The Australian bonds rebounded Thursday as investors await to watch the country’s retail sales during the month of February as well as the Reserve Bank of Australia’s (RBA) monetary policy decision, scheduled to be held next week.

The yield on the benchmark 10-year Treasury note, which moves inversely to its price, slumped 3-1/2 basis points to 2.70 percent, the yield on 15-year note also plunged 3-1/2 basis points to 3.08 percent and the yield on short-term 2-year also traded 1 basis point lower at 1.75 percent by 04:40 GMT.

After three straight weeks of falls, consumer confidence rose 1.6 percent in the week ending March 26. The four week average continued to fall, however, and is now back to early 2016 levels and close to its long run average.

The pickup in confidence was broadly based with four out five sub-indices posting gains. Households’ views of the 12-month economic outlook rose 2.7 percent last week, after a 3.3 percent fall the previous week. Consumers were also more confident regarding future economic conditions, with the index rising a solid 2.8 percent.

EM and risk outlook stays relatively supported but we see risk aversion alert signs across the board. While investors focus on US politics and especially on today’s vote on the repeal act of Obamacare, other developments should, in our view, not remain unnoticed: a research paper published by two Fed economists and released by the Brookings Institute suggesting US interest rates staying low with the Fed tolerating inflation overshooting targets, the ECB’s targeted LTRO allocations, and the continued fall of iron ore futures. Despite equity markets retracing some of the post-election rally, US monetary conditions have become more accommodative with the falling USD contributing most to this easing. Foreign conditions have turned from providing hefty headwinds as experienced from 2012-16 into tailwinds, helping US reflation gain momentum over time. Accordingly, we prepare for putting on FX trades that benefit from a steeper US yield curve. Short EURSEK and long USDJPY fall into this category. While short EURSEK should work from now, USDJPY’s current downward momentum suggests waiting for 109.50 or for a stabilisation above 112.50 before establishing longs.

US vote: Today markets will wait for the outcome of the vote but FX investors should note that the vote is not scheduled for a specific time. At the moment the vote count may be low so the Republican leaders need the time to gather votes, indicating why no specific time is provided. There is even a risk the vote may be delayed if the leaders feel the vote may not pass.

Watching iron ore. The PBOC-run Financial News newspaper highlighted that the recent rise of RMB money market rates should be put into the context of recent money market operations. China seems to be tightening its monetary conditions to deal with excessive leverage. Importantly, tighter RMB lending conditions have sparked China’s USD denominated loan demand, pushing its USD denominated liabilities up again. Should this loan-related USD inflow into China end up into a higher FX reserves (see chart below) – thus providing an additional signal that offshore USD liquidity conditions are on the rise – EM markets should see further inflows. Meanwhile, China has seen the ratio of mortgage loans to total credit of commercial banks reaching uncomfortably high readings. It has been China’s property and infrastructure investment driving commodity – including iron ore – demand. Authorities are now directing growth away from the property market which suggests that commodity prices may ease. Falling iron ore prices will not bode well for the AUD. Within this context we recommend using the AUD as a funding tool for high yield EM longs and for a long GBP position. GBPAUD has moved away from levels suggested by relative forward curves.

The Australian bonds traded in a tight range Tuesday as investors refrained from any major activity amid a light trading session. Also, the Reserve Bank of Australia’s (RBA) March monetary policy meeting minutes, painted a mixed picture of the economy, adding sluggishness to market sentiments.

The yield on the benchmark 10-year Treasury note, hovered around 2.82 percent, the yield on 15-year note also traded flat at 3.21 percent and the yield on short-term 2-year remained steady at 1.81 percent by 04:20 GMT.

The minutes of the RBA March board meeting continued to paint the picture of an RBA unwilling to move official interest rates anytime soon. The Board highlighted a range of positives, but concerns were also raised. The central bank was notably more upbeat about the global outlook and the flow on effect to higher commodity prices.

Concerns surrounding the outlook for the labor market were apparent, with the RBA noting that “conditions had remained mixed” and that “momentum in the labor market remained difficult to assess”. A further mixed picture on the labor market leaves the RBA between a rock and a hard place.

Lastly, markets will now be focussing on the RBA Deputy Governor Guy Debelle’s speech, scheduled to be held on March 22 for further direction in the debt market.

The Australian bonds jumped Thursday as investors poured into safe-haven assets after reading the higher-than-expected unemployment rate for the month of February. Further, the change in employment dropped steeper than what markets had initially anticipated.

The yield on the benchmark 10-year Treasury note, which moves inversely to its price, slumped 11-1/2 basis points to 2.82 percent, the yield on 15-year note also plunged nearly 11-1/2 basis points to 3.21 percent and the yield on short-term 2-year traded 7-1/2 basis points lower at 1.81 percent by 03:20 GMT.

The February labour market report disappointed, with a fall of 6.4k jobs and a rise in the unemployment rate to 5.9 percent. The detail was slightly more positive than the headline with full-time jobs rebounding after the previous month’s sharp fall.

The soft tone to the February report provides further confirmation that the RBA is likely to be on hold for an extended period. Spare capacity in the labour market is taking longer than expected to be worked off, and is weighing on wages growth and pushing out the return of inflation into the target band.

Australia’s February business conditions retraced some of the previous month’s gains, but remain at levels consistent with solid growth. Confidence also eased back slightly. Business confidence also edged down in February, alongside a further deterioration in the Federal Government’s standing in public opinion polling.

The Australian bonds traded modestly higher Wednesday as investors poured into safe-haven assets ahead of the February employment report, scheduled to be released on March 16. Also, the Federal Open Market Committee’s (FOMC) monetary policy meeting, scheduled for later in the day will provide further guidance to financial markets.

The yield on the benchmark 10-year Treasury note, which moves inversely to its price, fell 1/2 basis point to 2.93 percent, the yield on 15-year note dived nearly 1 basis point to 3.32 percent and the yield on short-term 2-year also traded 1 basis point lower at 1.89 percent by 03:20 GMT.

Australia’s February business conditions retraced some of the previous month’s gains, but remain at levels consistent with solid growth. Confidence also eased back slightly. Business confidence also edged down in February, alongside a further deterioration in the Federal Government’s standing in public opinion polling.

“We expect the February jobs report, out later this week, to show a solid rise in employment, but over the longer term a sharper downtrend in the unemployment rate is likely necessary for a sustained boost to households’ perceptions of their finances,” ANZ Research commented in its latest research report.

The UK gilts slumped Tuesday ahead of the country’s labor market report, due on March 15 and as investors remain cautious ahead of the Bank of England’s (BoE) monetary policy decision, scheduled to be held on March 16.

The yield on the benchmark 10-year gilts, which moves inversely to its price, rose 1 basis points to 1.25 percent, the super-long 25-year bond yields also rose 1/2 basis point to 1.88 percent and the yield on the short-term 3-year traded flat at 0.24 percent by 09:50 GMT.

The BoE is expected to maintain its neutral policy stance at the monetary policy meeting, scheduled to be held on March 16. Further, the central bank is also expected to hold its Bank Rate at 0.25 percent while leaving the targets for the stock of government bond purchases (APF) and the stock of corporate bond purchases (CBPS) unchanged at GBP435bn and GBP10bn, respectively.

“In our view, the BoE seems to be more worried about slower growth than too-high inflation if this is only temporary. EUR/GBP has reached our 1-3M target of 0.87 and we are currently reviewing our forecast. We still see risks skewed to the upside for EUR/GBP in the coming months ahead of and after the triggering of Article 50,” Danske Bank commented in its recent research report.

Latest data released yesterday show that the upward march of inflation that continued early last year is still gathering pace in Europe. Spain released its consumer price inflation report yesterday and it showed that consumer prices in February rose at the fastest pace since 2012. In February, Prices were up by 3 percent from a year ago and on a monthly basis it is up by 0.3 percent from January. Two major contributors were transport prices that rose by 8.2 percent and housing prices which rose by 5.9 percent. Furniture and household good is the only sector that took a dip of 0.4 percent compared to the year-ago level. Spanish inflation came in line with that of the entire Eurozone, where the price rose by 2 percent, highest level in four years and above the target of the European Central Bank (ECB).

Data from Poland points that the return of inflation is not just a Eurozone development it’s pan-European and global as well. Inflation in Poland rose by 2.2 percent in February, which is again the fastest pace in four years.

However, one should pay an ear to the European Central Bank (ECB) President Draghi’s comments that the central bank is not worried about inflation as it is being largely driven by an increase in the prices of commodities. Lately, the prices of commodities, especially energy and industrials have taken a hit and it is likely to get reflected in the numbers going ahead. We at FxWirePro expect the European Central Bank (ECB) to continue its easing as declared and throughout the year.

The euro is currently trading at 1.063 against the dollar.

The Australian bonds rebounded on the first trading day of the week as investors remain glued to watch the February employment report, scheduled to be released on March 15. Further, the 10-year bond yields have formed a ‘bullish gravestone doji’ pattern after two consecutive sessions of selling activity in the last week.

The yield on the benchmark 10-year Treasury note, which moves inversely to its price, plunged 3-1/2 basis points to 2.95 percent, the yield on 15-year note also dived 3-1/2 basis points to 3.34 percent and the yield on short-term 2-year traded 1-1/2 basis points lower at 1.91 percent by 04:40 GMT.

Australia’s unemployment rate unexpectedly fell in January, despite a plunge in full-time jobs, underscoring the mixed picture of the country’s labor market. The unemployment rate held below 6 percent partly due to discouraged job-seekers giving up the hunt, underscoring spare capacity in the labor market.

Commodity markets are taking centrestageas oil had its largest one day fall (- 4.5%) in 13 months. Oil net long positions from the CFTC have been overextended since the start of the year, but it was the combination of technicals and ever more inventory builds in the US that gave investors the signal to take profit. Within G10, CAD has been, and should continue to be, more sensitive than NOK because leveraged market positioning is still very long CAD. CADJPY is sitting on its 100DMA, with a move below 84.20 marking a technical break. AUDUSD is about to break below its 100DMA at 0.75,helped by iron ore prices falling 9% from their peak, keeping us bearish on this pair. AUDUSD has bounced off the top end of a trend channel, bringing the bottom end of the channel at 0.7080 into focus. Even with expectations of a neutral Norges Bank next week (or essentially less dovish than last time), we stick with our tactical long USDNOK trade of the week.

Oil inventory data from the EIA showed a rise of 8.2mb to 528.4m, which is the highest in the data series going back to 1982. US producers appear to be ramping up production quickly, helped by stronger margins from high oil prices and relatively low funding costs. According to Reuters, producers in the red-hot Permian Basin in Texas are expected to increase production soon. An observation from our oil desk highlights the extent of the extreme technicals. They say that there hasn’t been a time in the last 30 years when the weekly front end Brent contract has been in such a tight range, trading sideways for three months. The longer that went on for, the more positioning stresses built up, explaining the sharp drop yesterday. The next formal OPEC meeting isn’tuntil May 25.

The DXY is still under performingtherisein positive US data surprises: Yesterday’s bumper ADP jobs estimate of growth of 298k in February beat market consensus of 187k. Our US economist has revised up his NFP expectation from 200k to 250k. Jobless claims hitting a series of record lows all year, combined with one of the warmest Februarys on record, has helped outdoor industries like construction do well. The market now prices a 100% probability of a hike in rates by the Fed next week, and so any USD strength needs to be driven by expectations of a faster pace of rate hikes in 2018.

JPY: Investors sensitive to US yields: Weekly security flow data for last week showed Japanese net selling of 1.13trn of foreign bonds. There will likely be some volatile data in the run-up to fiscal year-end (March 31) but we think there should be more focus put onto country reallocations for Japanese investors, with a potential to shift into higher-yielding assets. Yesterday the Nikkei reported that the Japanese Financial Services Agency will start to audit regional banks who have large exposures in foreign debt. In particular, concerns have been raised about losses made on US Treasuries. The benefits of USD rising versus JPY as US Treasuries sell off are not there if the bank is holding the foreign asset with an FX hedge. This story needs to be watched to see if changing governance may push Japanese banking sector investments locally instead of abroad. Thinking about that flow, it may actually still be bearish for JPY if it puts downward pressure on JGB yields or increases local lending. If the BoJ’s central bank liquidity turns into ‘high-powered liquidity’ as the banks lend more to businesses, this would help local inflation and thus weaken JPY. Selling EURGBP over the ECB: Today’s market focus will be on the ECB press conference and specifically how much more confident Draghi is about the recovery in inflation. Should the market, against our economist’s expectations, perceive today to be a hawkish outcome, then we think that EUR will trade in two stages. Initially EUR should rally as bond yields rise (with our limit being at 1.08). However, the bond yield rise may be disproportionate across the region, causing spreads to widen. The spread widening is not a good sign for the monetary union as it will highlight further the divergence in economic data performance. EUR should fall as markets realise this and EUR becomes inversely correlated with peripheral spreads. On the UK side, Nicola Sturgeon has suggested to the BBC that a second independence referendum in autumn 2018 would make sense but still stresses thatno final decision has been made. This story adds to our bullish GBP view since it may bring Theresa May’s approach to the Brexit negotiations away from the ‘hard Brexit’ and towards the middle to accommodate Scottish views. We think that Brexit risks are largely in the price and still like selling EURGBP, with a stop at 0.88.

The Australian bonds continued to slump Wednesday as investors cashed in profits after the Reserve Bank of Australia (RBA) remained on hold at the latest monetary policy meeting held yesterday, hinting at no further policy easing in the near-term.

The yield on the benchmark 10-year Treasury note, which moves inversely to its price, jumped nearly 5 basis points to 2.87 percent, the yield on 15-year note also climbed nearly 5 basis points to 3.28 percent while the yield on short-term 1-year traded 1 basis point lower at 1.61 percent by 05:00 GMT.

The RBA has left the official cash rate on hold for a sixth straight meeting on signs the economy is strengthening and business investment has picked up. The decision to maintain rates at current levels comes as the labor market, inflation and wages growth continue to stutter at the same time that growth has recovered, housing prices continue to surge and business and consumer confidence hover around multi-year highs.

Further, the central bank expects the economy to grow around 3 percent annually over the next several years on steady consumption growth and expanding resource exports.

 

Commodities, US Oil rig count, Copper strikes

US rig count: Baker Hughes data shows that the US oil rig count increased by 6 over the week, taking the total number of active rigs to 597. Since the start of the year, the number of rigs has increased by 72, while from the lows in May 2016 the number has increased by 281. 

WTI speculative position: Over the last reporting week, speculators increased their net long position in WTI by 30,951 lots to leave them with a record net long of 390,338 lots. This sizeable position does continue to pose a risk to the market, although with the right catalyst. 

Escondida strike: Having failed to meet last week, BHP and unions at Escondida copper mine are scheduled to meet today, in the hope of moving closer towards an agreement. Workers at the copper mine have been on strike since the 9th February, which has continued to offer support to the copper market. 

Philippine mine closures: There is still plenty of uncertainty around the closure and suspension of mines in the Philippines. The president will now be reviewing the environmental secretary’s decision, while miners continue to fight the order. The Philippines in the largest nickel supplier in the world. 

Indian sugar production: Cumulative sugar production in India since the beginning of the season to mid-February totalled 14.7m tonnes according to Indian Sugar Mills Association. This is a 15% decrease YoY, and with a number of mills already shut for the season, production will be significantly lower YoY. We continue to believe that India will need to import around 2m tonnes of sugar for domestic needs this year. 

Corn spec position: Speculators continue to build their long position in the corn market, with their net long increasing by 56,527 lots to leave them with a net long of 85,360 lots. This is the longest speculators have been since July 2016, and expectations of reduced US acreage next season has been positive for sentiment. However this is some distance off still, and with good crops expected from South America this season, we would expect the upside in corn to be limited. 

Global FX Stories, USD, EUR, JPY and PLN

USD: Focus turns back to the domestic drivers The lack of focus on the currency manipulation rhetoric’s during the Trump-Abe meeting on Friday (note JPY was one of the currencies mentioned recently by the US administration as being unfairly kept weak) should allow USD to re-focus back on its domestic drivers. Bar the expectations of the details about the ‘phenomenal’ Trump tax plan, markets will be closely watching Chair Yellen’s testimony to the House (Tue) and Jan CPI and Jan retail sales (both Wed). With market pricing rather benign 30% probability of Fed March rate hike and much cleaner long speculative USD positioning, the bar is not very high for USD to record more gains this week, particularity vs low yielders such as EUR and JPY.

EUR: EUR/USD to move towards the 1.0500 level Very calm week on the EZ data front suggests that EUR crosses will be driven (a) news/data from elsewhere (b) potential additional increase EZ political risk. On the latter, EZ political risk premium pricing in EUR remains still very benign, allowing for more downside to EUR. We look for EUR/USD to move towards the 1.0500 level this week.

JPY: Scope for USD/JPY to resume its upside Japan Q4 GDP modestly disappointed the consensus expectations (0.2%QoQ vs 0.3% expected). Yet with the little scope for material shift in the BoJ policy stance in coming months, the driver of USD/JPY remains the USD side of the equation. Following the non-negligible adjustment in USD/JPY lower since the beginning of the year, the potential for higher UST yields and cleaner USD/JPY speculative positioning (ie, the speculative community is currently net short USD/JPY) point to USD/JPY re-testing the 115.00 level this week.

PLN: Boost from Jan CPI to provide a good entry point to short PLN Our economist look for an above censuses Polish Jan CPI (1.8%yoY vs 1.7%). While this may provide a boost to PLN, the zloty gains are likely to be short lived given the already stretched EUR/PLN levels. Equally, we don’t expect the Friday’s PiS leader Kaczynski’s confirmation on a dilution of CHF bill (see Snap) to lead to persistent PLN gains due to: (a) with PLN no longer pricing a domestic political risk premium (on short term basis), the Friday’s good news should not lead to material re-pricing of PLN risk premium; (b) the EZ politics and negative spill over into CEE FX should kick in as we approach Dutch and French elections. We retain negative PLN view and stay long EUR/PLN.

Commodities

                    Energy

  • Specs reduce WTI net long: Having held a record net long of 379,927 lots previously, speculators over the last week reduced their long by 20,540 lots to leave them with a net long of 359,387 lots. A further build in US crude inventories, along with US production creeping higher could see further liquidation by specs. Although OPEC and non-OPEC production cuts are a counterbalance to this. 
  • US oil rig count: According to Baker Hughes data, it has been another week where US producers have added to the rig count, rigs increased by 8 over the week to total 591. This is the highest number of active rigs since October 2015. 

Metals

  • Indonesia copper output: Copper miner Freeport-McMoRan has suspended production of copper concentrate at its Grasberg mine in Indonesia. The miner has not been able to export since 12th January 2017, and needs to apply for an export permit. As a result of not exporting, storage is full. 
  • Chinese iron ore imports: Strong Chinese imports continue to support iron ore prices, which traded to the highest levels seen since 2014 last week. However robust imports have seen inventories in the country build to record levels. As of the end of last week total iron ore port inventories in China totalled almost 127m tonnes, up from around 80m tonnes in September 2015. 

Agriculture

  • Russian sugar output: Over the 2016/17 season, Russian sugar production is expected to reach a record 6.1m tonnes, which has seen the country become a more important exporter. Expectations moving forward is for production to grow further. The head of Ros Agro says output could reach 6.3m tonnes in the upcoming 2017/18 season. 
  • Ivory Coast cocoa exports: According to reports, local cocoa exporters in the Ivory Coast are unable to fulfil about 350,000 tonnes of contracted exports. These local exporters have come under pressure with falling cocoa prices, defaulting on these contracts would see the industry regulator in the country having to re-auction this cocoa for export. However someone will have to bear the loss, given that the cocoa will have to be re-auctioned at lower prices. 

USD Strength trying to recover, ECB committed to low real rates, Japan bond buying and AUD outlook

Conditions for the USD rally have improved with three events becoming topical. First, ECB’s Praet and the BoE have made it clear that Europe is not aiming for early rate hikes and are comfortable with seeing real rates dropping further from here. Secondly, Japan’s money market operations have underlined its commitment to control the JGB yield curve, which we view as a step towards Japan’s commercial banking sector regaining profitability and thus creating conditions for a faster money multiplier growth. Within an environment of DM reflation, the side effect of this policy is JPY weakness working via widening rate and yield differentials. Thirdly, China tightened its monetary policy by 10bps overnight, reported slower January manufacturing activity, but fixed the RMB weaker compared to market expectations. USDCNY came off a moderate 0.2% while USDCNH rallied this morning by 0.24%.

 The next hurdle for the USD to overcome is the Fed. Wednesday’s interest rate statement left the impression it may be operating behind the curve by acknowledging that inflation ‘will’ reach 2%, but refusing to send a signal to turn March into a ‘live meeting’. Today’s release of the US labour market report is only important in respect of impacting the FOMC’s mind set. Concretely, a strong labour market report helping the Fed by sending hawkish signals will be USD supportive. However, should the Fed stay dovish then a strong US labour market report may only steepen the US curve, but do little to support the USD. Fed chairwoman Janet Yellen’s testimony on 14 February will be a key risk event. In between, today the Fed’s voter Evans will speak on the economy and monetary policy.

The BoE has upped its growth forecast, has kept its inflation forecast little changed and has maintained its neutral policy bias leading to sharp GBP losses. The BoE left the impression of possibly underestimating inflation risks and by doing so it may be able to run accommodative monetary conditions for longer. While the National Institute of Economic Research sees inflation reaching 4% by the end of this year, the BoE has found additional labour market slack allowing it to project wage growth staying muted. The BoE sees inflation averaging 2.7% this year and 2.6% in 2018, little changed from its November projections. Its long-term economic projections are based on the assumption of rates rising early 2019, differing significantly from current market pricing, and suggesting rates going up by 25bp by August 2018.

ECB’s Praet as presented an equally dovish message suggesting that the recent upward trend in inflation was due to temporary factors including energy and food prices and the ECB would continue to “look through” factors contributing to the underlying trend.” With the Maastricht contract framework becoming less effective and EMU remaining fragmented in fiscal and regulatory terms (lack of fiscal and banking union) the ECB has to conduct policy according to the needs of its weakest link (see here for more). Italy seems to fall into this category. EMU’s equity markets and volatility curves have steepened recently. While some of this steepening may be related to upcoming general elections in Holland and France, the recent widening of EMU sovereign bonds spreads has added to concerns. EURUSD is a sell at current levels with a stop at 1.0840 and a target 0.9700. The risk to this trade is Italian data turning better, but given the continued weak credit creation by Italian banks we regard this risk as minor.

Some investors link bullish AUD strategy into a global reflation framework. Associating reflation with rising commodity prices may provide support to this idea. However, reflation and commodity prices are unlikely to stay linked for long should our view prove correct that part of DM is developing into a cost push inflation environment comparable to the 70s. The 70s did see precious metal strength while other raw materials stayed lacklustre. Opposite, the deflationary past 15 years were accompanied by periods of excessive raw material strength. So far, the CRB Rind has kept on rising, but with China tightening its policies while its manufacturing sector is weakening (Jan Caixin PMI eases to 51.0 from 51.9) it may not take too long from here to see commodity prices topping out.

USD technicals and DXY strength, ECB and EUR

The USD has experienced a powerful rebound re-establishing post US election relationships between the performance of risk assets and US bond yields on the one hand and the USD on the other hand. Importantly, suggestions according to which US anti-trade rhetoric would increase US inflation but reduce US growth prospects have been dismissed by yesterday’s price action. A stagflation scenario would push nominal bond yields higher, the curve steeper and the USD lower, which was in line with price action witnessed earlier this week. However, stagflation would undermine shares too, but the share market rallied towards new highs, allowing us to express confidence in our bullish USD call by adding bullish positions to our strategic portfolio.

USD technicals have dramatically improved. The DXY has printed four marginally new lows earlier this week with Wednesday’s low not finding confirmation in the 9-day RSI and creating a ‘positive divergence’. More important has been the BoJ stepping into markets increasing its Rinban operation in the 5-10 year JGB sector from JPY410 to 450bln in line with our projection expressed here yesterday. This operation has steepened the JGB curve further with 40 year yields reachingnew cycle highs which should help banks and insurance companies to boost their profitability, but it does increase the chances too that the BoJ expands its operation into the long-end of the curve trying to reduce volatility. Keeping JGB volatility low must be one of the key BoJ policy objectives to allow commercial banks to shift their JGB holdings accounting for 17% of total assets from the negatively yielding part of the curve into positive yield territory without increasing the critical VAR.

Falling DM productivity rates in conjunction with demographics boosting savings relative to consumption and globalization has allowed DM real rates to decline over the past three decades. Lower real US rates were an important factor driving US financial and real sector investment abroad providing the fuel for the EM economic growth engine. This trend may terminate now with globalization slowing and the demographically related increase of savings relative to investment peaking. US productivity is the next factor to look at. Productivity has a structural and a cyclical component. Higher investment will boost cyclical productivity suggesting US capital demand and US real rates going up, both working in favour of the USD.

The EUR will not withstand these pressures either and we reiterate our view calling the EUR the ‘mini JPY’. Inner EMU sovereign bond spreads have widened with Italy, Portugal and Greece taking the lead, pouring cold water on the idea the ECB may head towards an early reduction of its monetary accommodation. Greece and its EU creditors continued to struggle on Thursday to reach agreement on a key review needed for Athens to unlock new loans and avoid a descent into renewed financial turbulence. Italy’s economy struggles with its real rates which are too high relative to its ailing investment outlook, leaving the ECB with little other choice but to create conditions under which Italian real rates can fall. Tightening its policy too early may come with too high costs putting Italy under even more stress. Hawkish comments from ECB members representing core countries (Mersch, Weidmannn, Lautenschlaeger) may be dismissed as the ECB directorate runs the show and here dovishness has prevailed. The EMU’s core may develop inflation while Italy may prevent the ECB from acting ahead of the curve, creating an ideal environment for EUR weakness.

 

Global equity rally fueled by the US, reflation trade sets in 

The anticipated reflation tradehas set in, with shares and DM bond yields breakinghigher, but USD has not participated in this move. Instead, USD has decorrelated from the performance of the US bond market, drifting lower while the US 10-year bond yield has breached the 10-year 2.52% technical barrier. The government’s monthly sale of US$34 billion in five-year notes drew the weakest demand since July, based on the number of bids received relative to the amount offered, seeing investors switching into equity holdings. Cyclicals such as transportation and financials have led to the upside, suggesting the market making bets on US economic expansion gaining momentum. In this sense the current equity market rally is different to the liquidity-induced, dividend-focused rally seen for most within the post Lehman world. The new structure of this equity market rally makes sense for an economy having closed its output gap now entering into a new area of re-building its capital stock.

China Economics – PPI jumps further in December

  • China’s PPI accelerated to 5.5% in December, against its previous reading of 3.3% and Bloomberg consensus of 4.5%. CPI inflation moderated to 2.1% from 2.3% previously.
  • The improved PPI is supportive of corporates’ cash flow and profitability. The PBoC may be able to pay more attention to financial risk management issues. Room for the PBoC to guide up the level and volatility of interbank rates is getting larger.
  • Current CPI inflation is still below the government’s upper bound. This offers room to keep overall credit and monetary growth at a steady rate for the time being.
  • In our previous note, we expected the PPI to overtake 5%. Based on the latest information, we believe the PPI is likely to increase further towards 6.5% in the coming months. The key risk to China’s inflation dynamic is an increase of consumer inflation expectations. This also offers motivation for the PBoC to introduce tightening elements for its policy setting.

Eurozone: Political clouds, Yields and Rates

While the economic momentum is clearly accelerating, the European political outlook continues to be highly uncertain in 2017. A new terrorist attack in December, this time in Berlin, is likely to play into the hands of populist parties, potentially jeopardizing free movement within the European Union. Likewise, it seems realistic to expect that the rise of populism in Europe will push traditional political parties to play a more nationalistic card to secure victory in the upcoming elections. That implies that 2017 is unlikely to see much political and economic coordination on a European level. Besides, Brussels will be completely absorbed by the difficult Brexit negotiations, which is likely to put all other pan-European initiatives on the backburner. For the time being financial markets seem to be taking it in their stride, but that cannot be taken for granted in 2017.

The outcome of the Italian referendum could have been a bombshell, but there wasn’t much of an impact on financial market sentiment. That said, the uncertainty has not disappeared, as once the electoral reform is approved, elections are likely to be called by June. As for the banking troubles, a solution seems to be in the offing, with parliament approving a €20bn fund to prop up banks. A precautionary recapitalization of Monte di Paschi is now all but sure, although it could take until April to put in place a scheme on the back of EC approval. At the same time retail junior bond holders will be compensated after a bail-in, to avoid populist parties capitalizing on the ill-fated small savers. Meanwhile in Greece, the European problem child, the involvement of the IMF in the third bail-out plan remains quite uncertain, while tensions between the Greek government and its creditors flared up in December. Short-term debt relief measures, which had been decided in early December, were withdrawn after a unilateral decision of the Greek government to hand out a pre-Christmas bonus to retirees. We believe that debt relief will be granted after all, but that it will remain a very difficult process.

The Eurozone economy is starting 2017 on a strong footing. December saw an acceleration in manufacturing activity, with the composite purchasing managers index (PMI) hitting its highest level since April 2011. With new orders picking up rapidly (foreign demand has been boosted by a more competitive euro exchange rate), activity is unlikely to slow in the short run. The message is equally positive when one looks at the household sector. As unemployment continues to fall and wages are now slowly picking up, consumer confidence ended the year on a high note, which augurs well for consumption in the first quarter. The pace of the recovery is speeding up, with the €-coin indicator, a monthly estimate of the underlying GDP growth pace, rising to 0.57% in December. Without the potential political uncertainty, GDP growth could hover close to 2% in 2017.

However, in our forecast we incorporate some political turmoil (given the heavy electoral calendar and the rise of populism). In addition 2017 will see fewer working days than 2016, which might also be a small drag on growth. We therefore now have a 1.5% growth projection for 2017, followed by 1.7% in 2018. In December headline inflation increased from 0.6% to 1.1%, while core inflation increased moderately to 0.9% after months of stagnation at 0.8%. We have already suggested that for a few months businesses have been feeling confident enough to increase output prices. However, it will take some time before this translates into higher consumer prices.

On top of that, we don’t believe that the oil price rally has much further to run, meaning that the initial inflation effect will peter out in the course of 2017. Inflation is clearly trending higher, but this is likely to be a very slow process, as witnessed by the painfully slow bottoming out of core inflation. After the decision to lengthen its QE programme until December 2017, the ECB seems to be done easing. But we still believe that there will be a new lengthening of the programme into 2018 to allow for some tapering. Although by mid-2018 the ECB should have stopped adding to its bond holdings, the upward bond yield pressure from a strengthening economy and slowly rising inflation will, to some extent, be capped by the continuing bond purchases.

 

Global Rates Mild reflation, Wild Politicisation, US Yields and Outlook

In a ‘post truth’, ‘fake news’ world, economic forecasters are troubled. After the political shocks of last year, the financial markets are banking on ‘peak populism’ this year. But the promise of mild reflation from the new Trump Administration in the US could easily be upended if his strong arm tactics backfire. And while polls in the Eurozone suggest that mainstream political parties will prevail in forthcoming elections, the question is at what price. The markets have taken on trust that incoming President Trump will deliver on his progrowth agenda. But the combination of fiscal reflation and deregulation will take time to deliver. Meanwhile, growth will face headwinds from the uplift in bond yields and the potential for Trump’s hawkish Cabinet to deliver on his hawkish rhetoric on trade. The US economy has regained the momentum it has lacked since 4Q15 with a strong 3Q16 GDP figure. We expect this to continue, with investment playing a stronger role than it has for years. But inflation is picking up too – providing the Federal Reserve with a headache in terms of further rate hikes, or instead shrinking its bloated balance sheet later this year. Any mid-year dip in bond yields will likely give way to rises later in 2017.

 For the Eurozone promising economic signals are overshadowed by the potential for fresh political shocks. Markets are drawing comfort from polls that suggest that it will be much tougher for populists to take power in the Netherlands, France, Italy or Germany. However, even if the mainstream prevails, it may only do so by leaning towards populist themes and backing off on closer integration. The UK economy shrugged off the ‘Brexit’ vote in 2016, benefiting from the inadvertent easing delivered by a big fall in sterling. But 2017 is looking more challenging. With Article 50 set to be triggered in the next three months, worries about the prospects of a deal may see businesses choosing to sit on their hands. At the same time, household spending power will be squeezed by rising inflation, leading to a marked slowdown in growth. This is likely to become the BoE’s main concern rather than inflation. In Japan the Bank of Japan (BOJ) is enjoying success in resisting the global upturn in bond yields, which has had the additional benefit of pushing the Japanese yen lower by around 9% on a trade-weighted basis, and the US dollar above the JPY120 barrier. With that stimulus in hand, the Japanese government is likely to hold off until the second half of the year before considering a further fiscal impulse.

The US dollar has largely held onto its late 2016 rally. We expect further gains through 1Q17 as the market further adjusts to the prospect of looser fiscal/tighter monetary policy in the US. EUR/USD could be dragged close to parity during this period, but our year-end forecast of 1.12 is above consensus. This is based on the view that a Trump Administration will not want the dollar to strengthen too much and that an undervalued EUR can recover. Japan aside, global bond yields are being led higher by the US. Firming economic data, a re-evaluation of economic growth post-Trump and a more aggressive Fed have driven up inflation expectations and real yields. Both aspects could rise further in our base view, with the major downside risks being failure of Trump to deliver growth promises, and political disruption stemming from Europe.

2017 could be transformational for the US. Questions about the aggressiveness or otherwise of trade policy will hopefully be answered. And uncertainty about the degree of any fiscal easing will also likely dissipate. Against this backdrop, the Fed will be trying to balance its cautious tightening, against growth and inflation that may be substantially stronger than its own forecasts. 2016 ended with market optimism about expansionary fiscal policy from an incoming Trump administration. The macro backdrop also ended on a more supportive note. After a soft-patch lasting three quarters, the final 3Q16 GDP growth estimate was an impressive 3.5%. This will make very little difference to the full year figure, finishing the year on a strong note is a very good way to ensure healthy figures for 2017.

We are forecasting growth for the US of 2.8% this year – substantially in excess of the 2.2% forecast shown in January by the Bloomberg consensus. Still absent, however, is a clear recovery in investment. Business investment recorded another negative score in 3Q16. But optimism is growing for a tax amnesty for America’s multinational firms and their $2tr-plus of retained overseas earnings. We expect this policy to be made contingent on some demonstration of increased domestic investment spending. The prospect of lower corporate tax rates could provide a further lift. In contrast, structures investment has shown a big improvement – a trend we think will continue. The rise in oil prices in recent months, helped by OPEC’s announced production caps, is lifting an already-rising rig-count, and with it structures investment. We retain some caution with respect to the scale of fiscal expansion that President-elect Trump will announce in February in his “President’s budget”. The timeline for such expansion is not a rapid one, and much of the benefit from whatever Congress actually decides to adopt will likely not emerge until late 2017 or early 2018. However, if that extends the growth spell from 2017 to 2018 (albeit at a rate closer to 3% than the 4-5% Trump suggested during the election campaign), whilst not generating too much alarm in terms of inflation or debt expansion, that would not be a bad thing. Longer dated bond yields will likely rise, but we think increases will be limited, and potentially suffer a mid-year pull back from higher levels as impatience over the delivery of fiscal stimulus plays with market nerves.

The outlook for trade, which is potentially far more threatening to US growth, remains concerning. Trump’s senior trade appointments include Wilbur Ross (Commerce Secretary), Peter Navarro (Head of White house National Trade Council), Robert Lighthizer (tipped for Head of US Trade Representative Office) and Dan DiMicco (transition team trade advisor). With a trade team that is heavy in terms of China critics, this is the big downside risk to both US and global growth prospects. Our base case is that this will be more of a war of words than a full blown trade war. Trump has already seemingly managed to influence Ford’s investment decisions to Michigan instead of Mexico through Tweets alone. And whilst aggressive rhetoric may weigh on the USD, that may not worry the incoming administration if it helps support US manufacturing.

The Fed threw a forecasting grenade into the mix at the end of 2016, signalling that it saw scope for three rate hikes in 2017. Like markets and the bulk of economic forecasters, we have our doubts. But while most forecasters can fall back on moderate growth forecasts as an excuse for Fed inaction, we think that the Fed will hike again in 1Q17 and potentially 2Q or 3Q17, before switching its attention to its balance sheet. The Fed has said repeatedly that it would not change its re-investment policy until the rate ‘normalisation’ process was well underway. “Well underway” probably equates with a Fed funds range of 1.0-1.25% – just two hikes away. In effect, this will remove from the bond market a substantial “buyer” each month, pushing up yields. In the meantime, we see evidence that the Fed is adjusting its holding of assets from longer to shorter dated assets, in a sort of “reverse twist” operation that is consistent with a steeper yield curve. If this becomes the Fed’s preoccupation in late 2017, there will be little need for additional tightening by conventional rate hikes, and we envisage a pause in rate movements in late 2017 and early 2018 whilst the market gets used to the new environment.

 

China tightened its checks on personal forex purchase

The SAFE introduced new administrative requirement for personal foreign currency purchase in China. Specifically, an extra form filling process is now required to declare the purpose of the foreign currency purchase. There is no change to the annual 50k USD FX purchase quota.

? We expect strict implementation of the new requirement and strong reinforcement by the SAFE and all of the commercial banks.

? Combined with the tightening rules on corporate’s ODI, we expect these measures to help ease some of the pressures on China’s FX reserves.

? However, with monetary policy still too loose and Chinese asset diversification rate still low, capital outflows are likely to continue. We maintain our forecasts for USDCNY to rise to 7.33 over the year ahead.

Tightening checks on personal FX purchase procedure The SAFE introduced new administrative requirement for personal foreign currency purchase in China. Specifically, an extra form filling process is now required to declare the purpose of the foreign currency purchase. There is no change to the annual 50k USD FX purchase quota.

In addition to the extra form filling requirement, the PBoC has also tightened the regulation on all of the bank transactions broadly in an announcement made earlier. Some of the elements effectively tightened the FX transaction too. For example, financial institutions have to report to the Center of anti-money laundering for “onshore transactions between individual account to other accounts if the amount is above US$100k equivalent per transaction or per day”. The reporting threshold is set at US$10k for cross border transactions.

May help ease pressures on FX reserves in the short term This follows a series of measures towards corporates’ outward. Combined with recent NDRC’s pledge to attract more foreign investment, we think the message is clear that the top authority in Beijing is paying substantial attention to FX reserves and CNY dynamic. However, the key risk is that participants may be able to find other loopholes if there is underlying need. Recent experience in other areas, e.g., shadow banking, suggests that players tend to find new channels fast, too. Over the longer term, the fact that Chinese households still have little relative allocation to overseas assets would be one of the key factors for more overseas allocation, and an increase of income per capita tends to suggest more demand for global services, too. On the other hand, successful reforms in the domestic economy, if they take place, will help China to attract more FX inflow.

USD Strength, China and Yuan Weakness, AUDUSD

Despite being with the consensus we underline our bullish USD view, but unlike November/December when the USD rise was mainly driven via low yielding currencies seeing USDJPY gaining 15% within seven weeks, we put our bearish focus towards Asia and Australia. The dominance of USD strength prevented the AUD from benefiting from rising commodity prices and the associated terms of trade improvement. Going into December, the AUD started to underperform other currencies, which we have partly exploited running AUD shorts against the CAD and the NZD.

First, improving terms of trade may not necessarily lead to better investment spending should Australian companies regard higher commodity prices as only a temporary development. Indeed, mining investment plans have not picked up as much as terms of trade have. During the 2009/2012commodity boom, Australia’s mining sector had built up overcapacities putting the return of equity during the following commodity slump under additional downward pressure. Nowadays, mining companies seem to be more careful, improving corporate cash positions instead of engaging in new investment activities. Hence, better commodity prices fail to develop growth supportive second round effects.

Secondly, there are two major risks for the global growth outlook and both of these risks will not bode well for Australia. Global trade growth has stalled since 2013, which may be linked to trade growth reaching its natural limitations as global imports and exports reach 60% of global GDP. This observation is already a negative for overcapacity-running and manufacturing oriented economies, of which most are located in Asia. Should the incoming US administration provide new trade hurdles it will hit trade surplus countries most. Note, China’s State Information Centre suggested a one-off devaluation of the yuan exchange rate should be considered to maintain the currency’s stability at a balanced level. These comments from the State information Centre may have to be seen within the context of the current trade discussion in the US.

The other risk is related to the underlying strength of the Chinese economy. Unlike January 2016 when most of the markets’ risk-focus was on China, investors are looking in other directions when trying to locate potentially upcoming market risk events. This morning’s release of a strong Caixin report (51.9 in December from November’s 50.9) showing growth momentum in China’s manufacturing sector in December posted the strongest monthly upturn since January 2013and seems to justify the view of China growth risks as not significant. Indeed, over the past year the Chinese economy performed better compared to downbeat expectations, supported by loose fiscal and monetary policies.

China’s monetary policy may from now on act less as a growth support. Instead, currency outflow pressures and ambitious house price valuations suggests a tighter PBOC policy approach, thus leaving, within an environment of lacklustre private sector investment activities, fiscal policy as the only game in town supporting the Chinese economy. Meanwhile, markets will carefully examine if the State Administration’s measures, effective from 1st January 2017,have the desired impact to reduce RMB outflow pressures. These measures include citizens not using the USD50k per person quota for purchases of property, securities, life insurance or investment-type insurance.

Last year, the AUD often appeared on top of many selling recommendation lists. Not so this year, where we feel markets may not recognize the entire AUD downside potential. For starters, AUD-USD sovereign yield differential is at historic lows. Hence, the AUD qualifies less as a ‘yielding currency’, bearing in mind that Australia’s net foreign liability position has further deteriorated. Its banking sector has reduced its whole sale funding exposures since the financial crisis, but within an international comparison its banks still feel the impact of rising USD funding costs more than most other G10 banking sectors. An interesting read is provided by the most recent BIS release examining the international impact of changing funding costs of the USD, EUR and the JPY. Countries with high foreign funding needs should be most exposed within an environment of rising international funding costs. Add to this mix global trade and Chinese growth risks and the outcome should be a much lower AUD.

Post ECB, EUR, Scandi FX and CEEMEA

EUR: Draghi achieving the unachievable

Despite reducing the pace of monthly ECB QE asset purchases, Drahgi’s dovish stance and technical adjustments to the QE programme actually weighed on EUR (as short dated German Schatz yields declined). More downside to EUR/USD due to EZ politics and higher UST yielders in coming months. The undervalued SEK is the main beneficiary in the European FX space. More uncertainty to PLN and HUF and scope for more downside to EM high yielders.

The ECB extended its QE programme by three more quarters until end-2017, yet it reduced the pace of purchases from €80bn to €60bn per month. Although EUR/USD initially rallied, it is now 1% lower. This is because: (1) Draghi did whatever it took to downplay the tapering concerns (tapering was apparently not discussed by the Governing Council); (2) ECB keeps in place the option to increase the monthly pace of QE purchases again should it be necessary (ie, if the risk to inflation increases) ; and (3) technical adjustments to the QE programme – decreasing the minimum maturity of bonds being purchased from 2-years to 1-year, scrapping the depo floor limit on these purchases.

Points (1) and (2) imposed a limit on the extent to which longer dated bunds sold off, which in turn limited the upside to the EUR as the longer dated yield differential between the US and Eurozone did not narrow materially. Point (3) has actually put an active downside to the EUR as it has led to a non-negligible decline in short-dated German Schatz yields, a wider US-EZ short dated spread and, hence, lower EUR/USD.

The above dynamics are clearly evident within our EUR/USD short term financial fair value model, which identifies the current EUR/USD levels as fair (Figure 1). In fact, the short-term EUR/USD fair value declined by more than 1% since yesterday due to the decline in short dated EZ yields.

More downside to EUR/USD in coming months

With Draghi being close to 100% successful in avoiding the taper-like EZ bond sell off and in fact generating lower short-dated EZ yields, the EUR/USD upside should be very limited in coming weeks/months. We look for the EUR/USD to move towards the 1.02 level in 1Q17 as: (1) the busy EZ political calendar weighs on the EUR via an increase in EUR risk premium; and (2) there is potential for another leg in UST yields higher in 1Q17.

Today’s ECB decision is favouring SEK, but adding some downside to G10 and EM higher yielders, while rising uncertainty about CEE FX.

SEK – Potential for less dogmatic Riksbank

SEK has been one of the key beneficiaries of today’s ECB announcement as the lower pace of ECB asset purchases suggests that Riksbank should ease its dogmatic approach. While we still expect the Riksbank to extend its own QE programme into 1H17 (by SEK25-30bn in total), there may be a less of a need for a rate cut. Importantly, SEK remains still meaningfully undervalued.

Risks to higher yielding FX and CEE currencies

The ECB reducing the pace of asset purchases should on the margin take some support away from G10 and EM high yielders as: (1) less extra liquidity will be pushed into the system; (2) potential for higher core yields. Hence, the negative knee jerk reaction in AUD and NZD in the G10 FX space.

In the EM, currencies such as TRY, ZAR or MXN are vulnerable. In our view, TRY remains particularly at risk given its high sensitivity to core yields, tricky domestic politics, concerns about the CBT credibility and the very high bar for an emergency rate hike. We continue to favour long RUB/TRY positions given RUB’s lower vulnerability to higher core yields.

In the CEE FX space, steeper bund yield curve and higher longer dated bund yields put PLN and HUF at risk. Moreover, should the lower pace of ECB bond buying increase concerns about the Italian banks recapitalisation process and rise EUR risk premium, PLN and HUF are likely to suffer. Overall, it will be a very tricky 1H17 for the forint and the zloty.

USD Bond Markets, Emerging Markets FX, GBP recovery, ECB

The USD bond markethas provided the signal for a USD downward correction. On Monday we discussed that US bond yields had risen too far, too quickly.Late last week volumes were higher for bond option investors to sell (put) rather than buy (call), reaching levels which in the pasthave signalled markets correcting their recent surge towards higher yields. While this extreme has come down somewhat, we still think there could be a pre-Christmas USD correction, which has been supported by China taking measures to curb FX outflows.

From its November 24 top, the Fed’s broad USD indexhas lost 1.3%, with most of the decline seen over recent trading days. In line with our projections, ithas been high-yielding EM currencies benefiting most from this USD correction, which makes sense with downward correcting US nominal bond yields pushing US real yields lower too. US real yield is the most important ‘external’ variable steering the performance for high-yielding EM FX. Over the course of the next couple of weeks we think this USD downward correction has further legs to run, with FX markets continuing to take the lead from the US bond market. Within the G10 we continue seeing value in GBP and CAD.

GBP has been helped with the UK government showing increasing sensitivities to avoid a ‘cliff edge’. Yesterday, PM May agreed to publish her negotiation plans and promised that MPs could vote on the final exit deal. A hard or closed Brexit will be more difficult to achieve under these conditions, suggesting GBP reducing some of its Brexit risk premium. Other ways the Brexit premium could be reduced are via the UK’s Supreme Court asking the ECJ to decide whether Article 50 is ‘irrevocable’ or Britain finding its negotiation enhanced by a possible interpretation of Article 127, suggesting that leaving the EU would not automatically cut the UK out of the single market. While yesterday’s release of weak November industrial production led towards a GBP setback, this morning’s release of a strong RICS house price indicator should provide GBP with some cyclical strength. GBPUSD should see 1.30/31.

Today’s focus will be on the ECB, which may steer its communication towards keeping EMU’s financial conditions stable. Click here for our ECB scenarios. The volatility of the peripheral bond market should be watched by markets. At this critical juncture, where Italy’s banks try to recapitalise any peripheral bond volatility, this would be unwelcome and expose long-term stability risks, with peripheral banks’high claims against their national sovereign providing the link. Note that yesterday Moody’s revised Italy’s outlook to negative. Hence PM Draghi may welcome better economic data releases, but these better data have not compensated for political risks when it comes to sovereign bond market spreads.


Commodities, Energy, Metals and Agriculture
Energy • US crude inventories: API are said to have reported that US crude oil inventories fell by 2.21MMbbls over the last week. The EIA are scheduled to release inventory data today, which the market is expecting will show a decline of 1.5MMbbls. • Chinese coal mine closures: Henan province in China has said to have shut down 100 coal mines over 2016, with a combined capacity of 23.9mtpa. This has seen the province exceed its 2016 target of shutting 22.2mtpa of capacity.
Metals • Record copper spec position: Unsurprising given the strength seen in copper prices recently, speculators have increased their net long in LME copper to a record 78,054 lots. Since the start of 4Q16, the speculative position in copper has increased by 35,796 lots. • Chinese iron ore inventory: Iron ore port inventory in China currently stands at almost 111m tonnes according to Steelhome. Inventories at Chinese ports have increased by almost 6% since the start of 4Q16. While stock levels are fairly close to the record 114m tonnes of inventory seen back in 2014.
Agriculture • Brazilian gasoline price increase supports sugar: Brazilian oil company, Petrobras has announced an 8.1% increase in gasoline prices in the country. The increase has been supportive to ethanol prices, and as a result also sugar prices. With the sugar market in deficit, sugar prices need to remain above ethanol prices so that Brazilian sugar mills allocate more cane towards sugar production. • Larger French wheat acreage: French cooperative, Axereal expects that farmers would have increased wheat acreage by up to 5% YoY. This is a result of farmers switching from rapeseed to wheat, given the dry conditions seen over the rapeseed planting period. A larger acreage for the next wheat crop, should see a recovery from this season, which saw a poor harvest.


AUD GDP Miss, CAD Divergence and OPEC, JPY correction, Interest Rate Drivers of FX
The focus is all on AUD today which weakened,at its most 0.7% overnight,as 3Q GDP contracted by more than the market was expecting (- 0.5%Q, market -0.1%Q). The story is clear – the prior quarter saw an upside surprise as public spending picked up by 4.8%. This couldn’t be repeated again at that pace of spending as the government is worried about losing its AAA credit rating. The result was 3Q public spending contracting by 2.4%Q,nothelping the overall GDP print. Usually the idea of government consumption is to boost business investment too, but as the mining industry is still dealing with a terms of trade shock and restaurants and retail consumption isn’t sufficient to compensate, the ‘fiscal boost’ of 2Q was short-lived. Even after today’s downside surprise, the market is still not setup for the RBA to cut rates next year, which we are forecasting. We believe that AUD remains a sell from current levels, especially on the crosses, with AUD/NZD helped by yesterday’s strong dairy auction.

2014 saw massive monetary policy divergence within the G4 space,allowing USD to rally over 15%. Now we look at the policy divergence in the commodity currency space and see renewed opportunities that are not yet priced in. From the USD side, the market is already expecting 1.7 x 25bp of hikes in 2017,and it is for this reason that we expect a short-term USD pause.From the AUD side,however, the markethas only priced 7bp of cuts by the middle of the year, while our economists expect 25bp. It may now take the RBA to shift its tone from yesterday’s note on downside surprises to growth to explicitly saying that it is worried and could act to make the rates markets reprice cut expectations. The RBA minutes, released on December 20, will now be in focus together with 3Q house price data on December 13. Of course, today’s strong iron ore trading during Asian hours again supports the terms of trade but we don’t think it is sufficient to keep AUD supported. The Canadian rates market is more fairly priced for BoC expectations, we believe. Today’s BoC meeting should help our short AUD/CAD position to break through the August lows.

USD/CAD has started to diverge from the 2y rate differential, but it should still be the monetary policy outlook driving the currency today. In general, our constructive outlook on CAD is based on the idea that the BoC is to keep rates on hold for now and the US economic growth expected in 2017 should spill over to Canada too. Yesterday’s Canadian trade balance was strong on the headline number -1.13b (-1.7b exp.) but was mainly driven by a contraction in imports. Non-commodity export volumes fell by 1.5% and, while this is not great for an economy that is trying to deal with a terms of trade shock and like Norway is also seeing a bit of a fiscal support, the data aren’t sufficiently bad to make the BoC take action to cut rates. This is why we see CAD outperforming on the crosses, with potential for EUR/CAD to cross below its December 2015 low around 1.40. Today we think the BoC could note that there are downside risks to growth, but we think that this isn’t sufficient to make it want to look to cut rates next year. Oil prices need to be on their way back to the US$30s for that to occur. Oil prices remaining fairly well supported after the OPEC deal should also help CAD on the margin. This environment of a tactical pause in USD could see MXN recover too, towards the 20 level. Mexico’s deep water oil auctions went well, with eight out of ten blocks awarded, while very strong bids for bonds issued by state oil company Pemex highlight strong demand for Mexico paper.
We outlined yesterday that we expect a short-term pause in USD’s appreciation, meaning even USDJPY could see a setback towards the 112level. However, we are not participating in the setback and would only use it to add to short JPY positions. This morning the BoJ’s Iwata reiterated the bank’s stance to buy as many JGBs as required to keep the 10y close to 0%, in particular he thinks the bank will need a large scale of JGB purchases to control rates. The expansion of the BoJ’s balance sheet and the interest rate differential with the world should continue to weaken JPY over the medium term. What is now becoming a driver of the story is the development of local risk appetite. Favourable tax policies and an outperforming local equity market should push more investment into riskier assets. Those riskier assets may be outside the country, which would weaken JPY if done on an FX-unhedged basis.

gfx

USD Rally Running Out of Steam, GBP Scenarios

For now the USD rally has run out of steam, suggesting some consolidation before the secular USD bull market may resume its rally, supported by rising relative return differentials. GBP and CAD are best positioned to benefit from corrective USD activity envisaged ahead of Christmas. Despite relative hawkish comments from Dudley yesterday suggesting that the US economy is on its way to reach it dual employment and inflation targets, it would be a surprise to see next week’s Fed action going beyond what we call “a lazy rate hike”.

In many aspects the US economy surprised to the upside, but business investment has remained slow. Lacklustre investment growth has held back productivity, which has fed low wage growth and real income stagnation. Now the incoming US administration envisages a neo Keynesian fiscal programme there is the chance of breaking the low productivity low real income growth link, but this policy requires investment spending getting kick-started. Keeping monetary accommodation in place may help this process. Yesterday, St.Louis Fed President James Bullard suggested that President-elect Donald Trump’s policy could jolt the US economy out of its low interest rate, low productivity regime if his initiatives improve productivity.

The US bond market continues to rule the FX markets. High put option premiums suggest that the recent bond yield increase may be in for some near-term consolidation. The latest IMM report showed investors switching from JPY longs to shorts for the first time since the end of December 2015, supporting our view that USDJPY has developed a short-term top near 114.90 after gaining more than 14% in less than four weeks. However, the anticipated correction may be muted and setbacks into the 112handle offer strategic buying opportunities with a stop placed below 111. Hence our call for a near-term setback must not be confused with our strategic view suggesting USDJPY breaking into the 130 handle next year.

Despite the release of disappointing UK November like-for-like sales (0.6%Y after 1.7%Y), sterling is positioned to extend its recent advance. Our trade of the week is to buy GBP/USD towards 1.31. The Exhibit below illustrates how much GBP has moved away from cyclical indicators such as provided by relative real wage growth. Over recent weeks ithas been the political risk discount combined with easy UK monetary conditions pushing GBP lower. On both ends there is now relief under way. Yesterday, the UK’s Supreme Court started its hearing concerning the government’s wishes to use royal prerogative rights to trigger Article 50. Early in November, the High Court of England and Wales declared that the notification could not be done by royal prerogative. A verdict is expected in early January. An important element of this law case will be whether the Article 50 notification can be revoked. If so, the government would not need to ask parliament for approval, but a potential revocation of Article 50 could open the possibility of the UK staying in the common market should negotiations work against the interest of the UK. Ironically, the Supreme Court could refer the case to the ECJ to find a decision on this case. The FT argues that according to Article 127 of the Lisbon Treaty,an exit from the EU does not automatically remove a country from the common market. Against this background, the GBP risk discount appears too high.

emfx

fx

US Data, OPEC cut, future US issuance and yields driving USD higher

US data beating expectations, OPEC agreeing its first production cut since 2008 and the incoming US Treasury Secretary suggesting to lengthen the bond maturity spectrum have pushed USD higher, with JPY once again falling most among its G10 peers. Global inflation expectations have moved higher, which is USDJPY-positive, but real rates and the US term premium have moved up too. A potential extension of maturity of US government issuance (say via 50 or 100y bonds) pushes the yield curve into even steeper territory, the opposite effect QE had, which had a yield curve-flattening impact. However, recent moves in the US bond market produced higher US real yields too, which suggests two things: USD strength vs.high yield currencies and caution on stock market valuations.

On the first point that higher US real rates should broaden the USD rally well into the high yield currency spectrum, we focus on countries with high foreign funding needs. The USD rally late last year into January was supported by higher real US yields. Within the G10, AUD looks vulnerable from its foreign liability position. The slowing housing market as we mentioned yesterday and today’s data showing apartment prices in Melbourne falling (-3.2%M) at the fastest pace in two years have the potential to release deflationary pressures which are not priced into the AUD rates curve. Second, higher real rates do not bode well for stock market valuation. High put option premiums for bonds and the VIX index having bounced off the lows may suggest taking caution with risk. USDJPY may still move higher, but may no longer be the pacemaker for the USD advance. AUD may be in line for getting it,and should risk correct lower due to higher real yields then KRW should fall too. AUD may be particularly vulnerable too as iron ore prices have started to fall again after Chinese commodity exchanges increased margin limits and reduced the daily trading limits to curb speculation, despite the rise of China’s Manufacturing PMI.

 On the first point that higher US real rates should broaden the USD rally well into the high yield currency spectrum, we focus on countries with high foreign funding needs. The USD rally late last year into January was supported by higher real US yields. Within the G10, AUD looks vulnerable from its foreign liability position. The slowing housing market as we mentioned yesterday and today’s data showing apartment prices in Melbourne falling (-3.2%M) at the fastest pace in two years have the potential to release deflationary pressures which are not priced into the AUD rates curve. Second, higher real rates do not bode well for stock market valuation. High put option premiums for bonds and the VIX index aving bounced off the lows may suggest taking caution with risk. USDJPY may still move higher, but may no longer be the pacemaker for the USD advance. AUD may be in line for getting hit, and should risk correct lower due to higher real yields then KRW should fall too. AUD may be particularly vulnerable too as iron ore prices have started to fall again after Chinese commodity exchanges increased margin limits and reduced the daily trading limits to curb speculation, despite the rise of China’s Manufacturing PMI.

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gfx

OPEC Meeting, AUDUSD and JPY

Today’s market focus will be on whether Saudi Arabia can persuade Iran to make oil production cuts. Expectations going into the meeting are fairly balanced, with crude futures traded in the past 30 days showing that net shorts added are not statistically large. OPEC likely needs a cut if there is any hope for rebalancing in 2017 but   there are increasing risks of there not being a market-friendly deal today. Our favoured way to play for oil price weakness is to sell NOK as the domestic politics and already long market positioning make this currency vulnerable. We prefer to trade USDNOK over USDCAD as Canadian data should remain strong today and the pair become less sensitive to oil price movements this year, driven more by rate differentials.

Australia’s current account deficit position makes AUD vulnerable to global rates and risk sentiment. Today that sentiment may be set by the outcome of the OPEC meeting and US data, but beyond that we need to turn to Australia’s domestic economy. Here we are seeing signs of cracks appearing, with Australian building approvals in October falling at their fastest pace (-12.6%M and -24.9%Y) since the Lehman crisis in 2008. The fall was particularly led by apartments, whose approvals fell by almost 25% in one month. We note that the data can be volatile but do offer a sign that construction companies have already got a lot of building work in the pipeline and may be starting to get worried about future demand.

The rise of US long-end Treasury yields may have taken a breather as markets have fully priced a 25bp Fed hike in December but that doesn’t stop us from buying USD. US economic data continue to come in strong, driven by both the consumer and business sentiment. Yesterday, Conference Board consumer confidence rose to a new cycle high (107.1 after 98.6) and our Capex Plans Index surged, suggesting further upside to investment spending. The momentum in US economic data strength may continue today with the release of ADP employment data and US PCE. We would position for USD strength via buying USDJPY. The fall in the cross USDJPY currency basis is making unhedged foreign investments more attractive. We believe that changing hedging ratios for the Japanese community will drive the next leg higher for USDJPY.

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embonds

Emerging Markets, Mexico, Turkey and South Africa

Long USD positioning remains relatively muted, as our positioning tracker indicates. As such we expect pullbacks in the USD to be reasonably shallow. Nonetheless, we believe that high yield EM currencies will post decent total returns in the near term as real yields in the US are starting to stabilize and commodity prices continue to rally. Typically EM currencies do fine during periods when real UST yields are stable, even as nominal yields move up. BRL is our top high yield pick.  

We maintain our bullish stance on Brazilian assets despite the latest negative headlines on Brazil. Focus has turned to concerns over the 2017 growth picture.  Tomorrow’s IPCA release could also support the trade if it continues to decline, opening the way for an aggressive cutting cycle. We are also watching headlines regarding uncertainty surrounding Temer’s cabinet, as domestic politics remain the greatest risk to our otherwise constructive view on the country, and in particular our long BRL/COP position. Today’s current account data will provide information on the external health of the economy.

The Turkish PM has stated that he believes the CBT will take measures on the TRY’s volatility, which has raised expectations of a 25bp hike at this Thursday’s central bank meeting. The impact of declining TRY deposit rates will mitigate the impact, and with the authorities doing little to change the dominant view in the market that they would prefer to have lower TRY interest rates over the medium term, we doubt the impact of a small rate hike on TRY will be meaningful. Latest data on FX deposit trends suggest that even as the currency depreciates, there is a reluctance of local deposit holders to shift back into TRY, from foreign currency. So far in November, the value of deposits in foreign currency has stayed broadly flat in USD terms.

South Africa continues to take measures that reduce the likelihood of a ratings downgrade and support market sentiment. Following labour market reform measures yesterday, the government has announced plans to delay building nuclear power plants, which will lower the market’s concern about potential contingent liability risks that the projects entailed. This should support ZAR in the near term, though we believe that the base case for the market is already that South Africa will avoid a ratings downgrade. Moody’s announces its ratings decision on November 25th,and S&P is on December 2nd.

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Japan and monetary policy, German Elections, China and AUD weakness

In Japan we see increasing signs of officials moving closer towards our way of thinking in respect of reviving Japan’s money multiplier which is conditional for ‘Abenomics’ to succeed. This morning the BoJ’s Takako Masai suggested that ‘excessive’ falls in interest rates could undermine the economy, a view we advocated in January when the BoJ rushed into its negative interest rate policy. A too flat yield curve not only runs the risk of leading to an deflationary increase of real yields via inflation expectations falling at a faster pace compared to the potential nominal yield decline, a too flat yield curve also tends to undermine bank profitability. A non-profitable banking sector faces balance sheet pressures making it difficult to turn central bank liquidity into high powered liquidity within the economy. It has been Japan’s banking sector balance sheet retrenchment reducing the amount of effective JPY in the system causing the JPY to rally. It was Japan turning towards yield curve management combined with internationally steeper yield curves allowing yield differentials to turn against the JPY.

This morning it isn’t the release of weak Japanese trade data moving the market. The 10.3% October export decline undershoot expectations (at -8.5%). The 16.5% fall in imports allowed net trade to add 0.5% to GDP. The driver for JPY weakness is found in the JGB yield curve, where the 10y now trades at 0.025%, which is above the BoJ’s 0% target. The BoJ should soon enter the market buying long dated bonds to push yield levels back to desired levels. When the BoJ moved towards yield curve management in September it had two incentives. First, to establish moderate steepness in order to allow commercial banks to shift their short-maturity JGBs (16.5% of total assets)holdings into the back end of the curve. This operation is essential to avoid another unwanted decline of broad money supply growth. Secondly, to create conditions for yield differentials to widen in favour of currencies creating an incentive for private Japanese entities shifting capital abroad and thus weakening the JPY. Last week the BoJ moved towards quasi-unlimited QE prioritizing managing the JGB curve. The BoJ has created an efficient mechanism to weaken the JPY according to its needs.

Japan needs to kick start inflation expectations suggesting to us that there will be front loaded JPY weakness. Next to USDJPY we have recommended JPY crosses such as EURJPY and GBPJPY too. The outcome of the French Republican Party primary seeing the former PM Francois Fillon gathering 44% support followed by 28% for Alain Juppé, leaves the impression that the probabilities of a populist party winning may be in retreat. Fillon stands for a Thatcher-like reform agenda. Should he win next Sunday’s second round bailout too then a significant political risk to Europe’s political agenda may be now be sharply reduced allowing the EUR to rally. EURJPY looks lucrative.

Unsurprisingly, Germany’s Merkel will seek a 4th term when Germany votes in late September next year. The lack of credible alternatives makes her re-election likely especially in the context of Germany’s well performing economy. In October, Germany saw a very strong 8.2% increase in tax revenue. However, FinMin Schaeuble is not ready for fiscal expansion. According to ‘Die Welt’ Schaeuble wrote a letter to the European Commission urging EMU sticks to tight fiscal rules suggesting that EMU’s general consolidation efforts have been insignificant so far.

Zeng Xiangquan,head of the China Institute for Employment Research, estimated the size of China’s labor force dropping further in 2016,at the same pace as in 2015 if not faster, with the total decline in the five- year period 2012-2016 amounting to some 20 million workers. China steers its economy from the labour market side. Hence, a falling labour force reduces the need for China growing fast. We maintain our strategic call for AUD weakness. 

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gfx

China PMI, Bond Yields and the USD, RBA decision

China’s October PMI data surprised on the firm side and,although this strength has come with the support of seemingly unsustainable debt acceleration, ithas produced some inflationary pressures which are now expected to spill over into other economies. The Caixin report showed that input costs accelerated at their fastest pace since September 2011 and output charges rose by the greatest extent since February 2011. Rising input costs may have come via rising commodity prices. Coking coal has rallied 200% while iron ore prices have gained 60%.

 Importantly, China is the biggest global exporter and the US purchases 22% of its total imports from China. Hence, rising inflation pressures in China will likely develop a global impact. The chart below illustrates how US inflation expectations have diverged from the performance of USD, presenting a new feature. This observation is most emphasised in the case of USDCNY. Previously,a rising USDCNY steered US inflation expectations lower, but when USDCNY rallied in October, US 5Y/5Y inflation expectations wenthigher and not lower. The once tight inverse relationship between the two broke. There are two explanations which in both cases should bode bearishly for bonds. First, the US may have closed its output gap (all eyes will on Friday’s wage release with the October NFP report), suggesting that USD-induced reductions of import prices no longer compensate for increasing domestic upward price dynamics. Second, China factory gate prices now rising at a faster pace (as indicated by the Caixin PMI report) are no longer compensated by the higher USDCNY.

Seeing nominal DM bond yields risinghas created an ideal environment for USD to rally against low-yielding currencies such as JPY. Importantly, the current USD rally has not yet found the support of higher US real rates and yields. Most of the recent yield lift-off has been driven by US inflation expectations, providing the current USD rally with an unusual feature, namely risk appetite staying relatively supported. Last year, it was falling risk appetite,asset volatility and its destabilising effect on cross border flows convincing the Fed to ease verbally, ultimately undermining the USD rally. Nowadays matters are very different. With US real rates and the term premium within the US bond market showing little movement, the risk outlook seems to remain supported for longer. Hence, the rising USD does not come with a significant tightening of US financial conditions, providing USD with additional space to rally.

USDJPY has to develop a daily closing price above 105.30 to open scope to 107.20 defined by the 200-day MA. EURJPY finds resistance at 115.65, which on a break opens potential to 119.70. Globally rising inflation rates work against JPY. Remember, it was Japan’s ‘exhausted’ yield curve converting inflation into the main variable determining JPY’s real rate level. The BoJ conducting ‘yield curve management’ suggests higher inflation rates translating one-for-one into lower real JPY rates and yields.

The RBA left rates unchanged and projected the economy to “grow at close to its potential rate, before gradually strengthening. Inflation is expected to pick up gradually over the next two years”. AUD rallied, but in light of anticipated USD strength, we view current levels as providing strategic selling opportunities. Mining sector investment is expected to stay weak, leaving the labour market weak as the construction boom runs out of steam. Real estate is overvalued and while China, as Australia’s most important trading partner, is doing ok for now, we see its current unbalanced growth as unsustainable. Last butnot least, Australia’s inflation remains subdued. Hence, it will not take a lot to turn the RBA around once again, in our view.

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resim2
Australia’s producer prices post quarterly rise in Q3, but annual inflation slows sharply
Australia’s national statistics bureau reported Friday that the nation’s producer prices gathered pace in the third quarter, but annual inflation slowed sharply. Australia’s producer price index (PPI) rose 0.3 percent q/q in Q3, following a 0.1 percent increase in Q2, below estimate of economists for a quarterly increase of 0.6 percent.

On an annualized basis producer price inflation slowed sharply, rising just 0.5 percent, compared to 1 percent in the second quarter. Details of the report showed that an increase of 11.9 percent in agricultural prices largely offset declines in the prices received for manufacturing products.

A gauge of intermediate demand rose 0.6 percent in the third quarter on higher prices received for electricity, gas and water supply. Preliminary demand also rose 0.6 percent, official data showed.

AUD/USD largely unchanged on the day, trading at 0.7583 at around 09:00 GMT. PPI data failed to provide any respite for the pair which maintained its offered tone as the greenback extended Fed rate-hike driven uptrend.Australia’s national statistics bureau reported Friday that the nation’s producer prices gathered pace in the third quarter, but annual inflation slowed sharply. Australia’s producer price index (PPI) rose 0.3 percent q/q in Q3, following a 0.1 percent increase in Q2, below estimate of economists for a quarterly increase of 0.6 percent.

On an annualized basis producer price inflation slowed sharply, rising just 0.5 percent, compared to 1 percent in the second quarter. Details of the report showed that an increase of 11.9 percent in agricultural prices largely offset declines in the prices received for manufacturing products.

A gauge of intermediate demand rose 0.6 percent in the third quarter on higher prices received for electricity, gas and water supply. Preliminary demand also rose 0.6 percent, official data showed.

AUD/USD largely unchanged on the day, trading at 0.7583 at around 09:00 GMT. PPI data failed to provide any respite for the pair which maintained its offered tone as the greenback extended Fed rate-hike driven uptrend.

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Australia Q3 inflation data mixed, makes rba’s rate decision next week a close call

Australia’s September quarter consumer price inflation (CPI) data released earlier on Wednesday showed that headline CPI rose by 0.7 percent for the third quarter, beating expectations for an increase of 0.5 percent and was higher than the 0.4 percent level reported in the June quarter.

Meanwhile, underlying inflationary pressures remain soft with the average of the two underlying measures rising by 0.32 percent q/q. In annual terms, core inflation rose by 1.5 percent, slightly weaker than the previous quarter’s 1.6 percent rise. CPI ex-volatiles in seasonally adjusted terms rose a soft 0.3 percent q/q. 

“The RBA would likely be disquieted by the soft tone for underlying inflation. On this data, it is too early to conclude that disinflationary pressures are abating or even stabilising,” said ANZ in a report to clients.

Details of the report showed that significant price rises from fruit (+19.5 percent), vegetables (+5.9 percent), electricity (+5.4 percent) and tobacco (+2.3 percent) were partially offset by falls in communication (-2.3 percent) and fuel (-2.9 percent). It is worth noting that factors pushing up inflation in the quarter, including fruit and vegetables, tend to be volatile and transitory. 

Tradable inflation which accounts for 40 percent of the ABS’ CPI basket rose by 1 percent for the quarter. Non-tradable inflation accounting for the remaining 60 percent of the basket rose by a smaller 0.5 percent.

“Today’s data may not be enough of a downside shock for the RBA. Indeed, we note that while very low, inflation is not inconsistent with the RBA’s forecasts published in August. With some hesitation, we continue to expect that the RBA will lower official interest rates by 25 basis points when it meets next week on Tuesday, but admit that it will be a very close call,” said St George Economics in a report.

AUD/USD spiked to hit new highs for the week at 0.7709 after upbeat CPI data. The pair, however, failed to hold the 0.77 handle and slipped lower to trade at 0.7670 at around 11:30 GMT. Downside currently finds strong support at 50-DMA (0.76). We see weakness only on break below. Next major hurdle on the upside aligns at 0.7740 (trendline).