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Daily Commentary 11/03/15

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• Dollar continues soaring, euro continues collapsing Nothing new here – the dollar just keeps on soaring and the euro just keeps on collapsing. EURUSD and the DXY index are back at levels last seen in 2003. The dollar’s strength is particularly remarkable given that the action in the US rates markets hasn’t been USD-supportive. Fed funds futures rate expectations have lost about half the gains made on payroll Friday, while the 10-year Treasury is back almost to where it was before the payroll data came out. So the effects of the higher payroll figure have faded in the rates market, but not in FX. Nor in US stocks either, which are down 2.7% from where they were at the close last Thursday and have lost all the gains made this year.

• ECB policy, currency hedging may be behind the dollar’s rally. The immediate cause of the dollar rally, in my view, is the ECB’s decision to institute quantitative easing (QE). That’s the only thing that can explain the timing of the incredibly rapid decline in EUR/USD. From May 2008 when it hit 1.50 to 1.20 in June 2010 and back to 1.39 in March 2014, the entire range was 30 cents. (In fact, with the exception of a six-month period in 2008, the 1.20-1.50 range largely held for the 10 years from 2004 to 2014.) From March 2014 to now, the range has been 32 cents. So in one year we’ve had a bigger range than in the previous six years. Almost half of that move has been just this year as EURUSD has fallen 14 cents. Nor has the decline been just against USD; the euro’s real effective exchange rate (REER), as calculated by the Bank for International Settlements, is also back to its 2002 level.

• What changed to cause such a rapid move? While the start of the dollar’s strength may be associated with the beginning of the Fed’s “tapering” off of its QE program in January 2014, the big change this year has been ECB policy. I believe that foreign investors, who were big buyers of euro-denominated bonds in past years, have been taking profits as the Eurozone bond market rallied ahead of QE and have been repatriating their money. In fact, net outflows from European assets have recently been running at a record high. While foreigners apparently have been buying European stocks, the flows in exchange-traded funds (ETFs) show that they’ve been doing so on a currency-hedged basis, so there has been no impact on the currency market.

• The activity in European stocks brings up another possibility. For several years, foreigners were net buyers of European assets. Given the stability in EURUSD over that time, they probably did not hedge their currency exposure. It’s likely that they are now rushing to do so, exacerbating the currency impact of the record outflow from European assets. My conclusion: the exodus from European bonds and the hedging activity of investors is likely to continue for some time, meaning these trends are likely to remain in place for the long term.

• China data: China released some data this morning, which was generally below estimates, justifying the PBoC’s decision to cut interest rates further in order to boost the economy. Retail sales were up 10.7% yoy, below estimates of 11.6%. Industrial production was up 6.8% yoy, below estimates of 7.7%. And fixed asset investment was up 13.9% yoy, below estimates of 15.0%. The news is likely to weigh on AUD and NZD today.

• Today’s highlights: During the European day, in Sweden, we get the CPI for February. Swedish CPI is forecast to be unchanged yoy, exiting deflationary territory, while the CPIF – the Bank’s favorite inflation measure – is expected to accelerate. We could see a short-lived strengthening of the currency, as this would confirm Riksbank board’s belief that the underlying inflation has bottomed out. However, while a CPI rate of 0% yoy is no longer deflation, it’s still far below +2% target. On top of that, last Thursday’s attempt by the Governor Ingves’ to talk down the currency and the Board’s stated readiness to take further action if necessary to lift the prices only reinforces our view that USDSEK has plenty room to the upside.

• In the UK, industrial production for January is forecast to have risen 0.3% mom after falling 0.2% mom in December. This would be the first rise after three consecutive months of declines and so could prove GBP-positive.

• We have several ECB speakers on Wednesday’s agenda: ECB President Mario Draghi, ECB Executive Board member Peter Praet, ECB Governing Council member Erkki Liikanen and ECB Governing Council member Ewald Nowotny speak. Bank of England MPC member Martin Weale also speaks. RBNZ Governor Graeme Wheeler will hold a press conference after the rate decision (see below) and will subsequently appear at a Parliament Select Committee.

• Then on Thursday, the highlight will be the Reserve Bank of New Zealand policy meeting. The Bank is expected to leave its policy rate unchanged at 3.5%. At its January meeting, the Bank said that they expect to keep the OCR on hold for some time, but they also added that future interest rate adjustments, either up or down will depend on the data. Since then, NZD strengthened instead and economic data have not been that supportive. This adds to the possibility that the Bank will maintain its neutral bias or even cut rates, in our view. The market view is that the RBNZ will hold rates steady; the overnight index swap market is assigning a 92% probability to that outcome, while 11 out of 13 analysts surveyed on Bloomberg also thought there was likely to be no change. On the contrary, we believe that a 25 bps rate cut seems likely, instead of Governor just trying to talk down the currency again. Given the market positioning, this would be quite a shock to the market and we would expect NZD to depreciate substantially if it happens.

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