It’s oh so quiet…for now

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Frequent u-turns in the Fed’s policy stance, central banks’ lack of monetary policy credibility, currency wars and gyrations in macro data are being blamed for financial market volatility and record lows in government bond yields. The forthcoming EU referendum has also buffeted UK financial markets.

But on the whole, financial markets and macro data have since 1 April showed a far greater degree of stability than in preceding quarters.

US interest rate, equity and currency markets have weathered the gyrations in the Fed’s policy stance and the ebbs and flows in US data. German and Japanese government bond yields have fallen but ultimately been less volatile than in Q1. The World Equity Index has also been constrained in a reasonably narrow range, thanks at least in part to signs that global GDP growth stabilised in Q1.

This relative stability has not been confined to the dollar. So far, Q2 2016 has been the least volatile quarter since January 2015 – as defined by the low-high range using daily data – for most major nominal effective exchange rates (NEERs). These include developed and EM currencies, as well as commodity and non-commodity currencies. Among G7 currencies, the euro NEER has been particularly stable in a 2.1% range.

The picture is also one of relative calm in emerging markets, with the pick-up in foreign capital inflows in April and June and in commodity prices since March helping to stabilise EM currencies without central banks having to draw on still significant FX reserves.

Commodity prices, including crude oil, have risen sharply so far in Q2 but their volatility has remained in line with historical standards, particularly in recent weeks. This has contributed to greater stability in commodity currencies, with the exception of the Australian dollar.

If anything, this lack of directionality has forced financial market players to be light-footed and adopt short-term tactical strategies. The question now is whether this relative calm is here to stay or whether it augurs more violent corrections as was the case earlier this year.

The UK referendum on EU accession has the potential to be far more destabilising to financial markets than the BoJ’s policy meeting on 16 June and in particular the Fed’s meeting the day before. While UK markets would likely feel the brunt of a decision to leave the EU, the euro would also likely weaken and global equity markets conceivably sell off.

The Fed’s policy meeting on 27th July could also prove disruptive at a time of potentially reduced summer-liquidity.

Some markets testing new lows but on the whole greater financial market stability

The press has been effusive in reporting that frequent u-turns in the US Federal Reserve’s policy stance, central banks’ lack of monetary policy credibility, currency wars and gyrations in macro data have caused much financial market volatility.

Indeed, government bond yields have tumbled to record lows in Germany and Japan, with 10-year bunds trading with a negative yield for the first time. A number of currencies, including the yen and sterling, and individual stocks have also continued to exhibit much volatility. Finally, key economic variables such as non-US farm payrolls have evolved rather erratically and remain unpredictable.

However, on the whole, financial markets and macro data have in recent months showed a far greater degree of stability. Hard evidence shows that so far in Q2 interest rate, currency, equity and commodity markets have actually traded in far narrower ranges than in previous quarters while global growth and a raft of tier-1 macro indicators have been broadly stable.

 

US, German and Japanese government bond yields in narrow ranges so far in Q2

The Fed has blown hot and cold ever since it hiked its policy rate for the first time in a decade back in December (see Fed on the ropes but not down, 7 June 2016), but particularly in recent months. It issued a benign policy statement after its 28th April meeting only to publish a hawkish set of minutes three weeks later. The Fed’s clear call for a June hike was then torpedoed by soft May labour data, which Chairperson Yellen acknowledged in her speech on 6th June. Markets have all but priced out a rate hike at tomorrow’s policy meeting and US treasury yields have tumbled.

And yet US yields so far in Q2 remain confined to a narrower range than in the previous five quarters (see Figure 1). The high-low range since 1 April 2016, using daily close data, for the average of 2, 5 and 10-year Treasury yields is 28bp, according to my estimates (the low was 1.13% on 14 June and the high 1.40% on 25 May).

German and Japanese government bonds have fallen to new lows but again the volatility in the past 10 weeks has been less than in previous quarters.

  • The average yield on German 2, 5 and 10-year bunds “peaked” at around -12bp on 26 April and hit a quarterly (and all-time) low of -26bp on 14 June – a range of about 12bp (see Figure 2). That range is half of the range recorded in Q2 2015.

Olivier Desbarres - So Quiet charts 1 and 2

  • a quarterly (and all-time) low of -18bp on 14 June – a range of about 6bp (see Figure 3). That range is a quarter of the range recorded in Q2 2015 and only in Q4 2015 has that range been tighter (about 3bp).

Olivier Desbarres - So Quiet charts 3 and 4

UK government bond yields have traded in a reasonably wide range in the past couple of months, unsurprisingly given the forthcoming UK referendum on EU membership (see Figure 4). UK interest rate and currency markets have tended to track opinion polls on the referendum, with the recent increase in support for the “leave” camp seemingly weighing on sterling and gilt yields. That volatility is likely to remain elevated in the run-up to the 23rd June referendum and could conceivably spike should the UK electorate vote to the leave the EU (see Sticking to forecasts, 25 May 2016).

 

US and global equity market trading sideways

It is also striking how poised major equity markets have been so far this quarter. The US Dow Jones index has traded in a subdued 3.8% range (using daily close data), despite the ups-and-down in US macro data and Fed policy statements (see Figure 5). By comparison, that range was in double-digits in all three of the preceding quarters. If we expand this analysis to global equities, the conclusion is very much the same (see Figure 6).

Olivier Desbarres - So Quiet charts 5 and 6

 

Global growth bottoming out?

Signs of more stable economic growth have likely in part underpinned this relative stability in equity markets. Most countries have released data for Q1 and I estimate that global GDP growth was broadly stable at around 2.8% year-on-year (see Figure 7). This follows eight consecutive quarters of declining growth.

Olivier Desbarres - So Quiet charts 7

 

Majority of world’s most traded currencies, including USD and EUR, far less volatile in Q2

While the US dollar, on a daily basis, remains at the mercy of the Fed and the vagaries of US data, the dollar NEER has so far had its second quietest quarter since January 2015 (see Figure 8). This may explain in part why recent Fed policy statements and FOMC members’ speeches have made little reference to the US dollar.

Olivier Desbarres - So Quiet charts 8 and 9

Moreover, this relative stability has not been confined to the dollar.

So far, Q2 2016 has been the least volatile quarter – as defined by the low-high range using daily data – for most major nominal effective exchange rates (NEERs). These include both developed and EM currencies, as well as commodity and non-commodity currencies – namely the euro, Canadian and New Zealand dollars, Norwegian krone, Brazilian real, Russian rouble, Chinese renminbi, Indonesian rupiah, Indian rupee, Singapore dollar, Taiwan dollar and Thai baht (see Figure 10 and Appendix).

Among G7 currencies, the euro NEER has been particularly stable in a 2.1% range (see Figure 9), suggesting that markets have a degree of confidence in the ECB’s monetary policy.

Olivier Desbarres - So Quiet charts 10

This relative stability in major currencies tends to poor cold water on the popular idea that central banks are engaged in brutal currency wars – or at least on the notion that central banks can achieve anything by trying to bully their currencies in a specific direction.

Sterling and yen NEERs have traded in wider ranges so far this quarter because markets, rather than policy-makers, have been in control (see Figures 11 and 12). The uncertainty associated with the forthcoming UK referendum, as well as some disappointing UK macro data, have buffeted sterling while markets’ distrust of Japanese monetary policy has so far contributed to the yen’s seemingly unstoppable appreciation.

Olivier Desbarres - So Quiet charts 11and 12

 

Capital inflows into emerging markets stabilise central bank FX reserves and currencies

The picture is also one of relative calm in emerging markets, with the pick-up in foreign capital inflows in April and June and in commodity prices since March helping to stabilise EM currencies without central banks having to draw down on admittedly still significant FX reserves.

A GDP-weighted basket of emerging market currencies[1] versus the US dollar has so far had its second least volatile quarter (see Figure 13). The CNY, which accounts for about 44% of this basket, has been reasonably stable in a 2.1% range versus the US dollar, cooling market fears about the direction of the Chinese central bank’s exchange rate policy (see Figure 28). If we exclude the reasonably stable CNY, EM currency volatility is greater but low by historical standards (see Figure 14).

Olivier Desbarres - So Quiet charts 13 and 14

A GDP-weighted basket of EM NEERs has unsurprisingly evolved in an ever tighter range of 1.5% so far in Q2 (see Figure 15) and this range is only marginally wider if the CNY is excluded (see Figure 16). In particular the INR, SGD, TWD and THB NEERs have stuck to 1-2% ranges for now.

Olivier Desbarres - So Quiet charts 15 and 16

The Korean won NEER has dipped since the Bank of Korea’s unexpected 25bp rate cut on 9 June but has remained well within its recent range (see Figure 32). The volatility in the PHP, MXN and PLN and NEERs has been more elevated this quarter but remains broadly in line with historical averages (see Figures 34, 39 and 40).

EM central bank’s FX reserves, adjusted for currency-valuation effects, were broadly stable between end-February and end-April at $7.93 trillion[2]. Moreover, based on countries which have so far released May data and which account for about 90% of total reserves, EM FX reserves were also broadly stable in May (see Figure 17). This compares to a $308bn fall between end-November 2015 and end-February 2016, according to my estimates.

Excluding China, FX reserves actually rose about $33bn between end-February and end-May, versus a $36bn fall in the previous three months (see Figure 18). This greater stability in FX reserves is reflected in Figures 42 and 43.

Olivier Desbarres - So Quiet charts 17 and 18

Commodity prices, including crude oil, have risen sharply so far in Q2 but their volatility has remained in line with historical standards, particularly in recent weeks (see Figure 19). This has contributed to greater stability in commodity currencies, with a GDP-weighted basket of commodity NEERs trading in a 4% range since 1 April (see Figure 20). The Brazilian real, Canadian dollar, Norwegian krone and Russian rouble have been particularly stable, and even the Malaysian ringgit and South African rand have kept to reasonably narrow ranges despite lingering political uncertainty (see Figures 33 and 42).

The Australian dollar is perhaps the one exception, with the currency appreciating forcefully on the back of better Chinese and in particular Australian data (see Figure 23).

Olivier Desbarres - So Quiet charts 19 and 20

 

The new normal or market complacency?

That is not to say it has become easier to trade these markets – if anything the lack of directionality has forced financial market players to be light-footed and adopt short-term tactical strategies. Trading ranges rather than buy-and-forget strategies have been the order of the day.

The question now is whether this relative calm is here to stay or whether it augurs more violent corrections, as was the case in January 2016 when global risk appetite collapsed and bonds rallied or in February-March when equity and EM currency markets turned far more bullish. After all, there are a number of key events on the horizon, including Fed policy meetings tomorrow and on 27th July, with a UK referendum on EU accession sandwiched in between on 23rd June (see Figure 21).

  • Tomorrow’s Fed policy meeting is unlikely to cause major disruption to financial markets in my view, with the Fed likely to present a balanced picture which keeps open the possibility of a rate hike should domestic and global data improve. FOMC members’ average forecast of two hikes in 2016 may be revised down, but only incrementally in all likelihood.

 

  • The Bank of Japan’s policy meeting on 16 June arguably has a greater range of outcomes, with markets having not discounted the BoJ announcing further monetary policy easing to counter the strong yen, particularly now that the G7 meeting is over.

 

  • The UK referendum on EU accession has the potential to be far more destabilising than either the Fed or BoJ policy meetings, particularly if the electorate votes for the UK to leave the EU. While UK interest rate, currency and equity markets would likely feel the brunt of a decision to leave the EU, the euro would also likely weaken and global equity markets conceivably sell off.

 

  • Based on recent meetings, the ECB policy meeting on 21 July should pass without much noise, except if it has to address a decision by the UK to leave the EU.

 

  • The Fed’s policy meeting on 27th July could also prove destabilising. If the UK votes to stay in the EU, US consumer prices continued to rise in May (data due on 16 June) and US non-farm payrolls (due for release on 8 July) recover in June, rates markets may well have to at least partly price in the possibility of a July Fed hike. This could in turn dampen global equity markets and EM currencies and bump up market volatility, particularly if liquidity is a little tighter during the summer holiday period.

Olivier Desbarres - So Quiet charts 21

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist

 

 

Appendix
Source: investing.com, BIS, IMF, national central banks

Olivier Desbarres - So Quiet charts 22 to 25 Olivier Desbarres - So Quiet charts 26 to 29 Olivier Desbarres - So Quiet charts 30 and 31 Olivier Desbarres - So Quiet charts 32 to 35 Olivier Desbarres - So Quiet charts 36 and 37 Olivier Desbarres - So Quiet charts 38 to 41 Olivier Desbarres - So Quiet charts 42 to 45

 


[1]  The currencies included are the Brazilian real, Mexican peso, Polish zloty, Turkish lira, Russian rouble, South African rand, Chinese renminibi, Indian rupee, Indonesian rupiah, Korean won, Malaysian ringgit, Philippines peso, Singapore dollar, Taiwan dollar and Thai Baht

[2]  The countries included are Albania, Argentina, Armenia, Belarus, Brazil, Bulgaria, Chile, China, Colombia, Croatia, Egypt, El Salvador, Georgia, Hong Kong, Hungary, India, Indonesia, Jordan, Kazakhstan, the Kyrgyz Republic, Korea, Lithuania, Malaysia, Mexico, Moldova, Morocco, Nigeria, Peru, Philippines, Poland, Romania, Russia, Saudi Arabia, Singapore, South Africa, Taiwan, Thailand, Tunisia, Turkey, Ukraine and Uruguay. I include Hong Kong, Korea, Singapore and Taiwan for the purpose of this analysis even if these countries are arguably developed rather than emerging – see Emerging Markets falling between the cracks (and BRICS), 5 March 2015.

 

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