Volatility returns with a vengeance as consensus trades are cleared out
20/Oct/2014 • Currency Updates•
Last week we saw some of the most violent moves in financial markets in a while. The FX and bond markets on Wednesday, in particular, were reminiscent of the worst days of the 2008-9 crisis.
The Euro rose nearly 3 full figures on the day, while US treasuries moved down by nearly 40 basis points, all in the span of a few minutes, only for the moves to be mostly reversed over the following hours. Obviously, there could be no change in the economic fundamentals that would justify such swings, and therefore we think that we have simply witnessed a clearing out of consensus trades by traders and macro hedge funds. In fact, in spite of Wednesday’s two-way volatility, the weekly change in major currency pairs and asset classes were not large; the Euro rose by about 1% against both Sterling and the Dollar, and US stocks fell by roughly the same amount.
We had two major macroeconomic surprises last week, each of them pulling the Bank of England in a different direction. Inflation came out much lower than expected in September. Headline inflation dropped from 1.5% to 1.2% YoY, led by a massive drop in core inflation from 1.9% to 1.5% YoY. The drops were mostly caused by a large fall in goods inflation, a clear indication that currency strength is filtering through to inflation levels faster than most had expected. Unemployment fell another 0.2% to 6% in August. Perhaps more importantly, wage data showed that the downward pressure on wages appears to be receding. Three-month YoY wage growth bottomed out in July at just 0.6% and rose to 0.8% in august. However, the fact that real wage growth is still negative overall means that the Bank of England was probably more affected by the news on inflation. Therefore, we are delaying our expected date for the first interest rate hike to June 2015, in line with current market expectations but later than most analysts and strategists expect.
The Eurozone was hit by another batch of bad economic news last week. Industrial production fell sharply in August, down 2.1% and more than fully reversing July’s hopeful 1.2% increase. Market measures of inflation expectations, most crucially the expected 5-year inflation rate starting 5 years from now, fell sharply again and reflect increasing scepticism that the ECB will be able to bring inflation back towards target for the foreseeable future. Also, the ECB cannot be happy to see the Euro rebound towards the 1.30 level. Pressure is piling up in President Draghi, and we expect he will ignore Bundesbank opposition and announce further measures in one of the two upcoming meetings.
We had mixed news out of the US last week. The retail sales report on Wednesday was quite weak, and incidentally served as the catalyst to spark the most violent moves in markets in a long time. However, this is a volatile data point; we need to see some confirmation over the next two months before we can conclude consumer spending in the US is at risk of a slowdown. However, industrial production and weekly jobless claims were both better than expected with both the weeks number and the 4-week average moving to another cycle low. We think these surprises just about cancel each other out and are still consistent with third-quarter growth in the range of 3-4%. Market wobbles so far are not large enough to really impact consumer or business confidence, and we see a moderate acceleration of US growth to the 3-3.5% level over the next four quarters.