Week gone by: China’s global influence grows, volatility falls
You know how sometimes you have a constant pain somewhere for so long that you almost forget about it, and all of a sudden it’s gone and you realize once again what a pain it was? Or a steady ringing in your ears stops? How about the dog next door barking constantly, and suddenly it stops and you realize how quiet the neighbourhood is? That’s how I felt during the week just ending: the first week in months with no Brexit noise. Unfortunately this isn’t going to last, of course. The first hurdle is whether Britain will field candidates for the European Election that’s going to start from March 23rd. There are more hurdles after that. I’m sure we’ll hear more, and more, and more. And while it’s starting to seem less likely that Britain crashes out without any agreement, the alternative seems to be a general election at which the Labour Party under the appalling Jeremy Corbyn has a good chance of getting in. Brexit + Corbyn = GBP parity party!
I was in New York this week talking with reporters who asked thought-provoking questions: what are the big themes in the market nowadays? This got me thinking a bit further beyond just what happened this week or is going to happen next week. I settled on three points:
1) The growing influence of China on the global economy in general and FX market specifically. We could observe that Wednesday of course when the Q1 GDP and March industrial production beat expectations. AUD went soaring as a direct result and was the best-performing G10 currency that day. But we can see it also in the overall movement of the market. Think of how many central banks have mentioned China either indirectly (e.g., the FOMC referred to “readings on financial and international developments” and the ECB mentioned “vulnerabilities in emerging markets”) or directly (e.g., the RBA explicitly discussed the China economy). While much of the turnaround in the Treasury market in January and the change in attitude towards risk assets was no doubt due to the change in the FOMC’s tone to one of “patience,” there was also a simultaneous turnaround in China that improved the global outlook. Analysts certainly have to pay as much attention nowadays to Chinese economic indicators as to those of other major countries.
2) Monetary policy convergence Immediately following the 2008 Global Financial Crisis, all central banks cut their policy rates sharply. Then starting in 2015 the US began tightening alone, and for several years the key phrase in the market has been “monetary policy divergence.” The question has been how soon other central banks would follow and at what pace. Now, most of the major central banks are either on hold or have an easing bias, including some that had already started on tightening cycles, such as the Bank of England and Bank of Canada. Only Norway and Sweden seem to be still aiming to tighten.
3) Low volatility The monetary policy convergence has led to extremely low volatility in the FX market. There’s just not that much to go for, since policy is largely on hold everywhere. The ECB and Bank of Japan for example have pretty much hit the end of the road as far as easing measures are concerned, and they’re not likely to hike any time soon, so we can’t expect any policy changes to affect FX rates.
This low-volatility environment – which is not only in FX but in other asset classes as well – may not last forever. Speculators have almost a record short position in the VIX futures (-164.4k contracts vs the record of -174.7k). Extreme positioning in the futures is often (but not always) associated with turning points in the underlying, as there’s no one left to buy or sell. And we can see that volatility did indeed go shooting up not long after the record short position was reached in October 2017.
Finally, although I think monetary policy may be on hold in most countries, politics certainly isn’t. With the publication of the Mueller report, Trump’s legal worries are just beginning. I think US political uncertainty could take the place of British political uncertainty as a market factor in the coming months.
The coming week: Bank of Canada, Bank of Japan, US Q1 GDP
There are two central bank meetings this coming week, but only one of them is really worth watching.
Just six months ago, the market was totally convinced that the Bank of Canada was going to hike rates this year – it was seen as a 98% probability (red line), with a 90% probability of two hikes. Now there’s almost zero probability of even one hike, and around an 84% probability of no change in rates at all this year (purple line).
But while no one expects any change in rates at Wednesday’s meeting – or any time this year for that matter -- there could be a change in nuance or bias.
At their last meeting, the BoC turned decidedly dovish. They said that “the slowdown in the global economy has been more pronounced and widespread” than they had forecast and that “the slowdown in the fourth quarter was sharper and more broadly based” than expected. “It now appears that the economy will be weaker in the first half of 2019 than the Bank projected in January,” they said, while also dropping any reference to a recovery to above-potential growth in 2020. “Governing Council judges that the outlook continues to warrant a policy interest rate that is below its neutral range,” they said, adding that “With increased uncertainty about the timing of future rate increases, Governing Council will be watching closely developments in household spending, oil markets, and global trade policy.”
Now things look a bit different. With the bounce in China, the slowdown in the global economy may not be as “pronounced and widespread” as they had feared (although the disappointing preliminary PMIs out Thursday show that the bounce isn’t as pronounced and widespread as I had hoped, either). Retail sales have started to turn up, Canadian oil prices are up 19%, and an end to the US-China trade bickering seems in store (although US-Japan and US-EU bickering continues). So the picture may be a bit brighter than when they last met. They could come out with a somewhat less pessimistic outlook, in which case we could see CAD gaining after the meeting.
As for Thursday’s Bank of Japan (BoJ) meeting, it’s pretty hopeless. BoJ Gov. Kuroda came into office in April 2013 vowing to get inflation back above 2%. According to Reuters, the BoJ meeting’s forecast update will show inflation remaining below its 2% target through the fiscal year ending in March 2022.
In fact, they’ve apparently given up. Just last week a former Bank of Japan official in charge of monetary policy admitted that the country’s 2% inflation goal is more of a symbolic target than anything else. According to Bloomberg News, he said that provided the economy continues growing, hitting the inflation target no longer matters to the government. Instead, the measure of success will be an improved economy, wage and employment growth. Nonetheless the BoJ can’t abandon the target, because giving up on its easing commitment could trigger a sharp rise in the yen and a fall in stocks. So with no hope of hitting the target and no chance of abandoning it, the meeting is likely to be yet another pro-forma affair that results in no market-affecting change in the stance.
As you can see, the trading range on BoJ days is generally lower than on other days, probably because people hold off trading in anticipation of some change in policy but then find no incentive to get back in after yet another anodyne comment.
The other big event of the week will be Friday’s release of Q1 US GDP. The market is expecting a fairly solid 2.2% qoq SAAR rate, the same as in Q4 of last year. It’s a little bit below the recent trend, but still healthy – the FOMC members, in their quarterly economic projections, estimate the “longer run” growth rate of the US economy to be 1.7% to 2.2%, so this would be at the upper range of their guess for the sustainable non-inflationary pace of growth. Their median estimate for 2019 is 2.1% and the “central tendency,” the range of the majority of members, is 1.9%-2.2%, so again, this would be at the upper end of estimates.
However, there’s a lot of uncertainty surrounding the figure. The New York Fed’s Nowcast GDP model says a much lower 1.4% (as of April 12), while the Atlanta Fed’s GDPNow model says a much higher 2.8% (it will be revised later today). The St. Louis Fed’s Nowcast however is exactly the same as the market consensus. The range of estimates on Bloomberg is from 1.0% to 2.9%.
I believe a result even along the lines of the market consensus would show that in fact the US economy is not slowing, contrary to popular belief. That would probably be good for the dollar.
Other major US indicators include existing home sales on Monday, new home sales on Tuesday and durable goods orders on Thursday.
In Europe, the Ifo indices next Wednesday could provide some relief after the disappointing German manufacturing PMI yesterday (Thursday). That might help boost the euro.
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