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Two 1,000-point drops for the US stock market push the USD index to 2-week highs. RBA and RBNZ in no rush to raise rates. BoE signaled hikes to come but UK politics weighs on GBP.

By Nick Parsons

After the previous Friday’s 666-point foretaste of things to come for the Dow Jones Industrial Average, Monday brought a 1,175-point plunge; the biggest ever points drop, albeit in percentage terms only the 112th largest drop in the 122 years since inception. The VIX index of volatility, meantime, had its biggest ever daily jump and will go down in the history books along with Lehman, the ‘flash crash’ and the US downgrade. Amidst the turmoil, the US Dollar was steadily bid throughout the day and continued to perform very well throughout the week; fully reversing the decline which had begun a fortnight earlier when Treasury Secretary Mnuchin spoke about the currency at the WEF in Davos.

The big fear all week was that further selling pressure would be seen in US equity markets as programme traders and algorithm-driven investment strategies were forced to cover short volatility positions, which in turn would add to the technical pressure on stocks. The second 1000-point drop came on Thursday with little or new fresh news, but a fear that the so-called ‘risk-parity’ funds were forced sellers, liquidating positions as both equities and bonds delivered simultaneous negative returns. Amidst the stock market carnage, a host of Fed speakers were out downplaying its impact. Federal Reserve Bank of New York President William Dudley said recent stock-market declines weren’t that big and don’t yet change his outlook for the U.S. economy. “This wasn’t that big a bump in the equity market… The stock market had a remarkable rise over a very long time with extremely low volatility…. My outlook hasn’t changed just because the stock market’s a little bit lower than it was a few days ago. It’s still up sharply from where it was a year ago. Having a bump up like this has virtually no consequence on my view of the economic outlook”.

In US stock markets over the past two decades, there has been lots of talk of the “Greenspan put”, the “Bernanke put” or the “Yellen put” to describe how stock market traders feel they are insured against declines by the Federal Reserve Bank. Perhaps the strike price on the “Powell put” is a bit lower than they’ve become used to… Certainly, there are few signs from the front end of the US money market curve that a 25bp rate hike at the March FOMC meeting is in any more doubt. Two weeks ago, with the stock market at a record high, the market-derived probability of a hike was 76%. Today, it has edged down only very marginally to 72%. Having touched a best level on Thursday of 90.25, the USD index ended the week at 90.00.

The Canadian Dollar began the week around USD/CAD1.2430 but this proved to be pretty much the low of the week for the pair. Since the beginning of the year, USD/CAD has been largely contained in a range from the mid 1.22’s to 1.26, even though we have seen extreme volatility in equity markets, a 25bp rate hike from the Bank of Canada and ongoing uncertainty over the renegotiation of NAFTA. As the week progressed and the USD was persistently well-bid, so USD/CAD moved higher on successive days and in Thursday’s New York session, the pair rose through the top of the range for a couple of hours before then returning to the 1.25’s.

In truth, there were very few highlights in what was a particularly dull week for Canadian news and the Canadian currency. Bank of Canada Senior Deputy Governor Carolyn Wilkins gave an interview to Reuters Thursday evening saying Canada’s high household debt is the biggest vulnerability facing the economy, while uncertainty about NAFTA is weighing on the outlook. “Every household is going to find it more or less difficult, so some households might find it extremely difficult, others will just need to tighten their belt a bit, but overall as you can see from our projection, we expect the economy to continue to grow, we expect consumption to continue to grow. I think we are being very clear that the biggest vulnerability to the Canadian economy is coming from high household indebtedness.” Wilkins declined to give “a running commentary” on recent economic data, but said that although GDP growth in the fourth quarter got off to “not the strongest start,” the latest data remained in line with forecasts.

The only important data point was Friday’s employment report where consensus looked for a 10k rise after a 78k gain in December. Instead, Stats Canada reported employment fell by 88,000 in January. Part-time employment declined (-137,000), while full-time employment was up (+49,000). At the same time, the unemployment rate increased by 0.1 percentage points to 5.9%. On a year-over-year basis, employment grew by 289,000 or 1.6%. Gains were driven by increases in full-time work (+414,000 or +2.8%), while there were fewer people working part time (-125,000 or -3.5%). Over the same period, hours worked rose by 2.8%. USD/CAD surged to 1.2645 when the numbers were announced as computer-driven algorithms responded to the headlines but within a few minutes, nearly all the gains had evaporated when it was realized that all the job losses were in part-time and seasonal employment. The moral of this tale is not to rely on the machines but to pay for a good FX Strategist who could have spotted this immediately! The Canadian Dollar ended the week at USD/CAD1.2580, AUD/CAD0.9825 and GBP/CAD1.7390.

The euro had a relatively calm week stuck between the opposing forces of stock market turmoil which was good for the USD and more strong economic data in the Eurozone. EUR/USD opened on Monday at 1.2450 though this subsequently proved to be within just a few pips of the week’s high. We wrote on Wednesday evening that, “We have seen what happened in the VIX market in the US when investors in a very crowded trade all tried to pile through the exit at once and there were some tentative signs in EUR/USD that the same might be happening in FX.” Strategists at the major banks had been chasing the spot rate higher, moving forecasts ever-upwards on incoming economic data. By midweek, the announcement of a new German coalition government proved the catalyst for a bout of profit-taking on long EUR positions.

On the one hand – as the economists say! - there was some relief that Germany had avoided a fresh, destabilizing Federal Election, but on the other was a concern that Ms Merkel might have conceded too much to the left-wing SPD. Early reports suggested that the SPD would be handed the Finance Ministry - a major victory for the Social Democrats - while CSU leader Horst Seehofer, one of the most conservative figures on Merkel's side, would become Interior Minister. The SPD also look set to keep control of the Foreign Ministry and the Labor Ministry. The SPD leadership confirmed the Coalition agreement in a group WhatsApp message, which began, "Tired. But satisfied." ECB Chief Economist Peter Praet hosted a Q&A session on Twitter Thursday morning; an innovative and transparent method of improving central bank communication. He said the salary increase secured by Germany’s largest trade union this week was “fully in line” with the European Central Bank’s inflation forecasts. Asked about economic models, he said, “Models are important to help us think about economic developments in a structured way, but the real economy is always more complex than models. Always to be complemented by other approaches, conjunctural analysis, and even anecdotal evidence!”

Mr Praet even displayed a great sense of humour for a central banker. One questioner asked, “Peter, how do we pronounce your name? Is the 'e' silent?” and received the classic reply, “In Praet indeed, but not in Peter.” Not to be outdone, his colleague and Executive Board member Yves Mersch said at an event in London that, “At these speeds, if you bought a bunch of tulips with Bitcoin, they may well have wilted by the time the transaction is confirmed”. Let’s hope that their peers around the world can make similarly witty and interesting observations as they try to explain the somewhat arcane business of monetary policy. The EUR ended the week at USD1.2250, AUD/EUR0.6375 and NZD/EUR0.5920.

GBP broke its amazing winning run in early February, setting it up for a potentially soft opening last Monday morning as the weekend Press was predictably negative about UK politics and the progress of Brexit negotiations. GBP/USD began at 1.41 exactly, and against a persistently stronger USD, fell to a low on both Wednesday and Thursday of 1.3850. In his appearance before a House of Lords Select Committee last week, BoE Governor Carney had hinted that the Bank was preparing to upgrade the forecasts in its Inflation Report and this is exactly what happened; albeit the language was more aggressive than had been expected. GBP/USD surged more than 1½ cents from 1.3890 to a high just over 1.4050. So far, so easy to explain…. Within the space of four hours, however, as the carnage continued in US asset markets, GBP/USD had reversed all its gains, coming back to its launching point with what we described as, “the precision of a Falcon-Heavy booster”. GBP was still the best performer of the day although its 200+ pip gains against both the AUD and NZD were more than halved.

In revising up both its UK and world growth forecasts, the Bank of England said that, “Over the past year, a steady absorption of slack has reduced the degree to which it was appropriate for the MPC to accommodate an extended period of inflation above the target. Consequently, at its November 2017 meeting, the Committee tightened modestly the stance of monetary policy in order to return inflation sustainably to the target. Since November, the prospect of a greater degree of excess demand over the forecast period and the expectation that inflation would remain above the target have further diminished the trade-off that the MPC is required to balance. It is therefore appropriate to set monetary policy so that inflation returns sustainably to its target at a more conventional horizon. The Committee judges that, were the economy to evolve broadly in line with the February Inflation Report projections, monetary policy would need to be tightened somewhat earlier and by a somewhat greater extent over the forecast period than anticipated at the time of the November Report, in order to return inflation sustainably to the target.”

In his subsequent Press Conference, the Governor was keen to play down the scale and speed of interest rate hikes and despite much probing from journalists, refused to agree that interest rates are likely to rise in May. The Statement noted, “Any future increases in Bank Rate are expected to be at a gradual pace and to a limited extent”. Market pricing doesn’t yet have a May hike as a done deal, though the implied probability of a 25bp increase has increased from just under 50% to something nearer 70%. All this, of course, is predicated on two Brexit factors - that there is “a smooth transition”, and that it leads to an “average of potential outcomes”. By Friday, rate hike talk had been pushed into the background as EU Chief Negotiator Michel Barnier warned that a transition period immediately after Brexit in 2019 is "not a given". He outlined continuing disagreements between the UK and EU over issues like freedom of movement during the period and said the UK's decision to leave the EU single market and customs union meant border checks at the Irish border were "unavoidable". GBP/USD fell to a 3-week low of 1.3770 on Friday and the pound ended the week at USD1.3820, GBP/AUD1.7690 and GBP/NZD1.9060.

Amidst the wild volatility in global asset markets – the Dow Jones Industrial Average had two daily drops of more than 1,000 points over the past week – the Australian Dollar has remained under pressure. The three main drivers of most of the valuation models of the currency are commodities, interest rate differentials and volatility. When asset markets are quiet, the incremental returns from higher interest rates look quite attractive. As we’ve said before though, when markets are very volatile, this strategy can be likened to picking up pennies in front of a train. Many investors unfortunately got run over last week as volatility surged and all three of the valuation metrics for the AUD turned negative. After the spookily prophetic 666-point drop in the DJIA the previous Friday, AUD/USD fell below 80 cents and opened the week at 0.7910. It was then pretty much downhill all the way to Friday’s low around 0.7770; its first time back on a 77 cents ‘big figure’ since late December.

The Statement released after first RBA Board meeting of the year seemed pretty upbeat overall. “The Bank's central forecast for the Australian economy is for GDP growth to pick up, to average a bit above 3 per cent over the next couple of years. The data over the summer have been consistent with this outlook. Business conditions are positive and the outlook for non-mining business investment has improved… Employment grew strongly over 2017 and the unemployment rate declined. Employment has been rising in all states and has been accompanied by a significant rise in labour force participation. The various forward-looking indicators continue to point to solid growth in employment over the period ahead, with a further gradual reduction in the unemployment rate expected.” The currency comment was reframed to mention the trade-weighted value of the AUD, which “remains within the range that it has been in over the past two years.”

In his speech to the A50 Australian Economic Forum dinner on Thursday evening, RBA Governor Phil Lowe did not sound a man in any hurry to raise interest rates. He said, “given recent developments in Australia and overseas, it is likely that the next move in interest rates in Australia will be up, not down. If this is how things play out, the likely timing will depend upon the extent and pace of the progress that we make. As I have discussed, while we do expect steady progress, that progress is likely to be only gradual. Given this, the Reserve Bank Board does not see a strong case for a near-term adjustment in monetary policy. It will of course keep that judgement under review at future meetings.” AUD ended the week just over a cent lower at USD0.7815, with AUD/NZD at 1.0770 and GBP/AUD1.7690.

The New Zealand Dollar began the week just below 73 US cents in what was a quiet day locally before the Waitangi Day holiday on Tuesday February 6th. After the first 1,000-point drop of the week for the DJIA on Monday, the NZD was boosted by some technically driven selling of the key AUD/NZD pair which fell through a big support level of 1.0850 and tumbled all the way to a 6-month low of 1.0750. Indeed, on Tuesday the NZD was the best performer of all the major currencies we follow closely here. From a high of USD0.7345, however, it was then downhill all the way to a low on Thursday around 0.7180; the weakest in almost 4-weeks, even as AUD/NZD remained stuck in the 1.07’s.

The RBNZ left interest rates unchanged at 1.75% on Thursday but cut its inflation forecasts and predicted it won’t reach the 2-percent midpoint of its 1-3 percent target range until late 2020, more than two years later than previously expected. Despite that, it maintained its projection that the official cash rate will remain on hold this year and start to rise in mid-2019. The RBNZ has been weighing the potential impact of Prime Minister Jacinda Ardern’s policies around immigration, housing, welfare and industrial relations on economic activity. The RBNZ said it has reviewed its estimates and “the net impact of these policies has been revised down in the near term.” The economic growth profile is “weaker in the near term but stronger in the medium term”. For the currency specifically, RBNZ said, “The exchange rate has firmed since the November Statement, due in large part to a weak US dollar. We assume the trade weighted exchange rate will ease over the projection period…. Monetary policy will remain accommodative for a considerable period. Numerous uncertainties remain and policy may need to adjust accordingly.”

Overall, the RBNZ statement read pretty dovishly. Assistant Governor John McDermott said the bank’s stance on rates was neutral. “There is a significant probability that the next rate move could be an increase sometime in the future, and there’s also a substantial probability that the next move could actually be a cut.” So, rates could go up or down, inflation expectations are well anchored and will reach the mid-point of target in 2 years’ time; a situation he summed up in the Press Conference by saying “That’s central bank nirvana.” For currency traders, it didn’t sound like any great reason to buy the New Zealand Dollar. By Friday’s New York close, the NZD ended the week at USD0.7250 and AUD/NZD1.0770.