Soul searching time for traders, central bankers and politicians

Soul searching   - “A penetrating examination of one’s motives, convictions, and attitudes.”

Looking back to the eve of the September Federal Open Market Committee meeting, the clouds over the global economic dynamic and subsequent investment decisions appeared at that time to be parting. The US was about to embark on a slow (but important directionally) process of monetary policy normalisation - tapering. The Eurozone, after a long period of negative growth had bounced back into positive territory in Q2 and while this was viewed as a positive for global macro risks, the level of growth was likely not enough to prevent further monetary accommodation (or indeed enough to make a dent in the still declining public and private debt mountain). In the UK, the data was clearly outperforming expectations with markets pricing in interest rate rises as soon as 2014, despite the official (Bank of England) expectation that rates would likely be unchanged through to Q4 2016.

“The world is disgracefully managed, one hardly knows to whom to complain”   Ronald Firbank

On the face of it the rationale was strong for an expectation of USD and GBP outperformance, particularly against the “weak, fragile and vulnerable” (Mario Draghi) economic recovery in the Eurozone.

Look back to summer's high volatility and low liquidity

Further, as is often the case in financial markets, the summer months greeted us with light volumes and reduced investor participation. Volatility in currency markets (albeit in relatively small ranges in absolute terms) was accordingly high and liquidity low. The timing of the important September Federal Reserve policy meeting extended the summer lull further as the ‘defining moment’ of the start of policy normalisation (or not as it turned out) was awaited. To add to the confusion Fed chairman Bernanke backtracked on his previous reference point of 7 percent unemployment (at the time just 0.3 percent away), as the point at which he would expect quantitative easing to have been ended completely – the level we subsequently referred to as the ‘mooted then refuted’ threshold.

“Fiscal shenanigans have swamped QE taper prospects”               - Fed, Richard Fisher

Muddies waters epitomises current market situation

Today in contrast, the debacle surrounding the US shutdown and debt ceiling debates has muddied the waters even further (indeed not only brought the clouds of uncertainty back over the global macro debate, but added new ones). The ‘non-taper’ Fed meeting was (we are lead to believe) a very close call. Fiscal uncertainty, and the implications for the legitimacy / reliability of the near-term US data, as a result of the shutdown, however, likely means that the October meeting will be less of a close call. Indeed some commentators are now suggesting that US monetary policy will remain unchanged until June next year.

Look at JPY on eve of Abenomics launch

At broadly the anniversary of the introduction of ‘Abenomics’ to the financial markets and to the world, it is also perhaps worth considering the JPY at this point. For most of October last year, USDJPY traded in the 78 region. Having reached as high as 103.74 in May, it has spent a long time consolidating those gains. In our view we are unlikely to see further monetary or fiscal steps from Japanese officials in the near term, other than the sales tax rise and related stimulus package that has already been forewarned. From here we will be watching for signs of success of the ‘three arrows’. The current risk positive backdrop, however, should be supportive of the underlying (if not explicit) desire of the Japanese authorities to see a weaker JPY.

Chinese data errs toward the positive

The recent global macroeconomic data (including this morning’s Chinese GDP data) have erred towards the positive and in conjunction with the implicit QE extension (and thus maintenance of super-easy global monetary conditions) risk assets and risk-positive currencies, such as the AUD are in something of a ‘sweet spot’. Anecdotal evidence suggests that the Reserve Bank of Australia (RBA) is ‘not best pleased’ with the political debacle in the US which has likely been the predominant driver behind the AUD’s recent strength against the USD, just as the RBA was beginning to become comfortable with the downward trajectory of the AUD and its positive implications for the competitiveness and rebalancing of the Australian economy. In our view this strengthens the case for a further cut in the Overnight Cash Rate from the RBA, if AUD continues to rise and at some point the AUD level may offer a good selling opportunity – watch this space

“Recent surveys suggest UK annualised growth of 3-4%”                              - BoE, Spencer Dale

Strong UK retail sales

In the UK, retail sales yesterday were stronger than expected. At +1.6 percent quarter on quarter Q3 retail sales saw their strongest rise since Q1 2008, which in turn underpins expectations of a strong Q3 GDP print on October 25. We are looking for an above consensus 1.0 percent quarter on quarter rise. In addition to the macro data, there is also an audible momentum behind inward investment into the UK both in terms of foreign investment (most prominently of late from China and Singapore) and also in terms of UK corporations re-domiciling their headquarters back to ‘blighty’.

 “Kicking the can down the road is not a fiscal solution”  - Fed, Richard Fisher

Economic momentum lost and confidence hurt?

Now we are left to consider how much economic momentum has been lost – not just in the US but in the global economy, and whether or not the impact is greater for those economies where the recovery is at its most nascent, fragile – and how much confidence has been hit by the long-term uncertainty that US politicians have built into the system. Indeed, perhaps more urgently we have to consider how this all affects monetary policy. It certainly pushes back the Fed calendar and may even lower the terminal or neutral level of the Fed funds rate. Finally we have to reassess the implications for financial markets.

Equities and risk positive currencies should outperform

Amid the current monetary accommodation and sufficiently positive economic data environment there is a case building for rising risk assets and, on that basis, equities and risk positive currencies should outperform. The big conundrum is likely the USD. From a technical perspective the USD index is currently sitting just above a significant long-term trend line, a line that has marked the low point for the USD for the last two years. On the flip side near-term US sentiment has taken a hit from the (mis) handling of the fiscal (and arguably monetary) policy of the US. Our longer term view is still resolutely one of USD outperformance as the global economy recovers, yet the current ‘speed bump’ could be enough to spark further declines in the short term.

Amid the increased uncertainty and reduced volumes, foreign exchange markets (indeed financial markets in general) have been at best disjointed. Ultimately, in the near term we expect the disjointedness of currency valuations in comparison to what we view as the long-term sustainable trajectories and values to be extended by recent events. That is not to say that the near term is without opportunity - The stand-out for us remains sterling, where we continue to expect broad gains.

Soul searching on the cards

The next couple of days are very quiet from a data perspective and we would anticipate that the lull will likely be used by market participants as a period of ‘soul searching’. Perhaps our advice on a global level would also be that US politicians and global central bankers use this period to do some soul searching of their own!

_{—Edited by Yvette Roper}