USD Index Momentum, the FED meeting, GBPUSD and China
Finally, conditions for a USD downward correction are in place. DM bond yields have moderated overnight, as nominal yield spreads have turned less USD-supportive, oil prices and other industrial raw material prices have come off their highs and importantly the better data releases coming out of China have failed to push bond yields higher. Technical and market sentiment indicators such as the increasing skew of option put prices being higher than calls for US Treasuries (see Exhibit) suggest USD falling from here. Higher yielding EM currencies are best positioned to rally, while the anticipated USD correction should find little traction against low-yielding currencies such as JPY and EUR. USDJPY should drift to 114 and only if it breaks this level does it have the chance of seeing 112. Anyhow, this pre-Christmas USD setback should lay the foundation for a stronger USD advance going into January.
GBP should resume its rebound as there are increasing signs within the British government of it avoiding the cliff edge. Yesterday, it was Chancellor Philip Hammond suggesting that there was an emerging view among “thoughtful politicians” that Britain might need more than the two-year period stipulated under the EU’s Article 50 divorce process to finesse its departure.
Today the Fed will start its two-day meeting. A 25bp rate hike is priced in. Some bond-bearish market participants suggest that the Fed may shift its dot plot towards higher levels, reacting to the Presidents-elect’s expansionary fiscal plans and increasing signs that the US economy may have closed its output gap. More likely appears to be that the Fed executes what we call ‘a lazy rate hike’, signaling a rate pause after today’s likely rate hike. First, the incoming government plans are not yet concrete. While lowering taxes may be easy to implement, expenditure increases are more difficult to find majorities for on Capitol Hill. Second, the Fed wants to see investment spending picking up. So far, investment has been weak and, with the US economy increasingly replacing capital with labour productivity, it has declined. At the same time, the ratio between labour and capital has become increasingly sub-optimal. Third, there is an increasing number Fed participants believing in the beneficial effects of a steeper yield curve. After years of pushing long-term bond yields lower, officials start to understand the importance of capital availability relative to the cost of capital. A commercial banking sector seeing its profitability supported by a steeper yield curve may increase its now more profitable lending activities, which would work in favour of the money multiplier.
Ahead of tomorrow’s Fed announcement, investors may reduce USD long positions while recognising that there is an asymmetric risk looming. A USD long-positioned community may find little appetite adding to longs within pre-Christmas markets even if the Fed – against our expectations – turns out hawkish. Moreover, Brent has scaled back from our technical target (57.60) on news that China has increased its output from a seven-year low. Former Fed Chair Bernanke has argued in his blog that 40% of the 2014/15 oil price decline had been driven by global demand moderation, suggesting that oil prices should rebound as global demand normalises. The ‘problem’ is that oil supply is now greater than at any time of the post-WWII period, increasingly driven by market oriented companies, with profit margins and access to capital determining the pace of capacity increases. Seeing the oil price moderating from here may allow bond markets to recover globally, delivering a weaker USD as a side-effect.
China saw November industrial production climbing 6.2%Y, compared with a median estimate of 6.1%Y. Retail sales rose by 10.8%Y, which was the biggest gain since December,and fixed asset investment increased by 8.3% YTD. These data points seem to support the global reflation story, but caution is warranted. Capacity utilisation rates have reached lower levels compared to 2008/09. The rising activity has come with the support of a strongly expansionary fiscal policy, rising by 12.2%Y in November and 10.2% YTD. The Chinese Academy of Fiscal Sciences has warned local authorities that the debt-moderating impact of debt swaps has not reduced medium-term fiscal risks. It appears that China’s current economic rebound has been fiscally driven. Private sector investment has stayed weak.