Author Archive for Marc Chandler

Spot the Secular Stagnation

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

This Great Graphic was tweeted by the Financial Acrobat. The charts show US and euro area GDP in log charts that also plot the pre-crisis trend.

It is clear that the crisis has thrown the US off its prior path, but it now appears to be on a parallel path, that is lower.

secular stagnation

Growth in the euro area has also broken down. It has yet to initiate a new expansion trend, which is in part, why some do think that it has not really and truly exited its recession.

One of the big macro views that has shaped the debate in recent months is the resurrection of the previously discredited “secular stagnation” hypothesis by Lawrence Summers. The concept was first proposed by Alvin Hansen in the 1930s. It died an ignoble death as the US (and world) entered a long expansion wave. Marxists, like Magdoff and Sweezy tried reanimating the theory in the late 1980s, but offered a considerably nuanced view.

Magdoff and Sweezy generally argued that while mature capitalism was prone to stagnation, there were a number of mitigating factors, like government spending and permanent government deficits. In an essay published in the early 1980s, Sweezy wrote: “Does this mean that I am arguing or implying that stagnation has become a permanent state of affairs? Not at all.”

Looking at chart on the left, the idea of secular stagnation in the US does not come to mind. The slope of the GDP in the euro area is not as steep as the US prior to the crisis and the economy appears to have gone no where in the last 6-7 years. Does this qualify as secular stagnation?

Chart of the Day: Inflation Fears are Rising

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

This Great Graphic was tweeted by SoberLook.com, and comes from Deutsche Bank which used EPFR data.  The chart depicts the money flowing in and out of the ETFs and open-ended mutual funds that offer investors protection from inflation.

Such funds have been experiencing net new inflows recently.   With stronger US jobs growth, and clear signs that the Q1 contraction was not a precursor of a recession, investors have become concerned about inflation.    June CPI figures will be released next week (July 22).  The core rate has risen by a cumulative 0.7% in the three months through May, which is twice the past over the previous three month period.

The Fed’s preferred inflation measure is the deflator of personal consumption expenditures (PCE) and, as we have noted, CPI tends to run at a slightly faster clip than the PCE deflator.  In addition, with wage growth stagnant  and other measures slack in the labor market, it is difficult to envision a bout of demand-pull inflation  At the same time, commodity prices have weakened, and cost-push inflation does not look particularly likely either.

There have been a few inflation scares in the recent past.  There have been some spikes of inflows into such funds as some investors seek protection.  At the same time, US yields rose last year without inflation rising.  Some investors seek protection not from inflation per se, but from rising interest rates.  Funds investing in floating rate notes have also been popular in recent months.  Not only has the US Treasury issued floating rate notes, but so have many corporations.

inflation

Exaggerating the Dollar’s Demise

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

The headline of the Financial Times today reads “Paris rails against the dollar’s dominance.” It could have been written nearly any time in the past half century. After all it was a former French President Giscard d’Estaing, who as finance minister in the 1960s, complained about the “exorbitant privilege” that the US drew from the role of the dollar (the phrase is often attributed to Charles De Gaulle).

In the mid-1960s, Servan-Schreiber’s book, “The American Challenge” warned that through the dominance of the dollar, the US was colonizing Europe. In the early 70s, it was France’s demand for gold in exchange for US Treasuries that strained Bretton Woods arrangement to a breaking point.

The proximate cause of the latest reiteration of the traditional French position is the large fine imposed on one of France’s largest banks for violating US sanctions. As part of the penalty, the US took what appears to be an unprecedented step to deny the French bank the ability to clear dollar trades for a full year, starting in January.

BNP pleaded guilty to two criminal charges. It was fined almost $9 bln (2013 profits ~$6.5 bln). Nearly four dozen employees were disciplined. About a dozen lost their jobs, including the COO of the US operation. Top officials in the French government tried to lobby for a smaller penalty, including the President, Finance Minister and Foreign Minister. They warned that it could tilt the balance away from the free-trade agreement that is being negotiated. The central banker warned that it could accelerate efforts to diversify away from the dollar.

In explaining its rationale for a stiff penalty, US officials cited several considerations. First, the sheer volume of the transactions is notable. They are estimated to be near $200 bln. Second, was the egregious nature of the conduct and circuitous efforts to conceal the activity. Third, the illegal activity apparently continued after the inquiry began. Fourth, high ranking officials helped hinder the investigation. Fifth, previous fines on international banks were not functioning as an effective deterrent.

Russian President Putin, no fan of the dollar and US hegemony, claimed that the actions against BNP were an effort by the United States to get leverage over France to renege on its agreement to deliver two Mistrial amphibious ships to Russia. Putin claimed that the US offered to reduce the fine on BNP if the French complied.

There is simply no evidence for this claim, and it seems to be predicated on a naive view of the US government. However, it has not stopped many in the blogosphere from simply repeating Putin’s claim as if disinformation and attempts to sow discord is not a tool of the Russian President’s arsenal. While the Department of Justice and the Federal Bureau of Investigation were involved, the NY Financial Services Department and the Manhattan District Attorney appear to be the driving force and it is not clear that they would have acquiesced to the kind of linkage Putin suggests.

The point is that US government is not some kind of homogenous whole with uniform interests. Consider that the nearly $9 bln fine was split between the Federal government and the state governments. The NY Financial Services Dept received about 1/4 of the settlement and this will be turned over to the state’s general fund. The Manhattan District Attorney’s office will receive another quarter of the settlement. The bulk ($1.7 bln) will go to state and city governments, but about $450 mln, which is five times the office’s budget, will be used for its anti-crime activities. Surely, if the Federal Government tried to strong arm the local authorities, there would have been a push back and Putin would not be the only one to make the claim.

BNP was the seventh large bank caught in 5-year investigation of the Manhattan District Attorney’s office into violations of US sanctions. The investigation is ongoing, and it may include at least two other large French banks, as well as a large German and Italian bank. For some banks and bankers, the statement by a Standard Chartered official chafing under its own fine, expresses a shared sentiment: “You Americans,” he was quoted in the press saying, “Who are you to tell us, the rest of the world, that we’re not going to deal with the Iranians.”

One might disagree with which countries the US sanctions, but surely it is the right of a sovereign to make such a decision. Yet the claim that the sanctions allow the US to police business arrangement that do not involve Americans is not really true. Given the way the financial system operates, if dollars are used for trade or investment, the transaction likely involves a US bank in the US.

Moreover, the sanctions were not capricious, not publicized (unknown) or imposed after the fact. The sanctions against Sudan, which is where BNP’s violations were concentrated, have been in place since 1997 and were tightened in 2006. Press reports suggest that internal BNP documents showed that senior bank officials were well aware of the atrocities that led to the sanctions.

Banks were also warned. In 2006, the Bush Administration warned foreign banks doing business in the US that they would be prosecuted if they helped sanctioned countries. According to the Wall Street Journal, BNP told employees in 2007 that it would cease sanction-busting actions. Instead, it appears they developed an elaborate payment structure, routing transactions through satellite banks, which would strip crucial information off wire transfers as they passed through the US system and banks.

Even though many senior BNP officials appeared to have known about the deceit, the CEO indicated that breaking the sanctions was “something that goes against the grain of the bank.” It has taken steps to strengthen internal controls and going forward, all dollar transactions will be properly routed through NY. Reports suggest that other European banks are tightening their internal controls to ensure compliance with US rules.

The US struggles to convert its financial power into political influence. Consider who the US provides aid to, for example, and then look at how countries vote at the UN. This effort becomes all the more important in an era in which the US is war weary. The function the dollar serves in the world economy is a “public good”, like protecting the sea lanes and its nuclear umbrella. Surely, it can have some say in how that public good it provides is used.

The US is saying that if one is going to use the public good it provides, do not do so to aid an adversary. Do not use dollars to harm US interests, as its elected officials have defined it. If a bank wants to function as the central bank of Sudan, as BNP was accused, it cannot use the dollar.

Will this increase the pressure to diversify away from the dollar as Putin hopes and French officials claim? Probably not. The problem is the lack of a compelling alternative. When the euro was first launched, many argued at the time, that this was the first alternative to the dollar and business and investors would jump at the opportunity. They really haven’t. Many investors still harbor serious reservations about the longevity of the experiment in monetary union without political union. For a brief moment a few years ago, the possibility of a new monetary regime, based on the SDR, captured many imaginations for naught.

The internationalization of the Chinese yuan is being heralded as the latest dollar-buster. It is not. The swap lines it has set up with several dozen countries have not been used. Last month, MSCI declined to integrate Chinese shares into its global indices because of various market restrictions and lack of transparency. Investors need permission to invest in China (QFII or RQFII) and countries have to negotiate with China to set up off-shore yuan trading centers.

Less than a year ago, some observers were arguing that the cyber-currency Bitcoin could supplant the dollar. One large US bank even argued that central banks should put some of their reserves in it. The desire to find an alternative to the dollar is real, but the role of the dollar in the global economy has not changed very much in recent years. In many respects, whatever rise the Chinese yuan is experiencing appears to be coming at the expense of other currencies, not the dollar.

The safety, liquidity and transparency of the US Treasury market know no rivals. More than half of all cross-border loans and deposits are in US dollars. According to the Bank for International Settlements, the dollar is on one side of 87% of all the trades in the more than $5 trillion a day foreign exchange market (up from 84.9% in the previous survey). The dollar remains the benchmark price for oil and most commodities. When investors want to hedge their exposures, they use a dollar-denominated derivative market instrument.

The US often is accused being short-sighted and not playing the long-game. Yet, at the risk of deterring buyers of its debt, the Treasury Department’s semi-annual report on the international economy and foreign exchange market pulled no punches. It wants officials to stop buying Treasuries, which it sees as a way countries evade making the necessary adjustments to reduce imbalances that the G7 and G20 have advocated. In fining foreign banks for aiding its adversaries, the US says it will not provide the rope to the hangman. If aiding Sudan, Iran or Cuba increases the use of the yuan, euro or Bitcoin, that is risk that the US is willing to take.

Refresher: CPI and the PCE Deflator

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

On Thursday, the US Department of Commerce will publish the May estimate of personal consumption expenditure deflator. Last week, investors learned that the consumer price index rose at its fastest rate in two years.

Since extraordinary monetary policy measures were taken, some observers have warned of inflation risks lurking around every corner. With CPI rising above 2%, could they finally be right?

Not so fast. The Federal Reserve’s 2% inflation target does not apply to the consumer price index. Since mid-2012, the Fed has identified the core PCE deflator as its preferred inflation measure. There is a significant difference. The PCE measure of inflation tends to be lower than the CPI measure.

In part, the two measure different things. The CPI is calculated by the Bureau of Labor Statistics of the Department of Labor. The PCE is calculated by the Bureau of Economic Analysis at the Commerce Department. An important methodological issue is the weights for the different components. The CPI uses the same weights for several years, while the PCE deflator uses current and preceding expenditures to calculate the weights. One implication of this is that the PCE measure also allows for substitution of goods with rising prices for similar goods with stable or falling prices.

pce cpi

When it comes to health care expenditures, which played a large role in the sharp downward revision to Q1 GDP, CPI and PCE measure somewhat different things. The CPI calculus includes only the expenses employees pay, while the PCE deflator also includes money that employers spend for their employee health care.

The CPI is calculated based on surveys of more than 14,000 families and 23,000 businesses they patronize. All told some 80,000 consumer items are included. Sales taxes are included.

The PCE deflator calculation is completely different, though both the PPI and CPI measures are used. Essentially, and at the risk of over-simplifying, the PCE deflator is derived from production, which is at the producer price level. The PCE methodology converts the producer priced goods/services into consumer prices, adding profit margins, taxes and transportation costs.

In addition, other data is incorporated. For example, it incorporates the monthly retail sales report, and the price of food grown and eaten on the farm comes from the US Department of Agriculture. The dealers’ margin on used vehicles is pulled from the National Auto Dealers Association.

The core measure strips out food and energy, mostly. Recent definitional changes, however, means that the core PCE measure includes restaurant meals. These have been redefined to be food services. Pet food is also included, seemingly as part of the pet expenditures rather than as part of the food budget.

Over the past 10 and 20 years, headline CPI has averaged 2.4%. The PCE deflator has averaged 2.1% and 1.9% for the 10 and 20 year periods respectively, or 0.3 percentage points and 0.5 percentage points respectively.

It is widely documented that for at least the past half century, headline inflation converges to core inflation (and not the other way around). This may help explain why the Federal Reserve prefers core measures.

The chart at the top shows the core CPI (white) and core PCE deflator (yellow) over the past 20 years. Over the past five years, the core PCE has undershot core CPI by 0.2% on average. Over the past ten and 20 years, the undershoot has been 0.2% and 0.4% respectively. The persistent lower estimates of the PCE deflator means that the Federal Reserve is likely to tolerate what may appear to be an overshoot of CPI.

There appears to be two elements that produce a more subdued rise in the PCE measure. One is the substitution effect that is not incorporated into the CPI measure. The other is the way that hospital expenses and airfares are calculated.

The consensus calls for the May core PCE deflator to rise to 1.6% in May from 1.4% in April. If accurate, it will keep this measure 0.4 percentage points lower the core CPI. It is consistent with the Fed’s assessment that the economy is evolving toward the Fed’s mandates. Some observers will make hay of the substantial contraction in Q1 GDP, but this too should not alter the outlook for Fed policy. The Fed’s economic mandates, as we have discussed, are on employment and prices and both did indeed move in the (Fed’s) desired direction in Q1 and appear to have done so further in Q2.

An OIl Update

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

West Texas crude oil prices are near their best levels of the year. The front month futures contract is near $104.50 a barrel. The high, thus far, this year was set in early March near $105.20 a barrel.

Declining US inventories appear to be a factor. The EIA reported that inventories at Cushing have fallen to five year lows. This has been a trend since January as the southern tranche of the Keystone XL pipeline has been shipping oil to the Gulf refineries.

There are several geopolitical considerations and these appear to be underpinning Brent more than WTI oil. First, a break away al-Qaeda group reportedly has taken control of Mosul, Iraq’s second largest city and are in a position to disrupt the country’s energy infrastructure. The critical 600k km pipeline has been closed for repairs since early March. Those repairs have reportedly been disrupted.

Second, reports suggest that China’s demand exceeds what is needed for immediate economic use. China is building a strategic reserve In the January-April period, China appears to have imported about 600k barrels of oil a day. Although the government data is scarce, industry watchers estimate a third to a half of the oil is for the strategic reserves.

Government figures suggest China’s strategic reserves were around 141 mln barrels at the end of last year. In comparison, the US strategic reserves were just below 700 mln barrels in late May. The US strategic reserves are sufficient to cover a little more than a month of consumption (~37 days). It can hold about 95 days of imports according to industry estimates. China aims at establishing strategic reserves to cover 100 days of net imports that are something on the magnitude of 600-700 mln barrels. Its coverage of current consumption is estimated to be around three weeks currently.

Third, OPEC decided to maintain the 30 mln barrel a day ceiling for the fifth consecutive meeting this week. There was some thought that it may have chosen to boost output to offset the shortfalls of Libyan and Iranian output. In the middle of May, the IEA called on OPEC significantly increase production. Libyan output is on the magnitude of 1/10 of its pre-conflict levels. If the Iranians does not reach agreement on its nuclear program by the end of next month, the sanctions that were lifted will be re-applied.

It is not a factor driving prices, but we note that apparently under pressure from the US and the EU, Bulgaria has halted construction of a pipeline that would have carried gas from Russia that would have circumvented Ukraine. The South Stream pipeline would go under Black Seat to Austria through Bulgaria. Bulgaria is an EU member and is thought to be among the most pro-Russian member.

The EU itself has expressed opposition to the pipeline on grounds of being counter-productive to diversifying suppliers away from Russia. The US is opposed, it appears on general grounds, but also because the company being used to build the pipeline is controlled by a person who is on the sanction list. The work stoppage ostensibly took place due to an investigation into how the project’s contracts were awarded.

There does not appear to be a stable correlation between the G7 currencies and oil prices. However, we do see for most of the year; the Canadian dollar (not the US dollar against the Canadian dollar) was inversely correlated with the price of oil (60-day percent change basis). However, since the start of the month the correlation has turned positive, but barely so (0.16). This correlation is just above sterling’s (0.15) and is the same for Brent. Looking at a somewhat broader array of major currencies finds that the Australian dollar’s correlation is also at the highest for the year, but still low (0.22). Ironically, the Norwegian krone’s correlation to Brent is inverse (-0.13).

Macro Perspective on the Investment Climate

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

One of the key issues hanging over the market since April when the policy signals pointed to a move by the ECB in early June was precisely what it would do. In recent days, it has become clearer that the ECB is more likely to cut rates than initiate an asset purchase program.

There are three interest rates the ECB could. The first is the lending rate, which stands at 75 bp and marks the top of its interest rate corridor. Usually in low or falling interest rate environment, the rate ceiling is of lesser importance. However, a lower lending rate, under current conditions, cold help reduce the volatility of overnight rates (EONIA).

The second rate it could cut is the re-finance. It is at 25 bp and under the current policy setting, the ECB is willing to provide as much funds at this rate as banks want, limited only by the acceptable collateral. A 10-15 bp cut seems to be the consensus view. The ECB also could extend the period for which is it willing to provide full allotment (unlimited funds). There have been some calls to reduce the refi rate to zero, but this seems to be an outside possibility. Even though EONIA has traded above the refi rate, a lower refi rate may still exert, albeit, limited downward pressure on overnight rates.

The third interest rate that the ECB could cut, and the most controversial is the deposit rate. It currently stands at zero, and there is much talk that the ECB could set it at -25 bp. This would, in effect, tax banks for leaving excess reserves at the ECB. The tax would hit banks with the most surplus funds that hardest and these of course are mostly from core countries, excluding France. Banks from peripheral Europe and France may account for 20% of the funds at the ECB. These banks typically are net borrowers and so lower rates would also likely benefit them the most.

There are secondary effects of a negative deposit rate that may overwhelm these primary effects. It is important to recognize that such a measure has not been implemented by a large economic area. Even at the worst of its deflationary phase, Japan never forced banks to pay for the privilege of leaving funds with it. Banks are likely to pass on the negative rates to customers, as some banks did when Denmark adopted a negative deposit rate. This may lead to a change in the way corporations and institutional investors manage their euro balances.

The prospects of a negative deposit rate may be a factor weighing on the euro. However, more importantly, the recognition that an asset purchase scheme is somewhat less likely, has helped encourage increasingly nervous investors in the peripheral European bond markets. As we have noted, IMF and EU officials have expressed concern about the sustainability of the peripheral bond rally and some institutional investors has been quoted by the press indicating some profit-taking had begun.

The flows leaving the periphery appear to be returning to core bonds. Last week, 10-year Treasury and bund yields fell 13-14 bp. Gilts, with the help of a dovish BOE’s Quarterly Inflation Report and soft earnings growth data, outperformed with 17 bp decline in 10-year yields. In contrast, Italy’s 10-year yield rose 9 bp, Portugal 16 and Greece 59 bp. Spain fared best, with only a 2 bp increase in the 10-year yield.

Funds also seemed to move into emerging markets. The MSCI Emerging Market Index (equity) rose 2.5% last week, easily outperforming the major indices. Emerging market bonds also rallied. Some investors are also moving into eastern and central Europe, including Poland and Hungary. HSCB will report its flash manufacturing PMI survey for China at midweek and some sign that the world’s second largest economy is not slow further may also provide some support for emerging markets as an asset class.

Global monetary conditions will remain extremely accommodative. Soft US industrial output and manufacturing data on the heels of a disappointing retail sales report continues to discourage investors from taking too seriously St Louis Fed’s call for a rate hike as early as Q1 15. Even now the Federal Reserve is buying more long-term assets than it was when it first announced QE3+ in September 2012. The rally in short-sterling futures suggests the BOE has been successful in pushing out interest rate hike expectations. The BOJ is the main exception. It is leaning against expectations that it will have to increase its $70 bln a month of asset purchases.

The economic data scheduled to be released in the coming days is unlikely to change the basic economic assessment and policy outlooks. The FOMC minutes will do nothing to change perceptions that those officials that are emphasizing the economic slack, particularly in the labor market, are in a majority over those who are emphasizing the risks of such extremely accommodative monetary policy. The stronger than expected housing starts reported last week, is likely the start of some more constructive housing data, including existing and new home sales reports this week.

We do not expect the minutes from the Reserve Bank of Australia or the Bank of England to be very revealing. The RBA is clearly on hold and prefers a weaker currency. The BOE’s minutes have been trumped by the Quarterly Inflation Report. Next month’s Financial Policy Committee meeting is more important in terms of macro-prudential efforts to address housing. This will reinforce the BOE’s signal that it is in no hurry to raise rates.

Separately, it appears that UK consumer prices are stabilizing while retail sales should accelerate from the nearly flat (0.1%) rise in March. They will be reported Tuesday and Wednesday respectively.

The flash euro zone PMI will be reported on Thursday. It should not be surprising to see the PMI begin to move broadly sideways after the strong advance in recent quarters. That said, the real economy has not performed much different than the ECB expected. There is no evidence that the risk of deflation is sparking a downward spiral in demand as consumers postpone purchases in anticipation of lower prices.

Politics, rather than economics, may be the key talking points in the coming days, ahead of the EU Parliament election in the second half of the week, with results announced on May 25. Polls suggest that the anti-EU parties may draw as much as a quarter of the vote, with France’s National Front and the UK’s Independent Party doing particularly well, with implications for national campaigns. It appears to be a very close race between the center-right EPP and the center-left S&P.

The Ukraine presidential election will be held on May 25. That will likely begin a new phase in the crisis. Reports suggesting that non-uniformed combatants (Blackwater) maybe confronting non-uniformed Russian allied combatants in east Ukraine also appears to be mark a new phase. It continues to appear that the limited sanction regime is having a somewhat greater cooling off effect on Russia’s financial and trade ties than it may have initially appeared.

Perhaps it is Putin’s trip to China that may be the most suggestive of change. It might take Europe a few years to cut its dependency on Russian energy if it wanted. However, that is the direction that its strategic interest lie. Russia’s actions, especially the annexation of Crimea and its continued bully behavior towards Georgia and Moldova, has alienated it from the Europe. It must turn to Asia. Chinese officials are well aware of this. They hold the whip hand. It is an opportunity to secure low energy prices on a long-term contract. That this can turn into a strategic relationship is unlikely, but it may serve Russia and China’s interest independently to at least pretend this is possible.

For its part, China has adopted different tactics in Hong Kong, and Taiwan than Russia is on its borders. China would not accept Tibet, for example, of having a referendum on independence. It abstained in the UN Security Council vote to condemn Russia. To the extent the Russia’s actions in Europe frustrate the US effort to implement its Asian pivot, China is unlikely to undercut it.

China has its own problems in securing its territorial claims. The regional hostility toward Japan and the nationalistic impulse of Prime Minister Abe win little general support. The Philippines dispute with China may be dismissed as a client state of the US. However, the confrontation with Vietnam has escalated over the weekend, leading China to evacuate some of its citizens. Unlike Japan and the Philippines, Vietnam does not enjoy a security treaty with the US, leaving it more vulnerable to Chinese reprisals.

Lastly, the electoral victory in India of the BJP and its allies is encouraging investors and fanning the hopes of reform. In the five sessions, through May 15, foreign investors bought $1 bln of Indian shares, almost 20% of what was bought since the start of the year. Last week, Indian shares rallied 5% about 50% of what they had risen up until then. The rupee was the strongest of the Asian currencies last week appreciating 2% against the dollar. Before last week, it had gained about 3% since the start of the year. We expect Modi to enjoy a honeymoon that will be good for investors and recommend global investors embrace potential near-term profit-taking as a new opportunity to participate.

 

Chart of the Day: New DM-EM Equity Convergence

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

This Great Graphic, created on Bloomberg, depicts the MSCI equity index for the developed countries (orange line) and the emerging markets (white line).

dm em

The charts begins at the start of last year. In the first several months of 2013, DM outperformed EM. The big EM sell-off coincided with first hint from the FOMC about tapering. EM recovered and tracked the DM until October. A new phase of divergence, with DM outperforming again lasted into early March.

Since mid-March the performance is a study in contrasts. MSCI emerging market equity index is up about 8.4%. During the same time the developed markets index is up a little less than 1%.

In the foreign exchange market over this period, the dollar-bloc is the strongest. The Australian dollar is easily the best performer rising 3.3% against the dollar, followed by the Canadian dollar (1.7%) and the New Zealand dollar (1.5%). Sterling is a distant fourth, up 0.4%, and all this was recorded today. The other major currencies have lost ground against the dollar this period.

Among the emerging market currencies, the Brazilian real (5.8%), Colombian peso (5.5%) and Turkish lira (5.5%) have led the advance. Chilean peso (3.5%) and the Russian rouble (3.0%) round out the top five. As with the majors, the high yielding/high beta currencies has generally outperformed.

 

4 Macro Changes to the Current Investment Climate

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

There are four changes to the broad investment climate.

1. The ECB has stepped up its threat of unconventional action and may have purchased a two month grace period.
2. Confidence in the US economic rebound from sub-par growth in Q1 is strengthening.
3. After a strong start, the major developed countries’ equity markets appear poised to correct lower into the start of the US earnings season.
4. While geopolitical risks with Russia have stabilized albeit at elevated levels, the risks in Asia are rising.

How is this for coincidence? The German newspaper, Frankfurter Allgemeine Zeitung (FAZ), broke two stories before the weekend. In one story, the paper quoted BBK President Weidmann and EU Economics Commissioner Rehn arguing against the push from France for greater leeway on its fiscal targets.

In another article, reported, without citing a source, that the ECB has modeled a one trillion euro QE program that would boost inflation between 0.2% and 0.8%. When queried by other journalists at a different forum, ECB Vice President Constancio denied knowing about the report, though seemingly, by implication, not the research.

One cannot help but suspect it is purposeful leak that is meant to reinforce the Draghi’s effort to step up his attempt to hold the market at bay. At last week’s press conference, following the ECB meeting, Draghi escalated his verbal jousting increased calls for action, including by the head of the IMF.

To appreciate what is going on, consider the contrast: in recent years, the Federal Reserve has been dominated by a single individual–Volcker, Greenspan, Bernanke–. The ECB is much more of a collective. We suspect that Draghi is slowly shepherding the national central bank presidents onto the QE path. Because of the Easter quirk, there is reason to suspect that April will see an uptick in CPI (the flash reading is due on April 30)) from the flash 0.5% March pace.

Judging from economic surveys, many economists expect Q1 to be the low point in the inflation, i.e., the greatest risks of deflation. The creditors in the euro area, especially Germany, are wary of pursuing unconventionally inflationary policies just as inflation begins to rise on its own accord.

This analysis points to a new realistic window for ECB action seems not in May, which would be many observers tendency (just push out the expectation another month), but in June. This seems to be also along the line former ECB board member Bini-Smaghi suggested in a newswire interview, as well.

The possibility of QE will help support peripheral bond markets. Although some US credit spreads are back to levels seen since before the crisis, Spanish and Italian premiums over German remain substantially above pre-crisis levels. The premiums now are around 150 bp. For many years, into 2008, Spain and Italy a smaller premium than France pays now. Indeed, according to Bloomberg generic bond data, between 2003 and 2006, there were brief periods when the Spain would trade through Germany (lower interest rate).

We note that there were some technical changes in the ECB’s collateral rules that went into effect last week. These changes will increase the haircut on Spanish and Italian T-bills used for collateral. It appears to be instrument specific and will not impact residual maturity of bonds. Reports suggest that this may not have much impact as Spanish and Italian banks use bills for managing liquidity more than collateral. On the hand, changes may also make more assets eligible for use in ECB operations.

We took the middle ground between those who suggested that the weakness of the US economy was only weather-induced and those who said the weakness showed that the economy was addicted to QE. We recognized that other influences, such as the build of inventories in H2 13 and the tax break on corporate investment brought forward some projects, also slowed the economy. We also recognized that some housing data had peaked in H2 13 and were already softening before the turn of the year.

However, weather also contributed to the sub-par performance and last week’s news, both the surge in auto sales and the constructive employment report, point to an economy regaining traction. In particular, we note that the participation rate rose to 63.2%, a six month high, without an uptick in the unemployment rate. We appeared to have been too cynical in our anticipation that the loss of emergency jobless benefits would generate further declines in the participation and unemployment rates. The workweek increased to 34.5 hours, the best since last November.

If the US economy expanded around 1.75% in Q1, then it appears that growth can return toward 3.0% here in Q2. This keeps the Federal Reserve’s path clear. Tapering continues apace. Indicative interest rates for the end of 2015 (look at both the Eurodollar and Fed funds futures strip) finished last week at their lowest levels since the FOMC meeting on March 19 and Yellen’s press conference. A rate hike in H2 2015 still seems like the most likely time frame, assuming no significant shocks, which would include renewed decline in core inflation.

The decline US interest rates before the weekend was more a function of the drop in equity market than the US economic news. The NASDAQ fell 2.5%, which is its third steepest drop since the start of 2012. It peaked a month ago. It finished last week below its 100-day moving average fore the first time since the end of 2012. The S&P 500 posted its record high before the weekend, but proceeded to sell-off and finished below last Thursday’s low. Technicians refer to this price action as a key reversal. There are also bearish divergences in some technical indicators like RSI and MACDs.

Given the magnitude of the sell-off in US equities and the appreciation of the yen, the Nikkei and other regional markets are at risk of steep losses at the start of the week. More interesting will be the European bourses reaction. On one hand, the risk of QE and lower interest rates would seem to encourage equity market flows.

On the other hand, consider the performances just since mid-March: the Italian and Spanish markets are up about 10.5%. The German DAX is up 9% and the French CAC up 7.5%. Spain and Italy’s markets are above the top of their Bollinger Bands, (two standard deviations above the 20-day moving average). France and Germany are flirting the top of their bands. Given that the UK’s FTSE has not fully participated in the latest leg up, gaining less than half of the CAC’s rise, it may hold up better, if a correction sets in. And it looks to us as if the risks of such a correction have increased. It is not uncommon, it seems, to see reversals at the start of new quarters or as the US earnings season begins.

The dispute over islands in the South China Sea appeared to pose the greatest geopolitical risks before Russia’s take-over of Crimea. While the tensions with Russia remain at high levels, they have stabilized. There is risk that the breakaway province of Moldova, on the east border of Ukraine, Transnistria, becomes a new flash point.

If Q1 was about Europe, Q2 might be about to Asia. Later this month, President Obama will visit South Korea, Malaysia, Japan and the Philippines. The Japan-China dispute had appeared the most pressing.

Unbeknownst to many, the dispute with between China and the Philippines has escalated and is, arguably, surpassing the dispute with Japan. There have been two developments that have escaped the notice of many observers.

First, China tried in vain to stop the Philippines from re-provisioning a garrison it created on the disputed Second Thomas Shoal in 1999. That China failed does not necessarily mean that it will give up, expressing it displeasure at the Philippines insistence of using force to resolve the dispute. It does not like fait accompli.

Second, the Philippines also pressed its legal case, filing a 4000-page opening argument with the International Permanent Court Arbitration at The Hague. China is not happy about this either. The sovereignty of the disputed islands is outside of the court’s jurisdiction, but it can decide whether it is really land or not, as they are often submerged. If it is not land, then the Philippines’ claim is stronger. But not just the Philippines’ but Vietnam, Malaysia, Brunei, Indonesia, and Taiwan’s claims may be stronger, as well.

At the end of last week, the US State Department’s point man on Asia, Assistant Secretary of State for East Asia, Daniel Russel warned China not to take inspiration from Russia’s annexation of Crimea (we anticipated this here). China took exception with the official remarks, Make no mistake about: although Russia’s threat in Europe is real and will not go away as long as Putin rules, the geopolitical problems in Asia are even more vexing. Yet, what Kissinger once purported to have asked about Europe (who do you call?) is more applicable to Asia now.

It is not just the US adversaries that ought to act in a restrained fashion, but so too should US allies. The nationalization of disputed islands by Japan prodded China with a stick. The Philippines are flaunting their security pact with the US to embarrass China. The US and China would have preferred to let sleeping dogs lie. But now that they have been awoken, they may come back to bite in the period ahead.

Chart of the Day: Estimating Wage Growth

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

This Great Graphic was tweeted by the Financial Times’ Cardiff Garcia, which he got from Goldman Sachs. It tries to assess the outlook for wage growth based on different measures of unemployment, including short-term unemployment rate.

wages

The problem is that wages do not seem to be tied to the measures of the unemployment rates. This is to say that wage growth is been considerably weaker than the improving labor market would suggest.

Wages are understood to be an economic function of supply and demand. Yet the relationship appears to have broken down. One response is that it is simply a question of time, Back in 1998-19900, wages grew faster than expected based different unemployment measures. This was a short run anomaly. An alternative hypothesis begins with the observation that since 2001, wage growth has typically under performed what the levels of unemployment would suggest. Could this be the implicit threat posed by China? It joined the WTO in late 2001. This hypothesis suggests that politics, as in power, is may be a better explanatory variable for how the social product is divided between profits and wages.

Given that the forward guidance of the Federal Reserve is evolving and, most recently, it dropped the reference to a 6.5% unemployment rate, and the comments by Yellen, investors will be watching earnings very closely. Recall that in February, the weather prevented many from going to work, but their salaries were not impacted. This helped generate a statistical quirk of a larger than expected increase in hourly earnings. They rose 0.4% for a 2.2% year-over-year rate, which is the upper end of the range for the past three years.

 

Chart of the Day: Rate Differential Gaining Traction

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

This Great Graphic is the bane of our euro bearishness, at least until last week’s FOMC meeting. This Bloomberg chart shows the US premium over Germany on 2-year money (white line) and the inverted euro (yellow line).

rates and fx

We have often found the spread helpful thinking about the euro’s movement. You can see how well the differential tracked the euro-dollar exchange rate until more recently and especially since February.

However, the divergence of monetary policy is reaching a point now that indeed seems to be re-coupling the two time series. Although most Fed watchers still expected the first hike in H2 15, there is clearly risk that it comes earlier.

At the same time, many do not think the ECB will move next week, but recognize the risks have increased by the low CPI readings in Germany, Spain and Belgium. Money supply growth remains lackluster and private sector (non-financial) lending continues to contract. Excess liquidity in the euro system is threatening to fall below 100 bln. EONIA has not spiked (yet) into month and quarter end, but around 17 bp, it is twice the US equivalent (effective Fed funds).

Chart of the Day: the CRB and Oil Prices

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

Commodities are very much the center of attention in the financial markets. The first Great Graphic, created on Bloomberg, is the CRB index. Through last Friday (March 7) it had rallied 13.5% since January 9.

It gapped higher on March 3and gapped lower earlier today, leaving a bearish island top in it wake. Technical indicators like the RSI and MACDs have turned lower. The gap extends from yesterday’s low (304.75) to today’s high (303.72). Completing the gap and moving above it would negate this bearish views. In late morning activity, there was an attempt to close the gap but it was rebuffed and the CRB returned to the middle of its range. We suspect is break away gap, meaning that it is unlikely to be filled in the near-term.

crb

The CRB index also gapped higher on February 19. This gap has not been completed. In can be found between 298.55 and 299.29. A move to this area will be the first bearish objective. The next one is 294.50 We suspect there may be potential toward 290.

The lower chart, also from Bloomberg is a chart of the May US crude oil futures contract. The rally was not as impressive as the one in the CRB. It did not gap lower and there is not island gap, but the technical condition appears almost as bearish. The RSI and MACDs are trending lower.

It closed yesterday at the psychologically and technically important $100 a barrel level, but follow through selling today has seen it loss another 2%. It has moved toward the 61.8% of the rally off the the early-January though early March high (found near $96.60). That rally has carried oil up a little more than 15%.

oil

Today’s sell-off may have been aggravated by conspiracy theories sparked by the unexpected announcement by the US Department of Energy. It said it would sell up to 5 mln barrels of crude oil from its strategic reserves as a test of its systems. It is the first sale since 1990 specifically for test purposes. It will off sour crude and bids are due March 14.

The test apparently has been subject of internal discussion for some time and was timed to be the most helpful for refineries in term of their maintenance schedule. The 5 mln barrels is roughly equivalent to the US daily import of crude oil and about 25% of the US daily consumption.

Many observers initially linked the release of the strategic reserves to confrontation with Russia over Ukraine and Crimea. Yet, 5 mln barrels is a drop in the bucket, so to speak and it is not clear, in any event, how much the announcement weighed on prices, which were already moving lower before announcement. If the US were really trying to depress oil prices, the amount would have been bigger and, more than likely, it would have tried coordinating with Europe as was the case when the last time the reserves were tapped. In 2011, in response to the civil war in Libya, in coordination with Europe, the US sold 30 mln barrels of oil from its reserves.

At the present, none of the major currencies, including some crosses, are particularly closely tied to the CRB in general or oil prices in particular. Sterling against the yen may be about the best (highest correlation with oil) and that is only about 0.28 correlated ( 60 day percentage change basis) We have looked at a number of emerging market currencies and the results were similar results.

 

Seven Event Risks in the Week Ahead

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

The week ahead could very well be the most important week of the month. Four central banks from the high income countries meet, the latest purchasing managers surveys will be released and the latest reading on the US labor market will be announced.

At the same time, Russia’s move on Crimea and the US and European response may eclipse, at least partially, the economic focus of investors. Lithuania and Latvia have invoked Article 4, which requires consultation over Russia’s actions when a member feels its security or independence is threatened. It is only the fourth such action in NATO history.

1. Ukraine (Moderate risk): Neither the US nor Europe are inclined to try to use military force to push Russia out of Crimea. There may be a short-lived wobble to the detriment of risk assets and beneficial for the dollar, yen and Swiss franc. Yet, the impact of geopolitics tends to be transitory. The early July G8 Summit in Sochi may be in jeopardy, but the G7/G8 had already been reduced to a caucus within the G20 and Russia’s special role had already been diluted. Dis-inviting Russia from the G8 on grounds of not going to the UN for authority is laughable, given what happened in Iraq, but it does not mean it can’t happen.

After Ukraine, Germany may have the most to lose from Russian actions. Its energy program and efforts to de-nuclearize seems to force greater reliance on Russian energy. The Soviet invasion of Afghanistan spurred an increase in military spending (which in the US began under Carter, not Reagan as often suggested). Many countries in the West are reducing military spending presently. There is some risk that China will use the West’s distraction to press is case in the South or East China Sea. There may also be knock-on effect in the EU parliamentary election in May, where the anti-EU parties seemed to have moved into ascendancy.

2. China (Low risk): China reported its official manufacturing PMI eased to 50.2 from 50.5 in January. The Bloomberg consensus was for 50.1. Output and orders slipped, while exports remained below the 50 boom/bust level for the third consecutive month. The PMI for large businesses eased to 50.7 from 51.4, while the reading for small businesses is contracting, as the HSBC flash PMI showed. The final manufacturing read and its service PMI, along with the official one, will be released first thing Monday in Beijing. In part, what is happening is a decline in investment, especially in the credit sensitive sectors, like infrastructure and real estate where investment has been excessive.

We expect the RMB to stabilize in the week ahead, though last week’s decline did not prevent the Shanghai Composite from finishing the week with a three-day rally or the MSCI Emerging Market equity index from ending February at its highest level since January 23. The depreciation of the RMB is too small, given the relatively low-value added being done by Chinese workers, too boost exports and therefore the direct impact on trade is likely minimal at best. The National People’s Congress begins at midweek and a solidification of the reform agenda should expected.

3. The Reserve Bank of Australia (Low risk): The RBA meets and the result will be announced Tuesday morning in Sydney. At its last meeting, it indicated that a period of rate stability is best and although the labor market continues to deteriorate and activity outside mining is not picking up sufficiently quickly, it is too soon to expect much of a change in the RBA’s stance. The market may decide to ease for it, by taking the currency lower. Technically, the February rally looks over and a new push lower appears to have begun. Its failure to resurface above $0.9000 signals initial downside risk back into the $0.8840-80 range.

4. Bank of Canada (Low risk): The Bank of Canada meets Wednesday March 5. There is little to no chance of a rate cut and the BoC has already shifted its rhetoric to a more dovish/neutral tone since Carney went to the Bank of England. As in the US, the extent of the weather-induced economic disruption is not immediately clear and reasonable people can and do disagree. The February IVEY (Thursday) and jobs data (Friday), the latter to overshadow the January trade figures due out at the same time, may be more important for the Canadian dollar direction.

5. Bank of England (Low risk): Under Carney, the emphasis at the BOE is on using forward guidance to push against market fears of a rate hike sooner than the first part of next year. There is practically no chance of a change in rate. And because the BOE does not say anything when it does not do anything, there is no statement-risk a there is with the other central banks. The three PMIs (construction, manufacturing and service) are expected to show that UK economic activity has leveled off a bit at a reasonably robust pace.

6. European Central Bank (High risk): Of the central bank meetings this week, the ECB’s is the only live one in the sense of a realistic possibility of a change. The failure to act in a substantive way could see the euro appreciate. Many, if not most, have focused on what we would regard as a symbolic 10-15 bp cut in the main repo rate. We suspect the euro could rally on this, as it is not the significant rate. It would unlikely even impact forward pricing. With the PMI likely showing continued expansion for the region and the preliminary CPI reading unchanged, officials will not feel compelled to take drastic measures such as adopting a negative deposit rate or launching a sovereign bond purchase program.

There has been some speculation that to boost the excess liquidity to keep EONIA (the key rate) stable and low, the ECB could formally stop sterilizing the SMP purchases. We suspect this would be a very controversial decision. Recall two German ECB member, Weber and Stark resigned over the program. In the absence of sterilization, this would leave the SMP too close to QE, given the treaty prohibitions. We have advocated cutting the lending rate, which is the top of the official rate corridor and now sits at 75 bp. It is true the cap on EONIA, The ECB is also expected to use the new staff forecasts, that will project out to 2016 for the first time, to point to its belief that the low inflation may persist but the risk of outright deflation for the monetary union is slim. The euro could rally on this because it would strengthen the view that there is no appetite for those drastic measures.

7. US data (High risk): The US jobs data, with the February assessment due on Friday March 7, tends to be among the most important economic reports of the monthly cycle. Yet, almost regardless of the report, whose thunder is partly stolen by the ADP estimate a couple days earlier, or the week’s other data, which includes auto sales, purchasing managers surveys, the Fed’s measured tapering pace is unlikely to be disrupted.

The Fed’s tapering has not pushed up US 10-year yields this year, which have fallen by 38 bp through the end of February. Nor has it lent the dollar support, which has fallen against all the major currencies and many emerging market currencies (including Indonesian rupiah, Polish zloty, Hungarian forint, South African rand, Mexican peso, Brazilian real and Turkish lira).

Most of the US economic data in recent weeks have been reported below expectations. It means that the market has not fully grasped the magnitude of the slowdown being experienced here in Q1. Few really claim that it is only due to the weather, which has become a bit of a straw man in the blogosphere. We highlight three other forces at work: a) the inventory cycle, b) the end of the tax break for capex and c) the loss of income for 1.7 mln Americans who had been collecting emergency jobless benefits. At the end of last week, there were a few secondary economic reports, notably new home sales, durable goods orders and Chicago PMI, were stronger than expected. With more important economic data out this week, it will be important to monitor this pattern, and if, better than expected data lends the dollar support. We suspect it may with a lag.

For the record, the Bloomberg consensus is for a 150k rise in February nonfarm payrolls. This is in line with the 3-month average of 154k, but below the 6-month average (177.5k), which is nearly identical with the 2-year average (179.6k). Although the consensus does not expect a decline in the 6.6% unemployment rate, we see the risk to the downside in response to the loss of the emergency jobless benefits. This is turn would reinforce expectations for a modification/evolution in the FOMC forward guidance at its March 18-19 meeting. Judging from the Fed funds and Eurodollar futures strips, the market is not pricing in the first rate hike until the second half of 2015.

Obama is expected to present the FY15 budget proposals on March 4. This tends not to be a market mover. Moreover, in recent years, due to the political paralysis, the Federal government has operated on the basis of continuing resolutions. Yet the budget proposal will help shape the coming debate. It takes place on the heels of news that FY13 budget deficit was only $680 bln from $1.1 trillion the previous year. The budget deficit fell to 4.1% of GDP from 6.8%. It is projected to continue trending lower over the next few years. Obama is expected to avoid further cuts in spending, drop efforts to use chain-weighted CPI measures to slow Social Security payouts and promote public investment.