Two weeks into the year and most investors are nursing sizable drawdowns. The recovery in the US equities on January 14 looked like a potential turning point. However, the coattails proved non-existent, and the bull trap was sprung with new downside momentum established before the weekend.
The obvious takeaway is that the current driver is not to be found in New York. And to be sure, we are not just talking about equities, but during this market meltdown, correlations between various asset classes and instruments have increased (or become more inverse).
Nor is what is happening in the foreign exchange market driven by the US dollar. We suggest that presently it is best to consider the dollar as the fulcrum though it has appreciated against most major and emerging market currencies through the turbulence since the start of the year.
There are a few currencies that have appreciated against the dollar over the past two weeks. They are the euro, and currencies like the Danish krone and Swiss franc that are closely linked, and the Japanese yen. What the euro and yen have is that they have been used extensively as funding currencies. Foreign portfolio investors are also believed to have been running high hedge ratios. Existing interest rate differential mean hedging not only does not cost money, but an investor is actually paid to hedge.
The emerging market currencies that have risen against the dollar over the past two weeks share a common feature. They are all from Central Europe: Hungary, Bulgaria, Czeck Republic, and Romania. This is largely a function of the euro's rise. They have mostly risen less than the euro against the dollar, which means that the euro has appreciated against them. The exception is the Hungarian forint, which is up 0.55% against the dollar compared with the euro's 0.50% advance. The difference is insignificant.
The Polish zloty is notable in its absence. The political climate has changed in Poland following the election last year. The agenda of the Law and Justice Party is scaring investors and spurred a cut in its ratings by S&P ahead of the weekend. Poland is also at loggerheads with the EU. Having lost 4.5% in the past two weeks, the zloty is one of the weakest of the emerging market currencies. The euro is trading at four-year highs against the zloty.
As international investors (and rating agencies) re-examine the policy and economic environment, the zloty is likely to weaken further. After closing at PLN4.48, the immediate target is PLN4.50, but the swing in investor sentiment warns of steeper euro gains with PLN4.60 being a reasonable objective. Further out, unless the government shifts gears, a return to the 2004 and 2009 extremes, in the PLN4.93-PLN4.95 cannot be ruled out.
II
The Federal Reserve did hike rates a month ago, but much of what has happened cannot be directly attributed to a 25 bp hike in the Fed funds target range. The policy-sensitive 2-Year Treasury yield has fallen 30 bp from the pre-New Year's high to the pre-weekend low. At its closing yield of 85 bp, it is more than 15 bp lower than where it closed on December 16, the day the Fed lifted rates. We also note that the effective Fed funds rate has consistently traded a little below the midpoint of the 25-50 bp target range.
Indeed, given that the hike was hardly a surprise, as of the first two weeks after the increase it was widely recognized that investors had absorbed it with little fanfare. The S&P 500 finished the year above where it closed on December 16. Indeed, the month after the hike can be broken into two parts, so far. The first is the immediate aftermath. No problem. The second phase is the first two weeks of the New Year.
One of the critical changes, rather than the hike, we would argue, was the resumption of the slide in Chinese equities, and an acceleration of the yuan's decline. Recall that after last August's debacle, Chinese officials had—through the use of the carrot and the stick—engineered stability in their financial markets. New pressure was seen on the yuan in November, even before the decision late in the month to include it in the SDR. However, as we noted late last year, anticipation of supply in the form of new IPOs and the end of the six-month ban on sales of large shareholders, left the market vulnerable.
What an understatement. The Shanghai Composite fell 18% in the first two weeks of trading this year, and the Shenzhen Composite has lost most than 22%. The yuan (onshore) has fallen 1.4% against the US dollar. The Chinese stock market is only loosely related to the economy, and the yuan's decline is less than many currencies.
The main challenge does not stem from what investors know, but from what they do not know. What is the intention of Chinese officials? Are they seeking a large devaluation of the yuan? After encouraging households to purchases stocks, how much of a correction to the subsequent bubble are Chinese willing to accept. By some traditional measures, Chinese shares remain rich.
A year or so ago, many in the media and other observers, made it sound as if teh Chinese were ten-feet tall: well on their way to supplant the dollar and dominate the world economy. That pendulum has swung back hard. It is now the "gang that can't shoot straight." The economy is depicted as being in a free-fall. The pace at which reserves have fallen has given rise to concern that China will shortly not have a sufficient war chest. China's reserve stands at $3.3 trillion. The last time they were at these levels (three years ago) many were suggesting that its holdings were too large.
China's data in the coming week is unlikely to have much market impact. The Bloomberg consensus is for steady growth in industrial output at 6.1% year-over-year pace. The risk is on the downside, but even a high 5% reading would be the envy of most countries. The consensus expects retail sales to accelerate to 11.3% year-over-year from 11.2%. Note that in the three months before the August plunge of Chinese shares, retail sales rose at an average pace of 10.4%. In the three months since the pace has quickened to 11%.
The other data highlight is China's Q4 GDP. The consensus is that the economy expanded at a 6.9% year-over-year. It is expected to be the third quarter that China recorded a 1.8% quarterly expansion. Many disparage the accuracy of Chinese data, which often seems quickly tallied, without the volatility that other countries show, and sometimes seemingly self-serving. However, critics often do this is by innuendo and accusations, not a robust examination.
In this context, we note the San Francisco Fed report in 2013 that found that:
"These alternative domestic and foreign sources provide no evidence that China’s economic growth was slower than official data indicate."
Of course, this is not a comprehensive study and it covers only a short period. Still, it is suggestive. We also note that China has agreed to adopt the more robust data regime offered by the IMF. Lastly, in comparison, reporting data and then revising it ad nauseum for years, which is what many countries including the US, do, might not, at any one point, be providing more accurate data, which ought not be confused with the latest revision.
The US will not report its first estimate of Q4 GDP until January 29. In the meantime, estimates have been slashed. The Atlanta Fed GDPNow is tracking 0.6% while the Bloomberg consensus stands at 0.5%. As these are annualized rates of quarterly growth, for all practical purposes, the US economy stagnated.
Nevertheless, the talk of a recession is an exercise in hyperbole. In December, the US reported its strongest job growth of the year. Simply, if crudely stated, the US does have a recession with such a pace of jobs growth and with a 5.0% unemployment rate. Something has to give, and we suspect Q4 will prove to be an anomaly. Remember the argument that one of the benefits of flexible capital markets is that the price of money can act as a shock-absorber so the real economy doesn't.
Perhaps QE compromised the ability of the capital markets to function accordingly, and as a result, the economy has become more volatile. On the other hand, the eurozone flash PMIs are expected to show that growth has remains remarkably steady. The composite has been between 53.3 and 54.3 since last February.
The US reports housing starts and existing home sales this coming week, but the most important report is likely the CPI. What has gone largely unappreciated, or at least rarely acknowledged is that core US CPI climbed steadily higher last year despite the fall in energy prices, and commodity prices more generally, and the dollar's appreciation. It finished 2014 at 1.6% and rose to 2.0% in November and is expected to have ticked up to 2.1% in December. The consensus expects the core rate to rise 0.2% for the fourth consecutive month.
The eurozone is expected to confirm that its headline inflation rose 0.2% year-over-year in December with a 0.9% core rate. The UK will report its December CPI figures as well. The consensus expects UK headline CPI to match the eurozone's by rising from 0.1%. The UK's core rate is anticipated to be steady at 1.2%. Separately, the UK's labor report will contain earnings data (with an extra month lag), and are expected to have continued to slow after peaking in late-H1 15.
The UK also reports retail sales. After the poor BRC figure (0.1% instead of 0.5%), the prospects for the December report worsened. The consensus is for a 0.3% decline in the headline figure and when gasoline is excluded. Sterling's resilience in the face of weak economic data would lend support to our suspicion that much of the bad news has now been discounted.
III
Among the G10 central banks, both the ECB and Canada hold policy meetings. After cutting the deposit rate by 10 bp and extending the purchase program by six months a few weeks ago, the ECB cannot reasonably be expected to take fresh action. Draghi's press conference, as is often the case, is the more important element.
While Draghi is unlikely to express the sense of urgency that he did last October and November, he is also unlikely to be satisfied. The Survey of Professional Forecasters may provide an early building block for another policy adjustment later this year if the sharp decline in oil prices weighs on inflation projections. Draghi may claim another building block for several of the downside risks he had warned of have materialized. While the general market conditions matter, the euro is likely to fall if Draghi follows this tack.
Evidence has accumulated that energy shock is having knock-on effects on the Canadian economy more broadly. And rather than dissipate, the oil challenge is growing as the price of WTI has fallen more than 25% since the Bank of Canada last met in early December. US output is more resilient than many expected, and next week Iranian oil will hit. The market has been anticipating this and expects Iran to ramp up production as quickly as it can.
In recent days, many economists have forecast a 25 bp rate cut, which would halve the overnight rate. The implied yield of the March 16 BA futures contract has fallen 20 bp in the past two weeks. The Canadian dollar has depreciated by 4.8% at the same time. Clearly, a rate cut would not be surprising.
We suspect it is a closer call for the central bank than the market. The markets are indeed off to a tumultuous start to the year, but policymakers look further afield. Under the new government, fiscal policy will become more supportive for the economy. The central bank may also want more data.
Two days after the BoC meets, Statscan will report December CPI. The headline rate is expected to rise to 1.7% from 1.4% while the core remains steady at 2.0%. Separately, November retail sales are expected to have risen 0.3%, which matches the six-month average.
Even if the Bank of Canada chose to ease policy, it may not choose to cut the overnight rate. Governor Poloz has already suggested that he would consider an asset purchase program. Launching an asset purchase program while the policy target rate is at 50 bp is what the Bank of England did.
Among the emerging markets, Brazil and Turkey's central banks meet. Turkey is understood to be on hold. Brazil is widely, though not universally, expected to hike the Selic Rate by 50 bp to 14.75%. A 3-month government bill pays 14.75%. This looks attractive. The US 3-Month bill pays 23 bp and a euro T-bill yields minus 38 bp. However, consider that the real has depreciated 2% against the dollar in the first two weeks while those yields are annualized. Moreover, unlike hedging the euro, yen or Swiss franc at a discount, one pays dearly for hedging the real.