Fed, BOC cede spotlight to the ECB, BOJ

Report Prepared by Ahmed

Shibley

This was a big week for the Greenback as the two biggest items on the calendar were USD-related. As has become the norm of recent, a relatively hawkish Federal Reserve was unable to inspire any lasting strength in the currency while U.S. data continued to disappoint. Markets’ attention has been focused squarely on economic prints out of the U.S. economy of late, and as we discussed two weeks ago, this has done Dollar bulls very few favors as data continues to print below expectations.

On Wednesday and Thursday, Fed Chair Janet Yellen testified in front of Congress as part of the bank’s twiceannual Humphrey-Hawkins testimony. Matters appeared to kick-off even before Chair Yellen’s opening statement was read at 10:00 AM on Wednesday, as the Monetary Policy Report to Congress that was released at 8:30 AM seemed to catch trader’s attention as the final paragraph of the report reiterated the ‘Fed Put’ that has helped to keep equity prices elevated. The ‘Fed Put’ is the idea that the Federal Reserve will loosen monetary policy in response to equity market declines, very similar to the ‘Greenspan put’ from 1987 in response to the S&L crash, or the ‘Bernanke put’ in response to the 2007-2008 Financial Collapse. The final paragraph in Wednesday’s report essentially said that the Fed could quickly go back to QE if necessary; effectively nullifying the fear that the bank has divorced their monetary policy stance from near-term equity market performance.

The response in U.S. equities was robust, as bids drove prices back towards fresh all-time highs in both the Dow and the S&P 500. The move in the U.S. Dollar, however, was rather weak as we had a simple test of ten-month lows without any significant continuation to speak of. That, however, started to show-up on Friday morning when we got even more disappointing U.S. data. Inflation came-in flat versus an expected .2% gain, and retail sales fell by .2% against the expectation for a .1% gain. This inspired another wave of selling in the Dollar as prices, again, broke down to fresh lows.

This appears to be a significant pain point for the Greenback at the moment. As we discussed two weeks ago, U.S. data has disappointed for much of 2017, and that’s created questions behind just how aggressively the Fed might be able to hike. As we walked into the year, expectations were flying-higher as the Dollar drove up to fresh 14-year highs, but since then – those higher expectations have only led to bigger disappointment as actual economic performance has simply been unable to keep pace. Meanwhile, growth and inflation has started to show with more consistency in Europe and the U.K., and this has led to even more deductive weakness in the Greenback as traders shift rate hike bets in the Euro and British Pound.

Next week brings no high-impact data out of the United States, and on Saturday the Federal Reserve enters the ‘quiet period’ before their next rate decision on July 26th. The bigger market-wide events are rate decisions out of Europe and Japan along with an updated inflation print out of the U.K.; and this will likely be where the bulk of market participants’ attention remains. From what we’ve seen of recent – both the ECB and the BoJ have made efforts to talk-down their currencies and, if they’re effective next week, this could bring a modicum of strength to the U.S. Dollar that would essentially amount to a retracement of the ‘bigger picture’ bearish trend.

That would certainly strengthen the position of the doves on the Bank of England’s monetary policy committee, who only just outnumbered the hawks pressing for an interest-rate increase at their last meeting. With news likely too in the coming week of stronger UK retail sales, the impact on the British Pound could well be negative.

However, GBP/USD is at an interesting technical juncture; pushing up again against strong resistance in the 1.3000/1.3100 area in late European trading Friday.

The Yen finds itself at something of a crossroads as the Bank of Japan mulls competing economic trends ahead of next week’s monetary policy announcement. On one hand, policymakers’ steadfast commitment to an ultradovish posture even as growth gathers steam seems to have finally created the backdrop for reflation. On the other, the central bank’s tactics may be starting to look self-defeating.

Economic

Japanese economic activity trends seemed to turn a corner in the fourth quarter of 2016, with the rate of expansion across the nonfarm sector (manufacturing and services) steadily accelerating thereafter. Not surprisingly, local stocks have risen in tandem, seemingly reflecting better earnings prospects.

The BOJ’s refusal to entertain tightening even against this backdrop has kept the currency firmly locked in as a funding currency, meaning optimistic investors are happy to borrow cheaply in Yen terms to buy higher-returning assets. That has meant depreciation, which has in turn helped boost inflation. Indeed, growth pickup over the past 9 months has been accompanied by a rise in the BOJ’s target core CPI gauge.

However, the markets have their own tightening mechanisms at play. The risk-on mood has translated into capital flows out of the safety of government bonds (JGBs), pushing yields higher alongside share prices. In an apparent bid to prevent this increase in borrowing costs from snuffing out reflation, the BOJ committed to capping the rate on the benchmark 10-year JGB near 0 percent.

The markets are now testing the central bank’s resolve. On July 7, it was forced to intervene with its first large fixed-rate bond purchase offering in five months as the 10-year rate hit the highest level since February. If policymakers are to sustain the nascent reflationary trend, they will need to convince markets of their wherewithal to contain borrowing costs as faster growth and a weaker Yen do their work.

A small step in this direction may be to downgrade inflation expectations even as the GDP growth forecast is nudged higher. The BOJ has tiptoed in this direction since the beginning of the year however and the latest need for intervention suggests the approach is insufficiently potent. The appearance of a global tightening push, with the likes of the BOE and ECB seemingly near a turning point, may further undercut it.

On balance, this means the BOJ may need to resort to heavier artillery. Recently disappointing economic newsflow may have defused the need an immediate shake-up of the policy mix, deflating the risk-on swell a bit dialing back upward pressure on bond yields. Signaling the clear prospect of stimulus expansion seems necessary however. In fact, a status-quo announcement may well result in unhelpful Yen gains.

Gold prices rebounded this week with the precious metal rallying 1.33% to trade at 1228 ahead of the New York close on Friday. The advance has been supported by continued weakness in the greenback with the DXY down more than 0.7%.

The June Consumer Price Index (CPI) & Retail Sales figures came in shy of consensus estimates on Friday, fueling another sell-off in the dollar. The data comes on the back of this week’s semi-annual Humphrey Hawkins testimony before congress where Fed Chair Janet Yellen cited a more dovish outlook on monetary policy. The committee judged that “because the neutral rate is currently quite low by historical standards, the federal funds rate would not have to rise all that much further to get to a neutral policy stance.” At the same time, Yellen left the door open for further easing measures should market conditions deteriorate.

Suggests

The commentary suggests that while the Fed does see the economy gathering pace, Yellen and Co may be concerned that the central bank will lack the ammunition to respond to another crisis given the current policy stanceshifting the focus to the balance sheet off-load. As such, markets have seen a slight re-pricing in expectations for a December hike with Fed Fund Futures now pricing a 39% likelihood for a 25bps increase in the benchmark interest rate. U.S. data is light next week and for gold prices, the focus remains on the sharp reversal seen this week off support.

While Crude Oil rose this week to the tune of ~5%, there were other factors that caught the attention of investors like the surprisingly weak US CPI on Friday, which shows how difficult of a job the Fed has a head of themselves. It is important to note that a key component of inflation is energy, but we could may still be a respectable distance away from seeing crude put upside pressure on inflation measures.

A few positive developments in the energy sector helped support Crude Oil this week led by the 7.56mln draw per the weekly EIA supply report. On Thursday, an IEA report showed the demand is growing faster than initially expected. These two developments combined with the US Dollar touching 10-month lows helped spark the 5% gain.

However, storm clouds remain above the oil market when looking at production. On Tuesday, an EIA report showed that U.S. crude production rose by 59,000 barrels to 9.397 million barrels a day in the week ended July 7, which is the highest level in almost two years. At the same time, rebalancing may be delayed as OPEC production is rising that shows compliance to implementing the OPEC cuts continues to weaken throughout the year, and is currently below 80% of what was proposed. Adding to increased OPEC production and a 45% increase of US active shale rigs, Canadian oil-sands producers are said to be running their thermal production sites 28% above capacity further adding to global supply.

By combining the increased supply pressure with the chart, you can see the importance of the $48 level that houses multiple forms of price resistance. Next week, traders who consult the charts will likely look to the 55-DMA ($46.70) as a point to see if last week’s momentum will continue.

While re-balancing may happen later as opposed to sooner, a much weaker USD could help support crude oil. However, a weaker USD would likely mainly help US oil exporters, which helps to show that aside from a surge in demand with current production, there appears to be no easy and quick fix to this problem.

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