The Fed’s 2015 dilemma: Equity market VS Oil prices

Even though the FX market is usually considered as an esoteric asset class, it happens that a lot of opportunities were in currencies last year. I mainly think about the Yen and the Euro, but the chart shows the main currency performances against the Dollar.

CurrenciesvsUSD

(Source: Hard Assets Investors)

We saw a couple of weeks ago that the economy increased at an annual rate of 5 percent according to the third estimates, the highest print since Q3 2003 when GDP rose by an outstanding 6.9.%. In addition, we saw in October that the final numbers for FY2014 federal deficit was $486bn (or 2.8% as a share of GDP), $197bn lower than the $680bn recorded in FY2013 and the lowest deficit since 2008 as you can see it on the chart below.

USDef

(Source: CBO)

On the top of that, the unemployment rate stands at a multi-year low of 5.8%, down 2.1% over the past couple of year. The only scary figures is US debt [like any other country], which now stands at a record high of 18tr+ USD, up 70% under Obama (10.6tr USD back in January 2009).

Another Good Year for equities…

I have to admit that with the Fed’s exit at the end of October, I was a bit anxious on the consequences it could have on the equity market, especially after the several ‘swings’ we saw (January, October). In my article Could we survive without QE (Part II with US yields), I added a chart (S&P 500) where you can see the impact on the equities each time the Fed stepped out of the bond market. Clearly not good.

But it didn’t. And after the 2013 thirty-percent rally, the S&P500 increased by another 11 percent in 2014 [and closed at records 53 times].

It looks to me that there are a lot of positive facts and the Fed can eventually start its tightening cycle. However, the collapse in oil prices will weigh on US policymakers’ decision in my opinion.

I think the question now is: which one will weigh more on US policymakers’ decision to tighten (or not)?

I strongly believe that the two main indicators the central bank is watching are the equity market and oil prices. An increasing equity market tends to have a positive effect on consumer spending (through the wealth effect). As a reminder, consumer spending represents 60 to 70 percent of GDP for most of the well-developed economies.

However, falling oil prices, with now Crude Oil WTI Feb15 Futures trading at $51.80 per barrel, is problematic. First of all, problematic for oil exporters’ countries (i.e. Chart of the Day: Oil Breakeven prices). We saw lately that Saudi Arabia announced that it will face a deficit of $38.6bn in FY2015, its first one since 2011 and the largest in its history (no projected oil price was included in the 2015 budget, but some analysts estimated that the Kingdom is projecting a price of $55-$60 per barrel).

I am just back from Kuwait City where I met a few investors there with a friend of mine (Business Developer in the Middle East), and most of them agreed that there were comfortable with a barrel at $60.

To me, falling oil prices reflect the weakening global demand and real economy effects. With the Chinese economy slowing down (GDP growth rate of 7.3% in Q3 is the slowest in five years), major economies back into recession (Triple-dip recession for Italy and Japan) and rising geopolitical instability, forecasts are constantly reviewed lower and problematic for debt stability [and sustainability]. I like the chart below (Source: ZeroHedge) which clearly explains that oil prices and global demand are moving together. In fact, lower growth projections combined with low oil prices and [scary] low yields are problematic for the Fed.

GlobalChart

(Source: ZeroHedge)

Moreover, falling oil prices is problematic as it will drive US [and global] inflation lower. The inflation rate is slowing in most of the developed economies: in November, UK inflation fell to a 12-year low of 1% in November, EZ policymakers are still working on how to counter rising deflation threat (prices eased to a 5-year low of 0.3%) and US CPI fell at the steepest rate in almost six years to 1.3%. Most of the countries whose central banks target inflation are below their target.

2015: New Board, new doves…

In addition, as you can see it below, the ‘hawks’ members – Fisher and Plosser – are out this year and this could change the tenor of debate within US central bank’s policy-setting committee.

FedBoard

(Source: Deutsche Bank)

Could we survive without QE? (Part II with US yields)

Last month, I wrote an article that summarized all the decision made by the US policymakers since GFC and the impacts as soon as the central bank was stepping out of the market (see article Could we survive without QE?)

We concluded that as soon as the Fed was ‘leaving’ the equity market and let it rely on fundamentals only, we saw sharp correction straight afterwards (See chart below: April—July 2010, July – August 2011, September-November 2012).

SP10Oct(1)

(Source: Reuters)

As we are ‘kindly’ approaching the last days of QE with the Fed stepping out of the bond’s market at the end of this month (October 28th), I thought it is a good time to give you an update on the current situation. And Guess what: this time is not different. Since the mid-September high of 2,019.26 (Sep 19th), the S&P 500 is down 7 percent and closed for the second consecutive session below the 200-SMA for the first time since November 2012. And the question I am asking myself is: how far it could go? I don’t have a specific answer to that, but what I can tell you is that the Fed’s Officials are now realising their mistake by expressing themselves on their ST monetary policy. My thoughts have always been that Yellen [& Co.] should have let the market swallow a period without QE before considering raising its ST interest rate. Therefore, we saw at the last minutes (last Wednesday) a different tone, with policymakers suddenly jawboning about the US Dollar Strength (Yes, even the Fed is not comfortable with a strong exchange rate) and the fact that global slowdown could rise risks to US outlook. I expect the tone to remain neutral until the end of the year, therefore capping the appreciation of the US Dollar against all currencies. If the equity market continues to tumble, I think we can even see/hear a couple of dovish statements/conferences as the equity market is one of the most important index (with oil) for US policymakers.

If we have a look at the LT interest rates, the 10-year US yield is now trading at its 18-month low at 2.20%. Clearly, that shows the situation in the market is much more fragile than expected. Moreover, I added a similar chart as the S&P 500 but this time applied to the 10-year yield. I read and heard analysts’ recommendations on yields, and most of them are quiet bearish on Treasuries in the next months to come, targeting a 10-year yield at 3%. However, if we look at the chart below, we can see that each time the Fed stepped back of the bond market, LT yields contracted (March – November 2010, July-September 2011). And it looks like this time is [also] not different with the 10-year yield down 80bps since December’s Taper Announcement.

10Year(1)

(Source: Reuters)

Risk-ON and US Dollar strength persist…

While tensions in Syria are still elevated with a second American ISIS fighter killed in a battle, Gazprom beginning accepting payment in Rubles and Chinese Yuan (via the ESPO – Eastern Siberia Pacific Ocean – pipeline), Ebola outbreak causing enormous damage to West African economies (economic growth expected to plunge by 4% in the region according to the African Development Bank), Argentina’s black market peso completely out of control tumbling to over 14 / USD (14.45 according to Argentine newspaper Ambito), French jobseekers surging to record high of 3.424 million (with PM Manuel Valls blaming the ECB to do more as QE was the solution to everything) and IMF head Christine Lagarde put under a formal probe for negligence in a corruption investigation… AUDJPY continues to climb and is now trading above the 97.00 level for the first time since June 2013 and the S&P500 closed above the 2,000 for the second time in history.

AUDJPY(1)

(Source: Reuters)

While European bourses have been also climbing during the same period with DAX and CAC40 both up approximately 6.5% for instance, yields on all German bonds out to 3 years are now negative (see current German yield curve in green) with the 10-year Bund 90.1bps and French 10-year OAT yield trading at all-time-low at 1.25%. The orange curve represents the German yield curve 1 month ago, and the histogram tells us the change over the past month).

image001(1)

(Source: Bloomberg)

Euro: the single currency still remains under pressure and is now trading below the 1.3200 level against the greenback, down 8 figures since May meeting (Draghi’s ‘ready to act next meeting’). It seems that the market is expecting more easing measures at the ECB meeting next week (September 4). As growth is weakening, the ECB will be much more intolerant of low inflation (flash August Inflation is expected to fall to 0.3% YoY from 0.4% the previous month) and high unemployment rate (currently stands at 11.5%). As a reminder, ECB staffs reduced its annual inflation forecasts in Q3 from 0.9% to 0.7% for the year 2014 and from 1.3% to 1.2% for 2015. With the 5Y5Y Euro inflation swap – ECB’s preferred measure of MT inflation – falling below the 2% level, investors are predicting another cut in the last quarter of this year therefore raising expectations of further measures from the ECB Governing Council. In addition, we saw this morning that loans to private sector fell by 1.6% in July (vs. -1.5% consensus) while M3 money supply grew by 1.8% from a revised 1.6% in June.

After Draghi delivered a dovish speech at the Jackson Hole central bankers’ meeting concerning the falling expectations of future EZ inflation, we heard yesterday that the ECB appointed money manager BlackRock to advise a program to buy ABS in order to revive the faltering Euro-area economy (announced at the June meeting). I would put public QE (sovereign bonds) option on aside for the moment, however I would opt for further updates concerning the ABS program and a potential rate cut. Otherwise, the next important date for the EZ will be on September 18, the first tranche of the so-called TLTROs.

The next support on EURUSD stands at 1.3150 (yesterday’s low), followed by 1.3100 (September 2013 low). Another interesting development to watch is EURCHF, which is now trading below the 1.2060 key support. The next support stands slightly above 1.2020 before the floor of 1.2000 (which remains our target in the coming weeks).

GBP: Sterling, the once used-to-be market’s darling, has fallen more than 6 figures since its mid-July high of 1.7191 and is now trading slightly below 1.6600. It broke its 200-day SMA on August 19 for the first time in more than a year, bringing in more participants in Cable’s bearish trend as the market likes trending market. If we have a look at the CFTC’s Commitments of Traders (see below), we can see that the net speculative positions fell from above 56K on July 1st to 13K+ reported on August 19th. I expect a pause at current levels in the coming days between 1.6550 and 1.6600.

COT-GBP(1)

(Source: OANDA)

UK strong GDP 2nd estimates (0.8% QoQ, 3.2% YoY) two weeks ago didn’t manage to bring investors’ interest on the British pound as annual inflation came in much cooler than expected in July at 1.6% YoY (vs. 1.8% eyed) shattering expectations of an early rate hike from the BoE. The implied rate of the Short-Sterling March 2015 futures contract is trading at 89bps, down from 1.15% in the beginning of July.

JPY: I will finish this article with a quick update on Japan and the Yen. Despite US yields running low, below the 2.40% level (trading at 2.33% at the moment), USDJPY broke its strong resistance at 103 to trade at 104.43 (Monday’s high) before edging back below the 104.00 level. We heard lately from Japanese Vice Economist Minister Nishimura that the Japanese economy may need more time than expected to swallow the sales tax hike (April 1st) and that the government may have to be more vigilant for the second planned one (October 2015). As a reminder, Japan GDP shrank by 6.8% (annual pace) in the second quarter and erased Q1 gains. The market is bearish on the JPY against most of the currencies and traders are quite confident that the government and especially the BoJ will do ‘whatever it takes’ to sustain Abe’s ambitious goal.

If we have a look at the recent figures, we saw that industrial production slid 3.4% MoM in June (biggest decline since the March 2011 disaster). JP trade balance deficit widened to 964bn Yen for July (vs expectations of a 702.50bn gap Yen) and the country reported a second current account deficit in June (399.1bn Yen) and the first January-June deficit in 29 years.

Important July figures to watch overnight: Core Nationwide CPI, expected to remain steady at 3.3%, Unemployment rate (also to remain steady at 3.7% according to consensus) and Preliminary Industrial Production (expected to tick up to 1.0% MoM after June’s decline).

Based on my last couple of discussions I had with some traders, it seems that the market is looking for buying opportunities on USDJPY. Pivot point is seen at 103.50/55, where there is talk of lots of buy orders.