Carry continues to conquer

Carry continues to conquer Weaker data from the UK and US yesterday diminished expectations of rate hikes and sent EM currencies higher almost across the board as carry came back into fashion.

As we mentioned in yesterday’s midday comment, UK average weekly earnings fell yoy in June and the Bank of England slashed its forecast for wage increases this year in half and cut it slightly for 2015 as well. Then later in the day, US retail sales came flat in July, the worst performance in six months. Retail control group – retail sales less food, auto dealers, building materials and gas stations, which is the figure that goes into the US GDP calculation – rose just 0.1% mom, while the previous two months were revised down. This caused many US economists to revise down their forecasts for Q3 GDP. As a result, Fed Funds futures rate expectations dropped as much as 6 bps in the long end (2017), continuing the decline in expectations that has seen long-end forecasts fall by 25 bps so far this month. Bond yields also fell.

The lower US and UK interest rate expectations helped to keep global stock markets rising and naturally fuelled a search for carry. Almost all the EM currencies that we track were either unchanged or higher against the dollar. The exception was BRL, which fell after presidential candidate Eduardo Campos was killed in a plane crash, throwing the October election into disarray. So long as US interest rate expectations remain contained, the additional pick-up in yield of EM currencies is likely to remain attractive and I expect such trades to do well. There certainly are both geopolitical and economic risks, but the continued low level of the VIX index (closed yesterday at 12.90, not far above its recent low of 10.32) suggests the market doesn’t put much weight on those risks. I am personally more concerned than that – having lived in Asia during the SARS epidemic, I’m particularly concerned about the growing spread of Ebola fever as an unprecedented global risk – but it may be that I’m just too worried an individual. As Charles Prince, former chairman of Citibank once said, “as long as the music is playing, you’ve got to get up and dance.” Thus I expect the market to continue the search for yield and for EM currencies to do relatively well going forward, at least as long as the music is playing.

EUR/USD initially eased after weaker Eurozone industrial production, but then came back after the US economic data disappointed as well. The range on the day was 0.55%, which is actually rather high in the context of a 0.84% range for the month so far. Nonetheless it was unable to break last week’s low of 1.3330, nor was it able to sustain the highs set after the retail sales figures for very long, confounding both the bears and the bulls. Given how quick the market was to sell the highs yesterday, I believe investors remain bearish on EUR. The expect that a break of that 1.3330 support is likely to trigger a new leg down in the pair. Today’s GDP data could provide that trigger (see below).

Today’s data: The focus during the European day is the preliminary GDP data for Q2 from France, Germany and the Eurozone as a whole. The consensus forecast is for Eurozone’s preliminary GDP to have slowed to +0.1% qoq in Q2 from +0.2% qoq in Q1. However, both Germany, supposedly Europe’s strongest economy, and France missed their forecasts. Germany registered a fall in output of 0.2% qoq, worse than the expected -0.1% and a marked turnaround from +0.8% qoq in Q1. (And this was before the Russian sanctions!) French GDP was unchanged qoq, below the forecast rise of 0.1% qoq, i.e. France continued to stagnate. Coming on top of the unexpected contraction in Italy’s Q2 GDP, EUR weakened as investors worry that the Eurozone is falling back into recession. The ECB today publishes its quarterly Survey of Professional Forecasters, which will show what the consensus view is on that issue. The bloc’s final CPI for July is also coming out.

In Canada, we get new housing price index for June as well as the revised labor market report after Statistics Canada found an error in the original report published last Friday. The Canadian dollar recovered all the losses ahead of the revised report amid expectations that the error understated the net employment change. We would expect CAD to strengthen further if a strong rebound above 20.0k (the original market forecast for the figure) is recorded.

From the US, we get the initial jobless claims for the week ended 9th of August. The forecast is for claims to increase marginally.

We have no speakers scheduled on Thursday.