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Trading Opportunities in March

Posted on: 04 March 2019 , by: Pepperstone Support , category: Market Review

December Opportunities by Chris Weston and Darren Sinden

Don’t have time? Skip to: Setting the sceneRBA interest rate meeting | Nonfarm payrolls | UK unemployment | Federal Reserve interest rate meeting

We’re in the final month of the first quarter of 2019. The previous couple of months created more questions than answers for the markets, causing a wholesale rethink on key items such as the future path of interest rates, the pace of global growth and the sustainability of debt and deficits. After the sharp reversal in market sentiment in January coupled with a strong performance in equity, credit and commodity markets, can the positive trend we’re seeing continue in February?

Setting the scene

Last month, the underlying theme running through FX markets was the sizeable reduction in implied volatility. EURUSD has been at the heart of this, with the pair trading a narrow range of 1.1488 to 1.1234 through February, and unless we start to see stabilisation and improvement to European economics then expect this pair to range trade for the foreseeable future. 

When all central banks are seemingly targeting looser financial conditions, then the result will be suppressed volatility and a hunt for yield, and to be paid to be in a position. Naturally, this means selling JPY and predominantly doing so against the higher-yielding emerging market (EM) currencies. The fact global equity markets have been so strong has prompted even further confidence in the EM 'carry' trade. 

We closed out the month with GBP the strongest currency in G10 FX, with GBPAUD gaining an impressive 3.3%, although the good-will has not spilt over into March just yet. Keep GBPAUD on the radar though, as a weekly close through the October highs of 1.8733 would suggest we can see 1.8920 come into play and potentially 2.000 later this year. GBP bears have been forced to cover through the month as the prospect of a no-deal Brexit has rescinded, with Labour pushing for a second referendum. At the same time, the hard-line factions in the Tory party have shown a willingness to vote on Theresa May’s deal on 12 May, should specific tweaks be added.
Should May’s deal be voted through and Article 50 is subsequently extended for a period, I see reasons to believe GBP could be the best performing G10 currency in 2019. 

The pair that has captivated traders and strategists is USDCNH, and whether we see CNH inflows on a better feel towards the China-US trade relations. Or, whether its Donald Trump signalling his desire for a weaker USD, we can see USDCNH trending lower, with the pair printing a series of lower highs and lows since November. Don’t fight the trend here, even if the move is a slow grind.  

The US Federal Reserve and the Reserve Bank of Australia have adjusted their monetary policy outlook for 2019, their March meetings will provide traders with an opportunity to gauge what comes next. Sentiment towards the UK and the British pound is being pulled in two directions currently, unemployment data this month will give traders a ‘last look’ at the economy's performance, ahead of the Brexit deadline of the 29th of March. But before then, we have the February Nonfarm payrolls and a chance for traders to decide if the month-long US government shutdown dented the economy or derailed job creation in the USA.

The RBA interest rate meeting 

5th of March 03:30 GMT (Server Time 05.30 GMT +2)

The RBA pivoted to a dovish stance on interest rates at its February meeting conceding that the downside risks to the economy were mounting and that a rate rise was no longer a definite conclusion. 

Markets reacted positively to the statement from the meeting but they were surprised, if not caught out, by comments from RBA governor, Philip Lowe, a few days later, about the equal likelihood of interest rate cuts as rises when the bank finally feels compelled to move them from their current +1.5%. 

Those comments were made on the 6th of February, during which AUDUSD moved from a high of 0.7246 to finish the session at 0.7105 only marginally above the day’s low of 0.7104. Australian money markets remain very cautious about the future path of interest rates and any recovery in the Australian dollar has been in sympathy with a resurgent kiwi rather than because of an improvement in sentiment towards the Aussie itself.

The minutes of the meeting were released on the 19th of February. n them, the bank confirmed that it was concerned about falling property prices and household spending. Australians have some of the highest household debt ratios in the G10. Borrowings that were often supported by rising house prices but as can be seen in the chart below house prices (the blue line) have been falling steadily in Australia for some time. Household debt ratios are below their recent highs but remain elevated. 

House prices (the blue line) falling steadily in Australia

Rising wages and falling unemployment have acted as a buffer against this divergence. However, the central bank is concerned about what could happen if the global economy goes into decline.

What to expect: the RBA is on a watching brief now and is closely monitoring both the domestic economy and those of Australia's major trading partners. It's unlikely that the bank will make any changes to interest rates at this meeting, but the market will be very interested in the language used in the statement and any post-meeting press conference. Will the statement be more dovish or more hawkish than that seen in February? If the tone of the bank's comments stay the same or have even a slightly more bullish outlook on rates, then the Aussie dollar could rally against both the US dollar and Japanese yen. However, if the market detects even a hint of an imminent rate cut, then we can expect the currency to be on the back foot once more.


Nonfarm payrolls

8th of March 13:30 GMT (Server Time 15.30 GMT +2)

US Nonfarm PayrollsUS Unemployment Rate
Forecast: 170,000  Previous: 304,000 Forecast: 3.80%  Previous: 4.0%

Job creation in the USA continued at a breakneck pace in January with 304,000 new jobs created in the first month of the year. That figure was well ahead of even the most bullish of forecasts and was the second month in a row to beat 300,000, although December's reading was subsequently revised lower by -100,000 jobs.

Has job creation been shut down?

The US government shutdown only ended in the latter stages of January and traders are keen to see what impact if any the closure had on employment in the USA. 

The Congressional Budget office calculated a cost of the shutdown to the US economy of some US$11.0bn. The exact figure, including harder to measure indirect costs, may be much higher than this.

Chart: US initial jobless claims vs. US continuing jobless claims

The knock-on effect of the shutdown may have shown up in rising weekly initial jobless claims data,  a measure that tracks new applications for unemployment benefits in the USA. At the same time, we’ve also seen a rise in the number of continuing claimants as shown in the chart above.

A decision to make 

The February Nonfarm payrolls release should help traders to decide if those rises are just a byproduct of the shutdown or are part of something more deep-seated and structural within the US labour market. Investment bankers Goldman Sachs recently noted that despite rising employment in the US, budget deficits are forecast to increase. Classical economics suggests that deficits should fall in a growing economy as additional tax revenues boost the government coffers but not this time it seems. So, perhaps there is a sea change underway?

What can other data points tell us? 

I note that the long-term unemployment rate in the US rose to 0.80% from 0.77% during December and that the US youth unemployment rate jumped to 8.7% in December and 9.1% in January, that data had trended lower since June 2018. 

Neither of those figures points conclusively to a slowdown in employment and job creation, but they could make you think that one is on the way. 

What to expect: a weaker set of job creation numbers and any revision lower to January’s data would suggest that the Fed has been correct in pausing interest rate rises during 2019.

However, if we see another solid set of numbers, then that stance will be called into question, and the market may start to price in 2019 rate rises once more. That should be positive for the US dollar as both the trade-weighted dollar index and as part of the EURUSD FX pair.



UK unemployment 

19th of March 08:30 GMT (Server Time 10.30 GMT +2)

The UK economy continues to perform well despite the ongoing and unresolved issue of Brexit. Employment data for the three months to December 2018 showed an estimated 32.60 mn people were in employment, a record high for the country and that this figure had risen by +444,000 over the prior year. What's more labour productivity picked up by +0.2% in the final quarter of 2018, having fallen by -0.40% in Q3. Even those modest gains are in stark contrast to the situation in Germany where productivity has been falling consistently for more than a year, as per the chart below. The relative scaling and differences in the way the data are compiled tend to exaggerate the differential between the German and UK figures, but you get the idea. 

Chart od UK productivity vs. Germany productivity

The UK is probably approaching what economists term full employment. This doesn’t mean that everyone who wants a job has one. Instead, it refers to an equilibrium rate of employment with only marginal changes as people move into and out of the workforce. There will always be a debate about the nature and quality of new jobs being created. However, full-time employment in the UK outperformed part-time job creation for most of 2018 as you can see below.

Chart of UK full-time employment vs. UK part-time employment

Of course, the obvious question is whether that robust employment outlook will continue as and when the UK leaves the EU? The terms under which it does so may have a big say in that.

What to expect: Brexit sentiment is the primary driver of the UK currency and stock market at the moment, ahead of macro data and the markets are probably more sensitive to the downside than to the up. That’s something of a change from the pre and post-Christmas period and can be explained by the fact that the 29th of March Brexit deadline is moving ever closer, and will be just ten days away at the time of this release. Another round of inline or positive employment data should provide some comfort for sterling, and the UK 100 index but any data that shows a reversal of fortune will likely push both currency and the stock market lower. However, as noted above, the bigger picture around Brexit will inevitably set the tone.


The Federal Reserve interest rate meeting 

20th of March 19:00 GMT (Server Time 21.00 GMT +2)

The Fed gave the markets a pleasant but unexpected surprise in January when it said that tightening was on hold for the foreseeable future. In effect, the markets got a period of extra time in the game of easy money. Stocks markets rallied, and the dollar appreciated.

Traders rarely question an opportunity when it drops into their laps, but they have now had almost two months to reflect on just why the Fed changed course and what they know or think they know that the market doesn't.

No easy answers 

That’s not an easy question to answer. The US economy continues to outperform its major peers, for example, look at this chart that plots US Composite PMI against the JP Morgan Global Composite PMI, though growth in US economic activity is currently moving sideways it's in far better shape than the downward sloping curve seen in the rest of the world. 

Chart of JPMorgan global composit vs. US composite PMI The US is also expected to grow its GDP faster than its major peers out to 2020 according to OECD forecasts shown in the chart below. 

Real GDP forecast graph

So, if there are no alarm bells currently sounding in the underlying US economy, could the answer lie elsewhere? 

What about government finances?

One area of concern could be the state of government finances something that the Fed has no direct influence over but has to consider when formulating its monetary policy. 

Goldman Sachs recently examined the state of the nation's finances and how sustainable the national debt is. They noted a growing body of opinion among economists that high levels of debt are not an issue in themselves, particularly in low-interest rate environments. The thinking is that as long as economic growth exceeds the level of interest rates in a country, then running a large budget deficit and high levels of debt should not be ‘too worrisome' and that deficits can, in theory, be sustained indefinitely under these circumstances. 

Things can change quickly

However, Goldman also found that the cost of servicing a growing debt burden in a rising interest rate environment or during a future recession, can quickly eat into the government's budget and limit their ability to stimulate the economy. 

Tax cuts under the Trump administration have already reduced the amount of funds available to the federal government and will do so throughout the balance of the administration’s term and beyond. The New York Times estimates that by 2028 the US government will pay US$900bn in annual interest costs, one of the most significant items in the federal budget. Separately the Congressional Budget Office forecast that interest payments in 2019 were already on track to hit US$390mn, a 50% rise over the figure from 2017.

A simple sum

I note that the OECD growth forecast for the US in 2020 is +2.13%, a figure that is below the current level of US base rates of 2.50%. That shortfall may be the real reason that the Fed changed course in January and why US money markets are not pricing in a rate rise before January 2020, and even then, they attribute less than a 23% chance of the Fed raising rates. 

At the moment, very few in the market are contemplating an interest rate cut from the US central bank. However, if US GDP were to slow below 2% per annum, widening the differential between interest rates and growth, then more of us may come round to that way of thinking.

What to expect: the Fed will almost certainly sit tight at this month's meeting and the market will be eager to hear more about the risks to the US economy. How many of these risks originate at home or abroad. And what Fed chair Jerome Powell believes is an appropriate response to these risks. 

Ironically, if the Fed were to have to cut interest rates in future, then Mr Powell would be likely to win the approval of President Trump, whose policies appear to have backed the central bank into a corner. 

For the next few FOMC meetings, the reasons why the bank might act on rates in either direction will be of more importance than the exact timing of that move, though of course as soon as a decision is made then the timing will assume a significance of its own. 

Expectations about the future path of interest rates are one of the primary drivers of FX prices. The dollar index is up by more than +7% over the last year and some of those gains were driven by Fed tightening if that process goes into reverse then so could the dollar.


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