By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman
1. The Federal Reserve will continue its tapering strategy outlined by the FOMC last month. The wobble in opinion caused by the unexpectedly poor December jobs report has been largely shrugged off. The Beige Book upgraded its assessment of US growth and recent data have spurred economist to revise up Q4 GDP forecasts, with many coming in around 3% now. Early survey data for January suggests the momentum has carried over.
2. At his press conference earlier this month, ECB President Draghi provided two general conditions for new action. a worsening of the disinflation outlook and an unwarranted increase in money market rates. There is little to add to the inflation picture over the past couple of weeks, but money market rates are elevated. EONIA was above the 25 refi rate in the second half of last week. Indicative prices suggest 3-month interbank lending rates have doubled over the past three months to 27 bp. Pressure will mount on the ECB to act, but politically possible effective options are few and far between. Banks will continue to pay down their LTRO borrowings and, while lending to households appear to be stabilizing, lending to SMEs continues to fall.
3. The BOJ is past the half way point toward reaching its 2.0% target (core inflation, which excludes fresh food prices). The December report is due out from January 30. The headline rate of 1.5% is just above the Germany’s December rate. Starting next month, the BOJ’s QQE purchases will surpass Federal Reserve purchases. The sales tax hike from 5% to 8% effective April 1 is the next key economic challenge and the BOJ appears more likely to react than to preempt. The rally in global bonds appear to have helped cap JGB yields that had risen from 60 bp to 75 bp in December and settled just above 66 bp before the weekend.
4. The Australian and Canadian dollars remain out of favor. Poor employment data in Australia has seen a dramatic swing in the pendulum of market sentiment toward a rate cut. The lack of a surprise by the Q4 CPI report on January 21 will underscore the idea that the RBA has scope to cut rates. The trimmed mean CPI remains well below the longer term averages (Q3 2.3%, 5- and 10-year averages 2.8% and 2.9% respectively). A similar pattern can be seen in headline rate as well.
A series of poor data and elevated official concerns about disinflation has spurred speculation of a rate cut by the Bank of Canada. Yet action this week, at its Wednesday, January 22 meeting is a highly unlikely. At most, a reduction in its inflation forecasts seems like the most that can be expected. Given the record short speculative position in the futures market and the pace of the recent decline in the Canadian dollar, there seems be heightened risk of a “sell the rumor, buy the fact” short squeeze.
5. European asset markets are outperforming here in early 2014. Turning first to flows, we note that ETFs that invest in European equities have seen assets under management (AUM) increase by $1.4 bln in the first half of January. Japan equity ETFs have also continued to report inflows. The AUMs have increased by $1.3 bln. The retreat from emerging markets equities has continued, with estimates of $4.2 bln leaving so far this year. US equity ETFs have experienced $1.3 bln of outflows.
Looking at some national bourse reports, Taiwan stands out. It appears to be non-residents’ favorite equity market in Asia, recording $1.06 bln of inflows already this year. In contrast, South Korea, which was favored by foreign investor last year, has seen light profit-taking. Interestingly, Japan also reports net foreign sales so far this year.
In terms of performance, Span and Italy continue to stand out with 5.5% and 5.3% gains respectively among the large European bourses, but Greece continues to shine (9%) and Portugal is main index is up nearly 7.5%. Of core European countries, Austria has begun the best, gaining 6.8%. The Dow Jones Stoxx 600 is up 2.3% here in January, while the Nikkei is off 3.4% and the S&P 500 is down 0.5%. The MSCI Emerging Market Equity index is off a little more than 3%. Lastly we note that like last year, small caps are generally out performing large caps.
6. The major bond markets have begun the new year with advances, despite Fed tapering and amid generally constructive economic data. The US benchmark 10-year yield is 10 bop lower than where it finished last year. The UK’s 10-year gilt yield is off 19 bp, while the benchmark bund yield is 17 bp lower. Japanese bonds have lagged in the rally as they lagged in the sell-off. The 10-year yield is 6 bp lower here in the first part of January. Asset managers continue to see value in peripheral European bonds. Italy’s 10-year yield has fallen 222 bp this year; not bad, but Spain’s 10-year yield is off 40 bp. However, growing confidence that Portugal can exit its aid programs has seen its 10-year benchmark yield drop 70 bp this year. Ironically, Ireland, which was upgraded by Moodys, back into investment grade, has the only 10-year bond in the euro zone that has weakened this year. The yield has risen a little more than 4 bp.
Turning to the short-end of coupon curve, the US and Japanese two-year yields are essentially flat so far this year, and Germany and the UK of 3-4 bp lower. Spain and Italy continue to experience yield declines in absolute terms and relative to Germany. Their two-year yields are 34 bp and 16 bp lower on the year. Portugal is also experiencing a bullish flattening, as its two-year yield is about 7 bp lower on the year.
7. China is experiencing another squeeze in its money markets and this may ahead of the new year celebration at the month. The 7-day repo rate surged before the weekend, nearing 9.8% before finishing near 8.47%, compared with 5.28% at the end of the previous week. The Shanghai Composite is off 5.25%, given the dubious honor of being the worst performing Asian market. In addition to Lunar New Year considerations, reports suggest a number of wealth management products are set to mature at the end of the month as well.
At the end of last week, new concerns about the China’s shadow banking arose. ICBC, the world’s largest bank by asset values, took what appears to be an unprecedented step, announced it would not make investors whole who bought some of a CNY3 bln (~$500 mln) investment product it had distributed four years ago. The investment product is set to mature at the end of January. The product reportedly offered a 10% yield when the benchmark deposit rate was around 3%. The regular practice by trust companies to make investors whole has created a moral hazard to which government officials are sensitive and looking for ways to rectify.