Carry Trade outlook, VIX lower and risk assets higher, Yellen keeps March alive

Selling EUR and JPY vs EM. As the VIX is approaching the lows again, and with iron ore prices bursting 10% higher over recent days, we continue to see risk currencies performing well, particularly vs the EUR. The drivers of risk support are emanating from the DM world, as China’s monetary conditions are tightening. After Yellen only marginally changed market pricing for hikes this year (52bp to 55bp), the sweet spot of low US real yields, with rising growth expectations, remains, helpinghigh yielding EM currencies to outperform. Our own portfolio includes long MXN, TRY and INR. Even Australia’s data is outperforming, with consumer and business confidence rising. Today’s US retail sales data are expected to be strong on the control group measure. While the USD has become less sensitive to US economic surprises, the data point will still add to the long term picture of an economy that is closing its output gap and so could see higher inflation down the line if companies increase capital expenditure.

China is tightening monetary conditions. New CNY loans grew in January (CNY2.03trn) but were lower than market expectations after the Jan 24 10bp rise in the Medium-term LendingFacility (MLF). The gap between M1 and M2growth has also narrowed for a seventh consecutive month to 3.2% last month from 10.1% in December. The result appeared in property sales data which slowed in January after tightening measures and potentially the Chinese New Year holiday. Data from local housing developers shows that average weekly property sales by area in Tier 1 cities in January fell more than 30%Y and more than 10% week over week. Shanghai and Shenzhen fell even more, according to the China Index Academy.

Cash ready to buy risk. The global impact of China’s tightening of monetary standards may not be seen in FX markets straight away as it is masked by still expanding balance sheets at the ECB and BoJ, rising commodity prices helping growth and now a newly developing point, cash ready to be deployed into assets. The FT is reporting on Swiss banks seeing increasing questions from private wealth on where they can invest cash in a rising inflation environment. Surveys among affluent US investors show they held 28% of their portfolios in cash in 2015,up from 25% the year before. Cash holdings in Europe and Asia are much higher at 40% and 37% respectively. The EUR may weaken in this environment as political risks may increase caution in investment into this region. EURGBP is about to break below its 200DMA at 0.8455.

Yellen did little to change our outlook on the USD, so staying positive vs the low yielding G10 and seeing high yield EM outperforming. The market is now pricing 55bp of hikes this year, including 6bp for March. Interestingly, historical G10 currency sensitivity to US front end yields played out exactly with the JPY and NZD under-performing, while GBP stayed flat. There was perhaps a hawkish tilt to the speech, with our economists noting that Yellen didn’t want to send a signal for a March hike by saying they will assess at upcoming “meetings” rather than “meeting”. Reiterating the FOMC’s stance that they will incorporate fiscal policy when details become more evident was a clear sign that the Fed, like the markets, will be waiting for details on Trump’s tax plans expected in coming weeks. Trump’s meetings and interactions with world leaders over recent days appear to be risk supportive as there has been less emphasis on increasing trade tensions. On the politics front, market focus may now turn to the G10 foreign ministers meetings in Bonn on Thursday and Friday. Market is long SEK. On Monday we outlined some scenarios on the details to watch for in today’s Riksbank Monetary Policy Statement (Krona and repo path). Since we think neither of the “hawkish” surprises are likely and that the market appears to be long SEK into the meeting, we worry that there could be a shock in store that would weaken SEK as markets unwind. We are not however saying that the Riksbank isn’t going to be optimistic, just that markets appear to be getting ahead of themselves, with the setup appearing to be very familiar to those who watched the RBNZ recently too. Swedish data may have improved but the fact that the SEK is now at the Riksbank’s year end forecast, the likelihood that enough members propose a rate hike sooner than mid-18 is low. EURSEK should see support around the 9.41 low and resistance around 9.50.

Theme of the Week: Fed speakers may spur hawkish excitement

A constructive US labour market report is likely to sustain the positive USD sentiment going into next week; the combination of modest job gains (+156k) and strong wage growth (+2.9% YoY) was enough to drive both short- and long-term US rates modestly higher, while equity markets remained unthwarted. Still, this jobs report was more a reconfirmation of expectations for two 2017 rate hikes, with the next moves currently expected in June and December.

Markets remain unconvinced over the prospects of an earlier March rate hike (ING’s base case) and we attribute this to a number of factors: (i) prior Fed cautiousness; (ii) Trump fiscal policy uncertainty and (iii) sub 2% headline US inflation. But all three headwinds could fade, and quite soon. We wouldn’t be surprised to see some hawkish Fed talk this week, with the intention of preparing markets for the prospects of a 1Q17 rate hike. Strong US inflation and growth data over the next month will likely see the reflationary uptick in US yields continue and this means a USD buy-on-dips strategy remains attractive.

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.

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US Equity Markets, USD Strength, GBP and China

US equity markets have reached new cycle highs overnight with inward looking and cyclical stocks such as financials leading the rally. The VIX index has declined towards its lowest level since August helped further by US real yields no longer rising. Markets have undergone a significant change with many correlations, which were ‘alive and kicking’ in August, either no longer in place or completely reversed. For instance, the higher USD has not prevented US inflation expectations or commodity prices from rising. Today the UK government will release its Autumn Statement. The GBP reaction should be positive if the tone of the government is to help UK businesses.  

 Investors are trying to get a handle on the growth and inflation effect of President elect Trump’s economic program. Some see these measures in the context of what has been claimed by Neo-Keynesians for a long time, i.e. to use fiscal expansion to overcome US investment weakness and hoping these fiscal measures may increase the effectiveness of accommodative monetary policies tools. A second group expects higher inflation, but growth staying subdued as the supply side of the economy may fall behind the demand expansion fuelled by increasing the money multiplier coming on the back of banks growing their balance sheets fast from here. The third group of investors expects the economy to maintain its low growth/low inflation profile citing substantial capacity reserves provided by the US’s main trading partners.

Confusingly, these three potential outcomes offer very different investment conclusions reaching from risk seeking towards risk aversion. What investors often overlook is that strong September and October US data releases currently hitting screens were achieved when markets were under a working assumption that Hillary Clinton was winning the Presidential election. It seems that something happened to the US economy over the summer months pushing it towards acceleration. Fading global headwinds with China’s growth rates stabilising and non-China EM growth accelerating had a supportive impact, but it may not fully explain the magnitude of the improvement. However, should the US have finally closed its output gap at a time when its household sector has completed balance sheet restructuring seems to provide the better explanation. Importantly, this explanation finds support in the way markets have changed trading from late summer onwards. In August, it was all about a liquidity imposed risk rally with the ‘hunt for yield and dividend’ driving markets. The USD was inversely correlated to US inflation expectations and commodity prices. Nowadays, we see the USD staying bid even when commodity prices move sharply higher. Overnight saw an 8% jump in iron ore prices. This new market regime makes sense should the US economy have closed its output gap.

The USD has entered a regime similar to what we saw in 1984 and 1999. In both cases, the US economy ran beyond its optimal capacity use, pushing its return expectations higher allowing the USD to gain exponentially. Only a few months ago, better non-US data would have weakened the USD. This is no longer the case as today’s release of the European November flash PMI’s may prove. Overnight, China’s Business Sentiment Indicator rose to 53.1 in November from 52.2in October. Both production and new orders picked up strongly in November, with the production indicator rising to a thirteen-month high of 58.0. Nonetheless, USDCNY has reached a new high at 6.8925 gaining 2% since the US election day.

CNY put option premiums have doubled over the past couple of weeks reaching their highest levels since 30th June. There are increasing voices in China warning about the impact of USD strength. Today it was Economic Information Daily warning about potential capital outflows from other countries should the USD become too strong. Meanwhile, Chinese reallocation efforts out of RMB deposits into alternative investments seem to have rediscovered the equity market. Outstanding margin trading on China’s domestic equity exchanges rose to RMB950 bln ($138 billion) on Monday, the highest in 10 months, while the Shanghai Composite Indexhas rebounded 22 percent from its January low.

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China and Commodities, Oil, GBP early elections talk

We agree with Li Wei, deputy director of Development Research of the State council, saying that the disconnect between finance and the real economy is the main problem for China, citing bubbles in financial and property sectors (MNI). These bubbles are domestically funded suggesting that the likelihood of a sudden investors’ strike leading to an economic shock is minor. Instead, China may be due for a long-term adjustment process revealing long term deflationary pressures. Within this long-term cycle, there will be ups and downs. Recent data have continued coming in strong and after having experienced falling producer prices over the past five years, prices have started to increase again.

Chinese producer prices may surprise given the country’s falling capacity utilisation rates suggesting a higher output gap. The increasing slack suggests domestically generated prices may fall. However, ithas been rising input costs coming on the back of the falling RMB and, even more importantly, rising commodity prices that have pushed domestic factory prices higher. What counts for China’s producer prices are the costs for industrial non-oil raw material prices such as iron ore, copper, aluminium, coking coal,etc. These prices have rallied over the past couple of months.

Interestingly, these prices have de-correlated from the performance of the USD. From 2012until the summer of this year, the USD had an important reverse impact on commodity prices. Now the USD and commodity prices tend to rise simultaneously. Even more importantly the higher USD no longer undermines US inflation expectations. Over the past couple of months US inflation expectations and the USD both moved higher. Investors seem to conclude that the US may close its output gap suggesting higher commodity prices increasing the likelihood of the Fed hiking rates. The better US rate outlook is then expected to drive the USD higher.

The previous ‘model’ saw higher commodity prices in the context of better EM demand indicating a wider US – EM growth differential leading to US capital outflows and hence USD weakness. The US potentially closing its output gap suggesting marginal US investment and hence capital demand increasing may have made the difference. Higher US capital demand combined with the US household sector seeing its savings ratio declining from 6.2% to 5.7% over the course of this year suggests higher US yields unless USD supportive capital inflows compensate for the change within the domestic US capital – demand balance.

Oil prices have come under renewed pressure as investors worry that OPEC’s production limitation agreement may not hold. Indeed, Saudi Arabia could raise oil output again. Adding to the potential oil glut has been US oil rig count increasing from 316 in May to 450 suggesting US oil production (currently 8522 mln bpd, peak: 9644mln bpd In June 2015) rising again. Oil no longer trades in line with other commodity prices which may have some important ramifications for oil currencies. The deterioration of the relative oil price outlook does not bode well for traditional producers which explains our bearish NOK, CAD and COP projection.

In the UK, newspapers speculate Theresa May may call a spring election should the Supreme Court confirm the High Court’s verdict giving the Parliament a bigger say within the Brexit negotiations. Our economists also noted that the probability of early elections have increased. Should the government aim for new elections it could signal a tougher negotiation stance, diminishing chances of a ‘soft Brexit’.For now we remain long GBPJPY.

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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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