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FX Update - Low interest rates and low volatility are not here to stay

Written by Ian Dobbs on September 23rd, 2014.      0 comments

Market Overview:
After the United Kingdom dodged a bullet with the Scottish ‘no’ vote for independence the market turned its attention to the weekend’s G20 meeting. As usual there were a lot of sound bites, comments and quotes published, but nothing of real significance. The communique mentions stronger economic conditions in some key economies, but says growth in the global economy remains uneven and below the pace required to adequately generate jobs. It also stated that the G20 were mindful of the potential for a build-up of excessive risk in the financial markets, particularly in an environment of low interest rates and low asset price volatility. This is an important point. The relative calm of the past year in financial markets is unlikely to last. We are now entering a period where interest rate normalization is on the horizon for many countries and this has the potential to create more than a few ripples across various asset classes. Low rates, low volatility and quantitative easing policies have led to the mispricing of risk in many markets. As rates begin to rise the risk of disorderly moves will increase dramatically and it seems unlikely the normalisation process will all be smooth sailing.

There has been little in the way of economic releases from Australia since last Tuesday’s RBA minutes. The Australian dollar has been under some pressure this week thanks to a report from Roubini Economics that predicted the currency would fall to 0.7500 against the USD. They believe slower Chinese growth will be a big headwind for the Australian economy in 2015, that this will see GDP dip to 2% and that the RBA will cut rates again. That is certainly a very bearish view. There is little doubt however, that 2015 will see lower growth in China, and there is the risk it could be a lot worse than that. The huge amount of debt created in the Chinese economy of the past few years has been a point of concern for many China observers. If things start to unravel, it will be led by a major correction in their housing market. This is why a recent report in the Chinese press has raised eyebrows. The report says that in Handan, a third-tier city in Hebei province, a full-scale housing collapse is under way and that it will take 10 years to digest the current housing inventory. It seems unlikely Handan will be the only city to suffer such a result. Tomorrow we have the RBA financial stability review, and on Thursday Governor Stevens is set to speak.

New Zealand
The New Zealand dollar started this week on a slightly firmer footing, thanks in part to the market friendly election outcome. Last week’s stabilisation in dairy prices and the better than forecast GDP result have also helped improve sentiment toward the currency. There is little scheduled for release this week with only the trade balance on Wednesday of any note. Yesterday we did get the Westpac Consumer Sentiment index which saw a pull back to 116.7 from 121.2 previously. This is a quarterly survey and although it did decline somewhat current levels are still very healthy.

United States
The main focus in the US last week was the FOMC rate statement on Thursday. The market took the statement to be a touch more ‘hawkish’ than previously and as such it was supportive of the USD. However, much of the other data out over the week was not quite as supportive, with a number of key releases coming in below expectation. Inflation, industrial production, building permits and housing starts all disappointed somewhat and these have helped to limit the recent USD gains. We can add existing home sales to that list after it also came in below forecast when it was released last night. We have a number of Fed speakers this week to draw focus. The Fed’s Fisher was quoted late last week as saying he wants to see the first move on interest rates in the Spring of 2015. He is however, one of the more “hawkish” members of the FOMC. A speech by William Dudley last night was probably more reflective of the FOMC current view. He said that the economy needs to run a little hot given that inflation is tame due to economic slack, subdued expectations, and weak growth abroad. He added that rate rise guidance will be driven by economic data, although it will make him happy to see rates go up in 2015. Data wise this week the highlights will be new home sales, durable goods orders and weekly unemployment claims.

United Kingdom
Attention in the UK last week was dominated by the Scottish independence referendum. That provided such a big one-off risk event that all other data was side-lined with the market squarely focused on the outcome of the vote. In the end is seems fear of the economic consequences of a split swayed many votes and common sense reigned. The GBP rallied hard as the results started to come in, but by the time the outcome looked assured it had given back much of those gains thanks to profit taking by short term traders. With the referendum out of the way and the market ‘noise’ around the event now gone, the focus will turn back to prospects for a rate hike in early to mid-2015. Recent data has been supportive with an uptick in core inflation, better than forecast employment and solid retail sales figures all suggesting pressure will only build within the Monetary Policy Committee to signal rate hikes are on their way. This should see the GBP slowly start to appreciate as trend over the coming months. Data this week is mostly a second tier affair, with mortgage approvals, public sector net borrowing, the house price index and CBI realized sales all set for release.

We saw a mixed bag of data from Europe last week. Economic sentiment in Germany improved, but declined overall in the Eurozone. The final reading of inflation came at 0.4%, which is a touch better than the 0.3% forecast, but the take-up of the ECB’s first targeted LTRO was much lower than expected. This raises a number of questions about loan demand in the region. ECB President Draghi spoke last night to parliamentarians in Brussels and he offered a somewhat gloomy view of the Eurozone’s economic prospects. He said economic risks are clearly on the downside with unemployment remaining unacceptably high. He reaffirmed monetary policy will be expansionary for a long time and added the ECB’s efforts will fall flat if governments fail to make far reaching reforms to their economies. He also said the results from last weeks targeted LTRO should be taken in conjunction with the next offering which is in December. We get manufacturing and service sector PMI’s over the coming days along with the German IFO business climate index.

There hasn’t been much in the way of data released from Japan over past week, although there have been a couple of significant announcements. The first was from the Japanese Cabinet Office who released their September Economic assessment on Friday afternoon. They downgraded their assessment for the first time in five months sighting weak consumption. The added that improvements in corporate profits appear to be pausing with firms cautious about current business conditions. The other significant announcement came from Japan’s economy minister Amari. He signalled the second tax hike will go ahead, saying it was necessary to meet rising costs for social security and prevent a collapse in confidence of Japan’s ability to rein in its vast budget deficit. The Yen has weakened dramatically over the past month and this is starting to get the attention of officials who suggest rapid moves in the exchange rate are unhelpful. The former BOJ deputy Governor Iwata said the weak Yen puts Japan at risk of recession. Rising import costs are squeezing corporate profit margins and eroding consumer capacity to spend. This week we have inflation data to draw focus on Friday.

The Canadian dollar has been a strong performer recently and last week’s data was very supportive for the most part. The only disappointing data was wholesale sales that came in on the soft side, but other releases on the week in the form of manufacturing sales and inflation, were both much stronger than forecast. Last night we did see some slightly ‘dovish’ comments from Bank of Canada (BOC) Deputy Wilkins. She said the neutral interest rate was lower than before the crisis and that Canada may need loose policy even at full capacity. Tonight we have retail sales data to digest which is the only release of note on an otherwise empty economic calendar.

Major Announcements last week:
  • UK CPI 1.5% as expected
  • Canadian Manufacturing Sales 2.5% vs 1.1% expected
  • US PPI 0.0% vs 0.1% expected
  • NZ GDT auction 0.0%
  • NZ Current Account -1.07b vs -1.04b expected
  • UK Average Earnings 0.6% vs 0.5% expected
  • UK Claimant Count -37.2k vs -29.7k expected
  • BOE minutes 2-7 vote to keep rates unchanged
  • US CPI -0.2% vs 0.1% expected
  • NZ GDP 0.7% vs 0.6% expected
  • GBP Retail Sales 0.4% as expected
  • EUR TLTRO 82.6b vs 150b expected
  • Scottish Independence Vote “No”
  • Canadian Core CPI 0.5% vs 0.2% expected