Author Archive for Marc Chandler

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.


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.


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%.


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.


Chart of the day: Rewarding US Shareholders

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

Those who draw their income primarily from wages have been squeezed. However, those that draw more income from their savings and investments have fared better. This is the story behind the growing disparity of income in the United States.

Shareholders have been rewarded. The top Great Graphic was posted by Matt Phillips on Quartz. It was taken from Goldman Sachs Research. It shows both the authorized and executed share buyback schemes among the S&P 500 through Q3 13. The authorized programs area approached record size.

buy back activity

There are a number of ETFs that try to capitalize on share buyback programs or favorable insider activity or strong hand buying. The Bloomberg chart here shows a the S&P 500s performance since the beginning of last year (purple line), with three ETFs in this space. The white line is PowerShares Buyback Achievers Portfolio (PKW). The yellow line is the Guggenheim Insider Sentiment (NFO), which looks at trends in insider buying and analysts’ opinions. The green line is TrimTabs Float Shrink (TTFS). It uses a screen for to assess the quality of the reduction in the free float. This summary of ETFs in this space should not be confused with a trade recommendation or investment advice.

buyback etf

We are skeptical, though of Phillips effort to draw a connection between the cash holdings of almost $2 trillion to the share buyback efforts. Yet, it seems as if many corporations are borrowing to fund the repurchase programs.

Separately, Phillips points to another way shareholders are being rewarded: dividends. He notes that as of the end of January 420 of the S&P 500 were paying dividends, which is the most since 1998. S&P 500 companies will pay out an estimated $330 bln in dividends this year, which represents a new record.


Debt Ceiling Update

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

The US debt ceiling looms. The House Republicans are still formulating their strategy. Treasury Secretary Lew has said his ability to maneuver will be exhausted by February 27. While this sounds like ample time to avoid a delayed payment or default, the problem is that Congress recesses this Wednesday and will not return for a full day session until February 26. Time is really of the essence. Moreover, officials seems vaguely unaware of how it undermines US prestige after the government shutdown in Q4 last year.

The word from Washington is that the House Republicans are looking for a face saving way to avoid a confrontation. To this end, efforts to repeal or delay parts of the Affordable Care Act (Obamacare) have been jettisoned. The two demands that have received the most press attention do not seem particularly controversial. They include reversing recent changes to the cost of living for the military personnel and updating the rate at which doctors that treat Medicare patients are reimbursed (Sustainable Growth Rate).

However, there does seem to be a technical glitch of sorts with the Sustainable Growth Rate. A bipartisan group in Congress submitted a bill last week that eliminated it completely. The temporary fix suggested as part of a deal to lift the debt ceiling is seen as threatening the effort for a longer term solution and is opposed by powerful industry interests like the American Medical Association.

The Democrats in both chambers and the White House want a clean bill; that is one without any policy strings attached. A bill in the House of Representatives will require support from the Democrats because there are around 30 Republicans that are unlikely to support an increase in the debt ceiling no matter what.

We have likened the debt ceiling debate to going to a restaurant, eating the meal and debating about whether to pay the bill when it arrives. The government’s spending was authorized. The fact that the government may not be authorized to make good on its debt makes little sense to many inside as well as outside the US.

A deal, which will eventually take place, is expected to raise the debt ceiling until after the November mid-term elections. There was talk before the weekend of a full year extension. Part of the problem is that this time of year, heavily laden with tax refunds, the federal government has relatively high needs for cash. This is reflected in the increase size of US bill auctions.

Owing to the unresolved debt ceiling, the Treasury Department seems more reluctant to expand its issuance of 4-week bills, but has increased the supply of 3- and 6-month bills and cash management bills. Some dealers warn of an increase in general collateral rates of 3-5 bp, but potentially more tomorrow and Thursday due to the settlement of bills.

While we have not talked with any one that actually expects the US to default on its debt, the risk of disruption does weigh on some investors. Investors, for example, appear to be avoiding T-bills maturing over the next several weeks.

Nine Event Risks in the Week Ahead

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

The investment climate has proven extremely difficult for investors to navigate. Fed tapering and better world growth was to lead to higher interest rates. Yet interest rates for the developed world have fallen sharply in recent weeks. Aggressive quantitative easing by the Bank of Japan was widely understood to be yen negative, yet the yen is the only currency to have been stronger than the dollar in January. Toward the emerging markets, investors were to take a more differentiated approach. Countries with large current account deficit were particularly vulnerable, yet it appears that the entire asset class was tarred with the same brush. Reports suggest that ETF for Mexican equities (EWW) showed the largest outflow, which seems counter-intuitive, especially since the higher wages and economic slowdown in China appear to work to its benefit.

We identify, discuss and assess nine event risks of global investors in the week ahead.

Emerging Markets (High Risk): The MSCI Emerging Market equity index peaked in 2011 and is off a little more than 20% since then. Last month, it fell 6%. Investors’ post-2009 love affair with emerging markets is over. The fact of the matter is that most were emerging markets 20 years ago and are likely to be emerging markets 20 years from now. There were two attractors—liquidity and structural reforms and we suspect, as is their wont, investors have tended to emphasis the latter and under appreciate the former. One clear implication is that real interest rates will have to rise through most of the emerging market universe. And this will have negative knock-on effects for growth.

However, due to some structural reforms, including more flexible currency regimes, somewhat deeper capital markets, and the accumulation of reserves, which can be understood as a type of self-insurance, many emerging market countries are better able to cope with a capital outflows. The key to whether investor panic leads to a crisis seems to be largely a function of the response by policy makers. The IMF/World Bank and the US Treasury have urged developing countries to take advantage of the signals to strengthen their own policy reaction. They might as well be shouting in the wind.

Portfolio Allocation (High Risk): In addition to sizeable outflows from emerging market funds that have been widely reported, there have been three other notable portfolio adjustments. First, anecdotal reports indicate that in recent weeks, several large asset managers have shifted from stocks to bonds. In this context, we note that US Treasuries had their single best month in January since the middle of 2012. To the extent there is foreign investment component, we note that due to relative volatilities, foreign fixed income investment tends to carry a higher hedge ratio than foreign equity investments. Second, after strong foreign interests in recent months that has helped drive Spain and Italian rates to record lows, some large asset managers have reportedly begun adjusting positions on valuation grounds. Third, Japanese investor appetite for foreign bonds that was evident in the second half of 2013 appears to have waned in January, as they turned net sellers again. For their part, foreign investors have slowed their purchases of Japanese shares.

Trade Promotion Authority (Low Risk): Within 24-hours of President Obama’s State of the Union Speech in which he called on Congress to grant him Trade Promotion Authority to complete the negotiations for Trans-Pacific Partnership and the Trans-Atlantic Trade and Investment Partnership, Senate Majority Leader Reid underscored his opposition. Even though the risk that TPP, which was initially to be completed last year, is further delayed is high, the risk to investors appears minimal. Yet, it speaks volumes about the outlook for fresh initiatives ahead of the November election and the consequence of the erosion of support for President Obama. Note that this follows the recent refusal by Congress to ratify the long planned increase in the IMF’s quota. Some observers talk about a new wave of isolationism in the US, but sometimes in the past, isolationism was a shroud to cover unilateralism.

China (Near-term Low Risk): The Lunar New Year celebration will keep China out of the spotlight in the coming week. It will report the service sector PMI reading first thing Monday in Beijing, but other than that, it will likely be out of the news in the coming days. The official manufacturing PMI was reported at 50.5, which was in line with expectations, but is the lowest reading since last July. Output hit a four month low and new orders slipped to six month lows, though both are still above the 50 boom/bust level. Employment and export orders were below 50.

Reserve Bank of Australia (Medium Risk): The RBA is the first of the three central bank meetings from the high income countries. There is little doubt that policy is on hold with the cash rate at a record low 2.5%. The credit expansion, the somewhat higher than expected CPI inflation figures, and the roughly 8% decline in a trade-weighted measure of the Australian dollar over the last four months remove the sense of urgency to cut rate further. At the same time, the weakness of the labor market, the softness in producer prices (pipeline inflation?) and the erosion of the terms of trade, means the RBA is unlikely to close the door completely on another rate cut, which now seems more likely in Q2 than Q1. We attribute a medium risk to the prospect of a more neutral sounding RBA statement. We note that central bank officials have cited $0.8500 and $0.8000 as targets for the exchange rate.

Bank of England (Low Risk): The Bank of England is securely on the sidelines. BOE Governor Carney has already indicated that the next step in the evolution of forward guidance will be announced with the quarterly inflation report on February 12. Contrary to claims that Carney is jettisoning the forward guidance, we expect the BOE to drive home the point that the 7.0% unemployment rate was a threshold not a trigger for tighter policy. In effect, the BOE will say, we re-examined the economic conditions in light of the threshold being approached and we continue to judge the economy as recovering but still in need to very low interest rates. The September short sterling futures contract rallied in January and the implied yield is 16 bp lower than it was in late-December at an implied yield of about 64 bp. It can fall toward 50 bp bank rate on dovish comments and data that suggest the economic activity is leveling off, which is expected to be seen in the PMI reports in the coming days.

Euro Area PMI (Low Risk): The flash readings steal much of the thunder from the final reports that are out in week ahead. The focus will be on Spain and Italy for signs of continued recovery. The manufacturing PMI for the euro area is at its best level since 2011, which has lifted the composite as well. The service sector has lagged, though the flash reading put it at four month highs. We note that the criticism of the lack of progress reform in the German service sector appears to be on the rise.

ECB Meeting (High Risk): The two pillars of ECB monetary policy, money supply and inflation, disappointed on the downside. This has spurred speculation that the ECB will take action at its meeting on February 6. A large German bank has forecast a small cut in the 25 bp repo rate and, more important, a move to a negative deposit rate. Others have predicted an end to the efforts to sterilize the SMP purchases. Since EONIA has traded above the repo rate, we think a repo rate cut is largely immaterial. Cutting the 75 bp lending rate would be more significant in capping the increase in EONIA. A negative deposit rate could be potentially very disruptive as it puts the ECB in unprecedented territory. Even Japan through its deflationary years never adopted a negative deposit rate.

The ECB does not need to open the can of worms by formally ending its sterilization of the SMP sovereign bond purchases. It would likely be highly controversial as some (read Germany and its creditor allies) may see it is an illegal monetization of sovereign debt. It can take a stay with its more passive of failing to attract enough interest in its sterilization operations. This would be less controversial but effective in providing more liquidity on a weekly basis. We see ECB officials more concerned about lending to the SME sector. In one of the more important discussions at Davos, Draghi indicated a willingness to consider buying bank bonds, backed by loans to households and SMEs. Though it does not appear imminent, development along these lines seem more promising.

US Jobs Data (High Risk): The market generally anticipates a dramatic recovery in non-farm payrolls in January after the disappointing 74k increase in December. However, there is substantial risk that the frigid temperatures in the Midwest, South and Northeast will make for another disappointing report. Last month, we noted how well the ADP estimates had anticipated the official data, just in time for the large miss (ADP Jan estimates was 238k, while the private sector NFP grew by only 87k). Having been burned last month, investors will likely put less weight on it this time. The market will quickly look at the weather distortions and make adjustment accordingly. Before the Fed meets again (mid-March), it will see another jobs report, so the policy implications of a disappointing report may not be that great. Most investors and observers see the bar relatively high against the Fed deviating from the tapering strategy outlined by the FOMC in December. There is also substantial risk that without emergency unemployment benefits being extended there may be an unusually large decline in the unemployment rate as more people leave the labor market. Arguably the Fed’s forward guidance anticipates this possibility by saying rates will remain low even after unemployment falls through the 6.5% threshold.

While the employment report is the last major event of the week, at the start of the week, the US reports January auto sales. The consensus calls for a 15.7 mln unit selling pace after the disappointing 15.3 mln unit pace in December. If true, this would put the January sales above the average in H2 13. However, there is risk of disappointment due to weather disruptions and this would weigh on the retail sales report (January 13), which already are looking soft even excluding auto sales. Lastly, the debt ceiling debt poses headline risk, though distortions to the short-dated T-bills appears to have eased somewhat.


Chart of the Day: The Big Mac Index Updated

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

This Great Graphic show the highlights of the latest reiteration of the Economists Big Mac Index.  Since 1986, it has been illustrating the concept of Purchasing Power Parity by looking at the price of  McDonald’s ubiquitous Big Mac in various countries.  The spot currency price is as of January 22.

Big Mac 2014

Norway and Switzerland continue to stand out as the most over-valued of the major currencies. The Bank of Canada Governor recently said the Canadian dollar remains strong, suggesting it was a headwind and on the Big Mac basis, remains the move over-valued of the G7 currencies at about 8%. The euro is seen about 7% over-valued according to this metric and sterling is fairly valued.

The Governor of the RBA called for an $0.85 cent Australian dollar and recently another official at the RBA argued for $0.80. According to the Big Mac metric, it is about 3% under-valued already. With Big Macs about 37% cheaper in Japan than in the US, the Japanese yen is the most under-valued of the major currencies.

With most emerging market currencies selling off sharply in recent days, it is interesting to observe that according to the Big Mac Index, the Indian rupee, South African rand and Indonesian rupiah (three of the so-called vulnerable five) are already deeply under-valued. The Turkish lira is about 9% under-valued compared with almost 20% over-valuation in last year’s index. The leaves the Brazilian real as only one of the “vulnerable five” over-valued.

There are many criticisms of Purchasing Power Parity. One is that tradeable goods prices would naturally be lower in poor countries because labor costs are lower. The Economists proposes to address this in an adjusted index, which uses the best line fit between Big Mac prices and GDP per capita.

By this measure, the Brazilian real is the most over-valued currency (of the 48 countries and euro area included in its study) at about 73%. Colombia is next at about 55% over-valued. The Israeli shekel and the Turkish lira are both about 28% over-valued. Rounding out the vulnerable five, the rupiah is about 12.5% under-valued; the rand is about 23.5% under-valued, and the rupee is 40% under-valued.

The adjusted index estimates the euro is about 16.5% over-valued and sterling about 10%. China is fairly valued at current exchange rates, while the original index puts it at nearly 40% under-valued. The yen is about 34% under-valued, not far from the original index estimate.

The Investment Climate in 7 Points

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

1. The Federal Reserve will continue its tapering strategy outlined by the FOMC last month. The wobble in opinion caused by the unexpectedly poor December jobs report has been largely shrugged off. The Beige Book upgraded its assessment of US growth and recent data have spurred economist to revise up Q4 GDP forecasts, with many coming in around 3% now. Early survey data for January suggests the momentum has carried over.

2. At his press conference earlier this month, ECB President Draghi provided two general conditions for new action. a worsening of the disinflation outlook and an unwarranted increase in money market rates. There is little to add to the inflation picture over the past couple of weeks, but money market rates are elevated. EONIA was above the 25 refi rate in the second half of last week. Indicative prices suggest 3-month interbank lending rates have doubled over the past three months to 27 bp. Pressure will mount on the ECB to act, but politically possible effective options are few and far between. Banks will continue to pay down their LTRO borrowings and, while lending to households appear to be stabilizing, lending to SMEs continues to fall.

3. The BOJ is past the half way point toward reaching its 2.0% target (core inflation, which excludes fresh food prices). The December report is due out from January 30. The headline rate of 1.5% is just above the Germany’s December rate. Starting next month, the BOJ’s QQE purchases will surpass Federal Reserve purchases. The sales tax hike from 5% to 8% effective April 1 is the next key economic challenge and the BOJ appears more likely to react than to preempt. The rally in global bonds appear to have helped cap JGB yields that had risen from 60 bp to 75 bp in December and settled just above 66 bp before the weekend.

4. The Australian and Canadian dollars remain out of favor. Poor employment data in Australia has seen a dramatic swing in the pendulum of market sentiment toward a rate cut. The lack of a surprise by the Q4 CPI report on January 21 will underscore the idea that the RBA has scope to cut rates. The trimmed mean CPI remains well below the longer term averages (Q3 2.3%, 5- and 10-year averages 2.8% and 2.9% respectively). A similar pattern can be seen in headline rate as well.

A series of poor data and elevated official concerns about disinflation has spurred speculation of a rate cut by the Bank of Canada. Yet action this week, at its Wednesday, January 22 meeting is a highly unlikely. At most, a reduction in its inflation forecasts seems like the most that can be expected. Given the record short speculative position in the futures market and the pace of the recent decline in the Canadian dollar, there seems be heightened risk of a “sell the rumor, buy the fact” short squeeze.

5. European asset markets are outperforming here in early 2014. Turning first to flows, we note that ETFs that invest in European equities have seen assets under management (AUM) increase by $1.4 bln in the first half of January. Japan equity ETFs have also continued to report inflows. The AUMs have increased by $1.3 bln. The retreat from emerging markets equities has continued, with estimates of $4.2 bln leaving so far this year. US equity ETFs have experienced $1.3 bln of outflows.

Looking at some national bourse reports, Taiwan stands out. It appears to be non-residents’ favorite equity market in Asia, recording $1.06 bln of inflows already this year. In contrast, South Korea, which was favored by foreign investor last year, has seen light profit-taking. Interestingly, Japan also reports net foreign sales so far this year.

In terms of performance, Span and Italy continue to stand out with 5.5% and 5.3% gains respectively among the large European bourses, but Greece continues to shine (9%) and Portugal is main index is up nearly 7.5%. Of core European countries, Austria has begun the best, gaining 6.8%. The Dow Jones Stoxx 600 is up 2.3% here in January, while the Nikkei is off 3.4% and the S&P 500 is down 0.5%. The MSCI Emerging Market Equity index is off a little more than 3%. Lastly we note that like last year, small caps are generally out performing large caps.

6. The major bond markets have begun the new year with advances, despite Fed tapering and amid generally constructive economic data. The US benchmark 10-year yield is 10 bop lower than where it finished last year. The UK’s 10-year gilt yield is off 19 bp, while the benchmark bund yield is 17 bp lower. Japanese bonds have lagged in the rally as they lagged in the sell-off. The 10-year yield is 6 bp lower here in the first part of January. Asset managers continue to see value in peripheral European bonds. Italy’s 10-year yield has fallen 222 bp this year; not bad, but Spain’s 10-year yield is off 40 bp. However, growing confidence that Portugal can exit its aid programs has seen its 10-year benchmark yield drop 70 bp this year. Ironically, Ireland, which was upgraded by Moodys, back into investment grade, has the only 10-year bond in the euro zone that has weakened this year. The yield has risen a little more than 4 bp.

Turning to the short-end of coupon curve, the US and Japanese two-year yields are essentially flat so far this year, and Germany and the UK of 3-4 bp lower. Spain and Italy continue to experience yield declines in absolute terms and relative to Germany. Their two-year yields are 34 bp and 16 bp lower on the year. Portugal is also experiencing a bullish flattening, as its two-year yield is about 7 bp lower on the year.

7. China is experiencing another squeeze in its money markets and this may ahead of the new year celebration at the month. The 7-day repo rate surged before the weekend, nearing 9.8% before finishing near 8.47%, compared with 5.28% at the end of the previous week. The Shanghai Composite is off 5.25%, given the dubious honor of being the worst performing Asian market. In addition to Lunar New Year considerations, reports suggest a number of wealth management products are set to mature at the end of the month as well.

At the end of last week, new concerns about the China’s shadow banking arose. ICBC, the world’s largest bank by asset values, took what appears to be an unprecedented step, announced it would not make investors whole who bought some of a CNY3 bln (~$500 mln) investment product it had distributed four years ago. The investment product is set to mature at the end of January. The product reportedly offered a 10% yield when the benchmark deposit rate was around 3%. The regular practice by trust companies to make investors whole has created a moral hazard to which government officials are sensitive and looking for ways to rectify.


Chart of the Day: the Yen and Nikkei

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

This Great Graphic, composed on Bloomberg, shows the dollar-yen (white line) and the Nikkei (yellow line) and the 20-day moving average (purple line). The bottom chart shows the MACD rolling over.

yen and nky (1)

The dollar slipped through the 20-day moving average for the first time in two months. That average comes in now near JPY104.13. A close of the North American session below there would add to the bearish signal.

There does not appear to be a fundamental catalyst. It is true that the US service ISM was softer than expected, but this does not seem critical. The week’s big events, namely the ECB press conference and the US employment data still lies ahead. Position adjustment seems to be the key driver. We peg initial dollar support in the JPY103.50-75 area.

In the Nikkei, after the gap lower opening on Monday, which filled the gap created on December 26, we are monitoring the larger downside gap that extends from 15588 to 15798. Technical factors favor the downside as the RSI and MACDs show bearish divergences.

Separately, we not that the euro has also fallen against the yen and in the three sessions through today the euro has shed about 2.5%. It has spent the entire session below the 20-day moving average for the first time since November 11. The 38.2% retracement of the rally off the JPY131.20 area on November 7 to the JPY145.70 5-year high reached late last year is found just near JPY140.20.