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Yellin’ at the Hole

August 22, 2016

Record amounts of liquidity sloshing around in financial markets looking for suitable investment vehicles has complicated the roadmap for foreign exchange markets over the first half of 2016, with sufficient pressure on long-term yields pushing investors further out the risk curve in a hunt for yield.  The summer doldrums and a lack of carbon-based traders at computer screens have the market in a complacent slumber, with global equities near all-time highs almost midway through the second half of the year.  The mantra brandished about in the financial press about “this time being different” has market participants scuttling to try and seek out sufficient yield opportunities, while looking to sell inflation hedges as global central banks are struggling to reignite pricing pressures in the developed world.

Once the developed world’s best shot at normalizing monetary policy, the Federal Reserve has caught some unlucky breaks from an economic data perspective, and the delays in removing some of the abnormal levels of accommodation has tarnished the Fed’s credibility.  While it may be too early to suggest the Jackson Hole symposium is Janet Yellen’s last shot at restoring some of the Fed’s lost credibility, there is the possibility that Yellen’s remarks outline a distinct roadmap for monetary policy throughout the remainder of the year.  Much like there is a saying there will never be a perfect time in anyone’s life to have a baby, the Fed should realize by now that there will never likely be an optimal time where all the stars align and the Fed is 100% confident additional rate hikes will be required. Yet, we would argue enough of the building blocks are in place to witness an increase in interest rates by the end of 2016.  Yes, second quarter GDP data grew at a slower than expected pace, and it’s unlikely we see a material adjustment higher when the second estimate is released on Friday, yet consumer spending grew at an impressive rate, and industrial production numbers in July bode well for business investment and a rebuild of inventories in the third quarter.  The labour market also continues to tighten, and the upward pressure on wages should begin to filter through to the broader economy, though we do realize this will be somewhat of a longer than anticipated process.

From recent remarks and speeches from those on the FOMC, it appears as if the Fed is beginning buy into the view that on aggregate, the American economy is progressing in-line with expectations, and not to get too worried about one-off data points which appear to shake investor confidence.  While the FOMC meeting minutes were disappointing for USD bulls last week, it is important to remember the discussion points are relatively stale given the amount of data (specifically another robust employment report) that was received from the last FOMC meeting to when the minutes were published. And we would chalk up the greenback sell-off to some of the hawks being muzzled as opposed to any bearish commentary to be mindful of.  We had previously argued the NY Fed President Dudley would be the more important of the “Fed Watch” activities last week to assess, and while his hawkish commentary helped stem some of the American bucks’ losses, there is likely more room for investors to shift the pendulum on interest rate expectations towards expectations for an additional hike before the end of the year.  The technical condition of the DXY index is mixed, and having broken below the upward trend line that had been intact since early May is bearish, though support has been found at the 61.8% fib level from the most recent rally, and could be indicative the most recent round of dollar selling has reached its short-term conclusion.

From a fundamental perspective, this aligns with our view the risk for the American dollar in the week ahead is to the upside.  Assuming that Dudley’s views are echoed by Janet at Jackson Hole this week, and an upbeat outlook for the American economy into H2 coupled with a reiteration a rate hike could come as soon as September, this would lend further support for the greenback.  A lot of attention will be focused on Yellen’s speech in Jackson Hole Friday, and after skipping last year, the roadmap that is laid out from the chairwoman will be key for re-establishing the credibility of the FOMC.

Focusing on developments north of the 49th parallel, the loftiness of the loonie is a function of weakness in the USD and constructive price action in the hydrocarbon market as opposed to encouraging domestic fundamentals.  Of the two aforementioned drivers of price action last week, we would highlight we see significant risks of both those continuing in the week ahead.  We’ve previously opined at how the most recent run in crude prices is technical in nature versus a fundamental rebalancing of supply and demand, where the rebound in price could coincidentally sow the seeds of destruction in the current rally.  Over the busy summer driving month, there was less of a drawdown in crude stocks than in 2015, with a similar story for gasoline; combined with OPEC continuing to pull oil out of the ground in record amounts, demand and supply continue to move in opposite directions.  The most recent jawboning for a production freeze or cut from OPEC has helped drive prices higher in the short-term, but any follow-through at the next meeting that pushes prices higher will ultimately be counterintuitive to rebalance the market, as more shale players in the US will come back online to take advantage of the spike in prices.

The elevated levels of CAD that have the waterfowl at what is traditionally considered fair value against its neighbour to the south when measured by OECD standards is effectively what we would consider overvalued given the outlook for the respective economies, with demand being driven by a rebound in oil prices.  While the correlations with positive risk appetite have kept the loonie from giving up more real estate, the cracks that have been forming in the domestic economy are beginning to resemble worrisome fissures.  The engine that has been driving the Canadian economy showed its first signs of slippage in June, with retail sales figures decreasing on a month over month basis, falling at a greater clip when removing auto sales.  This corresponds with the relative softness we’ve been witnessing in the labour market, and without help from business investment or non-energy exports, GDP growth is at risk of falling short of what the Bank of Canada expects in the second half of the year.  Effectively, we are of the opinion the Canadian dollar will need to be at lower levels to help the economy rebalance away from consumer spending, and therefore there is a risk a reversal in oil prices and more bullish commentary on US interest rate hikes causes a rush for the exits in waterfowl holdings.


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