Nick Korzhenevsky — the senior analyst at AMarkets Company
Yes, we did expect elevated volatility. But no, we did not anticipate instability of that magnitude. January has proven to be an exceptionally rough start to the year. And there are few reasons to expect that the rest of it will be any better.
First and foremost, the Fed remains on the tightening path. As explained in our November and December reports, this is the core reason of all the recent bouts of volatility. The January meeting hasn’t altered U.S. monetary policy in any way. The text released with the decision was viewed as dovish by the commentators, but it was a balanced open-door approach, in our view. We stick to our forecast of at least three rate FOMC rate hikes in 2016, which should translate into more volatility. According to our estimates, the VIX index will average 24-26 points this year, reaching mid-30s in the second half. That sort of a move would be consistent with target fed funds rate around 1-1.25%, and a generally slower economic growth even in the U.S.
There is also the fact of money supply growing notably slower in the United States. Monetary base has dropped to its lowest in nearly two years, both in seasonally adjusted and unadjusted terms, and is now firmly under 4 trln dollars. This is obviously the direct ramification of the FOMC decision to halt quantitative easing. But it is also of interest to watch M0 (along with M1 and M2) to understand how the Fed’s reinvestment policy is working through the money transmission mechanisms.
This and a number of other measures signal that the global USD supply has stopped growing. Though this statement is too general to be scientific, it is a sensible precondition for further analysis. Another important development is the rise in short-term dollar borrowing rates. 3-month USD LIBOR has edged up from 0.35% as of late December to above 0.6% today. This supports the whole short end of the treasury curve, and makes the dollar relatively attractive for investments. It is worth remembering that rates in other liquid markets are now close to zero or negative.
Another general theme affecting markets is the fear of a global slowdown. Most activity measures now indicate that the global economy is cooling. And the latest negative surprise comes from the United States, where manufacturing seems to have lost its momentum. We disagree with the view, as our core indicators are telling us this is just a transitory period, and the U.S. economy should reaccelerate in the second of second quarter or the beginning of the third quarter of 2016. More importantly, the labor market still performs outstandingly well, and we expect hourly earnings to firm in the second half of the year. This would be yet another reason for the Fed to proceed with policy normalization.
Under this scenario general USD strength should persist. As it has been the case for three years now, the dollar should perform better against EM currencies. We’re adding a long USDCNY position to the list of our preferred trades, as the yuan now looks too vulnerable in the face of capital outflows. Another prominent theme is re-pegging local currencies to the dollar, as macroeconomic warrants this sort of adjustment. Among the most liquid trades, we expect EURDKK and USDHKD pegs to hold, while GCC countries, and notably Saudi Arabia might be forced to devalue later in 2016.
EURUSD: quite some room to drop
Euro has stabilized just below $1.1 after the infamous rally of December 2015. That development has obviously caught the ECB by surprise, and Mario Draghi was forced to commit to further policy easing. The vocabulary employed at the last press conference suggests that the deposit rate is to be lowered by 0.1% at the next meeting. Altogether, the decision to extend QE and now the expected step to cut rates in March actually add up to the very policy action that we suggested would be appropriate two months ago.
However, a QE boost and a rate cut split into two do not have the synergy they would possess when implemented together. This circumstance explains why EURUSD is still trading away from parity, and also signals lower effectiveness of the euro-area monetary policy. From a medium-term perspective this means worse fundamentals, and therefore lower rates for longer.
One way or another, the yield differential between the euro and the U.S. dollar is going to diverge further. The Fed has confirmed its readiness to raise rates again this year, and only a marked cooling of the labor market can alter the plans. We seek reentry points to go short EURUSD, and spikes into 1.10 area look quite attractive to start accumulating the position.
USDRUB: even more room to drop
Russian rouble stands out as the most volatile currency of 2016 in the EM world. Despite all these wild swings though, the technical picture remains fairly clear. And the fundamentals do too.
The dramatic fall of oil prices has taken the rouble to new historical lows. However, the correlation between the two had been steadily declining, and reached a low of 0.3 right before the mini-panic of January, 21st. That is the day when the rouble collapsed in a way reminiscent of December 2014. Trading volumes were nearly 4 times the average, and apparently, a very large stop order was taken out. Importantly, oil closed the session higher that day, which supports a weakening correlation claim.
The rapid pace of the move coupled with the surge in volumes look like a completion of a wave up. We now expect a full-fledged corrective leg that should take USDRUB to at least 73.50, and might stretch all the way to 70.70. Those are the two important short-term support levels. Seasonality is surely on the rouble’s side, as much of oil revenues are directed to Russia in the first quarter of each year. And under a free-floating exchange rate regime seasonality always matters. Another important factor that should support the rouble in Q1 is a major tax payment period in the end of March. The demand for roubles is set to increase, and exporters will be forced to sell some of their FX holdings as the Bank of Russia does not want to provide any extra RUB liquidity to the market. We are entering short USDRUB positions with 73.5 as the conservative targets, but will seek to reverse to the long position once 70.70-72 area is reached. Alas, the fundamental long-term trend for USDRUB remains firmly up.
USDCNY: another victim of EM capital outflows
The Chinese yuan has been in the spotlight for quite some time now. Volatility in both onshore and offshore markets increased in tandem with general EM weakness. Importantly, the People’s Bank of China has shown willingness to let the yuan depreciate this time.
The most important move, in our view, is the introduction of the CFETS RMB index. This implies that the regulator may allow USDCNY to drift higher, as it is now targeting a wide range of currencies instead of a single pair. The U.S. dollar has a share of only 27% in the new index, the euro follows with 22%, and the Japanese yen was assigned a 14% weight. Another meaningful introduction is the change of how the daily fixing is set. This was necessary to induce greater volatility into the market, which presumably should hold back the speculators.
Altogether these actions clearly herald readiness to align yuan’s exchange rate with other EM currencies. The PBOC has burned through 700 billion of FX reserves to defend a de-facto dollar peg around 6.2. Certainly, the scale of depreciation will not nearly be as high as that of the Brazilian real or the Russian rouble. We expect a total of 13% devaluation over the 12 month horizon, and set 7.00 as the end-year target for USDCNY.