This is the last full week of what has been a surprising quarter. Among the largest surprises in the foreign exchange market has been the strength of the Japanese yen. It begins the week up above 3% from the end of last year. That the Canadian dollar is the weakest of the majors, off 5.3%, is somewhat surprising, but understandable given the shift in the central bank’s bias (forward guidance?) from neutral to dovish. On the other hand, sterling is the second weakest. Many did not expect that sterling would slip0.5%, despite the likelihood that the BOE is the first of the major central banks to hike rates (next year, likely before the UK election).
In the equity market, Japan also surprises, with the Nikkei off 12.7%. This is among the worst Q1 equity performances among global stock markets. There are two markets that are down around the same magnitude, the Hong Kong Enterprise Index, which tracks Chinese companies listing on the Hang Seng, is off 12.8% while Russia’s MICEX is off 13.1%.
In the bond market, the rally in US Treasuries was unexpected. Under the weight of reduced Federal Reserve demand, Treasury yields were expected to have risen to find new clearing prices. Instead, going into the last week of the quarter, the US 10-year yield is off about 15 bp. This goes a long way toward explaining the decline in global yields. Perhaps, though the magnitude of the decline in the peripheral bond yields is also surprising. Yields in Italy and Spain continued to fall, with 10-year yields off 70-80 bp, while similar yields in Portugal and Greece fell 173 and 158 bp respectively.
We see ten events this week that investors will have to navigate.
1. There has been no attempt (yet) by Fed officials to guide the market away from the implication of Yellen’s definition of “considerable period” that the first rate hike is possible in Q2 15. Like Yellen herself, there has been some attempt to downplay the “dot plot” of forecasts, but the Fed cannot have it both ways. Either the “dot plot” is part of the Fed’s forward guidance/transparency or it is not. Investors may be particularly sensitive to Fed officials comments on these issues in the days ahead.
2. The longer the Fed waits, the more difficult its task. The spring thaw is likely to produce somewhat better economic data, even though it was not the only headwind the economy faced. This will likely be evident with the bounce in durable goods orders for February, helped by Boeing orders and a rebound in the auto sector. February personal consumption expenditures will be reported later in the week. The remarkable thing is how steady US consumption has growth, and largely without credit cards. The 3, 6, and 12-month averages converge at 0.3%, which is the February expectation, as well. Economists may solidify Q1 GDP forecasts, which looks to be tracking around 1.6%-1.8%
3. The Fed also draws attention at mid-week with the second part of the stress tests, which are essentially a review of the banks’ capital plans. Between dividend payments and stock buyback programs, large US banks want to return $77 bln to shareholders this year. Embarrassingly, the Fed had to revise the results of the first part of the stress tests within 24 hours of the initial release, and the adjustment was mostly minor covering half of the thirty financial institutions it reviewed. Nevertheless, the revisions underscore the focus on Bank of America. The revisions show its Tier 1 capital would fall below 6% under conditions of a deep recession, which is still above the regulatory requirement, but the second lowest behind Zions Bancorp, the only institution to have failed the first round.
4. This week’s flash PMI and money supply data from the euro area will shape expectations for the early April ECB meeting. After the ECB let the March meeting go by without taking fresh action, many participants gave up on the idea entirely, and this helped the euro rise to approach $1.40 for the first time since July 2011. What is expected to be the second consecutive decline in the manufacturing PMI is likely to underscore Draghi’s pointed remarks that the strength of the euro weighing on growth. The service sector, which is less sensitive to the euro’s fluctuation, is expected to continue to hold up better. Separately, money supply growth is expected to stabilize, but at 1.3% expected February print (up from 1.0% in December), it is hardly sufficient fuel for a stronger economic recovery. Lending to households and businesses likely to continue to fall, though the pace may lessen a little, an outright improvement still seems some time off.
5. The economic highlight from the UK will be CPI and retail sales. Headline CPI is expected to have slowed to 1.7% in February from 1.9% in January. This would the lowest print since October 2009. Few investors seem to appreciate the magnitude of the decline in UK inflation. It was at 2.9% last June. Retail sales in February, on the other hand, likely picked up after the out-sized 1.5% decline in January. Sales are expected to have risen by 0.5%, including auto sales, and 0.3% without. Nevertheless, the year-over-year pace is expected to moderate sharply to 2.4% from 4.3% including auto sales (2.9% from 4.8% without).
6. As Japan’s fiscal year winds down, Japanese inflation has stabilized; much as BOJ’s Kuroda had warned investors. The February national CPI report is expected to show core inflation, which in Japan, excludes fresh food, unchanged at 1.3%. Tokyo’s core inflation measure for March is expected to be unchanged at 0.9%. The impression one is left with is that the bulk of the rise in Japanese inflation is due to the yen’s weakness, which, as we noted above, stabilized in Q1. The economic environment, arguably, will change again with the retail sales tax hike on April 1. The key policy issue now is how long will it take officials to determine the impact of the tax hike and respond if necessary.
7. HSBC’s flash manufacturing PMI for China will be released early in Beijing on March 24. The consensus calls for a slight improvement to 48.7 from 48.5. The real point is that it remains below the 50 boom/bust level. The fact of the matter is that the Chinese economy has been slowing since 2011 (and the peak in the MSCI Emerging Market Equity Index around the same time is not simply coincidental). It may slow more as the government tries to manage a squeezing out of some excess. Officials we speak with seem cognizant of the risks. Consider what China announced last week that may mitigate some of those risks. It indicated it would expedite some already planned infrastructure projects. This is seen to help support the economy. It will allow some banks to issue preferred shares. This permits another source of funding that can help ease bank’s reliance on short-term funding and loosen the reliance on shadow banking activity. Chinese officials also indicated easing some funding restrictions for property developers.
8. Pressure on the yuan may continue. With the CNY6.20 level convincingly breached last week, which some reports had played up as a key level of speculative positioning, the next important chart point is seen in the CNY6.25-CNY6.26 area, which corresponds to the highs seen in December 2012 and February 2013. Above there and the dollar could have potential toward CNY6.30-CNY6.35. The yuan has weakened about 3.2%. It is far too early to take some pundits claims of a new currency war seriously. Moreover, the relatively low amount of value-added incurred in yuan related costs suggest such a small move will not impact trade flows. The purpose of the squeeze is not meant to address China’s international competitiveness, but rather the moral hazard and excessive speculation, primarily by domestic economic agents. That said; the yuan’s weakness must be included in any list of the surprises that have befuddled investors in Q1.
9. The threat by Kiev politicians to cut Crimea’s water and/or electricity off (Ukraine supplies Crimea with estimated 90% of its water and 80% of its electricity), is a dangerous provocation. Russia is amassing troops on the Ukrainian border. No US president, going back to General Eisenhower directly used military force to try to repel Soviet or Russian forces. It was not done in Hungary, Czechoslovakia, or more recently, Georgia. The sanctions being implemented now are the strongest since the end of the Cold War. There is scope for additional escalation, and there is little doubt that the “Russian issue” will dominate Obama’s trip to Europe and the G7 meeting. There may be a multiplier effect of sorts in terms of the sanctions as businesses may choose to refrain from dealing with Russian enterprises, especially state-owned or directed, as the case may be, for fear of additional sanctions. We quickly suspected that lion’s share of the $105 bln drop Treasury holdings in the Federal Reserve’s custody holdings in the week ending March 12 was likely due to Russia shifting its reserve holdings out of the US for fear that the Crimean referendum and annexation could result in the US freezing those assets. However, the $32 bln rise in custody holdings the following week, even with the settlement of US Treasury auctions is more mysterious. There is some suggestion that the reserves that were transferred out went to another central bank, who then used the Federal Reserve as a sub-custodian with a part of its new mandate. That said, the Federal Reserve and the US Treasury Department know who is doing what.
10. While politics may always be local, this weekend’s French municipal elections (run-offs next weekend) may be looked upon for insight into the May EU parliamentary elections. In this light, the success of a rejuvenated National Front will be watched very closely. It is little wonder that the euro zone finance ministers pushed hard to reach an agreement on the Single Resolution Mechanism (at least three months late) with the current EU parliament is that an agreement with the next parliament may be more difficult. If France is unwilling or unable to articulate and defend the interests of the debtors, the new EU parliament (and resulting new EU Commission) might be the check on Germany and the interests of the creditors. From a local lens, this will be the first voter response to the Hollande government. Even though the Socialists may manage to hold on to Paris, in a campaign that seemed to lack any meaningful substance, it is likely to get solidly trounced. Hollande will likely respond with a cabinet reshuffle. As Hollande tacks right, it will be interesting to watch what happens to Montebourg, the controversial industry minister: keep him close as a bone to the left-base or replace him as an olive-branch to industry, which he has alienated.