As noted in last week’s commentary, it’s tricky when investors are forced to make trading decisions in the vacuum between central bank meetings. This never used to be the case. But over the last twenty years central bankers have become increasingly interventionist, and never more so than now. Consequently, in the hiatus between meetings investors react to every utterance from Federal Reserve members and their counterparts around the world. Last week there was a stark demonstration of how violent such reactions can be.
It looks as if the Federal Reserve has become somewhat peeved that the markets were discounting any possibility of a rate increase at the FOMC meeting next month. As far as the fed funds futures market was concerned, the likelihood of a summer hike had effectively dropped to zero, helped in part by the FOMC’s April statement which was broadly viewed as dovish.
However, the minutes of that April meeting (which were released on Wednesday) revealed a more hawkish tone from Fed members. Crucially, it was noted that it “would be appropriate for the Committee to increase the target range for the federal funds rate in June” should incoming data be consistent with a pick-up in economic growth, including continued improvement in the US labour market and inflation “making progress” to the Committee’s 2% inflation target. Understandably, investors viewed this as setting the hurdle quite low for a rate hike. After all, despite a disappointing Non-Farm Payroll report earlier this month, at 5.0% the Unemployment Rate remains at the lower end of the band for the “natural rate of employment” which is estimated to be somewhere between 4.7% and 5.8%. At the same time, inflation as measured by Core CPI (which excludes food & energy) came in at 2.1% in April. Admittedly, Core CPI has been slipping since February when it peaked at 2.3%. In addition, this is not the Fed’s preferred inflation measure which is running closer to 1%. Nevertheless, the Fed is obviously desperate to keep the June meeting “live” to the possibility of tightening monetary policy. To that end we’ve seen a gaggle of Fed members come out with hawkish comments over the last few weeks.
Kicking things off we had Federal Reserve Bank of Boston President Eric Rosengren say that current market pricing implied a view of the US economy which was too pessimistic. Then Federal Reserve Bank of Kansas City President Esther George said that rates were ‘too low for today’s economic conditions’. Last week there were more hawkish comments from San Francisco Fed President John Williams and Atlanta Fed President Dennis Lockhart saying two or three rate rises may be appropriate. Then Federal Reserve Bank of Richmond President Jeffrey Lacker said he was comfortable with the idea of four hikes for the rest of this year. Rounding things off New York Fed President William Dudley (a FOMC-voting member and all-round “big cheese”) said a summer rate hike was likely if the economy met expectations. In addition, he said that the market’s pricing of the probability of future monetary tightening had been far too low prior to the release of the April minutes.
Analysts rushed to cut the odds on a rate hike at next month’s meeting after having discounted the likelihood of a June rise for most of this year. Not only that, but markets are also beginning to price in a rate hike in July as well. This led to a sharp rally in the dollar and an equity market sell-off.
But things calmed down somewhat as last week drew to a close. It was as if investors knew that this fresh hawkishness from the Fed was simply for effect and not to be taken too seriously. This made sense given that we are in the US Presidential Election year, there’s an upcoming referendum on the UK leaving the EU just a week after the Fed’s June meeting, the first quarter US earnings season has been poor and the US and global economic outlooks are cloudy at best. It’s possible that we get a US rate increase this summer, maybe in July after the UK’s referendum. But talk of three hikes this year just seems far-fetched.
This week’s major economic releases include:
EUR French, German, Euro zone Flash Manufacturing PMI and Flash Services PMI, Euro zone Consumer Confidence; USD Flash Manufacturing PMI; CAD Bank Holiday
JPY Flash Manufacturing PMI; EUR German Final GDP, German ZEW Economic Sentiment, Euro zone ZEW Economic Sentiment; GBP Public Sector Net Borrowing, CBI Realized Sales; USD New Home Sales, Richmond Manufacturing Index; NZD Trade Balance
EUR German Ifo Business Climate; CHF ZEW Economic Expectations; CAD BOC Rate Statement; USD Goods Trade Balance, Flash Services PMI, Crude Oil Inventories
NZD Annual Budget Release; EUR ECB Financial Stability Review; GBP Second Estimate GDP, Prelim Business Investment, BBA Mortgage Approvals; USD Durable Goods Orders, Unemployment Claims, Pending Home Sales
GBP GfK Consumer Confidence; JPY Tokyo Core CPI, National Core CPI; USD Prelim GDP, Prelim GDP Price Index, Consumer Sentiment, Inflation Expectations
Last week Walmart (WMT) brought the earnings season to an unofficial close. There are more companies set to report over the next few weeks, but nothing major. Walmart is the second biggest employer in the US after the government. The company posted first-quarter earnings of $0.98 per share versus $1.03 a share for the same period last year. Revenue for the quarter came in at $115.9 billion, against the comparable year-earlier figure of $114.83 billion. While earnings were light they were better than the $0.88 consensus expectation. Revenues were also better than the $113.22 billion expected. The company also predicted earnings per share in the range of $0.95 - $1.08, which was better than estimates focusing around $0.98.Free Cash Flow, which rose by $1.7 billion to $4 billion in Q1.The stock rose sharply bringing some relief to the retail sector which has, overall, had a dismal first quarter. As we saw a few weeks ago, major “bricks and mortar” department store chains such as Macy’s and Nordstrom are really struggling, as are fashion retailers. Over the past few months a number of iconic US retailers such as Aeropostale, American Apparel, Caché, Eastern Mountain Sports, Pacific Sun, Quiksilver, Sports Authority and Wet Seal have all filed for bankruptcy.
Nevertheless, US Retail Sales are showing remarkable resilience. Figures for April showed the biggest increase in over a year when they came in at +1.3% month-on-month on expectations of a 0.3% decline. This just goes to show the change in shopping habits where Amazon and other online retailers have now established their dominance. Department stores have suffered a 1.7% year-on-year decline in sales while online shopping is up 2.4%.
It is worth repeating that overall this really has been a bad earnings season. For companies in the S&P 500 this is set to be the fourth consecutive quarter of year-over-year declines in earnings since the period running from the fourth quarter of 2008 through to the third quarter of 2009. It will also mark the fifth consecutive decline in sales. Nevertheless, there will be investors convincing themselves that the worst is now over and that corporate profitability is bound to pick up from here. That may be so. However, it could still prove difficult to push the broader market much higher from here, particularly with the increased prospect of US monetary tightening to come. If the dollar starts to strengthen again, commodity prices will come under pressure and US multinationals will see a dip in sales and overseas earnings.
Commodity/ FX Outlook
Crude ended up again last week and hit fresh seven month highs. Both Brent and WTI have now closed up 11 weeks out of the past 14. However, both contracts lost some upside momentum as they closed in on $50 per barrel.
Oil dipped sharply on Wednesday following the latest inventory update from the Energy Information Administration (EIA). This showed an increase in stockpiles of 1.3 million barrels for the previous week on expectations of a 3.1 million barrel decline. However, the sell-off was short-lived as the build in crude inventories was offset to some extent by larger than expected drawdowns in gasoline and distillates. Nevertheless, the inventory data was in stark contrast to the EIA numbers from the week before. These showed a fall of 3.4 million barrels compared with an expected build of 100,000.
Oil subsequently headed lower again as the dollar shot up immediately following the release of the minutes from the FOMC’s April meeting. As noted before, these were viewed as more hawkish than anticipated. Investors also reacted to comments from a number of regional Federal Reserve presidents who came out in favour of a series of rate cuts for the rest of this year. This was rounded off by New York Fed President William Dudley (a FOMC-voting member) who said a summer rate hike was likely if data on the economy met expectations.
The increased possibility of a June rate hike helped to push the issue of supply disruptions onto the back-burner. Nevertheless, the Canadian wildfires, militant activity in Nigeria, hostilities in Libya and the political crisis in Venezuela have all fed into the view that supply and demand could come back into balance sooner than was previously thought. Despite this, some analysts are warning that the oil glut remains a serious issue. Last week Zero Hedge showed evidence of an unprecedentedly large number of oil tankers anchored off the coast of Singapore – the key hub for the Asian market. Cargo owners are sitting tight and hoping for a further rise in the oil price before docking and selling on their crude.
There’s a large amount of oil-related debt out there which needs to be serviced. There are numerous estimates flying around about what may be the “equilibrium” price for crude – that is, where a critical mass of producers can actually turn a profit on production, yet don’t then ramp up output too sharply and cause another self-defeating price slump. It could be $50, or it may be $60 per barrel. Time will tell.
Gold and silver continued to come under pressure last week as the US dollar pushed higher. Both precious metals ended lower for the third week in a row as investors cut back their exposure to the two “safe havens” and headed back to assets which may ultimately pay interest or a dividend.
On Wednesday gold broke below support around the $1,260 level while silver crashed through $17 per ounce. Both metals had pushed higher earlier in the week. But the minutes of the FOMC’s April meeting along with a barrage of hawkish comments from Federal Reserve members led to a sudden reappraisal from market participants over the likelihood of monetary tightening from the US central bank over the coming months.
The Fed seems desperate to keep market participants guessing over the likelihood of a summer rate hike. Or rather, it is unhappy that investors believed there was effectively no chance of monetary tightening at the next meeting. In some ways this is understandable. After all, investors were effectively saying that the US economy was still not strong enough to handle a modest rise in the cost of borrowing. That’s hardly a vote of confidence in the central bank or its forecasting abilities.
The dollar’s recovery (and hence the selling pressure on precious metals) over the past three weeks is down to a combination of short-covering and a growing belief that the US Federal Reserve will hike rates next month. The short-dollar trade was getting crowded but it now seems likely that the weaker hands have been forced to cover. The trick now is trying to work out how much further the rally in the US dollar may have to run. If we see a significant break below 1.1200 in the EURUSD then a move to 1.1000 can’t be ruled out. That would certainly take care of the dollar shorts. It would also be bad news for gold and silver. That could happen between now and the FOMC meeting in mid-June. However, if the Fed doesn’t come through with a hike we should expect the dollar to weaken once again, although its losses could be limited by the expectation of monetary tightening in July. What a circus!
So far gold has managed to hold above the psychologically significant $1,250 level on an end of day basis. However, this doesn’t look like much of a safety net and a bigger test of gold’s resilience may come in around $1,240. But a sustained break below here could see gold back to $1,220 or even lower.
While the technical picture for gold and silver looks uncertain, the zero/negative interest rate policies increasingly adopted around the world make owning precious metals very attractive. In a world of zero or negative yields there’s no “lost opportunity” cost in holding gold even if it pays no interest. However, the prospect of higher US interest rates takes the shine off precious metals to some extent.
The US dollar rallied last week and posted its third consecutive week of gains against most of the majors. The greenback’s latest push higher followed the release of minutes from the FOMC’s April meeting and a rash of comments from Fed members. These were all hawkish in tone and designed to ensure that the prospect of a summer rate hike was kept alive. The only significant currency to buck the strong dollar trend was the British pound. Sterling rallied sharply after two consecutive polls indicated a widening lead for the “Remain” vote in next month’s UK referendum on EU membership.
The Dollar Index pushed further above support/resistance around 94.00 to trade north of 95.00. This was an impressive recovery considering it was trading below 92.00 at the beginning of this month. Meanwhile, the USDJPY topped 110.00. Three weeks ago the yen hit its highest level against the dollar since October 2014 when the USDJPY broke below 106.00. This move prompted a barrage of verbal intervention from Japanese policymakers warning that such a “one-sided” currency move could warrant full-blown intervention from the Bank of Japan (BOJ) to check the yen’s rise. The notion that the yen’s rise was “one-sided” was taken as an effort on the part of Japan’s policymakers to circumvent the G20 agreement to avoid competitive currency devaluations.
Concerning this weekend’s G7 meeting, it appears that Japan was unable to garner any support from other members allowing it to intervene unilaterally to weaken the yen. According to Reuters, the US warned Japan against intervening in currency markets.
A stronger yen is a disaster for Japan. It damages the country’s competitiveness as it makes exports more expensive and is also deflationary as imported goods are cheaper. In the normal course of events cheaper imports should be good for an economy – especially one like Japan’s which relies on imports for most of its energy requirements. However, the only way Japan can deal with its horrendous debt mountain (government debt is running at around 230% of GDP) in a politically acceptable manner is to attempt to inflate it away. Yet despite repeated efforts to boost inflation through repeated round of monetary stimulus (which is expected to be increased once again next month) Japan’s most recent CPI reading fell 0.1% year-on-year.
*Prices are accurate at time of writing
Disclaimer: Spread Co is an execution only service provider. The material on this page is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by Spread Co Ltd or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. This material has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. As a marketing communication it is not subject to any prohibition on dealing ahead of the dissemination of investment research, although Spread Co operates a conflict of interest policy to prevent the risk of material damage to our clients.