By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman
The third quarter begins with a bang this week. The main highlights include four major central bank meetings, Japan’s quarterly Tankan survey, monthly purchasing managers’ surveys and the US employment report.
The larger context in which the data and events will occur is important. Retail and institutional investors are dramatically adjusting portfolios. The Federal Reserve is expected to begin what could be a protracted exit from its unconventional easing policy. The most acute phase of the Chinese liquidity squeeze may have been passed, but conditions have not completely normalized. Separately but related, the growth prospects of the world’s second largest economy are being downgraded.
At the same time, one of the main characteristics are the investment climate is the desynchronized business cycle and economic conditions. While the Fed is contemplating the thresholds and timing of its tapering exercise, other central banks, remain committed to either their accommodative polices or are considering extending them. The higher interest rates that emerged in the second half of the second quarter pose a new challenge for many countries that are experiencing contraction or weak growth.
Here is our list of ten things that should be on your radar screen in the week ahead:
1. Japan reports the Tankan survey first thing Monday in Tokyo. The recent string of Japanese data has been constructive and there is no reason to expect the Tankan survey to break this pattern. Indeed, the risk appears to be on the upside for the large manufacturers (consensus is 3 on the diffusion index and 7 for the outlook) and small manufacturers.
2. One of the surprising developments this year, namely the persistent selling of foreign assets by Japanese investors, show no signs of waning. In fact, the selling of foreign bonds reached a new high in the most recent reporting week. They have sold a net $93.5 bln of foreign bonds this year and $48.5 bln of foreign equities.
3. China reports purchasing managers surveys (Monday and Wednesday). Many economists have cut their forecasts for this year’s growth and the risk of the surveys appear on the downside. The new government appears more committed to financial reforms and regaining control over the financial sector than trying to boost growth in the short-run. After appreciating about 2% against the dollar from late February through late May, the yuan has been consolidating over the past month. As the credit crunch unfolded and interest rates rose, the yuan tended to soften. This lends credence to ideas that the yuan was part of a larger carry trade. The Shanghai Composite slumped 21.2% to new multi-year lows from late May through late June. The selling appears to have reached a climax and as the credit crunch eases, Chinese equities look poised to recover.
4. China and ASEAN countries agreed over the weekend to begin talks in September that will devise a broad framework of rules to resolve the regional territorial disputes. This represents a shift by the new government toward a more conciliatory stance after having rejected such efforts over the past couple of years. The volte face comes amid new openings for the US, which China seeks to avoid. Last week, Philippines President Aquino acknowledged an agreement was being drafted to give US forces to Subic Bay.
5. The Reserve Bank of Australia is the first of the central banks that meet this coming week. The decision will be announced first thing Tuesday. Most share our expectation that August is a more likely time frame for a resumption of the easing cycle. The 12% decline of the Australian dollar on a trade-weighted basis since mid-April in tantamount to some easing of monetary policy. It finished the second quarter at its lowest level since Sept 2010. We suspect RBA officials will be more comfortable cutting rates again after inflation report (July 23), however, of the central banks that meet this week, the RBA is the most likely to surprise the market.
6. Sweden’s Riksbank meets Wednesday. There is little chance of a change in policy. Surprising many observers, the Swedish krona and Norwegian krone have been the weakest of the major currencies since the eve of the June FOMC meeting, falling 3.9% and 5.5% against the dollar respectively. Although Sweden’s Prime Minister and Finance Minister have welcomed the decline in the krona and Norway’s central bank has shifted toward a more dovish posture, the magnitude of the currency appreciation appears to be more a reflection of the thinness of the market than a significant deterioration of underlying macro fundamentals.
7. The Bank of England meets Thursday. It is widely expected to do nothing. The meeting will be led by the new Governor, Carney, who replaces King starting Monday. Carney was chosen for largely the same reasons Kuroda was recently selected to lead the Bank of Japan. Their approach better fits with the government’s. Carney does not believe that monetary policy has been exhausted. However, the BOE needs a new policy framework to avoid the same fate at King, who had been repeatedly out-voted, trying to purchase more gilts. Carney is helping to shape the new framework and the next step is not until next month. On one hand, the backing up of yields in recent weeks suggests gilt purchases may be more effective then when yields were at record lows. On the other, the most recent prints of high frequency data suggests a nascent recovery is taking hold, while price pressures remain sticky. Market-based indicators suggest expectation that monetary policy will not be tightened for more than 2 years, which does raise questions over the effectiveness strengthening forward guidance.
8. The European Central Bank also meets on Thursday. In order to spur another rate cut by the ECB, a new deterioration of the region’s economy is necessary and this has not materialized over the past month. In fact, as the PMI data is likely to show, the worst of the latest downturn is past and a gradual and fragile recovery appears to be unfolding. The rise in yields and lower equity prices means that financial conditions, have tightened and lending to the private sector continues to contract. The tighter conditions has not been offset by the euro, which was largely steady on a trade-weighted basis in June. The ECB can only hope that its forward guidance will be sufficient to lean against the increase in short-term rates. One issue that we hope Draghi is asked and addresses is about continued decline in liquidity, as banks pay down their ECB borrowings, that if its persists, that may fall below levels consistent with the overnight rate (EURONIA) near zero. We recognize that the quarter-end pressures were behind the spike in rates last week that saw the EONIA more than double (to 20 bp), the EURONIA (7 bp) has been gradually drifting higher.
9. The US jobs data is most important economic report of the week. However, we do not expect a change in the underlying trend, which we argue has slowed a bit in recent months. The three-month average of net private sector job growth was 163k in May compared with 212k in Q1 and 232k in Q4 12. Aggregate hours worked are running about 2% over Q1, though this is still below the Q4 12 average. The composition of the downward revision to Q1 GDP and the softer expenditure figures warn that US GDP has not yet re-accelerated. If the Federal Reserve thinks the market is pricing in too early of a rate hike in the Fed funds rate, it can lower the threshold of the unemployment rate from the current 6.5% and we would not rule this out.
10. The IMF’s COFER data was reported at the end of last week. It showed that about 2/3 of the $300 bln increase in allocated reserves in Q1 (when adjusted for changes in foreign exchange rates) were accounted for by the US dollar. Separately, we learned from the Federal Reserve that foreign central banks patronizing its custodial serves sold a record $32.4 bln worth of Treasuries in the most recent reporting week, according to the Financial Times. Foreign central banks have reduced their holdings of Treasuries for the third time in four weeks. Some of the selling appears fit well with reports of some emerging market countries trying slow the decline of their currencies as some of the capital that flowed in, now flows out. Redemptions of emerging market bonds reached a new record ($5.6 bln) in the week to June 26, according to EPFR data. Over the past five weeks, EPFR figures show that $22.5 bln has been pulled from emerging market funds and $22.5 bln were equity funds. Separately, according to their figures, US funds accounted for $10.6 bln of the $23.3 bln that left fixed income funds during that week. Japanese equity funds continue to report net inflows. Weekly MOF data shows foreigners have bought about $93 bln of Japanese equities this year.
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