Buy the Rumor, Sell the Fact Ahead of Jackson Hole

BBH CurrencyView

• Global stocks continue to push higher ahead of speech tomorrow; dollar remains soft
• Fed unlikely to deliver QE3 tomorrow and therefore markets may be disappointed
• Is a potential change in PBOC policy in the pipeline; Hawkish comments from Polish central bank

The markets continue to trade with little conviction ahead of tomorrow’s Jackson Hole speech, with the dollar marginally under pressure as sentiment improves amid hopes of policy action and rumors that the PBOC may cut its reverse requirements. The euro headed up to $1.45 but continues to break down as the on-going debate over Greek collateral and subsequent move in Greek bond yields continues in part to prove a temporary headwind for a sustained rally. Sterling, meanwhile, saw muted reaction CBI reported sales dropped faster than expected at the fastest pace since May 2010. Elsewhere, a sharp drop in the private sector Swiss ZEW survey continues to underscore the problems associated with a weakening economy driven in part by an extremely overvalued currency. Bund and Gilt futures continued to decline as stocks extended gains, with the EuroStoxx Banks index up nearly 2% and Chinese shares advancing nearly 3%. Energy and industrial metals both positive as well.

Many observers continue to expect an announcement by the Federal Reserve of new policy action but in our view this quite unlikely. Rather, we suspect Chairman Bernanke is likely to outline possible measures the Fed may take in order to improve financial conditions and thus lend support the economy. We view the probabilities of an announcement of QE3 as quite low and in turn view the economic situation this year as quite different as when Bernanke signaled QE2. In fact, despite the potential for a continued slowdown in global growth that the markets face as this juncture, US deflation is not imminent. Additionally, the intensification of global financial stress this time around is much more EZ-centric, which means that more forceful action on behalf of European policy makers would be quite essential to reduce market volatility. Admittedly, the sharp drop in equity shares lately have been driven in part by downside US economic data surprises but as we witnessed again yesterday “hard” US data surprises continue to surprise to the upside, suggesting that real economic activity is still growing, albeit at a slower pace than would be desired. Indeed, data surprises over the past month have consistently performed well in Asia, Japan and Australia in particular, and Emerging Markets as well driven in part by Emerging Asia and Latin America. That means, a stabilization of the macro data in US along with more forceful action by European policy to mitigate the EZ debt crisis would most likely allow the markets to refocus its attention on fundamental drivers. Today, we get more high frequency jobs data out of the US with initial jobless claims, though, we suspect most data likely to be overlooked ahead of tomorrow’s speech. Nonetheless a strong reading will likely underpin sentiment and keep the dollar under pressure. Overall, with the price action this week likely reflecting an a “big” announcement tomorrow, we suspect that a buy the rumor, sell the fact may prevail tomorrow and some disappoint may lead the dollar to pare back some of its recent gains. That means, the euro is still likely to come under pressure near $1.45 and in turn leaves SEK and NOK vulnerable to a short-term bounce after big gains this week.

Chinese equity markets registered the biggest one day gain since mid-October, with the Shanghai composite index up nearly 3.0%. One of the key drivers of the price action was an article in the government-backed newspaper China Securities Journal stating that if August CPI improves, the government could begin selectively easing of monetary policy. We have been expecting a change in policy directive for some time now in response to a moderation in (non-headline) CPI items and some evidence that bank activity is slowing. Policymakers are keenly aware of the slowdown in major economies and will not risk the currently soft landing trajectory observed in China. We would not discount further residual tightening ahead, but we expect it to come in the form of FX appreciation and hikes in the deposit rates. Hawkish comments by Polish central bankers drove 1-year 7 bps higher and are providing some support for PLN. As we have been saying, the fall in short-dated yields and growing expectations for monetary easing in several countries over the last few weeks has been overdone. Aside from Poland, we think that moves in Canada, Brazil, Mexico and Korea also fall into this category. Once things settle down, this should support currencies from these countries in relative terms. We don’t think that EUR/PLN will remain above 4.00 in the medium term. The economic slowdown in Poland is proving deeper than expected, but Q2-Q3 weakness was part of the forecasts of the CB and most investors.