Higher USD a risky outlook

Outlook:

Today we get existing home sales and the Baker-Hughes rig count, neither a serious market-mover unless they vary to the downside by a lot.

The G7 finance ministers meet today and tomorrow. High on the list of concerns is what Japan can or should do about the rising yen. Several sources say the US and Japan are barely concealing their dis-pute—Japan might want to intervene and considers intervention a sovereign right, while the US wants to hold Japan to the G7 and G20 commitments not to manipulate currencies. The WSJ calls it a “ standoff,” more drama than is warranted, and reports US TreasSec Lew said “If we see countries deviate from the agreements, it would be a very damaging thing,” he said late last week after Japanese officials ramped up their yen-intervention threats. A breach of those commitments “is something that would do real harm to the global economy and to relations… Bank of Japan Gov. Haruhiko Kuroda said Thursday he would act quickly if the yen’s rise threatens his inflation goal. But economists aren’t sure whether Japan will actually intervene or if officials are just jawboning to limit upward pressure on the yen.”

We can hope that Lew is more sympathetic and empathetic in person than he sounds in print. Besides, over the past month-to-date, the yen has softened considerably, from 105.51 on May 3 to 110.45 today. It’s only when you look at a longer timeframe that your nerves fray.

The monthly chart shows the dollar/yen falling perhaps to a 50% retracement at 100.73 and worse, a 62% retracement to 94.80. This is really scary and reminds old-timers of the drop to 79.75 in April 1995, when the Emperor’s palace in Tokyo was worth more than the state of California, obviously a ridiculous state of affairs.

Possibly rushing to the rescue is the Fed. After all, we expect the yield differential to work in the favor of the currency with the higher and rising yield. Right now the US yield is 1.857% and the JGB is yielding minus 0.104%. And adding to the minutes opening the window to a hike sometime soon, yesterday NY Fed Dudley repeated that a June hike is appropriate if the data holds up. The FT notes that “the chances of a rate rise at the Fed’s June meeting are sitting at 28 per cent compared with 4 per cent a week ago and 32 per cent in the previous session, according to calculations by Bloomberg.”

Oh, dear. A one-third chance of a hike means a two-thirds chance of no hike. What will it take to over-come this skepticism? And Bloomberg throws more cold water on the outlook, reporting that the “long-term premium” fell to -0.38% on Tuesday. It hasn’t been this low since 1962. The long-term premium is the measure of how much extra yield investors demand over short-term paper and a measure of the riski-ness of the long stuff. “Many bond professionals view a level below zero as signaling the debt is theoret-ically overvalued.”

There is more than one factor at work, but it starts with investors fleeing negative-return assets—Bloomberg says $9 trillion, presumably all of it available to the US. “At the same time, they see little risk of an unexpected jump in inflation or growth as central bankers and finance chiefs globally struggle to boost a flagging world economy.” It would take some really strong growth and much higher inflation expectations for investors to demand a risk premium for longer-dated notes.

“The New York Fed’s term premium measure has been negative for most of 2016, after falling below zero for the first time in four decades in 2012. It peaked at over 5 percentage points in the early 1980s, more than triple its long-run average of 1.64 percentage points, according to New York Fed data going back to 1961.”

As long as growth and inflation remain low, rates will be lower for longer. No wonder equities are not in a panic, although our chart looks pretty grim. Don’t forget “if you can’t buy it, sell it.” We could have the unhappy outcome of the Fed hiking only once but equity indices tanking anyway. Reuters reports “Global investors remained risk-shy over the past week, pulling $5.8 billion from equity funds - the sixth straight weekly outflow - while pumping more money into bonds and precious metals, Bank of America Merrill Lynch (BAML) said on Friday. Its fund flow report showed investors making for the safety of bond funds, which have now taken new money for 11 of the past 12 weeks. Such funds re-ceived $2.8 billion over the week while precious metals - a category which includes gold - took in $1.8 billion, having received inflows in 18 of the last 19 weeks.”

BAML calls it a “summer of shocks” as the Fed is hawkish but everyone else is retreating from more stimulus. Is that true? Japan is not retreating, or at least we don’t yet know whether it’s retreating. We could still get another postponement of the April 2017 sales tax hike and a big stimulus package. We don’t buy the BAML picture. We expect the Fed to keep the pressure on for markets to accept its hawkishness, which clearly hasn’t happened yet. But if you think about it, the hawkish stance from De-cember got derailed by China at the start of the year. For traders to accept the Fed’s view of things is only to return to the mindset we had in December after a big and overly long-lasting bump in the road.

In a nutshell, traders are under-estimating the Fed. The Fed knows it. The Fed is about to flood us with carefully phrased warnings to lift expectations for the hike. As the FT puts it, the “Central bank is pre-paring the market for its campaign of monetary tightening.”

Forget those Fed funds futures—look at the 2-year. “As the calendar flips into June and the next policy meeting looms, currency traders will closely monitor the US two-year Treasury note yield. When the Fed finally raised overnight rates from the zero bound last December, the policy barometer was about 1 per cent. A rise towards 1.20 per cent would represent the market fully pricing in a tighten-ing for June, delivering a powerful tailwind for the dollar.”

That’s if the Fed doesn’t chicken out.

One scary factor may be vanishing—Brexit. The odds of Brexit are now quite low, about 17%, accord-ing to one bookmakers report in the FT. That bookmaker took a 4-figure bet on the “remain” side after new polls showed the “leave” side crashing in polls. Another bookmaker has the implied odds of “remain” at 77%. The amounts are big and still coming, despite the odds lengthening. “Brexit worries drove the pound 6.5 per cent lower in the first two months of 2016, reaching a near seven-year low of $1.38. But the opinion polls have changed the mood and sterling is enjoying one of its best weeks since the referendum date announcement, rising 1.8 per cent to be worth $1.46.”

So, no train wreck. We don’t expect it to last all the way to the referendum. Normally polls get more even as the Event gets closer.

To sum it up—the dollar “should” be firmly on the path to higher levels across the board because of the Fed’s new campaign to convince markets it is serious about normalization. The problem is that these scenarios almost never work out in practice. It’s always risky to forecast a rising dollar because the mar-ket treats good US news as only to be expected and exaggerates any bad or questionable news. Still, that’s the outlook. Just don’t bet the ranch just yet.

		Current	Signal	Signal	Signal
Currency	Spot	Position	Strength	Date	Rate	Gain/Loss
USD/JPY	110.29	LONG USD	STRONG	05/08/16	107.91	2.21%
GBP/USD	1.4560	LONG GBP	WEAK	05/19/16	1.4629	-0.47%
EUR/USD	1.1217	SHORT EURO	STRONG	05/16/16	1.1309	0.81%
EUR/JPY	123.71	SHORT EURO	WEAK	05/02/16	122.33	-1.13%
EUR/GBP	0.7703	SHORT EURO	WEAK	05/02/16	0.7864	2.05%
USD/CHF	0.9909	LONG USD	STRONG	05/10/16	0.9738	1.76%
USD/CAD	1.3108	LONG USD	WEAK	05/10/16	1.2945	1.26%
NZD/USD	0.6761	SHORT NZD	WEAK	05/10/16	0.6749	-0.18%
AUD/USD	0.7232	SHORT AUD	WEAK	05/08/16	0.7354	1.66%
AUD/JPY	79.77	SHORT AUD	STRONG	04/02/16	81.17	1.72%
USD/MXN	18.4325	LONG USD	WEAK	05/06/16	17.9418	2.73%