FX Daily: Two leading central banks; two very different biases

18th June 2014

  • UK Chancellor Osborne “broke Treasury rules” by implementing the Help to Buy home ownership scheme. The influential Commons public accounts found that Osborne failed to compare the scheme with possible alternatives, as stated in Treasury guidelines. (the FT)
  • A front page editorial warns against markets getting too excited about the Chinese government’s targeted easing steps, warning that because of worsening credit conditions, poor earnings and administrative lending constraints, banks may not actually want to lend to agriculture and small and medium businesses. The real problem is a distinct lack of demand in the economy after years of over-expansion and the targeted reserve requirement cut isn’t going to do much to solve that. (China Securities Journal)
  • Ma Jun, the chief economist of the PBoC’s research bureau, says the yuan exchange rate is closer to its equilibrium level as China’s current account surplus normalises and in the wake of this year’s depreciation.(Shanghai Securities News)
  • Falling Chinese house prices may raise fresh questions about the stability of the country’s debt-laden financial system, but the central government isn’t expected to provide direct relief any time soon. (MNI Market News)
  • Japanese companies undertaking large-scale construction projects in Iraq are scrambling to reassess their business plans there as violence spiked and as militants swept towards the capital. Japanese engineering companies have already been evacuating their employees from the country.(The Nikkei)
  • According to the BoJ minutes, board members maintained the view that exports will pick up slowly in tandem with a recovery in global growth while some warned that the political crisis in Thailand, a key supply chain hub, could hurt shipments. Members agreed private spending would remain solid, with one member dissenting. (www.boj.or.jp/)
  • Japan’s Trade Balance narrowed to –Y909.0B, against expectations of –Y1189.3B and –Y811.7B previous. Exports posted their first annual drop in 15 months at -2.7%, with imports down -3.6% on the year.
  • New Zealand’s Current Account deficit narrowed from 3.4% of GDP to 2.8% for the year to March 2013. The NZ$1.4B surplus for the first quarter is the biggest recorded in history.

Two of the world’s leading economies are heading into pivotal monetary policy events today and both reported starkly different inflation results yesterday. There is some irony that both reported inflation reading which jeopardise their respective monetary policy bias. The UK May CPI reversed all of April’s gain and then some. The headline reading fell sharply to 1.5%, returning to its downtrend after higher seasonal transport costs temporarily supported price growth in April. The biggest decline came from food, down 0.6% annually with seasonal foods down a colossal -3.3%. To some extent, supermarket price wars are helping to squash food price pressures but a stronger sterling is also importing a good deal of disinflation, something more clearly seen in the PPI input reading. The Bank of England’s forward guidance is now pinned to the abstract idea of economic spare capacity which is inflation by any other name. However all rhetoric from the BoE shows that they are not concerned about low headline inflation but inflation expectations which remain anchored at 2%. This reality allowed sterling to almost immediately retrace its initial losses following the release and closed the session higher against the euro.

Following Carney’s infamous Mansion House speech last Thursday, the first vote for a rate hike is now partially priced in to sterling-dollar. Carney’s “sooner than markets expect” comment could well have been a warning shot to markets that the first hawk was out of the starting gates and voting for the first rate increase in over 5 years. The one basis point move in sterling last Thursday and its resilience following UK CPI suggests more downside risk then upside for today’s meeting minutes. The market is still heavily long sterling leaving substantial scope for a short squeeze.

US Core CPI rose for its third consecutive month in May to reach 2.0%, with the headline reading at 2.1%. This reinforces what we have previously maintained – the US does not have the same degree of inflationary room as the rest of the West with economic slack substantially narrower. Just yesterday the IMF downgraded the US long term potential growth rate to just 2% for several years and pinpointed falling labour market participation and slow productivity growth as hampering the US potential output growth. The US also does not have the benefit of a stronger currency to deflate import prices like the UK and Eurozone examples. As energy prices continue to rebound inflation will continue to rise.

The dollar trade weighted index was up 0.17% yesterday and recorded gains against all G10 currencies with the exception of the kiwi. This inflation print mattered for monetary policy. The US 10 year yield rose 6 basis points to 2.65%, its highest level in over a month. The two currencies recording the biggest decline against the dollar were members of the so called fragile five – the Indonesian Rupiah and Indian Rupee. Admittedly the higher price of Brent may have weighted but it underlines that specific EM’s are still at risk once the Fed starts to tighten.

The focus will likely be on the staff economic projections at today’s Fed meeting, no matter how much Yellen tries to downplay their importance. The results will be mixed. Growth is likely to be downgrades after the economy’s dire performance in Q1, unemployment downgraded and inflation upgraded. Both unemployment and inflation are now within their previous end 2014 projection range. With these mixed results, the focus will be on any shift in the dot plot, members’ expectations for the Fed funds level. There has been a more hawkish tone coming from the Fed of late and not just due to inflation risk or falling unemployment. The eerily low levels of market volatility are unnerving some market participants and they may vote to bring forward the first rate rise to force out some of the complacency in markets. Today’s price action could bring about a stronger dollar and maybe even a weaker sterling but this is a temporary blip in an otherwise upward trajectory for sterling-dollar. We advise sterling buyers and dollar sellers to take advantage of the short term volatility, something which has been in short supply recently.