Investors Like Fed’s Promise Of Continuity

Investors Like Yellen’s Promise of Continuity

Currency and equity traders liked what Janet Yellen had to say Tuesday. Her promise of continuity and taking “measured steps” in reducing stimulus was well received by the market. In reality, she did not say anything new. The Fed plans to keep rates low for a very long time and want to rethink their unemployment rate threshold because the labor market conditions, growth and inflation are still at undesirable levels. Yellen shares Bernanke’s optimism about the economy, frustration with the unemployment rate and lack of concern about the swings in emerging markets. She also refuses to commit to anything before the next Fed meeting, choosing instead to say there is no preset course for bond purchases and tapering. Changing the unemployment rate threshold remains a possibility in March but there’s no benefit to front running the FOMC. Here are our top 10 takeaways from Janet Yellen’s Testimony. With no U.S. economic reports scheduled for release Wednesday, we believe currencies and equities will hold onto their recent gains.

My Top 10 Takeaways from Janet Yellen’s Testimony:

1. Expect Continuity > Taper to Continue in Measured Steps
2. There’s No Preset Course for Anything
3. Don’t Expect a Rate Hike when the Unemployment Rate Drops to 6.5%
4. 6.5% is a Threshold for Re-considering Overall Economic Outlook
5. Yellen Saw Economic Improvements in Second Half of Last Year
6. But She’s Not Satisfied with Labor Market Recovery
7. Not Happy with Unemployment Rate because it Doesn’t Provide a Full View of Jobs
8. Don’t See the Swings in Emerging Markets as a Big Risk for US Outlook
9. Believes Softness in Inflation Likely to be Transitory
10. Expects Monetary Policy to Remain Extremely Accommodative after QE Ends

GBP: Less than 24 Hours before BoE Quarterly Inflation Report

The British pound traded slightly higher against the euro and U.S. dollar Tuesday ahead of Wednesday’s Bank of England’s Quarterly Inflation Report. The main question for the BoE Wednesday has to do with forward guidance. Will they lower their unemployment rate threshold or abandon it completely. Either option should be negative for sterling because it would imply that the Monetary Policy Committee is in no rush to raise interest rates. If the central bank lowers the threshold to 6% for example, it would likely be more negative for GBP/USD than having no threshold at all because removing the bar leaves the market guessing. If the threshold remains unchanged, we expect GBP/USD to rally. Aside from changes to forward the central bank will also release their latest growth and inflation forecasts. If the BoE eliminates the threshold but raises their growth forecasts, any initial losses in sterling could be recovered quickly. The BoE Inflation Report is the most important event risk for GBP/USD this week and like the Fed, U.K. policymakers have their backs are against the wall because the unemployment rate is falling faster than they anticipated. The BoE tied itself to an unemployment rate threshold and are now only 0.1% away from that level. Unfortunately the recovery in their economy is not strong enough to handle an increase in interest rates, which they promised would be their first step in unwinding stimulus. Tying monetary policy to the jobless rate was a big mistake for U.K. and U.S. policymakers and both should abandon this rule completely and move to a more qualitative guidance. In the long run, this option would create less volatility for their financial markets. Bank of England Governor Carney will also provide explanations about the changes in the Inflation Report when it is released so buckle up for potentially big moves in sterling.

The Underperformance of the Euro

Unlike all of the other high beta currencies, the euro failed to benefit from the risk rally. There is no specific explanation for the underperformance outside of the subdued growth prospects for the Eurozone and the smaller increase in German yields relative to U.S. yields. The spread between U.S. and German 10-year bond yields widened by 4.4bp, Tuesday, in the U.S.’ favor while the US-UK yield spread changed 2.7bp and for AU-US rates, the change was less than 1bp. The larger increase in the yield spread between the U.S. and Germany makes the dollar more attractive versus this euro. This sentiment should be confirmed by Wednesday’s Eurozone industrial production report. Earlier this month, Germany, France and Italy reported a decline in industrial production at the end of last year. While the Eurozone economy is expected to recover in 2014, growth in the last few months of the year was anemic. Later this week we look forward to the Eurozone’s fourth quarter GDP report that will show the region’s economy expanding only modestly.

Stronger Data Sends AUD to 3-Week High

Speculators continued to unwind their short Australian dollar positions on the back of better-than-expected economic data and improvement in risk appetite. AUD/USD broke through 90 cents to rise to its highest level in more than 3 weeks. The Reserve Bank of Australia’s decision to drop its easing bias last week was validated by Tuesday's stronger than expected business confidence report. The confidence component of the NAB index rose for the first time in 4 months from 6 to 8 while the current conditions component rose from 3 to 4. Australian house prices also increased 3.4% in the fourth quarter, bringing the annualized pace of growth to 9.3% from 8%. While home loans dropped 1.9%, investment lending rose 2.9%. On balance Tuesday’s reports confirm the RBA’s belief that the worst is over for Australia’s economy. If China's trade numbers surprise to the upside, AUD/USD could rise to a new year-to-date high around 91 cents. Unfortunately Chinese export growth is expected to have slowed at the beginning of the year. Exports are only expected to grow 1% in January, down from 4.3% at the end of last year. If exports decline and the trade surplus contracts concerns about slower Chinese growth could erase the gains in equities and currencies. Meanwhile the Canadian dollar held onto its own gains after the release of the Budget. Finance Minister Flaherty promises to return the budget to a surplus in 2015.

Improvement in Risk Appetite Drives Yen Crosses Higher

The overall improvement in risk appetite Tuesday drove the Japanese Yen traded lower against all of the major currencies. Overnight the Nikkei also tacked on 1.7% in gains, helping to lift the Yen crosses. No major Japanese economic reports were released overnight and Tuesay night only had machine orders in the wings. Economists are looking for orders to decline by 4%, after rising 9.3% the previous month. We have seen quite a bit of evidence of slower growth in Japan’s economy towards the end of last year. Thanks to the success of Abenomics, 2013 was a great year for Japan. However the recovery started to lose momentum towards the end of the year. The next few months will be crucial because a sizable buffer is needed before the consumption tax is increased in April. In the meantime, USD/JPY traders should keep their eyes on U.S. yields. If they continue to rise, we could see further gains in the Yen crosses. Having traded higher on the back of Janet Yellen’s comments, USD/JPY appears poised for a test of 103.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.