Strong Dollar Acts Against the Fed and Accelerates Global Yield Hunt

Following our last week’s discussion of rising deflation in the major currencies’ economic domains, on Thursday we faced just another evidence of this disturbing trend: the US core CPI MoM went down -0.7% in January comp. with -0.3% in December, so the trend is apparently intensifying as dollar gets stronger and stronger. Equitywise, problems created by stronger dollar were recently admitted by many American exporters and general manufacturers with significant shares of overseas sales (let’s recall that, as an instance, Apple (AAPL) enjoys around 60% of its sales outside the United States). For example, Hewlett-Packard Co. (HPQ), preparing for the complex division into two separate entities as part of its M&A affair, recently complained about what becoming a trivial problem – continuous strengthening of the US dollar. HP’s guidance reported that the continued appreciation of the U.S. dollar directly decreased the expected annual revenue by whopping $3.3 bn compared with the company's own forecast late last year. HP's net profit for the reported quarter was $1.37 bn, or $0.73 per share, compared with $1.43 bn, or $0.74 per share a year earlier. In similar fashion, Herbalife (HLF) in its Thursday’s quarterly earnings report blamed the most in its lackluster performance the hard-to-deal-with dollar appreciation. Herbalife reported decline of its adjusted quarterly EPS by 11.8% to $121 m, or $1.41 per share. Some critics rushed to ridicule such a reasoning saying Herbalife simply missed its own guidance and no strings should be attached to that. However, it would be incorrect to expect foreign sales to be perfectly proportionate to the U.S. dollar performance: something that becomes too expensive for a customer simply gives up its space to more competitive merchandise, so relevant sales segment might easily go down to zero in some circumstances. Last but not the least, struggling J.C. Penney (JCP) disappointed by another quarterly loss of $59 m, or 19 cents per share, also partially fingerpointing, among other factors, at slower foreign shipments. Table. 1. Summary of the U.S. Blue Chips’ EPS Current/Previous Qtr, Average Deviations and Surprise Factors (cannot be shown in plain text mode) Source: Bloomberg What we see from the above table is that although the typical selection of the U.S. companies managed to beat the market expectations by average 2.3% QoQ, it showed earnings’ drop by 3.3% over the same period while at the same time the Dow Jones index rose +9.5%. This perfectly explains why investors are uncertain about sustainability of the current market trend. Notably, the U.S. Fed’s chief Janet Yellen at her semiannual testimony before the U.S. Congress was reluctant to give guidance on the time frame of the first rate hike, despite she was rather optimistic on overall performance of the American economy. Why that mismatch occurred then? We suspect that a true reason was her wariness not to spook the stock market as persistent appreciation of the greenback evidently creates material obstacles for the expected monetary tightening. Indeed, markets have created very ambiguous situation: dollar was rising in anticipation of the rate hikes, but the rate hike proved to be highly contingent on the pace of the dollar strengthening, since what we see now – its excessive muscling against most currencies – acts as a big brake on the U.S. companies’ earnings. Another spectacular ‘investment opportunity” is the global bonds with near-zero or even negative yields. Thus, on Wednesday the German government sold 5Yr notes at a negative yield for the first time in its history. Beginning in March, the ECB is aiming to make €60 bn a month in purchases of government bonds and other ABS to try to stimulate growth, so there is no much hope for improvement in this sense. Elsewhere the picture is not substantially more inspiring: the 10Yr US Treasury yield eased by 9% in Q4 2014 alone. Global investments are fluttering between a rock and a hard place: still lower bond yields in Germany, ahead of the ECB’s controversial move, drew some buyers into U.S. bonds and notes for relative value. However, in the longer run the bid-to-cover ratio at the Treasury auctions is falling for account of both primary dealers and non-residents, so there is very strong hint that global capitals are chasing other opportunities. Speaking about commodity markets, just oil and gold now remain in the main focus, whereas the rest of them, including industrial metals and softs are dull as they are largely perceived as highly correlated with China’s macro data, and inversely – with the Dollar index, DXY. In terms of oil, it should be remembered that what we are seeing now is a tug of war between factors driving the oil price up and down. In the fast moving oil market much of the fundamental data only becomes available for general consumption at least one month in arrears. But EIA oil price data and Baker Hughes rig counts are available weekly and with much action going on it is worthwhile updating. On the one hand, enormously rising U.S. oil inventories are dragging the price of WTI lower, while on the other hand the decreasing number of U.S. shale oil rigs is pulling the price up. But market seems to allow one systemic error while assessing its near-term prospects. Indeed, one of the major beneficiaries of steadily rising oil prices is the oil futures market. Brent crude oil futures have spiked as much as 30% since the January lows, but prices are being kept low as a result of above-mentioned high EIA’s inventories. It is this inventory issue that is triggering these corrections in prices. However, the truth is that the U.S. inventories stay inside the States, so they cannot affect the supply/demand outside the country – particularly, the Brent pricing. That’s exactly what we see happening now: the WTI/Brent price spread is widening like it was back in 2011. Conclusion: Reallocation of the global capitals will accelerate in the comings months, unless the U.S. dollar is going to moderate to its historically justified levels between 80 and 85 based on the DXY. This, in turn, will enable the Fed to resume its tightening rhetoric which will justify the currently poorly warranted valuations on the stock and bond markets.