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Divergence Resurgence

Scott Smith July 25, 2016

Financial markets have more or less absorbed the major geo-political events risk that have arisen as of late, taking the developments in stride and propelling global equities to new highs.  Foreign exchange markets have focused on the potential for further monetary policy divergence, helping the greenback edge higher against a basket of major currencies.  The aforementioned points are correlated to some extent, as assets viewed positively when risk appetite rises have benefited from central banks around the world hinting that further monetary policy accommodation will be required to battle stagnant global growth.  More specifically, while US economic data over the second quarter has continued to surprise to the upside on an aggregate basis, the light data calendar from last week is insufficient to fully describe the outperformance of the USD.  While the expectation for a resurgence of economic growth in the US over the second quarter has helped underpin the American buck, the assumption of additional stimulus from the Bank of England, the potential for ‘helicopter money’ in Japan, along with a basis towards more interest rate cuts in Australia, have all worked in concert to boost the value of the greenback.  Sterling’s hopes of a sustained rebound after some hawkish commentary of select members of the Monetary Policy Committee were quickly dashed after post-Brexit PMI data showed purchasing manager activity ran into some strong headwinds and has brought market participants back to siding with Mr. Carney that more monetary policy stimulus will likely be required by the next MPC meeting.  That said, the immediate week ahead will be dominated by the Federal Reserve and the Bank of Japan who both hold monetary policy meetings this week, and will be important for overall direction in the foreign exchange market, but for completely different reasons.

The Federal Reserve monetary policy meeting this week will be important, despite the expectation there will be no change in the actual policy rate, as the tone of the prepared statement will set the stage for how the evolution of monetary policy will take place into the end of 2016.  We’ve previously opined that the minutes of the meetings give more weight to non-voting regional presidents who have traditionally leaned more ‘hawkisly’ than the center of leadership among the FOMC, and the statement immediately following the policy decision is crafted to better reflect the views of the power base of the FOMC.  That being said, we feel there is a risk to see the generation of a statement with hawkish leanings given the developments in financial markets post-Brexit.  The median analyst estimate for the first estimate of second quarter GDP growth is expected to come in at 2.6% on an annualized basis (though there is the potential to see a slightly disappointing print on Friday given both the Atlanta and New York GDP trackers are projecting a slightly softer reading) and global equity markets have shrugged off the initial shock of Brexit, with the S&P charging to fresh highs.  The relative robust structure of equity markets since the shocking Brexit vote and a Chinese yuan that has been grinding lower since May (other than last week’s advance) will likely help the overall tone of the FOMC’s assessment of international developments, and coupled with domestic data evolving in-line with expectations, the Fed will likely keep its options open for September, although we see a greater probability of a move by December.  The interest rate market is still betting the chances of a December move are still worse than even money, but there is a risk that odds for a rate hike in December improve over the coming months, helping the big dollar re-test the highs the DXY witnessed in early March.

While we think there is a risk the Federal Reserve’s language has a hawkish slant to it after the conclusion of this week’s meeting, there is an equally likely chance the Bank of Japan’s monetary policy decision disappoints market participants, especially given the yen’s close to six percent decline since early July.  Market participants had gotten excited about the potential for ‘helicopter money’ from the Bank of Japan at this month’s meeting, though an earlier interview with Kuroda makes this seem unlikely given the legality of having the BoJ purchase bonds directly from the government.  While the blurring of lines between fiscal and monetary policy might be what ultimately ends up materializing in Japan, it doesn’t appear policy makers have arrived at this conclusion.  Whispers of a more aggressive fiscal stimulus package from the government have kept downward pressure on the yen, and to keep the momentum of yen selling from easing, the BoJ will likely have to announce some form of additional easing at the conclusion of this week’s monetary policy meeting.  Given the foray into negative interest rates has yet to yield the desired results, and the aggressive balance sheet expansion through bond purchases can sometimes create liquidity concerns, the BoJ may take this opportunity to tweak the quality of assets its purchases, leaning more on the ETF market as a way to inject liquidity as opposed to purchasing more government securities.  While the BoJ has traditionally been difficult to predict how it will act, the weakness of the yen over the past two weeks is likely to heighten volatility into the end of the week, especially given the potential for a short-squeeze in the yen to materialize if the BoJ disappoints with their prescription for monetary policy.

The week ahead of the loonie is light in terms of economic data, though as far as direction is concerned, that may be of little consequence given policy decisions from the Fed and BoJ.  The loonie ended last week on unstable footing, though this was not for lack of better than expected economic data, and more to do with overall sentiment based on an exodus of capital from the energy complex.  Retail sales data has remained robust over the past few months, a factor of hot housing markets that are buoying consumer buying power, and helping to cushion stagnant export data and business investment.  GDP data for May is due out on Friday and expected to witness a large drawdown from April’s number, though the more pertinent drivers for the loonie in the week ahead will likely be price action in the hydrocarbon market and Federal Reserve monetary policy.  Technical considerations suggest the downdraft in oil over the near-term has not exhausted itself fully, with an increase in inventories and the lagging increase in US rigs weighs on short-term sentiment.  Further upside for USDCAD as a result of continued softness in energy should not be taken for granted by corporates that are long USD in the normal course of business operations, and if there is a subsequent uptick in implied volatility, it could give those long USD some much-needed relief after the sideways price action that has been registered over the past few months.


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