The markets are on edge. The heightened state of anxiety is often over-determined in the sense of having many caused. Now is no exception. The disappointing HSBC flash China PMI has been widely cited as a key factor. At the same time, the US House Republicans have indicated that a bill with no new spending cuts to raise the debt ceiling is unlikely. Their initial feint is to seek a number of specific changes in the Affordable Care Act, renewing fears of a repeat of last October.
In addition, confidence in monetary policy has been shaken. It is now well appreciated that forward guidance has become the preferred tool of monetary policy. The Financial Times proclaims that the Bank of England is scrapping it. A Reuters column called it a "Guidance Flop".
While we have been skeptics of forward guidance as such, we do not think that it is being abandoned by the BOE or any other central bank. First, our skepticism: 1) it is guidance not a commitment; 2) investors always looked for comments and signals from central banker for insight into the trajectory of monetary policy, so it is a question of emphasis (explicit) and spin; and 3) changing conditions required adjustment of views and therefore an evolution of forward guidance. Ultimately forward guidance is a communication style not policy.
Second, it is this latter point that has become confusing for investors. At the Bank of Canada, Carney's forward guidance was in the form of a time frame. At the Bank of England, Carney's forward guidance has been linked to a 7% unemployment threshold. That threshold is being approached much sooner than the BOE anticipated six months ago. The US Federal Reserve may be facing the same thing soon, as the unemployment rate is pushing closer to the 6.5% threshold.
The media, or at least the headline writers, make it seem like a modification and further development of the central bank's communication, which is in the direction of great transparency--another meme--that central banks were gradually moving, is tantamount to abandoning it. It is not. Strategically, it might not be very helpful just to lower the threshold. Instead, the strategic goal is help the market understand that threshold was suggested as a representative macroeconomic variable, but in the development of policy, a broader view of course would be taken into account.
Bernanke has already to some extent prepared the market for this in the US. It is clear that most of the decline in the unemployment rate is not so much a tightening of labor market conditions, as people leaving the labor market as so defined. Given the understanding that the key to underlying inflation is wages (which we are suspicious of, but that is a different issue), a compelling case can be made forward guidance, the anticipated trajectory of monetary policy, that wage growth should be a key component.
Some observers attribute the emerging market sell-off to the Fed tapering. We are sympathetic to arguments that higher interest rates and a reduction of global liquidity would hurt those emerging markets that rely on external financing (account deficits), but the problems in Turkey or Thailand, or Venezuela or Argentina, or the Ukraine, don't have much to do with Fed policy or global liquidity.
While the euro, sterling and the Swiss franc are consolidating yesterday's gains against the US dollar, the yen has continued to recover. The dollar is at its lowest level against the yen since mid-December. The break now of JPY102.50 could see another near-term big figure decline (~JPY101.65, which are the lows from December 5-6). The drop in US Treasury yields (2.73% on the 10- year now, down another 4 bp on the day and bringing the year-to-date decline to 29 bp) has been an important factor. Continued weakness in the S&P 500 and the downdraft (1.95%) in the Nikkei also took a toll.
Many international fund managers have bought Japanese shares but hedged out the currency. As month end approaches, the Nikkei is off 5.5% and the worst performing G10 market, fund managers many find themselves over-hedged, in which case they may buy yen to reduce the short yen hedge. They could trim Japanese equity exposure, which would have little net yen impact and equity is liquidated (assumed yen negative, though could be parked in the yen money market) and short yen hedge is covered.
The Canadian dollar is consolidating yesterday's sharp losses ahead of today's CPI report. While the month-over-month figures are set to ease (0.2% and 0.4% on the headline and core respectively, according to the Bloomberg consensus), the year-over-year rates are expected to tick up 1.3% from 0.9% and 1.1%. The slip to CAD1.1050 from CAD1.1175 yesterday essentially retraced half of this week's dollar rise. The market has much bad news for discounted and market positioning is extreme. Momentum traders may be key to the near-term price action. The lack of new US dollar gains after a soft inflation report could be the signal they are looking for to cut bait.
The Australian dollar has taken another leg down. It is off a little more than 1% and has retaken the title of poorest performing major currency of the week from the Canadian dollar. There are two culprits. First there are a number of cautionary reports on China, warning of credit problems, growth challenges during the economic transition phase, and demographics that will give China a higher median aged population than the US by 2020. There are concerns too over China's bank regulator has ordered a closer examination of credit risks to the coal mining industry.
Second, Australian officials continue to talk the currency down. Not just any officials, but the central bank is leading the charge and this is a bit unusual. RBA board member Ridout was cited in the Wall Street Journal opining that an $0.80 Australian dollar was a fair deal for everybody. Last month, Governor Stevens suggested $0.85. This kind of specific price reference seems to violate the best practices. It is typically not tolerated. It wasn't when the Japanese officials were making such comments in the early days of the Abe government.