The Week Ahead

December 13, 2010 — Mitul Kotecha

As markets make the last strides towards year end it appears that currencies at least are becoming increasingly resigned to trading in ranges. Even the beleaguered EUR has not traded far from the 1.3200 level despite significant bond market gyrations. Even news that inflation in China came in well above expectations in November (5.1% YoY) and increased prospects of a rate hike is likely to prompt a limited reaction from a lethargic market.

At the tail end of last week US data provided further support to the growing pool of evidence indicating strengthening US economic conditions, with the trade deficit surprisingly narrowing in October, a fact that will add to Q4 GDP growth, whilst the Michigan measure of consumer confidence registered a bigger than expected increase in November to its highest level since June.

The jump in consumer confidence bodes well for retail spending and highlights the prospects that US November retail sales tomorrow are set to reveal solid gains both headline and ex-autos sales driven by sales and promotions over the holiday season. Other data too, will paint an encouraging picture, with November industrial production (Wed) set to reveal a healthy gain helped by a bounce in utility output. Manufacturing surveys will be mixed with a rebound in the Empire manufacturing survey in December likely but in contrast a drop in the Philly Fed expected.

The main event this week is the FOMC decision tomorrow the Fed is expected to deliver few surprises. The Fed funds rate is expected to remain “exceptionally low for an extended period”. Despite some recent encouraging data recovery remains slow and the fact that core inflation continues to decelerate (CPI inflation data on Wednesday is set to reveal a benign outcome with core CPI at 0.6%) whilst the unemployment rate has moved higher means that the Fed is no rush to alter policy including its commitment to buy $600 billion in Treasuries including $105 billion between now and January 11.

In Europe there are also some key releases that will garner plenty of attention including the December German ZEW and IFO investor and manufacturing confidence surveys and flash purchasing managers indices (PMI) readings. The data are set to remain reasonably healthy and may keep market attention from straying to ongoing problems in the eurozone periphery but this will prove temporary at least until the markets are convinced that European Union leaders are shifting away from “piecemeal” solutions to ending the crisis. The EU leaders’ summit at the end of the week will be important in this respect. A Spanish debt auction on Thursday will also be in focus.

Assuming the forecasts for US data prove correct it is likely that US bond markets will remain under pressure unless the Fed says something that fuels a further decline in yield such as highlighting prospects for more quantitative easing (QE). However, following the tax compromise agreement last week this seems unlikely. Higher relative US bond yields will keep the USD supported, and as I have previously noted, the most sensitive currencies will be the AUD, EUR and JPY, all of which are likely to remain under varying degrees of downward pressure in the short term. The AUD will also be particularly sensitive to prospects of further Chinese monetary tightening.

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FX sensitivity to yield

December 9, 2010 — Mitul Kotecha

It’s all about yield. The back up in US bond yields in reaction to the US tax compromise from the Obama administration has been particularly sharp. US 10 year bond yields jumped around 35bps this week prior to a small correction in yields overnight whilst 2s were up 21bps. US bond yields are now back where they were in June, a fact that makes a mockery out of the Fed’s attempts to drive bond yields lower via quantitative easing (QE). Yields elsewhere increased too but by a smaller degree whilst equity market sentiment has been dampened by the rise in global yields although US stocks still ended higher overnight.

There is plenty of commentary discussing the impact on currencies of the move in bond yields so it’s worth looking in more detail how sensitive FX markets have been to yield. The most sensitive currencies i.e. those with the highest 3-month correlations with relative bond yield differentials (2 year) are the AUD/USD, EUR/USD, and of course USD/JPY. However, there is less sensitivity to gyrations in 10 year yields with no currency pair registering a statistically significant correlation with 10-year bond yield differentials over the past 3-months.

Assuming that US bond yields continue to push higher into 2011, with much lager increases in both nominal and yields expected, this means that AUD, EUR and JPY will face the most pressure relative to the USD. Moreover, the stimulus measures agreed by the US administration will likely lead to many analysts penciling in higher growth forecasts over 2011 whilst reducing the prospects of QE3 from taking place, all of which is USD positive. I still retain a degree of caution in Q1 2011, especially with regard to a potential bounce in EUR, especially if the ECB becomes more aggressive in its bond buying, but even so, any EUR rally is likely to prove termporary.

The impact of higher US yields on the AUD may be more limited however, despite the high correlation with relative bond yields, as Australian bond yields are also likely to rise somewhat given the resilience of its economy. This was clearly demonstrated by Australian November employment data released overnight revealing yet another consensus beating outcome of +54.6k, with all the gains coming from full time employment. Against the background of a generally firm USD, the best way to play AUD resilience is via the NZD, with the currency pair likely break through resistance around 1.3220 (21 October high).

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Addicted to the medicine

September 7, 2009 — Mitul Kotecha

It comes as a relief to markets that G20 officials have agreed it is too early to begin withdrawing massive fiscal, monetary and financial support.   However, it is hardly surprising that officials are not formulating an early exit from emergency measures especially given the ongoing uncertainty about the pace and shape of global economic recovery.  

The latest US jobs report did not help clarify the outlook for markets as a smaller than forecast drop in employment in August (-216k) weighed against a surprise jump in the unemployment rate to a 26-year high of 9.7% and downward revisions to past months employment data.

There is a growing possibility that the Fed’s expectation the unemployment rate will breach 10% by the end of the year looks may be hit even earlier.  Fears about a “jobless recovery” will likely increase as a lack of hiring is set to persist for some time yet. 

The absence of any near term reversal of stimulus measures reduces the risk of a “double dip” recession but at some point there has to be a reckoning. Fiscal positions have blown out for many countries and will eventually require spending cuts, higher taxes and/or privatisation in addition to likely increases in the retirement ages for workers, to rectify them. It is questionable how sustainable recovery will be once such measures begin to be implemented.

In the meantime, it is not even evident that policy is working efficiently. Arguably yields on bonds and corporate debt are lower than they would otherwise have been had it not been for central bank actions but lenders are still not passing the additional liquidity to consumers and households against the background of fears about a rising tide of bad loans and delinquencies.

I would compare this to a patient who came close to death and has finally come off life support as the worst passed but has relied on support in the form of various strong medicines to keep him (or her) going.  The risk that the patient has become overly dependent on the drugs has grown but it is highly unclear how he will fare once he is weaned off.  

Fears about the ability of the patient to stand on his own two feet will increase.  The risk that the patient will relapse is intensifying but his ability to pay for more medicine is already diminishing and his options are running out quickly.

Posted in Bond markets, central banks, Economics, Economy, Financial crisis, Monetary Policy, US. Tags: , , , , , , , , , , , , , . 1 Comment »