Euro Bears Aren’t Hibernating

Euro (2)

The euro was greeted with fresh selling amid reports suggesting the ECB is preparing to throw everything but the proverbial kitchen sink into its unorthodox monetary policy

A two-tiered negative deposit rate is likely to be resisted by Germany and France, whose banks are the largest users of the ECB’s facility   

Higher US interest rates preceded each of the significant dollar rallies

Governor Stevens of the Reserve Bank of Australia has, for all practical purposes, ruled out a rate cut next week

Minutes from the recent BOJ meeting shows that it too is not in a hurry to expand its already aggressive operation

The Brazilian central bank meets today and is expected to keep rates steady at 14.25%, a nine year high

Price action: The dollar is mostly firmer against the majors, with the Kiwi the lone exception and up 0.1% on the day. The Swedish krona and the Swiss franc are underperforming. The euro gained almost a cent between Monday’s low (when it briefly dipped below $1.0600) and today’s high (which stopped shy of $1.0690 in early Europe) before coming under selling pressure following reports of more aggressive ECB action. It is now making new cycle lows near $1.0580. Sterling is trading near $1.5050, while dollar/yen is edging higher to trade near 122.75. EM currencies are mostly softer. BRL and RUB are underperforming, while KRW and MYR are outperforming. MSCI Asia Pacific fell 0.4%, with the Nikkei down 0.4%. EM Asian equities were mostly lower, but the Shanghai Composite closed 0.9% higher while the Shenzen Composite was up 1.9%. Euro Stoxx 600 is rebounding, up 1.3% near midday, while US futures are pointing to a small positive open. Commodity prices are mixed, though copper is down 1% and oil is down around 1.5%.

 

 

The divergence of monetary policy is discounted, it is argued.  Ahead of next week’s big events – the IMF’s SDR decision, the ECB meeting, the OPEC meeting, and the US jobs data – the euro, against which speculators have amassed a large short position (just shy of a record) were supposed to be content.

The euro was greeted with fresh selling amid reports suggesting the ECB is preparing to throw everything but the proverbial kitchen sink into its unorthodox monetary policy.  The latest reports suggest that a two-tiered negative deposit rate and the purchases of bank loans that are at risk of non-performing are under consideration.

A two-tiered negative deposit rate, which would ostensibly punish large depositors at the ECB over small depositors, is likely to be resisted by Germany and France. Their banks are the largest users of the ECB’s facility.  Purchases of loans at risk seem like a non-starter for a number of reasons. Some are technical, like pricing such loans, and some are based on principle, like a reluctance to take measures that so overtly look like a deterioration in the quality of the central bank’s balance sheet.  The BOJ may be comfortably buying a range of assets, including ETFs, REITS, but the ECB has preferred the course of the Federal Reserve and the BOE, which is to buy the risk-free assets (sovereign bonds and agencies).

Even if these latest ideas are not very likely to be implemented, they are important.  They show why claims that “it is all priced in” are misleading.  The market does not know what the ECB will do next week.  The ECB itself may not know.  There are four broad categories of action:  the deposit rate, the composition of what is being bought, the pace of the purchases, and the duration of the program.  On top of this, there is scar tissue, in the sense that the market often has under-estimated the dovishness of Draghi.

This does not preclude the possibility of “sell the rumor, buy the fact” behavior, though the proximity of the US jobs data after the ECB meeting may deter it.   There are the famously unpredictable lags between monetary policy and foreign exchange developments.  In the popular press, it is frequently argued that the dollar falls following Fed hikes.

Higher US interest rates preceded each of the significant dollar rallies.  The Reagan dollar rally was preceded by rate hikes by Volcker under Carter, which is when the dollar bottomed. The Clinton dollar rally in the second half of the 1990s was preceded by Greenspan rate hikes in 1994.  This may be more important for medium- and long-term investors.  All Fed tightening cycles do not spur a significant dollar rally, but the previous two significant dollar rallies since the end of Bretton Woods has been preceded by less accommodative US monetary policy.   Moreover, it is not just about the Fed hiking, but also other central banks easing.

Governor Stevens of the Reserve Bank of Australia has, for all practical purposes, ruled out a rate cut next week.  He told investors to “chill out,” enjoy the holidays, with a promise to review the economic situation again in the middle of Q1 16.  The Australian dollar is the strongest of the majors so far this month, rising about 1.6% against the US dollar. For the record, this is despite a 12% slide in iron ore prices, new five-year lows in gold, and a decade low in copper.  On Steven’s comments, the Aussie extended its recent gains to a little beyond $0.7280 before hitting a wall of offers, which some linked to a large option expiry today at $0.7300.  A potential reversal is underway in Europe.  Initial support is seen in the $0.7230 area.

Minutes from the recent BOJ meeting shows that it too is not in a hurry to expand its already aggressive operation.  Although the press and some economists play up the significance of two consecutive contracting quarters, the central bank did not.  It sees the economic recovery continuing and a gradually rising trend in underlying inflation.

The dollar slipped to the lower end of its recent range against the yen near JPY122.25 before finding a bid.  It briefly traded below its 20-day moving average (~JPY122.40). A move now back above JPY122.75 would reinforce the new narrow dollar-yen range. The top side comes in near JPY124.00.

On the other hand, BOE comments suggest that it is in no hurry to raise rates. Haldane’s observation that wage growth may be slowing added pressure on sterling. It is the poorest performing of the majors over the past week, losing a little more than 1% against the greenback, or almost half this month’s decline. The implied yield of the December 2016 short-sterling futures contract has fallen from 107 bp earlier this month to a little below 90 bp now.

There are several US economic reports to be released today. None has the heft to alter market expectations for Fed policy next month. The reports include the October personal income and consumption readings. They are expected to confirm that consumption, which drives two-thirds of the US economy is firm despite some softness in August and September. In both months, PCE rose 0.1%. It is expected to have risen by 0.3% in October, which would match the six-month average. The consensus also expects a small tick up in the core PCE deflator to 1.4% from 1.3%. It would be the highest print of the year.

Separately, the two-month drop in durable goods orders may have snapped in October. The consensus expects a 1.7% increase that would more than offset the 1.2% decline in September. The underlying details, including orders excluding transportation and defense and the shipment of the same, are also expected to snap a two-month contraction as well.

The Brazilian central bank meets today and is expected to keep rates steady at 14.25%, a nine year high. But there is a lot of uncertainty going forward. This is one of the few countries where investors don’t even agree whether the next move will be tightening or easing. According to a recent poll by Reuters, forecasts for Brazil’s interest rates at the end of 2016 ranged from 11.50% to 16.00%. The median forecast stood at 13.25%. Looking at this week’s official central bank survey (FOCUS), economists increased their SELIC forecast for end-2016 by 50 bp from last week to 13.75%. This compares with forecasts of 12.75% back in the week of October 16. Also, the average inflation (IPCA) forecast for the next 12-month period is now just over 7.00%, meaning that the central bank’s 4.5 +/- 2% inflation target is looking ever more elusive.