The first three months of 2016 saw the unwelcome return of the turbulence that had marred financial markets in the summer of 2015. Equity indices across the globe saw sharp losses accompanied by high volatility. Major currencies were also exposed to unusual fluctuations as safe-haven currencies were back in demand.
It was also a busy quarter for central bank activity, particularly from the European Central Bank and the Bank of Japan. But it was the changing tone of the Fed that had the biggest impact on financial markets.
Meanwhile, commodities continued their decline to hit fresh lows in January/February before making a recovery in March.
Dollar in retreat after Yellen
After a sharp rally in 2014, the US dollar spent much of 2015 moving sideways as traders tried to speculate when the Federal Reserve would raise interest rates. The Fed’s move came in December when the federal funds target range was lifted from 0-0.25% to 0.25-0.5% – the first increase since the onset of the financial crisis.
It wouldn’t have been totally misguided to predict that after the first hike, the dollar would have extended its gains against other currencies. But the uncertainty surrounding the slowdown in China and the health of the global economy in general, combined with the renewed slide in commodity prices, prompted the Fed to adopt a more cautious stance at its March policy meeting.
Fed Chair Janet Yellen reiterated the need for caution in raising rates further at a speech on March 29, contradicting some of the more hawkish members of the FOMC who in the run-up to Yellen’s speech had expressed confidence about the strength of the US economy.
The dovish tone coming from the top at the Fed triggered quarterly losses for the dollar. The US currency has fallen about 4% against a basket of currencies during the first quarter. US equities only stand to gain though from a weaker dollar and the subsequent improvement in market sentiment. The S&P 500 managed to recoup all of its losses from January and February after the March FOMC meeting to post gains of 1% for the quarter.
Euro unmoved by ECB
The European Central Bank has been one of the more active of the world’s major central banks in recent months as it has loosened monetary policy twice in the past four months. Markets were unimpressed in December by the ECB’s decision to cut the deposit rate by 10bps to -0.3%, while leaving the size of the asset purchases unchanged. The single currency jumped 3% against the dollar after the decision.
In March, lacklustre growth and very low inflation prompted the ECB to take more aggressive action. The central bank cut its deposit rate by a further 10bps and increased the size of its asset purchase program from €60 billion to €80 billion a month. Market response was more positive this time but the euro’s sell-off was very brief as it quickly reversed after ECB President Mario Draghi hinted that rates are not likely to be cut much further into negative territory.
The dollar’s own weakness and increased risk aversion have only helped the euro extend its gains, with only the risk of ‘Brexit’ being the major factor currently weighing on the single currency. The euro gained about 5% against the dollar during the first quarter.
Bank of Japan fails to talk down yen
Apart from the ECB, the Bank of Japan has been the other major central bank taking action in the first quarter. The BoJ had made some tweaks to its QQE program back in December, giving the impression that it’s not likely to make any further policy changes anytime soon. But markets were shocked in January when the BoJ announced it is introducing negative interest rates on excess reserves held by financial institutions at the central bank.
The yen initially fell after the surprise move as markets were encouraged by the BoJ’s renewed determination in lifting inflation towards its 2% target. But the yen’s decline proved short-lived as market sentiment turned against the Bank and the decision was strongly criticised by both the public and politicians in Japan. Subsequent comments by various BoJ officials to reiterate the Bank’s readiness for further easing have failed to convince traders.
However, the main factor in driving the yen higher during the quarter was safe-haven flows. The increased volatility and the uncertainty about the health of the global economy have increased the attractiveness of the Japanese currency. The dollar’s recent weakness has only exasperated the yen’s strength. The greenback is down 6.4% versus the yen in the first quarter.
The stronger yen hasn’t been good news for Japanese stocks though, which are sensitive to changes in the exchange rate due to Japanese firms’ dependency on overseas earnings. The Nikkei 225 index lost about 12% of its value in the first three months of the year.
Pound weighed by ‘Brexit’ risk
The British pound was one of the worst performing currencies in the first quarter as fears of a possible UK exit from the European Union in an upcoming referendum heightened concerns about the country’s prospects outside of the EU. Sterling had already declined sharply back in November when the Bank of England drastically scaled back the potential timetable of when interest rates would have to go up. The Bank downgraded its outlook further in February in its latest quarterly forecasts.
In February, British PM David Cameron successfully negotiated a revised deal of the UK’s membership in the EU and set a referendum date of June 23. Recent opinion polls have been mixed with some polls putting the ‘leave’ campaign slightly ahead, fuelling the pound’s losses. Sterling has depreciated by 6.3% in the first three months of the year against a basket of currencies, and is down about 2.5% versus the dollar.
RBA and RBNZ maintain easing bias
The Australian and New Zealand dollars were one of the worst performing currencies of 2015 as the slump in commodity prices took a major hit on resource-dependent economies. However, despite China’s economy continuing to slow and commodity prices remaining on a downtrend, both the Australian and New Zealand economies performed better than most other advanced economies. Booming property sectors, falling unemployment and strong domestic demand characterized the two economies.
The impressive growth rates of the two nations may be catching up with their currencies as the Australian dollar is up over 5% versus the greenback in the first quarter, while the New Zealand dollar has appreciated by a more modest 1%.
The Reserve Bank of Australia has kept its cash rate at 2% since May 2015, and while it has maintained an easing bias in its policy statements, it has yet to show a strong response to the aussie’s impressive rally this year. The Reserve Bank of New Zealand on the other hand is worried about low inflation and has been cutting interest rates aggressively for the past year and last cut its cash rate by 0.25% to 2.25% in March.
Commodities may have bottomed-out
Commodity prices hit the lowest since late 2002 in February according to the Thomson Reuters Core Commodity CRB index. But a rebound in crude oil helped commodities post a 15% rally, helped by the weaker dollar, before declining again by 7% since mid-March.
The main reason for the reversal was the changing outlook for oil prices. Crude oil prices hit a 12-year low in January/February before posting a 50% rally as optimism grew that major oil producers would agree on a deal to limit supply. That optimism has since waned and oil prices have come off their yearly highs.
Looking at other commodities, iron ore prices soared by 24% in the first quarter despite the ongoing oversupply of steel in the global market. Copper has also seen a modest recovery, increasing by almost 3% over the quarter.
Another big gainer has been gold, which has risen by 16% during the first quarter. The prospect of interest rates in the United States going up more gradually than expected, as well as the market volatility increasing the demand for safe-haven assets have boosted the yellow metal’s appeal, helping it reach a 1-year peak in March.
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