Recap 2014-07-31: Equities, EURUSD

Commentary:

I read lots of different ‘explanations’ for the equity move today. I think the major driver is month end selling into a temporarily over extended market, as I detailed on July 10th. These types of corrections usually take several weeks to play out. In addition, seasonality is negative for most of next month, and more importantly, note that yields did not moved lower in response. I.e. – there was no easing of financial conditions in connection to this move. All this suggests that we may still be in the early stages of a moderate, but healthy correction.

Separately, I’ve been spending a lot of time thinking about the dollar over the past couple weeks. I think that the time for a major USD bull market is finally here – a bit earlier than I’d expected previously.

For around a year now, the consensus view has been for a stronger dollar, driven by higher US yields. Goldman published a piece on it today reiterating that. In contrast, I’ve been a bit less certain on the timing. For one, the correlation between yield differentials and currencies has always been unstable, and over the past couple years has been not much different from zero:

In particular, I thought that portfolio inflows into Europe was likely drive a persistent bid in the cross, a view that now seems more broadly accepted. However, I now think that may have been an incomplete explanation. A deeper dive into the EU flows data actually shows that portfolio flows have been only roughly average relative to the past decade:

In other words, the hypothesis that portfolio inflows have offset what would otherwise have been interest rate driven bearish flows out of Europe is not especially strongly supported by the data. What may be a more complete explanation is that the portfolio flows, in conjunction with an extremely high current account surplus, have been offsetting interest rate driven bearish flows out of the EUR. Note the massive the EU current account surplus below. At almost 10%, it is large not only relative to history, but also by most standards of what is a ‘sustainable’ current account balance. In fact – the current account surplus is almost twice as large as portfolio flows over the past couple years, which when combined helped push the Basic Balance of Payments for the EUR hit all time highs earlier this year:

The differentiation between the portfolio and current account components of the basic balance is crucial because not only are the drivers different, but the volatility different as well. In particular, we can say with a much higher degree of certainty that the current account balance is likely to be lower at some point in the future. In fact – and this is very tentative – we may have passed the peak earlier this year. Not only has momentum slowed, but the EU also pulled out of a recession a year ago. (Recall that usually, higher domestic growth causes a deterioration in the trade balance as imports increase) A continuation of EU growth thus could continue to pull the EU current account balance lower, although like all economic ‘rules,’ there are exceptions. On the topic of EU growth though – note that the EU Unemployment print today is the 5th consecutive positive surprise:

In aggregate, this suggests that interest rate differentials could once again become the primary driver for FX. This hypothesis is further supported by the fact that 2 year interest rate differentials, which has historically been more strongly correlated to FX than other points on the curve, has finally begun moving away from zero. Note that the correlation breakdown occurred whilst the 2y differential was at zero, and seems to be coming back now that the differential has moved away:

I’ve written in the past that we may need to wait until 4Q before we get a move lower in the EUR. I now think that may be incorrect – the move may have already begun, and it may be just getting started.

This is a good read: http://www.pimco.com/EN/Insights/Pages/Principled-Populism.aspx

I disagree, however, that low inflation will mean significantly higher labor compensation as a percentage of GDP. The mutli-decade decline is secular, IMO, and not likely to end soon.

New Yorker via FTA:

Most hedge funds fail: their average life span is about five years. Out of an estimated seventy-two hundred hedge funds in existence at the end of 2010, seven hundred and seventy-five failed or closed in 2011, as did eight hundred and seventy-three in 2012, and nine hundred and four in 2013. This implies that, within three years, around a third of all funds disappeared. The over-all number did not decrease, however, because hope springs eternal, and new funds are constantly being launched.

Notable:

• Chicago PMI dropped sharply to 52.6 vs 63 exp and 62.6 prev
• EU Unemployment ticked lower to 11.5% vs 11.6% exp and prev.
• EU CPI declined to 0.4% vs 0.5% exp and prev. Core Inflation was stable at 0.8% as exp.
• UK GfK Consumer Confidence declined to -2 vs +2 exp and -1 prev
• Australia Building Approvals was stable at 16% YoY vs 23.8% exp and 14.3% prev

Upcoming:

• Thu: Australia PMI, China PMI,
• Fri: EU PMI, US Employment, ISM
• Mon: China Non-Mfg PMI, Australia Retail Sales, Turkey Inflation, EU PPI, AU Services PMI, Trade Balance
• Tue: RBA, EU PMI, US ISM Non-Mfg, NZ Employment,
• Wed: US Trade Balance, Australia Employment