Jerome Powell and the FOMC are entitled to at least a tentative note of self-congratulation at this week’s meeting, on Wednesday, as so far the Fed’s measures in response to the covid-19 crisis appear to be having their desired effect on the US economy and financial markets.
The FOMC took historically aggressive action in response to the seismic shock that hit the US economy in March. In addition to cutting rates rapidly to their lower bound, commencing massive open ended asset purchases, and opening a plethora of credit easing facilities worth trillions of dollars, the Fed also opened swap and USD repo facilities for a wide range of foreign central banks.
Judged by the standard of preventing tightening in financial conditions, the Fed’s interventions so far have been a success. The aggressive provision of US liquidity via swap lines with central banks, seems to have been decisive in calming FX market volatility and easing the dollar strength seen in mid-March. Financial conditions, which had been rapidly tightening prior to the commencement of open-ended QE, have either stabilised, or improved. In particular, the Fed’s plethora of corporate and business credit easing measures have seen credit spreads for high yielding corporate and municipal debt begin to shrink after rapid expansion in mid-March. Given the effectiveness of the measures taken so far, the Fed has no immediate reason to expand any of them at present.
The key thing’s to look out for at Wednesday’s meeting are likely to be:
- The Fed’s assessment of the economy. With its current measures calming financial conditions and USD liquidity, the FOMC is instead likely to focus on assessing the nature of the developing shock to the US economy. In particular, the labour market is likely to be a focus of attention. More than 26 million people have made initial jobless claims since lockdown measures began in the US, effectively wiping out the past decade of labour market expansion under presidents Obama and Trump.
- Forward guidance on QE and credit easing. Although the Fed’s current QE guidance promises purchases “in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions”, this statement is fairly vague. Some clarification may be issued, perhaps to make it clear that credit easing and quantitative easing measures will remain in place for as long as necessary, it seems premature for the FOMC to move to a regular pace of monthly purchases of the sort that characterised its third QE programme from 2012 to 2014.
Chart: Fed’s Decisive Intervention on 19th March eases pressure on US dollar
After the Fed significantly expanded USD FX swap access on the 19th March and announced open ended QE on the 23rd, volatility eased in cross currency basis swap markets and USD strength moderated.
Loonie likely to stay range bound despite oil market as industry already in tatters
The Canadian dollar’s lack of volatility last week relative to that seen in crude markets and other petro-currencies supports the idea that the economic implications of marginal moves in oil at extreme price levels is limited. This helps explain the falling correlation of USDCAD to WTI compared to “normal times” – i.e. when oil is trading around historical averages.
Graph: USDCAD correlation with Western Canada Select (WCS) and Western Texas Intermediate (WTI) benchmarks has fallen substantially after oil crashed below breakeven rates
With WTI trading below $20 and Western Canada Select below $10, the extraction of oil in Canada is lossmaking regardless of any further price movements. Additionally, at the time of writing, the prices of some North American blends such as Bakken and WTS are lossmaking. The lossmaking nature of oil has dramatic repercussions for the Canadian economy, with the energy sector accounting for over 10% of nominal GDP and supporting over half a million jobs indirectly in 2018. Arguably, the Canadian dollar has already priced the collapse in the oil industry and the loss of CAPEX when it started to trade up towards the $1.46 level. A recovery in that sector isn’t likely until prices stabilise above breakeven levels for an extended period of time, allowing for repairs in balance sheets. Only then will wells begin to re-open and investment levels pick up, although this seems inconceivable in the foreseeable future in the current market without intervention measures.
In Canada, while mining projects can be ramped up and down relatively easily, steam assisted gravity drainage wells, used in Alberta’s oil sands to extract bitumen, are more difficult to adjust. These projects heat up entire subsurface reservoirs via steam wells, creating a steam chamber to increase the viscosity of the bitumen and allowing for it to flow downstream to an extraction well. Once these gas chambers are shut off, the bitumen falls and eventually solidifies around and below the production well – meaning it can’t be heated up again. Once shut off, restarting these projects basically means starting from scratch, which takes about 18 months. This is a hard decision to weigh for producers; continue producing and pay for people to take the barrels away in order to not incur the cost of shutting wells and re-opening, in effect destroying their balance sheet, or run the risk of closing production and risk losing it for the longer-term. The pain felt in the energy sector will be difficult to avoid. Even with the Bank of Canada’s measures to limit the destruction of credit, therefore reducing the consequences of keeping wells open at minimal capacity, the implications of the negative cash flow will be difficult to repair and will obliterate capex in the coming periods.
With this in mind, we believe the loonie is unlikely to break the $1.40 level without oil futures returning to pre-virus levels at the front-end of the curve.
This will likely require further coordinated supply cuts or improved demand conditions. The latter could come in the form of increased government purchasing by major players such as the US and China, which would also require an increase in storage capacity for their respective SPR’s, or the loosening of containment policies globally. With the latest OPEC+ supply cuts of 9.7m bpd coming into effect on May 1st, withdrawing about 10% of global production, and a further estimated 1.75m bpd at immediate risk due to immediate shut-ins in the US, WTI may find a weak floor on the supply side. However, rapidly filling storage space globally suggests that demand conditions are also set to deteriorate. This means that another end of month tantrum in front-end futures could be on the horizon, creating further headlines relating to negative oil prices. Many analysts expect further announced cuts from oil industries and OPEC+ in the coming weeks with the prolonged suppression of oil prices set to become an inevitability.
All of the ingredients are there for further volatility in crude markets, but with Canada’s energy sector currently in tatters, we expect the loonie to remain relatively numb to oil market dynamics.
To culminate, with the lack of timely data scheduled in next week’s calendar, we expect USDCAD to remain relatively range-bound in the $1.40-$1.42 region. The main catalyst for volatility in the currency pair is likely to come from global market sentiment, which has been shifting of late, with the loonie trading in between the more sensitive open-economy currencies, such as AUD and NOK, and the more resilient G10 currencies such as EUR and JPY.
Graph: USDCAD volatility has been lower than other petro-currencies but still higher than other G10 currencies such as EUR given changing risk sentiment and oil dynamics
BOJ to step up corporate bond market participation
After dealing with the initial turbulence in financial markets driven by the global outbreak of coronavirus and a raft of monetary easing, the Bank of Japan is faced with a bleak domestic economic outlook. As economic activity plummets and oil prices fall, deflation is becoming an increasingly likely scenario. With the 2% inflation target looking like an impossible mission at the current juncture and a large deal of policy weaponry already implemented, the BoJ´s is likely to shift its focus towards more targeted measures. After balancing out the sharp moves in financial markets at the outset of the crisis, the BoJ´s task is now to address more impending funding needs to help restore the economy. The BoJ is scheduled for its 1-day policy meeting on April 27th, when fresh forecasts for the quarterly economic outlook are also due, although they may be cancelled due to a high degree of uncertainty following similar actions from the Fed and Bank of Canada.
Recent headlines from local media have increased speculation that the BoJ will increase its government bonds purchasing program, which currently targets an 80 trillion yen ($742 billion) annual balance sheet increase.
Reports suggest that the central bank will discuss the possibility of introducing an open-ended target for JGB purchases, while keeping the already negative interest rate unchanged.
This idea may prove convenient after the 1 trillion stimulus package recently unveiled by Prime Minister Shinzo Abe. Even though the 0% target for 10-year bond yields seems well managed after the market turmoil in early March, the BoJ will probably signal willingness to buy more government bonds. Unlimited purchases might not be a game changer under the light of recent stability in public debt markets, but this step could instead prove effective in signalling commitment to broad monetary support.
Alternatively, current conditions might call for further action relating to concerns in private credit markets…
The BoJ is likely to increase participation in corporate bond markets and commercial paper funding. After raising the ceiling on holding those assets by 1 trillion yen each ($9 billion) in the last policy meeting, tight liquidity has triggered an increase in interest rates on these loans as companies struggle to meet their financing needs while investors remain cautious. Against this backdrop, the most likely policy move is to strengthen support for corporate finance, in line with recent Fed moves.
Stress in corporate bonds and commercial paper yields points to next BOJ policy action
Ranko Berich, Head of Market Analysis
Simon Harvey, FX Market Analyst
Olivia Alvarez Mendez, FX Market Analyst
Ima Sammani, FX Market Analyst