Events in China and Ukraine are dominant macro drivers
Weekend developments will dominate the first part of the week ahead. Two developments stand out.
First, China announced a doubling of the permissible band from 1.0% to 2.0% around the daily fix. There had been some speculation that Chinese officials were moving in this direction. PBOC officials indicated that this was their intention some time this year. Although past moves to widen the band (May 2007 and April 2012) were not preceded by an increase in volatility, some observers did see the doubling of volatility (3-month implied volatility) to about 2.5% in the past month as a signal of the move.
The PBOC deliberately and preemptively facilitated the narrowing of onshore and offshore yuan interest rates to avoid a new influx of capital that might have been spurred by the widening of the trading band. The increased volatility and the small depreciation of the yuan over the past several weeks likely had a different motivation. It was arguably more about the one-way bet that was drawing excessive speculative and leveraged attention as well as presenting moral hazard issues.
Major currencies rarely move by 2% in a single day. Yet, China’s announcement does not mean that the yuan is for all practical purposes floating. The PBOC still will play a critical role. The yuan had rarely explored the full 1% band.
We note that the 3-month implied volatility averaged a little more than 3% from the time the band was widened from 0.3% to 0.5% (June 2007 through March 2012). It has been nearly halved (averaging about 1.65%) since the band was widened to 1.0% (May 2012 through February 2014).
That said; the widening of the band should be understood within the broad financial reform commitment outlined by last year’s Third Plenary session. These reforms will likely include acceptance of more defaults and business failures as the ubiquitous moral hazards are addressed.
There are two elements to watch to monitor the effectiveness of China’s efforts. Many of the structured speculative vehicles that embody the moral hazard are thought to be particular sensitive to yuan weakness that extends to the CNY6.35 against the dollar. It finished last week near CNY6.15 where the pressure on those structured positions just begins in earnest, according to reports. Is the PBOC willing to continue this path?
In addition, a measure of the extent that China is willing to let market forces play a greater role is the extent of its reserve accumulation. China’s currency reserves rose by more than $325 bln in the H2 13. They had grown by $185 bln in H1 13. Does China’s reserve growth slow dramatically?
The second development over the weekend was the Crimean referendum. The precise outcome is not known at this hour but in some way they do not matter. The key was always what happens next. The US and Europe will announce sanctions and, likely, a framework for their escalation.
Russian forces reportedly made an incursion into east Ukraine and seized a natural gas terminal. Some argue that because of clear reluctance of the US and Europe to show a more forceful response to the grabbing of Crimea, Putin is now going to press on into the eastern part of Ukraine.
However, the immediate evidence suggests otherwise, and this seizure was meant to secure Russia’s position in Crimea and prevent Ukraine from trying to isolate Crimea in terms of cutting off its energy supply. In addition, it appears that the foreign ministers of Ukraine and Russia reached some tentative agreement that involves constitutional changes in Kiev. The details are not clear, but it may involve accepting a fait accompli Crimea. There also seems to be an agreement that prevents Russian forces more directly confronting the Ukrainian forces trapped in Crimea for a week or so, ostensibly allowing some space of diplomacy.
The week’s main economic event is the Federal Reserve meeting, the first that Yellen will chair. There are four components that do not seem particularly controversial.
First, is the FOMC statement. It is likely to recognize that weather and other temporary factors slowed the economy. Growth is expected to pick up in the coming months and quarters.
Second, the Fed will announce another $10 bln reduction in its asset purchases. Many officials have acknowledged that the bar to altering the path that Bernanke put it on is high.
Third, the FOMC will provide new economic forecasts. It is likely to pare slightly this year’s GDP forecast of 2.8-3.2%, which would simply recognize weaker Q1 activity, without changing its medium term view. The unemployment forecast may also be tweaked lower. We would not expect the core PCE forecasts to change.
Fourth, and this is what most of the focus will be on, is the adjustment to forward guidance that has been hinted by several officials and required, as the 6.5% unemployment threshold has been approached. There is general agreement that the numerical threshold approach will be morphed into a qualitative approach.
This more qualitative approach means looking at a wider range of economic indicators. We suspect that this will be the main subject of Yellen’s press conference after the FOMC meeting concludes.
The key is that the forward guidance is strategy to reassure households, businesses and investors that interest rates will not go up for some time, even as the Fed slows its asset purchases. The shift from the threshold approach to the qualitative approach will be presented in such a way to reaffirm this. The measure of Yellens’ success will be if expectations of the first rate hike remains late Q3 15 or Q4, depending on the instrument and interpolation.
In the UK, the employment report and budget are the highlights. The market expects another 25k drop in the claimant count, which is about average over the past 12 months (-27k). The unemployment rate is expected to hold steady at 7.2%, just above the BOE’s 7.0% threshold, for which it too has moved to a more qualitative stance approach. Earnings may tick up.
The Chancellor of the Exchequer Osborne will present the new budget at midweek. Upward revisions to growth forecasts could point to a smaller deficit and better debt trajectory. However, there is some thought that this budget will help shape the economy ahead of next year’s election, that some of the potential fiscal improvement will be used to increase some targeted spending, such as the Help-to-Buy program that assists in the purchase of houses.
On Monday, the euro area will finalize its estimate of February’s CPI. Initially, it was estimated at 0.8%. Owing to new data and the effect of rounding, the original estimate may be shaved to 0.7%. This, coupled with Draghi’s (and other ECB officials’) comments last week, will renew speculation that the ECB, which did not move a couple of weeks ago, will take further accommodative steps at the meeting in early April.
Japan is likely to report a marked improvement in its February trade balance. The January trade shortfall was JPY2.79 trillion. It was likely distorted by seasonal factors and the lunar new year. The consensus for the February deficit is near JPY602 bln. This probably understates the real size of the Japanese monthly trade deficit. The 12-month average is near JPY820 bln. At the same time, a seasonal improvement in investment income suggests a trade deficit this size may not fuel a current account deficit. The streak of four consecutive monthly current account deficits may come to an end when the February balance is reported in early April.
Canada reports January retail sales and February CPI at the end of the week. Retail sales are expected to rebound from the -1.8% slide in December. The consensus expects a 0.7% increase. However, the focus will be on the CPI as that is what the Bank of Canada officials have been emphasizing in recent months. Headline CPI is expected to have slowed to 1.0% from 1.5%, and the more (policy) important core measure is expected to slow to 1.1% from 1.4%. Even though the Bank of Canada is still not prepared to cut interest rates in response, the Canadian dollar may suffer.
Lastly, we note that Australia’s governing Liberal Party won the state election in Tasmania over the weekend. The contest in South Australia was not yet clear at the time of this note. Regardless of the outcome, Prime Minister Abbott is likely to embrace the results, which gives his party control of all but one state, as a referendum on his policies. In particular, the push for privatization of state infrastructure projects will likely intensify.