- Uncertainty surrounding US and Chinese economic prospects has dominated markets recently. Macroeconomic linkages have had strong implications for currencies such as the AUD and the CAD. As fears of a US slowdown recede and the policy-driven soft landing continues in China, we see opportunities in FX (see Focus below).
- Yesterday, we published a report entitled: Debt sustainability and restructuring: A unified framework in which we discuss the mathematics and economics of debt sustainability and restructuring. We show how combining top-down debt sustainability analysis with the bottom-up analysis associated with credit risk, bond valuations and recovery values can shed light on Greece and Spain, among other countries.
- We also published an FX Focus entitled: Currency valuation from a macro perspective. In this report, we describe in detail the macro-based model for real effective exchange rates, which we first published in March, and discuss the strategic implications of the model. Our model estimates long-term fair values for a system of real exchange rates. Relative to long-term fair value, we see commodity currencies as largely overvalued, USD and GBP as undervalued, and EUR and JPY at about fair value. In EM, Asia as a whole is undervalued, and LatAm currencies are overvalued, in our view.
- US retail sales declined 0.2% in May, above our forecast (-0.4%) and the consensus (-0.5%). The anticipated drop in auto sales was partly offset by gains in sales of building materials and gasoline. Our tracking estimates for both US real consumption and US real GDP growth in Q2 remain close to 2%.
- The retail sales report demonstrated an important tendency in economic data releases and market sentiment. After suffering a string of negative surprises, economists have revised down their forecasts. Now, it is more difficult for data to surprise on the downside. In the short run, this can help support sentiment and a return to risk.
FOCUS
Beware the killer charts
Paul Robinson
Despite the ongoing euro area issues, prospects for the Chinese and US economies continue to dominate the outlook for asset markets at the global level. Will there be a hard or soft landing in China? Just how soft is the current soft patch in the US likely to be (the whole “landing” metaphor does not seem to apply to an economy that has shown little sign of taking off in the first place)? And how should people trade given their views on both economies? One approach is to think of the two economies together, which
effectively means considering prospects for global growth and inflation. Another is look for trades that will perform if one economy does well but the other runs into more serious difficulties in the short run. After all, the two have huge differences, in terms of the structural issues they face and their cyclical positions. In May, Chinese CPI inflation reached its highest rate since July 2008 and though we and the market expect the US CPI inflation data today to show an increase to 3.4%, core inflation remains well below 2%, and there remains significant spare capacity in the US economy.
FX markets offer a convenient way to take positions that are correlated with prospects for the two economies. It would be natural for USD/CNY to be related to the economies’ relative prospects, but because it does not float freely, many investors have used the AUD as a proxy trade for Chinese growth. It tends to benefit from higher commodity prices that are increasingly dominated by Chinese output; has close trading links with China; has relatively liquid, transparent markets with fairly non-interventionist policymakers; and weathered the financial crisis well.
An obvious way to position to take advantage of relative growth prospects is to buy AUD/USD if Chinese prospects appear bright, and vice versa. But this will stop working at some point, and both the strength of the AUD and weakness of the USD in trade-weighted terms must give investors pause. An alternative is to trade AUD/CAD. This has several advantages: the CAD is also at a very strong level relative to the USD, leading AUD/CAD to be less overvalued than AUD/USD according to our long-term fair value models. It also reduces to some extent the exposure to commodity price movements. And as Figures 1 and 2 show, there has been a close relationship between US and Canadian growth and between Chinese growth and the strength of the AUD.
“Killer charts” are seductive but can be dangerous. They tend to be based on strong bilateral co-movement when the underlying mechanism involves many more variables and a much more complex relationship. There is also a natural temptation to explain patterns, and by explaining them to place too much weight on the relationship continuing to hold – we end up convincing ourselves. There is normally a meaningful basis to the relationship, but that does not mean that it will carry on indefinitely.
We think that this is a case in point and caution against buying AUD/CAD, even given the positive carry and for those who are relatively bullish about Chinese growth prospects. First, fears of a significant US slowdown are overdone, in our opinion. Second, discussion of the possibility of QE3 is probably overdone (see “The bar is high for QE3,” Global Economic Weekly, 10 June 2011) and US yields have little room to fall further. Third, even if Chinese growth does stabilise at a high level, the lack of spare capacity means that risks are probably greater than was the case for most of the period shown in Figure 2. Fourth, the relatively muted response of equity prices to increased concerns about global growth may not persist: if there is a more significant slowdown in the US, it may lead to greater pressure on risky assets globally. AUD/CAD performance has been positively correlated with global equities over the past couple of years. More generally, periods when equities come under pressure tend to be associated with a reversion of currencies towards longer-run fair value, and despite the CAD’s strength relative to the USD, AUD/CAD appears to be stretched as well. Finally, while the AUD and Chinese growth have been closely related, Australian and Chinese growth have been less so. If the world economy stabilises, the AUD appears to have little upside but if the recent weak data are a sign of tougher times to come, it has a lot of potential downside. Selling AUD/CAD appears attractive.
MARKET INSIGHTS AND EVENTS
Asia Pacific
China: PBoC confirms policy stance with sixth RRR hike; rate hike likely within a month
Jian Chang
The PBoC announced its sixth reserve requirement ratio (RRR) hike this year, effective 20 June, following China’s May data release which showed CPI inflation rising to 34-month high while IP and FAI continue to hold up. The 50bp RRR hike applies to all banks and will impound about CNY380bn of liquidity from the banking system, according to our estimates. The RRR for large banks has now reached a new record high of 21.5%. For smaller banks, it is 19.5%. The timing of the move took the market by surprise.
BoJ MPM follow-up: Pushing on a string
Kyohei Morita, Yuichiro Nagai
The BoJ voted to leave policy rates and its asset-purchasing program unchanged at today’s meeting, while expanding credit available for “strengthening growth foundations” in a way that arguably enters the realm of fiscal policy. Amid weak demand for loans, it may do little more than push on a string. In our estimates, policy is already accommodative. In its economic assessment, the BoJ noted improvements on the supply side, while citing “signs of deceleration” in emerging and commodity-exporting economies.
India: Inflation – upside surprise repeated
Siddhartha Sanyal, Kumar Rachapudi
May WPI inflation surprised on the upside at 9.06% y/y (BarCap and consensus: 8.7%), largely driven by stubborn non-food manufacturing. Core inflation stayed above 7% y/y in May. We continue to expect the RBI to hike 25bp on 16 June and suggest holding 1y paid positions, targeting 8.15-20%. However, we expect incremental policy tightening to be slower and recommend receiving 5y OIS on spikes as a medium-term trade.
JPY: How did Japanese investors/corporates respond to the earthquake from an FX perspective?
Yuki Sakasai
The latest flow data show Japanese investors remain cautious about investing abroad, while the corporate sector has been a net seller of JPY since March. The combination of a lower level of capital exports/reduced trade (current) account balance and JPY appreciation observed after the earthquake in Japan can be thought of as part of the adjustment process to keep more capital domestically for reconstruction work, in our view.
North America
Better-than-consensus data trigger sell-off
Anshul Pradhan
The Treasury market sold off sharply on Tuesday on economic data that were only slightly better than consensus forecasts; 2y, 10y, and 30y yields rose 4.4bp, 10.7bp, and 9.8bp. Retail sales declined 0.2% in May, but were better than the consensus-expected decline of
0.5%. Retail sales ex-autos and gas rose 0.3 % in May and were revised higher for April as well. Furthermore, the core producer price index, which rose 0.2% m/m, in line with consensus, highlighted building pipeline price pressures. Business inventories rose 0.8% in April, which was slightly lower than the consensus forecast of 0.9%. After today’s data releases, our economics team’s tracking estimate for real GDP growth remains unchanged at close to 2%. Further aiding the rates sell-off was a decline in risk aversion, as Libor-OIS basis spreads declined, global equities and commodities markets rose, VIX declined, and CDS spreads on peripheral European sovereigns (with the exception of Greece) narrowed.
We had recommended initiating 10s30s curve steepeners hedged with a 40% short position in 5y Treasuries (see Market Strategy Americas, June 9). Despite the sharp sell-off, the 10s30s curve flattened only 1bp. We believe this is because the sell-off was driven largely by inflation expectations; 10y TIPS breakevens widened by 7bp. We maintain our steepening view as debt limit negotiations evolve but suggest hedging with a short 5y position against upside economic surprises. On Wednesday, market participants will focus on the CPI, Empire Manufacturing, and TIC flows reports.
Autos drive decline in US retail sales
Peter Newland
Retail sales declined 0.2% in May, above our forecast (-0.4%) and the consensus (-0.5%). The anticipated drop in auto sales was partly offset by gains in sales of building materials and gasoline. Core retail sales were up 0.2%, in line with our forecast. Our tracking estimates for both real consumption and real GDP growth in Q2 remain close to 2%.
Retail Sales: Surprises Beginning to ‘Mean Revert’?
Jeffrey Young
Yesterday’s retail sales report demonstrated an important tendency in economic data releases and market sentiment. After suffering a string of negative surprises, economists have revised down their forecasts. Now it is more difficult for data to surprise on the downside (and easier to surprise on the upside). In the short run, this can help support sentiment and a return to risk in the markets. However, the underlying data trend remains pointed toward a very slow expansion, limiting the positive effect on risk.
Core PPI price pressures continue to build
Peter Newland
Both the PPI and core PPI rose by 0.2% in May, in line with our forecast. Movements in energy, food and vehicle prices (the latter partly related to supply constraints in Japan) are likely to cause volatility in the PPI in the coming months. However, looking beyond these components there is increasing evidence of building pipeline price pressures.
Rise in US business inventories at the start of Q2
Peter Newland
Business inventories rose 0.8% in April, close to our and the consensus forecast (0.9%). Auto inventories rose in April but are likely to decline in May, reflecting supply disruptions following the Japanese earthquake, and this may lead inventory accumulation to be a drag on GDP growth in Q2 as a whole.
Europe
UK inflation profile little changed
Chris Crowe
We have revised our UK inflation profile following the release of May CPI and RPI data. Our profile for CPI inflation is essentially unchanged. We continue to expect CPI inflation to remain flat at 4.5% y/y in June, before edging up later in the year, peaking at 5.2% in October and falling back to 2.0% by the end of 2012 as the effect of temporary factors such as the VAT increase and higher commodity prices drop out of the annual inflation rate.
May CPI was unchanged at 4.5% y/y, in line with market, while RPI inflation was steady at 5.2% y/y. In the CPI, food inflation picked up to 5.8% y/y, from 4.4% in April but this was offset by slight falls in prices across a broad range of goods and services.
Spain: Core inflation likely to stay elevated for a while
Fabio Fois
Spanish HICP inflation declined 0.1% m/m, consistent with a y/y rate of 3.4% (in line with our and market expectations). The CPI was reported to have held steady at 3.5% y/y (consensus: 3.5%, BarCap: 3.7%). Core CPI inflation was unchanged at 2.1% y/y (consensus: 2.0% y/y, BarCap: 2.2% y/y).
Bundesbank’s Weidman favours voluntary investor participation
Thorsten Polleit
Deutsche Bundesbank president and ECB Board member J Weidmann, in a guest commentary in Sueddeutsche Zeitung, wrote any private sector involvement in a second Greek bailout must be voluntary: “Participation of private investors is basically sensible and right” and “there can’t be any objection to a voluntary extension of maturities” on Greek bonds.
Decent demand at today’s ECB rolls
Giuseppe Maraffino, Laurent Fransolet
At today’s ECB refinancing operations, the demand for ECB liquidity was decent, reflecting the recent increase in EONIA rates and the quite tight liquidity conditions (the liquidity surplus has fallen below zero over the past few days). Total borrowing increased by about EUR22bn.
Latin America
Chile: Preparing for another hike with an eye on the global conditions.
Marcelo Salomon
The Chilean Central Bank sanctioned market expectations and hiked the target interest rate by 25bp to 5.25%. In the statement, monetary authorities acknowledged the slowdown of developed economies, stating that even though inflation continued to move up, there were some signs that expectations are starting to moderate. Meanwhile, on the internal front, while activity remains strong, inflation continued to hover around 3% with core well behaved.
THE NEXT 24 HOURS
North America
CPI: We expect a 0.0% print on the CPI and a 0.2% increase in the core CPI in May, consistent with an NSA CPI index print of 225.6, up from 224.906 in April. Within non-core components, we forecast a small negative contribution from gasoline prices, with the gain during the month likely to be dominated by a negative seasonal factor. We expect this to be broadly offset by a positive contribution from food prices. Within the core, we think the recent trend of small increases in the heavily weighted owners’ equivalent rent (OER) index will continue, boosting core services prices. Meanwhile, anecdotal reports suggest that new and used vehicle prices rose during the month, which should boost core goods prices.
Empire State manufacturing: We expect the Empire State manufacturing index to bounce to 14.0 in June after falling to 11.9 in May. Manufacturing activity decelerated sharply in May across the nation, but we think the slowdown was due largely to transient factors and expect improvement in June. Also, the Empire State new orders index remained fairly resilient in May, supporting our expectation of a pickup in June.
IP: We expect both industrial production and manufacturing output to rise 0.2% in May. This follows a 0.4% decline in manufacturing in April, which largely reflected a sharp drop in auto production resulting from supply chain disruption following the earthquake in Japan. We expect this to reverse partly in May, although the declines in the production component of the ISM manufacturing survey and manufacturing employment in the May employment report suggest less momentum in manufacturing activity more broadly, too.
Europe
Euro area IP: In spite of a strong Italian IP reading of 1.0% m/m in April, negative readings elsewhere do not make us significantly more buoyant about April euro area IP than we were initially. We therefore keep our forecast of -0.2% m/m, although with possible upside risks.
UK labour market: We forecast earnings growth to have been unchanged in April, with headline average weekly earnings increasing by 2.3% 3m/y and core earnings up 2.1% 3m/y. The subdued trend in earnings growth, higher taxes, and rising inflation mean that real income growth remains negative. Furthermore, we forecast another increase in the number of claimant count unemployed by 6.9k and a rise in the unemployment rate to 7.8% after three consecutive months of decreases.
EEMEA
Poland CPI: We expect y/y inflation of 4.6% in May, an increase from April’s 4.5%.
Israel CPI: We forecast inflation of 4.1% y/y in May, up from 4.0% in April.
Latin America
Argentina CPI: We expect another 0.8% m/m increase.
BARCLAYS CAPITAL
RESEARCH | GLOBAL MACRO DAILY | LONDON OPEN