Four Drivers for the Week Ahead
In the first full week of 2014, we identify four main sets of drivers for the foreign exchange market: the significance of last week's price action, interest rate differentials, central banks, and data releases.
1. Significance of last week's price action: Many observers have been discussing the dollar's weakness since the Fed announced its decision to begin slowing its long-term asset purchases. Instead, we have emphasized the divergent performance of the greenback, noting that its weakness was concentrated against small number of currencies that move with the euro and sterling's orbit. Against the yen, dollar-bloc currencies and many emerging markets currencies, the greenback has been fairly strong.
Yet last week, this pattern was reversed. The four strongest major currencies were Antipodean currencies, the Canadian dollar and Japanese yen. The four weakest major currencies were the Swiss franc, euro, Danish krone and sterling.
The key question is whether this price action reflected a bout of position adjustment exacerbated by thin market conditions or a reversal of the underlying trends. While wary of attributing too much significance to last week's price action, we recognize some fundamental developments that will likely underpin the US dollar. These fundamental considerations include the trajectory of interest rate differentials and the data surprises, which for important releases, have surprised on the upside in the US, but the downside in the euro area and UK. This means that the dollar may be vulnerable if there is disappointment with the employment data at the end of the week.
2. Interest rate differentials: We grappling with the euro-dollar exchange rate, we have often found the 2-year interest rate differential between the US and Germany and useful guide. That differential has widened from just below 7 bp in mid-December to almost 19 bp presently, which is the highest level since mid-November.
The reason for the widening is also important. The US 2-year yields has crept higher from about 25 bp on November 20 to almost 40 bp now, perhaps helped by the positive data surprises. There is also a sense among some money managers that the market is vulnerable to stronger US growth and a more hawkish Federal Reserve.
On the other hand, the German 2-year yield, which had fallen to about 5 bp in early November as speculation that ECB would adopt a negative deposit rate reached a crescendo, peaked around 26 bp in mid-December and has trended a bit lower since. Softer euro zone data and some growing ideas that with low inflation and the continued contraction in private sector lending, the ECB may move again.
Another force at work here are spreads within the euro area. In particular, the spread compression between Spain and Italy (and Portugal), on one hand, and Germany on the other is noteworthy. Over the past month, Italian and Spanish 2-year yields have fallen 22 and 44 bp respectively, bringing both within spitting distance of the one percent threshold (Portugal's 2-year yield has fallen a little more than 60 bp in the same period).
This pattern is repeat through the entire yield curve, with one notable exception, the Germany yields curve had a bearish steepening, meaning that yields rose more tat the longer tend of the curve. The move in the Italian and Spanish yield curve was much more symmetrical. Its benchmark 5-year and 10-year bonds rose 16 and 13 bp respectively over the past month, compared with 4 bp in the benchmark 2-year yield.
As we have argued, France is a weak link in the euro area. It had neither the fall of the Berlin Wall as Germany did to spur reforms, nor an intensive financial crisis as the periphery to incite change. While the periphery appears to be recovering, France appears still mired in contraction. The divergent economic performance though has hardly been reflected in the debt markets.
Over the past month, the premium France pays over Germany on 10-year bonds widened by about 2 bp (to about 60 bp). Over the past three months, the premium has widened 8 bp. At the 2-year sector the spread has narrowed. It has been cut by a third to 6 bp over the past month is half of what is was three months ago. Where the disappointing French performance is more evident is in the equity market. Over the past month, both the DAX and CAC are up almost 3%, but over the past 3-months the CAC is among the worst performing EMU equity markets, up a mere 2%, while the DAX is up 9.4%.
Turning to the dollar-yen exchange rate, we tend to find more interesting insight from the interest rate differential at the longer-end of the curve. In September, when so many had expected the Fed to taper, the US 10-year premium over Japan was around 220 bp. After narrowing on the disappointment, the spread widened again to new high just above 230 bp, keeping the long-term trend intact.
One of the under-appreciated developments that has prevented a more dramatic widening of the US premium is that Japanese 10-year yields have also been trending higher. The 10-year JGB was yielding about 60 bp in early December and was near 75 bp at the end of the month. This represents 3-month highs and comes despite speculation that the BOJ is likely to step up its efforts to reach the 2% inflation target.
3. Central Banks: The Bank of England and the ECB meet this week. The BOE is largely a non-event. When it does not do anything, it rarely says anything. The ECB is not expected to announce any new measures, leaving the focus on Draghi's press conference. The head of the ECB is likely to remain dovish, recognizing downside risks to growth and emphasizing that there are a number of policies that could be adopted if needed.
The EONIA has trended higher in December, reaching nearly 45 bp at the end of the year, but has quickly fallen back and at just above 11 bp is at its lowest level since November 21. The tight year-end liquidity conditions may have made it more difficult for the ECB to sterilize the SMP purchases (Trichet's peripheral bond purchase program). It failed to do so for three consecutive weeks. This week's attempt will be important and is likely to be discussed by Draghi.
Some observers expect the sterilization effort to end as a way the ECB can provide additional liquidity. We are less convinced. The purchases themselves were quite controversial, leading to the resignation of the two German members of the ECB. The end of the sterilization would likely be controversial and the lasting benefits suspect.
Judging from various ECB official comments, the problem, as they see it, is not liquidity per se, but the lack of funding, especially for small and medium-size businesses. The financial sector may have more excess liquidity without sterilization, but to what end? And won't that excess liquidity to quickly offset as banks return their LTRO borrowings (especially French and Italian banks were appear to have lagged behind others) ?
The Federal Reserve does not meet, but the minutes from the meeting in which the tapering decision was made will be released. The discussion surrounding it will make for interesting reading. However, one should not forget that the minutes are carefully crafted as it part of the Fed's communication strategy (in contrast the ECB does not yet publish minutes,but some kind of general record is expected to be forthcoming this year).
Separately, Janet Yellen is expected to be confirmed as the next Chair of the Federal Reserve as early as January 6. Bernanke is likely to resign shortly thereafter; before the FOMC meeting later this month. We continue to believe that it would have been better for the Federal Reserve as an institution, to have had Yellen announce the tapering and the new forward guidance.
That she agreed with it is beside the point. The market impact was modest and the real economic impact likely less so. With many (though not us) perceiving her to be a super-dove and/or Bernanke-lite, the timing of the decisions will make it more difficult for her to exert strong leadership. This is all the more true is Bernanke (and Draghi's) Ph.D dissertation adviser, and more recently, the head of the Israeli central bank, Stanley Fischer becomes the vice chairman, as apparent trial balloon from the White House has it.
4. Economic Data: Japan does not have much data in the week ahead to note. This is a big week,though, for Chinese data. Three reports in general are the focus for investors: the trade, inflation and lending figures. The risk is that exports slow after the suspicious surge in November, as the government cracks down on such deception to disguise capital flows. Consumer prices are expected to ease from the 3% pace seen in November. New yuan loans and aggregate funding are expected to have ratcheted down.
Arguably, the most important report from Australia is the November retail sales reading due out on Thursday, January 9. Australian retail sales have been particularly robust since mid-year and have beaten expectations consistently in recent months. The three-month average gain through October was 0.6%, twice the 12-month average. The RBA easing appears to be having some impact. However, the greater recovery in the Australian dollar and Australian yields rise, the greater the risk that the RBA cuts rates again, especially if inflation remains tame (Q4 CPI due out January 21).
In Europe, the service PMIs and composite readings will be reported at the start of the week. The general pattern of continued recovery in the periphery and strength in Germany is expect to continue. France, as noted above, has been the major disappointment. On Tuesday, the preliminary December CPI will be announced. The year-over-year rate is expected to be unchanged from the November reading of 0.9%. In December 2012, it stood at 2.2%.
While price increases have slowed, retail sales have generally improved, in the sense that they are no longer contracting. Retail sales are expected to have risen by 0.3% in November from a year ago. It would be the second positive reading in three months and the strongest since April 2011.
Separately, the November unemployment rate is expected to remain unchanged from November at 12.1%. It has stood at 12% of above throughout 2013.
The economic highlight of the week, the report is often associated with the most dramatic market reaction, is the US monthly jobs report. The thunder of the January 10 report may be stolen by the January 8 ADP estimate. The three and six month average of each time series dovetail nicely. The 3 and 6 month average ADP job growth is 195k and 181k respectively. For the private sector component of the non-farm payroll report, the averages state at 193k and 180k respectively.
A report near these averages, which the consensus expected, will most likely be seen as sufficient for the Federal Reserve at its meeting late this month that it will slow its purchases by another $10 bln in February to $65 bln.
From a larger perspective, we note that many economists are revising up their Q4 GDP forecasts toward 2.5%. The Bloomberg consensus stands at 1.5% (no doubt will be updated shortly). Although headline GDP is unlikely to match the 4.1% in Q3, final demand appears to be stronger.
That said, we suggest two caveats. First, lost in the Northeast storm disruptions before the weekend, the US reports very disappointing auto sales figures for December. Instead of selling at a 16.0 mln unit pace that was expected, the pace was 15.3 mln and the disappointment was nearly completely accounted for domestic producers. A less obvious reason why this is important (not just the coming knock on retail sales) is that the inventory build up has been especially pronounced in the auto sector.
Second, the expiration of emergency jobless benefits at the end of last year may bite income and consumption now and is likely to spur less participation in the work force and a lower unemployment rate. There are proposals in Congress that can be voted on to renew the emergency program, but some are demanding it to be funded by other spending cuts, making for greater near-term uncertainty.
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