This week (commencing 31st March) could be a crucial week for financial markets. The most important events are the ECB meeting on Thursday and the US Employment Report on Friday.
To put these events in context, after around six years of all major central banks heading in the same direction, we now have the possibility that the US Federal Reserve and the European Central Bank could head in opposite directions. If this happens for a sustained period of time, then there are potentially significant implications for financial markets.
On the FED front, the current path of US$10 billion QE reduction per meeting means that QE will end in Q4 2014. We also know from last week’s FOMC meeting that the FED are pencilling in rate rises sooner than many expected and also at a faster pace. What has also become apparent from speeches given by several FOMC members in recent days is that the committee is now worried about financial market stability, a.k.a. bubbles forming because of their excessively loose policies. In short, it appears that we may have a very different and more hawkish FED than we had under Bernanke.
On the ECB front, prior to the German election last September, it appeared that the Bundesbank was following its usual anti-inflation orthodoxy regardless of the pain in the periphery countries. Then, at the first meeting after the election, Mario Draghi announced not only a cut to the repo rate (from 0.5% to 0.25%) but also launched his version of forward guidance in which the idea of negative interest rates was floated. Earlier this week Jens Weidmann, the Bundesbank President, said a QE programme was not “generally out of the question”. Furthermore, ahead of the EU wide CPI report early next week, Spain announced that their CPI moved into deflationary territory at -0.2% year on year. Simply put, the ECB appears ready to engage in the next round of easing with expectations that QE will be launched sometime in the next few months.
So it appears that the two major central banks are setting out on diverging paths. Conventional wisdom would lead us to believe that the US Dollar would begin to strengthen at some point against the Euro although this has not happened yet. What seems to be really missing is signs of a stronger US economy as the data for January and February has undoubtedly been impacted by the harsh North American winter weather. The March US employment report next Friday will therefore take on perhaps more importance than usual. Even if the report is not that good, nearly every economist and pundit expects the US economy to perform much better during the second, third and fourth quarters, and so it is just a matter of time before the data improves. We have our doubts but will go with the consensus.
The chart below plots the Euro versus US Dollar FX rate (in blue) versus the yield differential between German and US Government 2 year bonds. Historically, yield is one of the main drivers of FX returns, and this seems to have held up until last summer. Since last July, the Euro has risen from 1.28 to a recent high of nearly 1.40 during which time US yields have moved marginally in favour of the US Dollar. So, if we believe that the two central banks are setting out on diverging paths, we should really expect the Euro to weaken against the US Dollar at some point, especially if the US economic data begins to improve.
Although we don’t actually expect the ECB to announce a QE programme next week, their words may be more important than their actions. With the Bundesbank seemingly giving the thumbs up to QE at some point later this year, Mario Draghi could talk dovishly and thereby weaken the Euro. He has had ample opportunity at recent press conferences to do so and has decided against such talk. However, we detect both a change in thinking at the ECB, and a more vulnerable Euro which would almost certainly decline if Draghi said the right words. We have to believe that there are many in Europe who actually want a weaker Euro.
Of course, interest rates are not the only factor that drives exchange rates. We believe that factors such as German corporate recycling of her enormous current account surplus has helped the Euro together with relative changes in the balance sheets of the Fed and the ECB, investment fund flows from US to Europe and, from time to time, reserve diversification from major central banks. We expect these issues to become less of a headwind for the US Dollar over time.
What happens elsewhere in this scenario? We expect US yields to move higher relative to those in Europe and we expect the US yield curve to flatten (as explained last week). And if the ECB does move to QE, or Draghi openly talks of such a move, we expect that European equities will outperform US equities. Indeed, there was a substantial outperformance last week with the EuroStoxx 50 index up 2.4% compared to the S&P down 0.5% and Nasdaq down 2.2%.
This weakening US performance is something we have been looking for in recent weeks. Note again what we said in last week’s commentary...“We believe that the Biotech sector has been one of the focal points of recent speculation and that the price action has bubble-like characteristics. If the Nasdaq Biotech index is indeed a bursting bubble, this could well be an indicator that widespread equity market weakness is close at hand.” The concerted selling in the more speculative sectors of the market (the Nasdaq Biotech index fell 7% last week and is 16% from the all time high at the end of Feb) is a concern ahead of month and quarter end when performance gaming often generates higher prices. When bubbles burst they don’t deflate gently they go pop. Generally there is no selling into strength you just have to sell at market. There certainly seemed to be an urgency to sell Biotech and other speculative markets last week.
It appears that the main reason for the sell-off was simple price momentum, but we also believe that the fast money players trading these stocks were doing so on leverage. These leveraged investors have to be mindful of risk, hence the urgency to sell when price momentum turns lower. Indeed, leverage has now built to record levels when measured by New York Stock Exchange Margin Debt (February figures released last week). The chart below shows the amount of margin debt alongside the Nasdaq Biotech Index (updated through last week). If the margin debt was driving sectors like Nasdaq then we would expect the March update to show margin debt falling. This, along side rising volatility spells trouble for the broader market.
So to wrap up, central bank policy changes ahead should lead to a stronger USD against the Euro and probably most currencies. Within equities, the risk appears to be that the bubble sectors are bursting, and as liquidity tightens due to the Fed ending QE and rate rises being priced in, the broad equity market looks vulnerable. We suspect the ECB QE could help European equities outperform those in the US. However, a US equity bear market would drive all equity markets lower.