USD Strength, Chinese Reserves, Low yielding currencies

Our bullish USD call and global reflation will work hand in hand as long as USD strength mainly works out against low-yielding currencies. The December US labour market report – released last Friday – is consistent with our view of seeing the US closing its output gap. Related labour market tightness has pushed average wage growth up to 2.9%, representing its highest reading since June 2009.Fed comments suggest that the balance of risks has shifted from the Fed being too optimistic on rates towards assuming that the Fed may have to hike more than currently priced in by the markets. The Fed’s Kaplan and even the super-dovish Evans see two to three rate hikes as appropriate. Jerome Powell said “overheating has shown up in the form of financial excess”, suggesting that continued equity market strength may increase the pace of Fed rate hikes. Lastly, the Richmond Fed’s Director of Research Kartik Athreya warned Friday that the fed funds rate may have to be hiked faster than markets currently anticipate as economic conditions are more uncertain than usual now. On Friday, 10-year US bond yields rose by 9bp, pushing USD higher.

Low yielders suffering most: It is global reflation pushing relative real yields in Japan and EMU lower which works against JPY and EUR as long as the BoJ and the ECB maintain their dovish courses. The BoJhas signalled that it may consider moving away from keeping JGB 10-year bond yields near zero when inflation exceeds 2%Y. Even so Japan has closed its output gap and now sees wages and unit costs movinghigher, so it will take some years before inflation reaches the BoJ’s target. In the case of the ECB, the matter is economic divergence leading to an overheating core while the periphery continues to struggle. In the absence of further political integration pushing the ideas of a fiscal and a bankingunion forwards (which is unlikely to happen in a German election year), the ECB may have to stay accommodative. Accordingly, rising inflation rates push real yields lower,not only translating into a weaker JPY and a weaker EUR, but also allowing the Japanese and European stock markets to seek higher valuation levels.

China’s FX reserves: China seeing a US$41.1bn fall in its currency reserves in December, moderating from a US$69.1bn decline in November, provides a better headline than suggested by the currency valuation-adjusted reading of its reserves. Adjusting for the effects of FX valuation,actually FX reserves fell faster in December (by US$29bn) relative to November (US$, reaching the largest outflow since March 2016. The Exhibit below shows that, relative to M2 growth, China’s currency reserves have fallen to their lowest level since 2002, possibly suggesting that China should aim for a more careful use of its monetary policy.

Dealing with outflow risks: Last week’s RMB short squeeze coming on the back of sharply higher RMB-denominated short-term funding costs bear goods news. It shows that China’s authorities pre-empted the increased accumulation of outflow risks, which is good news for risk-takers. However, should China fail to remain on top of this issue, it may have the potential to undermine the global reflation trade, with falling commodity prices acting as a catalyst. The other risk to our short EUR and JPY strategies could come via USD strength increasingly materialising against high-yielding EM currencies. EM currency weakness tends to tighten global liquidity conditions, as witnessed in January 2016 when EM weakness translated into outright JPY and relative EUR strength.

These risks about global liquidity conditions are not trivial; therefore it is important to add GBP shorts into our portfolio. Last week we added short GBP/SEK and today we propose short GBP/USD. It is not only that Britain’s current account deficit may not adjust as quickly as previously hoped as post Brexit domestic demand has remained strong – thus keeping the UK dependent on international funding – but also the absence of a Brexit negotiation strategy now being suggested by the British press. The UK’s ambassador to the EU Ivan Rogers’ resignation and his critical remarks (Brexit leading to “mutually assured destruction”)have put market focus back on the UK experiencing a potential cliff edge when exiting. With less than 50 days left before the UK may trigger Article 50 – according to its government’s current timetable – GBP-denominated assets may see their risk premium rising again.

The first cabinet meeting dealing with the EU will be held on Thursday. The cabinet may have to discuss a strategy should the Supreme Court force the government to seek parliamentary approval when triggering Article 50. The Supreme Court’s ruling is expected on January 23according to the Sunday Times. Next Monday, PM May is expected to outline her Brexit strategy. In a Sunday morning interview with Sky News she said that Britain will make a definite break with the EU. Closing North Sea oil platforms costing£24bn and PM May calling for a bigger government as she moves from Cameron’s ‘Big Society’ towards a ‘Shares Society’ concept will not help GBP either, in our view.