Market Commentary


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Date: 31 July 2018 / Time: 17:00

Bank of England preview: It’s not about the rate hike…

The Bank of England will reveal its third Inflation Report of the year on Thursday 2nd August at 1200 BST. The market is pretty much convinced that the BOE will hike rates, the GBP Overnight Index Swaps market is pricing in a rate hike this week with a 91% probability.

Usually when the market is so convinced of something the central bank responds. We believe that there is only a very remote possibility that the BOE won’t hike rates on Thursday. Due to this, the rate hike is the least interesting part of this Inflation Report. Of more concern are the following:

  • The mechanics of the rate decision: The includes the split between the MPC members, the market is currently expecting an 8-1 split in favour of a hike, with Sir Jon Cunliffe the only member expected to dissent and vote against a hike. However, if we get more MPC members voting against a hike then sterling could come under pressure, as it would suggest a future dovish stance by the BOE.
  • Economic forecasts: the BOE will also release its latest GDP and CPI forecasts for the next four years. There is not expected to be any change to the GDP forecasts, and the BOE is expected to confirm that it is looking for the UK economy to expand by 1.4% this year. Watch out for the CPI forecasts, global inflation pressure is rising and the UK is no exception, thus we expect the BOE to raise its CPI forecast for the entire forecast period. Higher CPI could be GBP positive if it coincides with a steeper UK yield curve.
  • The new neutral: earlier this year the BOE Governor Mark Carney said that the Bank would give its view on the latest equilibrium, or neutral, interest rate for the UK economy. This is also known as R*. The market is expecting this rate to come in around 1.5%. If an R* of 1.5% is confirmed by the BOE, then it would suggest another three rate hikes are likely in the next 3 years. This would require a slight adjustment to current market expectations, which could be mildly pound positive. Obviously, anything higher than this could trigger a rapid increase in UK bond yields and a broad-based increase in the pound, and anything below this level could see a rapid decline in sterling.

The pound:

As we mention above, confirmation of a rate hike is unlikely to be a market-moving event since the market has already priced in one rate hike from the BOE. Instead the update on the UK’s neutral interest rate is likely to be the most market-moving information in this Inflation Report.

GBP/USD has fallen sharply since the last report in May, and it is drifting lower as we lead up to the meeting. If the BOE can convince the market that the neutral interest rate for the UK economy is now 1.5% or above, then GBP/USD may start to recover, with 1.3285 – the base of the daily Ichimoku cloud – a key level of resistance, since a break above this level would suggest an end to the recent downtrend. A weaker neutral interest rate could make it hard for GBP/USD to sustain gains above $1.30, and trigger another leg lower in the pound’s downtrend.
Date: 31 July 2018

Apple will announce its earnings at 2130 BST this evening, and it is easily the biggest event for stock markets today, even this week. After some big earnings misses from the likes of Netflix, Facebook and Twitter, the heat is on for Apple to deliver at least the $2.18 earnings per share that the market anticipates.

As you can see in chart 1, which has been normalised to show how the biggest US tech firms move together, Apple has been in the weaker half of performers in the US tech sector since the end of 2017. However, its share price has been relatively stable in recent days, and it has not suffered the major declines that have plagued Twitter, Netflix and Facebook since last week.

Date: 31 July 2018

ECB in a bind, BOJ plays stick not twist, and why the dollar is looking weak

Inflation may become the hot new topic for financial markets as we move into the latter stages of the summer months. The July CPI rate for the Eurozone came in stronger than expected at 2.1%, the fastest rate of price growth since 2012. Core prices are also rising, albeit at a slower pace, to 1.1%.

Price growth is starting to weave its way into the financial narrative after a plethora of US companies announced price rises in recent months including Starbucks, Colgate Palmolive, Chipotle and US rail companies, blaming the price rises on higher input costs. While consumer prices may be held in check in the Eurozone for now, they may not be for long, as headline inflation pressures have a habit of seeping into core prices with a lag.

Growth vs. Inflation, the ECB needs to decide

All of this makes life difficult for the ECB. Although the Bank has set the stage for a rate hike at some stage in late 2019, its mandate – to maintain prices at close to 2%- may mean that they have to start hiking prices sooner, particularly if this is the beginning of a trend for higher prices in the currency bloc.

Rising inflation has given the euro a boost, it is currently trading at $1.1730 – its highest level since late last week, the next resistance level to watch is 1.1750 – the high from last week, and then 1.1791 – the high from 9th July. How EUR/USD reacts as we lead up to the crucial $1.18 level is worth noting. The ECB is essentially on a summer break during August, so the market will have to speculate whether the ECB will react to stronger inflation or to weaker growth - Q2 GDP was 2.1% YoY, down from 2.5% in Q1, and Spain’s growth for Q2 was at its slowest pace for 4 years.

Why it could be a good month for euro bulls

If the market expects the ECB to stand by its mandate, even in the face of slowing growth, then interest rate expectations may be brought forward. Even a subtle shift could boost the euro and $1.20 could be on the cards over the next few weeks. Of course, for euro bulls, the risk is that the ECB does not play ball, but with the ECB out of office for the next few weeks, the euro could have free reign to get back to $1.20 in August, a level that was last reached in April.

BOJ leaves it to fiscal policy to do the heavy lifting on price growth

Elsewhere, the BOJ failed to deliver a big shift in its monetary policy stance at its meeting earlier on Tuesday, even though expectations were high that it could deliver an end date to its QE programme. The trouble for the BOJ, however, is the 2019 proposed increase in the consumption tax. A rise in Japanese VAT is a political hot potato that is resisted by voters and has been the undoing of many a Japanese government. However, with a debt-to-GDP ratio of 98%, the country is crying out for some form of tax reform. Thus, the BOJ has to consider the implications of a change in fiscal policy next year when it is planning monetary policy for this year.

Overall, we believe that the consumption tax binds the BOJ to stick to its current policy path because the fiscal reform could do enough tightening without the BOJ needing to intervene. Hence why 10-year JGB yields have given back 61.8% (key Fib level) of their recent gain on the back of today’s BOJ meeting. Japanese government bond yields may continue to rise, not because of BOJ policy, but because of the upcoming consumption tax.

Signs the dollar could slide into August

Overall, with the euro looking perky on the back of inflation pressures and an absent ECB, and with the yen’s decline most likely capped due to impending inflation pressures due to next year’s tax hike, the dollar may take the hit in August. The dollar index has been stuck in a tight range between 95.60 on the upside and 94.00 on the downside in recent weeks, and it has recently fallen below its daily Ichimoku cloud support at 94.36, which is a bearish development. In the short term, a break below 93.90 could open the way to further weakness back towards 92.50 in the coming weeks.

Date: 30 July 2018

Understanding volatility and the summer months

As we reach the end of July it is worth looking at volatility, which can be notoriously hard to predict in the summer months. The Vix index is close to its average of the last 12 months, at 13.48, the average of the past year is 13.68. However, it is worth noting that since 1990, the Vix has never recorded its highest level of the year in July, that tends to come in August. Thus, we could be experiencing the calm before the storm.

Why tech could be the driver of volatility this summer

Some may argue that if volatility doesn’t rise on the back of a global trade war, deteriorating geopolitical relations or a potential synchronised tightening by the world’s leading global central banks, then what will make it rise? We believe that the answer could be found in the tech sector. If Apple does not deliver a decent set of earnings when it releases its 3Q earnings on Tuesday, then we could see stock markets start to unravel and volatility start to rise.

The reason for our focus on the tech market is two-fold. Firstly, investors have had a violent reaction to disappointing tech earnings this season. Take Facebook, its share price fell nearly 20% - bear market territory – on the back of its earnings miss last week. Another sell off could occur if Apple does not meet analyst expectations of $2.155 earnings per share later this week.

Secondly, the market has become extremely reliant on the tech sector, as you can see in the chart below. The tech sector has been the key driver of the S&P 500 for most of this year. If Apple also disappoints expectations then we may see investors lose even more confidence in the sector, and a broader decline occur, at least in the short term.

Where to find volatility: EM FX vs. G10 FX

Also worth noting, the emerging market FX and G10 FX volatility ratio is at its highest level since 2002, as you can see in chart 2 below. This has occurred, as volatility in the G10 FX space remains extremely low, while EM FX has experienced a sharp upswing in volatility in recent weeks. The key driver for the sharp increase in this ratio is usually put down to global trade wars impacting the EM space more than the G10 space, however, we think that China’s yuan is more of an important reason for the differing volatility levels. As the yuan has declined, it has put pressure on other Asian countries’ to weaken their currencies, particularly in the EM space, as they try to remain competitive with Chinese exports. Thus, China’s currency decline is the main reason, in our view, why EM FX is more volatile than G10 FX right now.

After a further decline in the yuan at the start of this week, if you are looking for some volatility in the FX market, the EM space, particularly in Asia, is worth a look.

Date: 24 July 2018

European stocks: ripe to shine

European stocks are recouping Monday’s losses as investors become more comfortable with holding risk. The turnaround is down to better PMIs in the Eurozone as well as strong US earnings, and growing expectations that the US Q2 GDP report will beat expectations after White House advisors have said that they expect a 5% annualised growth rate for last quarter when the data is released on Friday.

These are powerful drivers for risk markets, and, for now at least, the prospect of higher interest rates in the US and a potential end to QE in Japan, is not phasing markets when the other headlines are this positive. We believe that the real winner could be European stocks. The European market has had a torrid year so far, only the Cac and the FTSE 100 are in positive territory for the year so far, which compares to a 5% gain for the S&P 500 and a 14% gain for the Nasdaq.

So, why are we upbeat on the outlook for European indices, at least in the near term? We think that there are three reasons for this:

  1. Growth: a strong US growth rate could ease Trump’s trade war rhetoric, which may benefit the export heavy European indices, especially the Dax. Added to this, stronger growth in the US could be catching, and the Eurozone’s economy could play catch up in the coming months.
  2. Politics: Trump is scheduled to meet European Commission President Juncker next week, in an attempt to diffuse tensions regarding car tariffs. If a deal can be reached then we could see European car stocks, such as Germany’s Volkswagen and BMW, bounce back after a weak performance for most of this year.
  3. Relative value: last, but definitely not least, the European indices are looking cheap in comparison to their US counterparts. The P/E ratio for the S&P 500 is 21.09 and 27.97 for the Nasdaq, compared to 15.89 for the Eurostoxx 600 and 14.16 for the Dax. Dividend yields are also looking more attractive in Europe, with the average yield on the Eurostoxx 600 at 3.53%, vs. 1.84% for the S&P 500.

We believe that the Dax, in particular, is starting to look like an attractive prospect in the European market. The chart below shows the Eurostoxx 600 index (orange), the Cac (green) and the Dax (white). As you can see, the Cac is the best performer, followed by the Dax, and both indices are out-performing the overall Eurostoxx 600 index. However, the impact of an end to the deadlock around US/EU car tariffs at the Trump/ Juncker summit next week, and the fact that the Dax is cheaper than the Cac right now, could make the Dax the most attractive European option for investors in the coming weeks.

The Dax is also looking attractive from a technical perspective; it is close to its 200-day sma, a major level of resistance, at 12,772. A break above this level may trigger further gains back to the mid-June highs of 13,185.

Date: 23 July 2018

2 things to watch in FX this week

Two key events are dominating the FX world this morning: the first is the Reuters report that the Bank of Japan will alter its stimulus programme. The yen is the top performing currency in the G10 this morning, which reverses a month-long period of weakness for JPY.

The report suggests that the BOJ is looking at ways to reduce its footprint in the markets, the bank currently has a target to increase its bond holdings to 10 trillion yen a year. Considering the yen is currently the largest of the major central banks pursuing such an aggressive QE programme, this is big news. However, the impact on the yen could be short-lived. Firstly, the report did not suggest that the BOJ will aim to normalise policy, and thus end QE altogether. Although the 10-year Japanese government bond yield has surged by 56 basis points since the report surfaced, this is still below the high of the year when the 10-year yield reached 1% on 1st February.

Secondly, although the Bank of Japan appears to want more flexibility when it comes to its stimulus programme, and may remove its bond-buying target at its next meeting, we still expect the BOJ to keep interest rates in negative territory after lowering its inflation outlook earlier this year. With rates in negative territory, it is hard to see how far the yen can rally.

Trade wars could keep yen in check

Lastly, outside forces may also weigh on the yen. The Japanese economy is exposed to global trade wars because of the importance of global trade to its economy – both exports of its goods and imports of raw materials that it needs including oil. Thus, with trade wars still a major theme this summer, we may see the yen struggle to maintain today’s rally if we see further upticks in the rhetoric from the US or China.

Bargain hunters starting to emerge

The spike higher in USD/JPY volatility is justified today, however, we don’t expect to see USD/JPY volatility back to the February highs anytime soon, even though we may see volatility in the yen drift higher as we wait for next week’s BOJ meeting on 31/7. USD/JPY has taken a sharp tumble today, and extended Friday’s losses dropping as low as 110.75 earlier, which is ahead of the 50-day sma at 110.50, a key support level. However, the yen is already showing signs that it may be in recovery mode, and is back above the 111.00 level as we head into UK lunchtime.

This suggests some USD/JPY bargain hunters are starting to emerge and some in the market are doubting just how aggressive the BOJ will be when it comes to scaling back its QE programme. We tend to agree with the market, and expect the BOJ to tread a very careful path when it comes to policy changes in the coming months due to the external threats to the economy from a global trade war.

Although a big change to the BOJ’s stimulus programme is likely to materialise, we still think that lose monetary policy is the order of the day at the BOJ for the foreseeable future. However, the risk is rising as we lead up to next Tuesday’s BOJ meeting. We expect yen volatility to remain elevated compared to last week’s levels, and for the yen to trade in a choppy fashion. We would expect USD/JPY to trade in a 110.50-112.50 range in the lead up to next week’s meeting.

Chinese Yuan: how low can it go?

The second key theme in FX right now is the Chinese yuan. It continues to fall after the Chinese authorities injected cash into the banking system, a sign that the PBOC is keen to loosen monetary policy at the same time as the rest of the world is actively tightening policy, or at least starting to think about it.

Beijing: the ultimate way to annoy Donald Trump…

Offshore renminbi spot is now at its lowest level since June 2017. We do not expect the Chinese authorities to intervene to stem the yuan’s decline unless we see a pic- up in volatility and a disorderly crash in the yuan, which is not currently expected. Thus, Donald Trump’s complaining about the Chinese currency may do more harm than good. One way China could punish the US in a trade war is by allowing its currency to continue to slip, thus making US exports to China expensive and less attractive, hurting Trump’s efforts to reverse the US/ China trade deficit. Thus, the next frontier in a global trade war could be a currency war. However, with the Chinese economy under-performing the US‘s right now, a challenged banking sector, and signs that the PBOC may want to loosen policy, we believe a currency war between China and the US is likely to be won by Beijing.

The Chinese authorities may not get too worried about yuan weakness until we see 7.00 vs. the USD, which would be the weakest level since the end of 2016. Thus, a weaker yuan could be a theme in the FX market for some time. A weaker yuan has implications for other Asian currencies who not only want to import goods to China, but who also compete with China on the export markets. There is pressure for Asian currencies to follow the yuan lower, and it is no surprise that Asian currencies dominate the worst-performing emerging market currencies since the start of June, as you can see below. While the yuan continues to fall, we may see further weakness in the Malaysian, Indonesian, Taiwanese, Thai, and South Korean currencies.

Overall, Asia is the centre of the FX action right now, and we expect it to remain so while we lead up to next week’s BOJ meeting. China’s faltering currency may also trigger a race to the bottom in the Asian FX space, which is another reason why we believe that the BOJ will need to be extremely careful to make sure that its next steps do not trigger a wave of yen appreciation in the coming weeks, at the same time as its Asian FX counter-parts continue to see currency declines.

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