2014 in review: the year of “not quite”

As 2014 draws to a close we take a quick look back at some of the key inflections points and defining trade themes from the year just gone and their potential implications for the year to come.

Euro, from hero to zero, not quite…

A year ago, market commentary was discussing how deleveraging ahead of the ECB’s year-end AQR assessment and the Eurozone’s strong Balance of Payments position was keeping the EUR too firm. Those factors have not substantially changed. What has changed substantially is the ECB’s attitude to ‘low inflation’ and the means to address it. Markets think the policy choices the ECB has taken this year, particularly negative deposit rates and now the prospect of aggressive balance sheet expansion, are a thinly-veiled attempt to get the EUR a lot lower. Barring the surprise unfolding of a non-Eurozone event risk, such as an implosion of the US shale industry, markets expect President Draghi to get his wish of a weaker EUR in 2015.

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Perhaps it should not have been such a surprise given weak Eurozone domestic demand, but the Eurozone is currently running a current account surplus worth 2.5% of GDP. and the failure to re-cycle this surplus via direct investment (which has narrowed to a 0.5% deficit) increasingly places the burden on portfolio flows if the ECB does indeed see a weaker EUR as the least contentious way to reflate the Eurozone economy.

Communications in 2014 have made it clear that the ECB does indeed expect the EUR to play a major role in reflating the Eurozone economy. Starting with a speech in March, President Draghi has been at pains to emphasise the divergence between real rates at home and abroad – and how this should weaken the EUR. Having employed negative deposit rates to collapse nominal EUR swap rates out along the curve, the ECB is now very much focused on the inflation expectations channel via enlarging the balance sheet. Success will see inflation expectations rise, real interest rates turn more negative and the EUR weaken.

Failure to address falling inflation expectations would see real interest rates rise and the EUR rally. This would be disastrous for the ECB. Given that the ECB will have clarified and started to deliver a broader balance sheet expansion by the end of 1Q15. The market is pencilling in the ECB balance sheet growing to €2.5tr by the end of 2015. At the same time the market sees the low point in the Eurozone inflation cycle probably being registered in Q115 – all pointing to H215 as the period when inflation expectations pick-up, real rates turn more negative and the EUR weakens more broadly.

Rouble to rubble, not quite…

The RUB has undoubtedly stolen the limelight at the end of 2014, and it will likely still dominate EMEA FX themes in early 2015.  As it stands, the Russian authorities have taken a bold stance in allowing the currency to fully float in November, while increasing the range of tools to boost FX liquidity at the CBR level, introducing FX repo auctions on various maturities, setting up FX swaps (USDRUB sell/buy swaps) in an attempt to mitigate the RUB softening (fuelled by the deteriorating inflation outlook and softer oil prices). Since June, it weakened by 35% in nominal trade weighted terms and has come close to 80 vs the USD in spite of the CBR’s most recent action of an emergency 650bp rate hike. In early December, Putin’s annual address reactivated the fear of capital controls via suggesting FX sales policies for Russian exporters.

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At this juncture, the RUB weakness versus USD is primarily driven by a lack of an FX offer on the Russian markets fuelled by Russian exporters holding on to their USD and a Russian banking sector struggling to unfreeze USD assets. Persistence of oil below $70 is likely to maintain this status quo in the short term this should keep the CBR under pressure to “optimise” further its portfolio of tools, while attempting to mitigate inflationary risks and local financial stability risk.

USDRUB has recently reversed off a high near 80 and the 5-year Russian sovereign CDS is trading close to the levels Ukraine printed in summer 2013. The fear for many with conviction calls that the USD trades higher is that Russia is on the verge of a 1998-type moment – well at least the Rouble is performing like it’s 1998.

Suffice to say markets are wary of, but not looking for, a repeat of the 1998 Russian sovereign default that prompted the collapse of the LTCM hedge fund, triggered wholesale deleveraging (USDJPY dropped from 145 to 110) and sparked a mini 75bp easing cycle from the Fed. 1998 was a fiscal crisis when Russia could not service its increasingly short-term GKO debt. The current crisis is driven mainly by FX liquidity issues made worse by an energy price war. Public sector defaults are highly unlikely in our view and instead the question is whether Russia is treating current events seriously enough to respond with more targeted policy.

The market suspects that Russian asset markets may have to fall further before authorities address the issues of FX shortages for corporate Russia. But the prospect of Russian retail demand for FX should sharpen the senses and prompt more aggressive market-based measures (rate hikes and FX intervention) given that the authorities are loathed to reverse course and employ capital controls.

USD to the moon, not quite…

Forecasting a stronger dollar is now a very popular view. As opposed to the defensive dollar strength seen through the height of the Eurozone crisis in 2010 and again in 2012, the current dollar rally is built on much firmer foundations. And the market believes these foundations plus the cyclical/monetary position of the US should be worth another two years of dollar strength.

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In terms of the cyclical story, the US faces fewer headwinds to growth than those of many trading partners. Having undertaken the Supervisory Capital Assessment Programme (SCAP) as early as May 2009 to address the strength of the banking system, US banks were forced to re capitalise later that year. This set the scene for the kind of pick up in credit growth that Eurozone policymakers crave.

At the same time, the sharp decline in unemployment and the very much intended wealth effects of the Fed’s three QE schemes have combined to drive US consumer and business confidence to cyclical highs. In addition, the aggressive sequestration applied in 2013 now leaves the US in the enviable position of a budget deficit of less than 3% of GDP and with even the prospect of some modest fiscal stimulus in 2015. The easing of the 2008/09 headwinds should finally allow the US economy to grow close to 3%. It also fondly recalls the kind of out performance that the US economy enjoyed in the second half of the 1990s.

This economic out performance was very much played out in portfolio flows. Given the nature of equity in relation to FX volatility, international equity investments are often not FX hedged. Big swings in these flows can help determine FX trends and this was certainly the case in the latter half of the 1990s. As confidence has grown in the US recovery over recent months, portfolio flow data from the US Treasury is starting to show quite a turn in net buying of US equity securities. This has been driven not only by increased demand for US equities from foreign residents, but also US residents cutting their purchases of foreign equities. Markets expect this trend to continue and support the dollar certainly in 2015.

An extension of the cyclical story is, of course, Fed policy. The by product of the Fed’s reflationary QE programmes was clearly a weaker dollar although the dollar actually held its value well in the face of the QE3 programme. Now that headwind of Fed balance sheet expansion will fade and the market will shift to the next major chapter of Fed policy tighter policy rates.

Notwithstanding the challenges facing the Fed in actually getting the effective Fed Funds rate higher e.g. , the success of reverse repos or term deposits – markets expect the Fed tightening cycle to start in 3Q15 and lift the target rate to 1.50% by the end of 2016. Typically two year swap rates can trade as much as 150- 200bp over the policy rate ahead of the first Fed hike which clearly presents a lot of upside to the current 60bp two year swap to target rate spread. This is important since two year swap spreads (e.g. , USD versus EUR) have been a key driver of dollar strength this year and look set to move markedly in the dollar’s favour.

BOJ JPY knockout blow, not quite…

Unlike the ECB, the BoJ remains explicit about its balance sheet plans and surprised at its October meeting by increasing its annual asset purchase to a rate of JPY80tr per annum. Unlike QE schemes already seen in the US and UK, and yet to be seen in the Eurozone, the BoJ’s QQE policy is open ended. Markets expect the scheme to remain in place throughout 2015 and most likely 2016 as well resulting in a significant divergence in US Japan central bank balance sheets and a higher USDJPY.

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While the surge in USDJPY since late October may have front run the expected FED:BoJ balance sheet divergence in 2015, there is no denying that this will remain a very positive USDJPY story over coming quarters. This is especially the case since the BoJ lost some credibility in 2014 over the economy’s ability to withstand April’s consumption tax hike and the BoJ’s expectation for higher prices. Given the continued BoJ mandate of returning inflation to 2% as quickly as possible and the validation of PM Abe’s policies at the December election, the next BoJ policy change looks more likely to be a quickening, rather than a slowing, in the pace of its balance sheet expansion.

The BoJ’s QQE policy may also have some positive impact for USDJPY more directly through the portfolio channel. The BoJ’s target of buying JPY80tr per annum will exceed the new JGB issuance from the Japanese government. Thus BoJ buying will decrease the number of JGBs held in the private sector, perhaps with implications for Japan’s weighting in World Government Bond Indices. At the same time this will encourage the crowding out of investors into the likes of US Treasuries.

In addition, Japanese investors are likely to be reducing FX hedge ratios on US Treasury investments, i.e., selling fewer dollars forward. Bearish US yield curve flattening has typically proved positive for USDJPY . Here the hedging costs of 3 month forward sales of USDJPY will be rising relative to the yield pick up in the 10 year area of the bond curve. The 100% FX hedge ratios run during the Fed’s QE period are unlikely to be seen if 3 month USD interbank rates are pushing close to 1.00% by end 2015.

Inevitably there will be periods when equity corrections prompt sharp, but temporary set backs in USDJPY. These could see USDJPY correct back to 112/113. Yet over the year the markets look for macro/monetary trends to play out and USDJPY to end 2015 higher.

Gold lost its shine, not quite…

Gold appears to be finding stability around the psychological $1200 level, which incidentally is where the market started this year. This flattish annual performance in a way summarises the gold market in 2014 – not so much as to say that nothing happened this year, but instead that 2014 was a year of consolidation, where conviction levels were low, investor participation was limited, and a clear direction was difficult to find.

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In 2014 price moves have not been as violent as they were last year, in many ways the rangebound price action was much more difficult to trade. Many market participants had been disappointed on a number of occasions, getting stopped out when gold looked like it was going to break either direction but failed. The $260 trading range we’ve seen this year may sound fairly wide when taken in isolation, but it pales in comparison to the $500+ range in 2013.

And in reality, prices this year have actually stayed within a narrower trading band between $1180 and $1330. There was no big theme in 2014 for investors to trade on and no obvious catalyst to provide a clear sense of direction. Much of the macro environment – current and expected – had been reflected in the price in one way or another. Many lacked conviction and this manifested in lower participation rates, limited trading sizes and shorter investment time frames.

Volatility in various currencies attracted the attention of investors at the expense of gold. The gradual improvement in the global economy, and particularly the continued uptrend in equities, meant that gold faced stiff competition from other assets for investor interest.
In many ways, gold needed this year to consolidate, to reassess and to try and find some equilibrium.

In a sense, it allowed the market to distance itself from the overly negative sentiment that dominated in 2013 and approach gold with a bit more objectivity. Many of the ‘ trading tourists’ in the market – those that only got involved during the peak of gold’s bull-run – are no longer around, and gold is now left with relatively fewer, yet perhaps more experienced participants. Although physical demand was lower this year versus 2013, the role of physical markets have been stronger than ever, especially when gold needed support the most in Q3.

Gold’s resilience this year has been encouraging and this is perhaps something that investors can take some comfort in and this year may prove to have been the corrective platform gold needed ahead of a potential decent phase of recovery next year.