By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman
This has been an important week in terms of price action throughout the capital markets. The down draft in the equity markets, most foreign currencies, most commodities, is both a cause and effect of rattled investors.
Often it seems that market sentiment tends to overshoot in one direction and then the other. Sentiment is clearly in one direction. It remains to be seen if it is overshooting. There are six observations that we’d like to share as you think about not only this week but next week.
First, the recent post here suggests there is increased risk that sentiment is indeed getting ahead of itself. Yet the steady drum beat of negative news from Europe, the single most important force shaping the investment climate, continued on May 17th with Moody’s slashing the rating of Spanish banks and several regions. While new lows for the euro (and other currencies) were recorded, the market failed to sustain the downside momentum. If the elections in France and Greece gave one a green light to sell euros, the price action’s reaction to recent poor news, is flashing an amber light. This is not to be understood as recommending one should buy euros. Rather it means that the bears may want to avoid chasing the euro lower at this juncture. Sell into the bounce may seem banal, but we are warning that the technical conditions increase the risk of such a bounce.
Second, the yen surged and this has sparked some speculation that the BOJ is poised to intervene. We suspect this is not very likely, even though the decibel of the official rhetoric has increased and the Noda government is interventionist in principle as last year’s large scale unilateral intervention reflected. What appears as yen strength is likely to be understood at the highest levels as really euro weakness. Japan also just reported the strongest GDP for Q1 among the high income countries. Many European countries would be happy with for their economies to grow in a year what Japan’s did in the Jan-March period. The 1.0% quarter-over-quarter pace is a 4.1% annualized pace. The US, by comparison grew 2.2% annualized, but subsequent data warns of likely downward revisions. German expanded at half the pace as Japan. Judging from the recent past, it takes the dollar to be closer to record lows against the yen for a pro-intervention consensus to crystallize. Lastly, Japan’s modus operandi suggests intervention is more likely after a G7/G20 meeting than before it.
Three, if the yen bulls showed their hand, the sterling bears came out of the wood work. Despite the deterioration of the situation in the euro zone, sterling has actually fallen more than the euro over the past five sessions against the dollar. The data has not been favorable. The BOE’s Fisher seemed to attempt to talk sterling down. The prospects for more QE appear to have increased. Market positioning was may be the most important consideration. As the commitment of traders in the futures market has shown, and sterling’s gains in the spot market have illustrated, many had embraced sterling as the better alternative to the euro than the dollar. That view was called into question in recent days. Long sterling positions, against the dollar, euro and yen have been shaken out in dramatic fashion in recent days. The next level of support is seen near $1.5760 and if that breaks, the $1.55 area may beckon. Against the yen, sterling can move toward JPY123.50. The euro faces an important test closer to GBP0.8080.
Four, many market participants seem to believe the central banks are back in play. The BOJ meets next week and there is increased talk, especially after the yen rallied, that act to offset the deflationary impulses. Yet is unlikely to announce an expansion of its asset purchase plans. Reports suggest that it is falling behind in implementing the purchases it has already announced. This cannot be the result of accident or oversight. Market conditions do not seem a compelling explanation,which makes purposeful intent. Soft data including and the dovish inflation report has seen spurred speculation that the BOE’s recent decision not to expand its gilt purchase program will be reversed as early as next month. This is possible, but we expect it, like the Federal Reserve, to remain in a wait an see mode. The market is doing a lot of the work that QE may do in terms of lowering yields. US and UK bond yields are at or near record lows. The ECB is under pressure to act. Spanish and Italian bond yields are rising, which in it terms, weakens the transmission mechanism of monetary policy. While Q1 GDP was flat instead of negative, the data thus far for Q2 suggests that is a bit of a statistical quirk and/or in any event, a function of the upside surprise of the German economy. Yet the ECB does not appear poised to cut rates, which the IMF has urged it to do. At the June meeting, though the groundwork for a cut may be laid, if its economic forecasts are cut sharply. A resumption of the sovereign bond purchase program seems more likely than a rate cut or a new LTRO, and this of course runs into German objections.
Five, some investors think that QE3 by the Fed is the “Bernanke put”. They argue that it is not simply the threat of deflation or recession that will get the Fed to act, but the fall in the stock market. This seems to exaggerate the weakness of the stock market. Consider it not as short-term, momentum trader, but from the point of view of a policy maker. The S&P 500 appreciated by nearly a third between early Oct 2011 and early April 2012. It is since sold off by about 8%, which leaves it still up by a quarter in 7 months. The retreat has orderly but nearly constant. The next level of technical support is seen near the 38.2% retracement objective and 200-day moving average, which comes in 1275-1290 area. If the economy continues to point to near trend growth and in line with the Fed’s base line forecasts, the job market does not deteriorate and inflation remains near the Fed’s target, the case for QE3 solely based on the stock market seems a stretch.
Six, policy makers see the same things that investors are. They are going to try to push sentiment away from the edge of the abyss. It is not just the G8 and G20 summits, but the intensification of the crisis is likely to force compromises. Ultimately, investors do not care, we would argue, whether the 3% deficit to GDP target is reached in 2014, 2015 or 2016. What the markets want is a vision and a sense that the commitment to implement it is there, and this implies a sustainable path. We have drawn parallels with to the NY Mets. There was a policy response to getting the least amount of home runs (hitting the ball out of the park) in the Major Leagues. It did not put the players on special diets or feed them steroids. It did not spend much more money on buying new talent. No, it simply brought in the fences–made the target easier to reach. This is not fantasy. There does seem to be a move underway to extend the fiscal objectives in Europe. This is not simply kicking the can down the road, it is buying more time to make the necessary reforms without triggering a political or economic backlash that topples the entire project, for which the European elites do not have alternative strategy.