04/03/2011 - Fed hawks squawk, but doves carry the tune

Fed hawks squawk, but doves carry the tune

A number of Fed speakers offered quite hawkish comments in speeches late in the past week. Minneapolis Fed’s Kocherlakota, Phila.’s Plosser, KC’s Hoenig, Dallas’s Fisher, and Richmond’s Lacker all suggested the economy was strong enough, and inflation threatening enough, that extraordinary accommodation should be removed. Kocherlakota went so far as to suggest rates should be ¾% higher. Importantly, only Kocherlakota and Plosser are 2011 FOMC voting members, and even more importantly, they’re all known hawks, so such comments deserve to be discounted, especially with unemployment still at 8.8% (and U6 underemployment at 15.7%). NY Fed pres. Dudley countered with a distinctly cautious view of the recovery and indicated in no uncertain terms QE would be completed on schedule and that it’s too soon to consider tightening measures. The NY Fed president is the second among equals on the FOMC as vice chairman (the chairman is first, of course), and his comments reversed earlier market moves based on the hawks and better (but far from great) US employment data. US Treasury yields turned negative and may be signaling a near-term peak. The USD reversed its post-NFP rally, and is also showing signs of having topped out.

While we expect future Fed comments to develop along similar lines, we think the Fed will ultimately remain on hold for quite some time, likely into 2012, after wrapping up QE2 on schedule. This is likely to keep the USD biased to the downside in the meantime and makes us cautious about further gains in USD/JPY (see below). However, this is not to say that JPY-crosses may not see further gains. Instead of rallying further on a higher USD/JPY, they could see higher on a steady USD/JPY and higher EUR, AUD, CAD, and NZD against the USD. Which brings us back to the question of why is risk rallying so strongly in a still highly uncertain environment? In fact, key risk markets like stocks have only returned to prior highs, so JPY-crosses stand out as a potential overshoot at this point, rather than a leading indicator. Below we suggest JPY-cross strength is mostly due to positioning, which also makes us cautious on further gains. Still, we will look to use remaining USD strength against all but the JPY as a selling opportunity while the following support levels hold on a daily closing basis: EUR/USD 1.4000; AUD/USD 1.0150; USD/CAD (resistance) 0.9850; NZD/USD 0.7550. Fed chairman Bernanke speaks on financial stability on Monday evening ET, but there will Q&A and we’re sure he’ll get a chance to weigh in on the outlook.

The return of the JPY funded carry trade?

USD/JPY and related crosses have surged out of the gates since the historic coordinated G7 intervention on March 18th. Expectations for widening interest rate spreads as a direct result of easy BoJ policy for the foreseeable future has set the ‘JPY funded carry trade’ on its proverbial course – USD/JPY has gained 8 big figures, EUR/JPY is fast approaching the 120.00 figure, GBP/JPY recovered 13 big figures, and AUD/JPY is nearing 2008 levels around 90.00 in just a matter of weeks. JPY has been ripped away from the normal currency landscape as market participants have become exuberant on prospects for higher yields and accelerating growth – possibly even over-exuberant.

While many have attributed the move higher in yen pairs as a reflection of shifting fundamentals, we are cautious to make such an assumption. Instead, we think position adjustments may have been the main driver to post-intervention yen weakness. The sharp JPY decline is likely to have caught Japanese exporters over-hedged and scrambling for the exits, even reversing long JPY hedges to the short side. As part of its intervention efforts, the BOJ ‘requested’ that exporters needing to buy JPY should transact directly with the BOJ. This also removes a significant source of JPY buying from the spot market, effectively lifting the lid off USD/JPY and JPY-crosses. Additionally, model types no longer remain on the offer and have likely switched to the long side, exacerbating recent JPY declines. Finally, 4Q data from the IMF suggest international reserve managers increased their JPY buying during the period, and we can reasonably presume they were still active JPY buyers for much of the 1Q given persistent JPY strength. After the G7 opted for intervention, however, that JPY accumulation is likely on hold and may even be reversing. As with any major position adjustment, it’s next to impossible to know in real time when it has run its course.

There is a lesson that can be learned from the 2008 financial crisis - the ‘carry trade’ can unravel at a much faster rate than it develops. Accordingly, we think caution should be heeded on the recent wave of ‘JPY funded’ carry trade optimism especially as many JPY pairs trade near significant levels. USD/JPY ran into a brick wall into the 84.50/75 level, a key horizontal pivot on a daily basis, and faces additional resistance directly above into its declining primary trendline around 85.75 (extended from the 2007 peaks). 120.00 is likely to be a key technical and psychological barrier in EUR/JPY as is 90.00 in AUD/JPY. Strength above these levels would suggest further gains ahead, but overall we believe it may be too early to call a complete reversal in the JPY’s underlying trend.

What happens once the ECB bites the bullet?

The European Central Bank is set to hike interest rates on Thursday – the first of the major central banks to do so. While ECB speakers were fairly thin on the ground this week, the March estimate for CPI all but sealed this week’s rate rise. Prices expanded by 2.6 per cent up from 2.4 per cent in February and prices are now well above the ECB’s target rate of 2 per cent.

This rate hike is all but fully priced in by the forex market, which has kept the single currency supported above 1.4000 in recent weeks even in the face of further peripheral debt turmoil. But future gains for the single currency will depend on what ECB President Trichet has to say after the interest rate announcement on Thursday afternoon.

In March he said that a 25 basis point rate hike in April would not signal the start of a tightening cycle. But one hike will do little to thwart the currency bloc’s inflation pressures, which are mostly driven by commodity prices. A 25 basis point hike would still leave real interest rates in negative territory. Is there a point to only executing a one-off hike especially with the oil price cracking new highs in recent days?

We tend to think not, and Trichet - although he may stop short of signalling the start of a tightening cycle – is likely to be wary of future inflation pressures and leave it open-ended if this rate hike will be followed by others later this year.

This has ramifications for FX markets. The 2-year German-2-year US government bond yield spread has started to narrow since the start of this month as US yields outpace those in Europe. Unless Trichet is on the look-out for future inflation pressures then this yield spread will narrow further, which could weigh on the euro. Look for a break of 1.4240 in EURUSD for further gains towards the 1.4500 August 2010 highs.

There has been some concern about what a rate hike would do to the troubled peripheral economies in the currency bloc. But the ECB will continue to offer liquidity support to Europe’s troubled banks, and late last week the central bank suspended its minimum credit rating threshold for collateral that banks need to deposit with the ECB to secure access to funds. This is vital, especially for Ireland as its banks’ credit ratings are so low their assets would not be accepted as collateral if the normal rules at the ECB still applied.

So the ECB isn’t abandoning the periphery, but nor is it willing to tolerate above target inflation. This really is policy for a two-tier economy.

RBA likely to remain on hold

On Tuesday April 5, the Reserve Bank of Australia will meet to decide on interest rates. The bank is expected to remain on hold for the fourth consecutive meeting at 4.75% as recent data has showed a moderation in inflation with yearly CPI last released at 2.7% (prior 2.8%). The economic picture down under is strong as indicated by better than expected retail sales for February at 0.5% (cons. 0.4% prior 0.4%) and a faster than expected pick up in private sector credit (0.5% vs. exp. 0.3% prior 0.3%). Despite a February employment change of -10.1K, the economy is nearly at full employment which is seeing upward pressures on wage inflation. We would also note that the -10.1K change in February employment was a result of a larger drop in part time employment (-57.7K) than the rise in full time employment (+47.6K). The addition of full time employment is more significant as the overall numbers may have been distorted by the lingering effects of the floods. The risk is to the upside if the RBA surprises and tightens rates which may see AUD gains extend.

The Australian dollar has seen new post float highs this past week and is trading at record highs which are around 1.0385 at the time of writing. It is likely that the Aussie will continue to march higher in the week ahead as investors’ increasing appetite for risk leads them to search for yield. Key levels to the upside are likely to be psychological figures of 1.0400 and 1.0500. The RBA may address the elevated levels of AUD as a concern to its export sector which may spark profit taking. Levels of note to the downside are the 1.0300 figure and 1.0200 pivot which were prior highs.

Key data and events to watch in the week ahead

United States:

Monday – Fed’s Bernanke speaks on clearinghouses and stability Tuesday – March ISM Non-Manufacturing Composite, March 15th FOMC Meeting Minutes Wednesday – April 1 MBA Mortgage Applications Thursday – Weekly Jobless Claims Friday – Feb. Wholesale Inventories

Eurozone:

Monday – EZ Feb. PPI Tuesday – EZ March PMI Composite & services, EZ Feb. Retail Sales, German March. PMI Services Wednesday – EZ 4q F GDP, German Feb. Factory Orders Thursday – ECB Rate Announcement, German Feb. Industrial Production Friday – Finance Ministers & central bankers meet in Budapest, German Feb. Current Account, German Feb. Trade Balance

UK:

Monday – March PMI Construction Tuesday – March PMI Services Wednesday – Feb. Industrial Production, Feb. Manufacturing Production Thursday – BOE Rate Announcement Friday – March PPI Output

Japan:

Wednesday – Feb. prelim Coincident and Leading Index Thursday – BOJ Target Rate Friday – Feb Current Account Balance, Mar. Eco Watchers Survey

Canada:

Wednesday – Mar. Ivey PMI Thursday – Feb. Building Permits Friday – Mar. Employment Report, Housing Starts

Australia & New Zealand:

Monday – AU Mar. AiG Performance of Service Index, NZ Mar. ANZ Commodity Price Tuesday – AU Feb. Trade Balance, RBA Interest Rate Announcement, NZ 1Q NZIER Business Survey Wednesday – AU Feb. Home Loans Thursday – Mar. Employment Report

China:

Monday – Mar. Non-manufacturing PMI Wednesday – Mar. HSBC Services PMI

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