’s economy stabilized in late Q2 and early Q3. The lending data shows that officials have been successful in reining in the shadow banking activity. The yuan has been drifting slightly higher and, far from protesting, the PBOC has actually fixed it higher each day last week. Of the commonly traded and referenced currencies, the yuan is among the strongest this year still, appreciating about 1.8% against the dollar. Recent gains have turned the euro and the Danish krone higher (~1.1%).
Separately, reports in the South China Morning Post suggests Beijing is quietly offering fiscal support to some key cities and provinces and may lift the ban on property developers raising fresh funds if through equity offerings. There have also been reports of second tier banks raising rates offered on long-term deposits, which may help to strengthen their balance sheets and compete with wealth management products. The Shanghai Composite rose 2.4%, its biggest gain in over a month, to stand just above 2100, its highest level since June 20.
3. European recovery: The euro area is expected to report a quarterly expansion in Q2 that ends the three-quarter contracting phase. The consensus calls for a 0.2-03% Q2 GDP, though the pre-weekend release of disappointing French industrial output figures, may warn of downside risks. Essentially, what has happened is that the periphery has shown a slower contraction, while the core, especially Germany and France strengthened. The consensus anticipates that Germany expanded by 0.8% and France half as much.
In the UK, this week’s data, which includes prices, employment and retail sales, are unlikely to change the general view that Q2 recovery has continued apace in Q3. As noted previously, the base effect works very much in the BOE’s favor, especially starting in August.
One point that has arisen from recent discussions, and suggested by the changes in the positioning in the futures market, is that the euro bears have not changed as much as the latest entrants have been playing with the short-term trend higher. In recent weeks, the gross long euro positions have grown twice as fast as the gross shorts have been covered. The issue now seems to be at what level will the euro shorts capitulate? We suspect it is above $1.35. Also at issue is what level will the bulls acknowledge the uptrend is over. We suspect that is near $1.3270 initially, and maybe $1.3200 itself.
4. Japanese flows: Japanese investors have bought foreign bonds for the past five consecutive weeks. On this run, MOF data shows net purchases of JPY3.6 trillion worth of foreign bonds. What this has done is nearly offset the net sales of the prior five weeks (JPY4.1 trillion). On the other hand, foreign investors’ appetite for Japanese shares has waned. Although they have been net sellers over the past two weeks, it has been in small amounts. Rather, the pace of buying has slowed considerable. The four week average is now new JPY161 bln, down from JPY754 bln at the end of April and half of the end of May pace of JPY334 bln. Ironically, just as the portfolio flows are leaving Japan, the yen has strengthened to trade at its best level against the dollar since late June. The yen’s gains do not appear speculative in nature. The gross short positions, for example, in the futures market remain elevated at almost 100k contracts. The recent high was in late May near 118k contracts.
Instead, the yen’s rise seems more linked to the stock market, where a statistically significant inverse correlation exists. Consider that over the past month, the Nikkei was off around 6%, but the yen appreciated by about 5% against the dollar, suggesting some investors likely found hedging to be disadvantageous. Yet, the Nikkei slipped 0.7% today despite a 0.5% drop in the yen, sparked by the disappointing GDP report.
The Japanese economy slowed more than expected in Q2, with a 0.6% quarter-over-quarter pace, down from a revised 0.9% pace in Q1 (initially 1.0%). That puts the annualized rate at 2.6%, not 3.6%, which the consensus expected and down from the revised 3.8% rise in Q1. Despite the weakness of the yen, net exports added a 0.2 percentage points to GDP. Domestic demand added 0.5 percentage points. Most disappointing for the Abe government was that capex fell for the sixth consecutive quarter by 0.1% after a 0.3% fall in Q1. Residential investment also fell; its first decline since Q1 12.
The GDP deflator fell 0.3%, about half the decline the market anticipated. It follows a 1.1% decline in Q1. By this measure, deflationary forces are the mildest in four years. Separately, but consistently with this was news that domestic corporate goods prices rose 2.2% year-over-year in July, matching the 2011 peak, which was the highest since 2008. This appears to be mostly reflecting the weaker yen and higher import costs.
- Participation has thinned and volatility has generally trended lower, but events next month promise to inject fresh volatility into the market – and we expect it to be in a dollar positive direction. Japan’s Prime Minister Abe will make a decision whether to modify or block the controversial retail sales tax, the first of two stages is to be implemented at the start of the new fiscal year. Germany holds its national election, and although German policies are unlikely to change significantly, there is a sense that in the run-up to the election (and, perhaps partly a function of the summer holidays) many issues have been simmering, which may turn to boil afterwards. Issues like the funding gap in Greece, Italy’s fragile government, Spanish banks, and their vulnerability to continued falling real estate prices and Portugal may command attention. Moreover, there is a potential exogenous shock in the form of Fed tapering, with many still expected it to begin as early as next month.
- Towards the end of the week, local media suggests that higher duties on non-essential imports and easier norms for external commercial borrowings are amongst the new measures expected to be unveiled shortly by the India government. Indeed, it seems as if today’s trade numbers are already showing some improvements. Imports came in at -6.2% y/y in July from -0.4% in June, while exports grew 11.6% vs. -4.6% in the previous month. Much of the fall in imports was due to lower demand for gold and silver. Meanwhile, the RBI continues to keep liquidity tight via draining operations, probably buying time. The bank’s reluctance towards using FX reserves is understandable. After declining $3 bln in the week to August 2, reserves are now down to $277 bln, or 7-months of imports. While we appreciate and mostly agree with the rationale behind the short INR trades, we caution investors that: (1) positioning for this trade appears to be heavy at the moment, (2) much of the bad news has already been priced in, (3) the negative carry cost of holding short INR trades is very high, and (4) new measures are imminent. Depending on what gets announced by the government, we could see a sharp a short-term move lower in USD/INR, or just a gradual short INR fatigue should we stay within the 60-62.00 range for some time.