Augmenting the Bonus Pool

May 25th, 2016 5:48 am

Trading revenues have been difficult to come by of late particularly as fixed income trading revenues enter a period of secular stagnation. The WSJ details one strategy employed by major banks to increase revenue and that is block trading of equities. Dealers by large blocks of equity at a small discount and “hope” to move it to end users by the end of the day at a profit.

That is a very novel strategy. Buy low and sell high.

Via the WSJ:
By Corrie Driebusch
May 25, 2016 5:33 a.m. ET
0 COMMENTS

Hungry for revenue, Wall Street banks are taking on more risk to help companies sell large chunks of stock.

In block-trade deals, a bank typically buys stock from a company or its private-equity backers at a discount, and then aims to flip the stock to money managers after the market closes that same day. If they can fetch a premium, it is a win for them. But if they can’t unload the shares and prices fall, they bear the loss, minus fees.

About half of all share sales by already-public companies listed in the U.S. have been block trades this year, according to data provider Dealogic. In the past five years, these deals typically accounted for about a third of all share sales, and in the past decade that figure averages about a fifth, according to Dealogic. Energy companies, in particular, have sought block trades this year to quickly raise funds and pay down debt.

Banks generally do block deals for their most-favored customers, such as private-equity firms, in an effort to curry favor for future business. But lately, with few initial public offerings or subsequent corporate sales of new shares by U.S.-listed companies, banks have been doing a higher percentage of block-trade deals, exposing them to more risk.

The increase in such deals comes as a slump in banks’ trading revenue and the low-interest-rate environment have pressured profits.

“This is a particularly tough year for equity capital markets,” said Daniel Klausner, a managing director at audit and advisory firm PricewaterhouseCoopers, referring to the business of raising money through stock sales. “The profits, market share, number of deals are all down. Blocks are a quick way to pick up some market share.”

Companies and selling shareholders like block trades because they are guaranteed a specific price, certainty they can’t get when they sell shares directly in the stock market.

A decade ago, only a handful of banks were actively involved in such deals. Now, most major Wall Street banks compete to win block trades.

For the most part in 2016, the shares of companies sold in block deals have risen the following trading day, fueling their popularity. The average one-day return from the offer price for block deals this year is 0.5%, according to Dealogic.
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J.P. Morgan Chase & Co. is one bank that has built up its block trading recently. In 2010, the bank received about $2 million in net revenue from block trades, according to Dealogic. It has earned $38.7 million this year as of Tuesday, roughly on par with the same period in 2015.

J.P. Morgan closely follows Credit Suisse Group AG as having done the most block trades for U.S.-listed companies in 2016, according to Dealogic. Credit Suisse, like last year, has dominated such deals in the energy sector.

This year, share offerings by already-public companies, which includes block trades, have raised about $61 billion, $30 billion of which was raised in block deals, according to Dealogic. In the same period last year, these follow-on offerings raised $104 billion, $34 billion of which came from block deals, Dealogic data show.

Private-equity firm KKR & Co. sold 15 million shares of Walgreens Boots Alliance Inc. to Citigroup Inc. the first week of May, according to a regulatory filing.

The bankers paid $80 a share and reoffered the shares to clients for $80.10, aiming to make as much as $1.5 million, according to regulatory filings and Dealogic.

Walgreens’s stock fell 2.5%, to close at $79.43, the first day of trading after the share sale was announced. It is unclear whether Citigroup was able to flip all the shares. Walgreens’ shares closed above $80 the next three trading sessions. On Tuesday, Walgreen’s stock closed at $77.15.

These types of deals will remain popular until a bank loses a lot of money on one, bankers said.

In another deal, private-equity firm Blackstone Group LP sold $2.7 billion in stock of Hilton Worldwide Holdings Inc. with a block trade over Mother’s Day weekend last year.

Deutsche Bank AG , Bank of America Corp. and Citigroup bought 90 million shares of the hotel chain and were unable to sell all the stock before the market reopened on Monday, according to people familiar with the offering. The banks bought the shares at $29.71 apiece, according to a regulatory filing. The stock ended its first day of trading after the deal at $29.69. It hasn’t closed at or above $29.71 since.

A return of market volatility could stem the rise in block trades, even at a time when banks are seeking to bolster fee revenue, said Brian Reilly, global head of equity capital markets at Barclays PLC.

“In a year when [equity capital markets] revenues are down across the industry, the last thing you want to do is give back a significant portion of them by doing a bad block trade,” Mr. Reilly said.

Write to Corrie Driebusch at [email protected]

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Weak Yuan

May 25th, 2016 5:42 am

Via Bloomberg:

  • Strengthening greenback is ending period of stability for yuan
  • China’s currency still above January low as no panic seen

China’s central bank weakened its currency fixing to the lowest since March 2011 as the dollar strengthened.

 

The reference rate was set 0.3 percent weaker at 6.5693 per dollar. A gauge of the greenback’s strength rose to a two-month high Tuesday as traders boosted wagers that U.S. interest rates will rise. The yuan declined 0.06 percent to 6.5631 a dollar as of 5:10 p.m. in Shanghai.

A resurgent greenback is shaking up a strategy that the People’s Bank of China pursued over the past three months — a steady rate against the dollar, combined with depreciation against other major currencies. Traders are now pricing in a better-than-even chance of the Federal Reserve boosting borrowing costs by its July meeting, with officials lining up to indicate their willingness to support such a move, should the current strength in the economy be sustained.

“It could be because the authorities want to alleviate some of the depreciation pressure before the Fed interest rate decision in June,” said Christy Tan, head of markets strategy at National Australia Bank Ltd. in Hong Kong. “If there are signs of panic dollar buying, the PBOC will step in.”

While the fixing is below levels reached during the currency’s turmoil in January, the market rate is still 0.5 percent stronger than its nadir in January as traders show few signs of panic. Even so, investors are watching the currency as a barometer for the health of the world’s second-largest economy. The earliest batch of private indicators suggest sluggish growth in May.

“Compared to our model prediction, it’s a little bit weaker, so that’s quite significant,” said Irene Cheung, a foreign-exchange strategist at Australia & New Zealand Banking Group Ltd. in Singapore.

Chinese officials plan to press their American counterparts in annual talks next month on the chance of a U.S. interest-rate increase in June, according to people familiar with the matter. In China’s view, if the Fed does lift borrowing costs, a July move would be preferable, the people said.

The offshore yuan was little changed at 6.5673.

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Early FX

May 25th, 2016 5:38 am

Via Kit Juckes at SocGen:

 

Solid US economic data yesterday and a ‘risk-on’ day in Asia today; there ought to be smiles at the Federal Reserve: So far, so good for their plan to persuade markets to price in a faster pace of rate hikes without throwing the baby (and the S&P 500) out with the bathwater. Europe wakes up to $50 oil, solid equity indices and in FX-land, a marginally softer dollar. I’m watching the bond market today, wondering whether it will react to the cheerful mood by driving yields a little higher. FX volatility remains firmly anchored, but we could see USD/JPY edge higher though the brightest lights in FX-land today are likely to be the resource currencies. EUR/USD is going nowhere, GBP/USD is a mystery to me, and the dollar overall remains in an uptrend even if that move pauses today.

Yesterday’s US economic data reflect the Jekyll and Hyde nature of the current recovery. Existing Home Sales bounce by 16.6% (biggest monthly bounce since 1992) to a 619,000 annual rate, the highest since January 2008. Falling unemployment, (slowly) rising real incomes and low interest rates are helping the slow rehabilitation of the housing market. The Richmond Fed index meanwhile, fell to -1. Our US economics team, when they reassemble the Richmond data in ISM format, reckon this is consistent with a sub-50 manufacturing ISM, and it reflects the on-going weakness of global manufacturing. Today’s US data calendar sees the trade balance (exp a $60.1bn deficit) and the Markit services PMI (exp little change from 53 last month).

The overnight Asian news was all cheerful enough – strong trade data in New Zealand, stronger skilled vacancies in Australia. We are bearish and short of both AUD and NZD, despite the better data and stronger tone overnight. And the bounce in commodity prices too. Chinese growth will hold the key and we have heard nothing new on that front, while the slow march upwards of USD/CNY continues.

The newspaper headlines in Europe this morning are mostly about the latest Greek debt deal, which kicks that issue down the road for a while. The IMF is suggesting the ESM issue very long-dated, low-yield debt to cut Greek debt interest costs, which is possibly the most interesting development of the talks. Otherwise, IFO in Germany is unlikely to be much changed from 106.6, and we’ve got a lot of ECB speakers to hear from. EUR/USD is glued into its range.

The UK sees no data today, so the focus is on referendum opinion polls, still encouraging bookmakers to view an exit from the EU as increasingly unlikely. I thought GBP shorts had been all but squeezed out, so yesterday’s bounce caught me completely by surprise. The UK economy is slowing irrespective of the referendum and that’s why we don’t think the MPC will hike for the foreseeable future regardless. l’m keen to stay short GBP/USD if possible for now, to be short after the vote, and Jason Simpson recommends receiving 5y5y GBP vs. USD, a trade which currently offers the promise of fewer sleepless nights than shorting the currency.

 

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Running Out of Bonds

May 24th, 2016 8:46 pm

Bloomberg reports that the ECB has hoovered in most available bonds as it pursues its aggressive stimulus program.

Via Bloomberg;

  • It’s like building ‘a boat in the open sea,’ says Rabobank
  • Germany could face hurdle in executing QE plan: DZ Bank

The biggest buyer of European government bonds may have to start spreading its money around a bit more widely.

The European Central Bank expanded the size of its debt-buying program in April by a third to 80 billion euros ($89 billion) a month and appears to be running out of securities eligible under its own rules.

Monetary policy makers increased purchases of Irish and Portuguese bonds last month by less than it did for German debt, suggesting demand already threatens to outstrip supply from some countries. Banks say it might have to include more bonds or risk diluting the stimulus to the economy the quantitative easing is designed to inject.

“Everything is on the table,” said Richard McGuire, head of rates strategy at Rabobank International. “Whenever they meet resistance, they get around it by adjusting the rules, adjusting the limits or targeting new asset classes.”

Purchases at the moment are based on the size of a country’s economy and there are exclusions linked to debt restructuring. Rabobank estimates 1.13 trillion euros of bonds currently off limits could be eligible should the ECB change the parameters.

The ECB started buying sovereign debt in March last year and has spent more than $800 billion. An ECB spokesman said on Tuesday that the bank is confident the program will continue to be implemented smoothly and it sees no shortage of eligible assets under the current rules. President Mario Draghi said a month ago that there were no plans to make any changes.

German Pressure

The securities are acquired through each country’s central bank and broadening the remit would particularly help relieve pressure on Germany. While the country has a lower amount of outstanding debt compared with say Italy, the Bundesbank currently must buy a greater amount because its economy is the largest.

“Germany is definitely affected very much by lack of eligible bonds,” said Daniel Lenz, lead market strategist at DZ Bank in Frankfurt. “Outstanding volumes compared to other countries are low and new bond issuances are also low.”

German bonds have been the best performers among the 10 largest markets eligible in the ECB program, returning 2.2 percent over the 14 months of its lifespan. But at today’s pace of bond buying, Germany would exhaust the supply of sovereign bonds by September 2016 or February 2017 if the debt of German regions is included.

“They are basically building the boat in the open sea,” McGuire said.

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Deja Vu All over Again

May 24th, 2016 5:38 pm

The WSJ reports that an unusual confluence of circumstances (low levels of capital and derivative accounting) might necessitate another government bailout of either FNMA or Freddie Mac (or of both agencies).

Via the WSJ:
By Joe Light
May 24, 2016 3:34 p.m. ET

Eight years after the financial crisis, the core businesses of mortgage giants Fannie Mae and Freddie Mac are remarkably healthy.

But an unusual confluence of factors all but guarantees that one or both of them will need another taxpayer bailout in the future.

The problem is twofold. First, the government allows the companies to carry only a tiny capital buffer, meaning even a small loss can result in the need for more taxpayer funds.

Second, the companies’ use of derivatives to hedge risks in their mortgage portfolios exposes them to accounting quirks that can cause large—but illusory—losses to appear from quarter to quarter. For the first quarter, for example, Freddie Mac posted a loss of $354 million due to derivatives accounting, despite an otherwise healthy mortgage market.

The combination of low reserves and volatile earnings boosts the chances that taxpayers come to the mortgage giants’ rescue again. The issue has been noted by the chief executives of Fannie and Freddie as well as the companies’ regulator. In the meantime lawmakers, who were expected to have addressed Fannie’s and Freddie’s futures years ago, haven’t yet decided what a future housing-finance system should look like.

 

While the potential scope of the next bailout isn’t clear, some worry that a large one could set off a knee-jerk political reaction with uncertain consequences.

If there is a large bailout, “You’re going to see some pressure to do something about it,” said Mark Calabria, director of financial-regulation studies for the libertarian Cato Institute.

Fannie and Freddie don’t make loans. Rather, they buy loans from lenders, wrap them into securities and provide guarantees to make investors whole in case of default.

In 2008, the U.S. government took over the companies, putting them under the control of the Federal Housing Finance Agency. Taxpayers eventually sent the companies $187.5 billion.

Under the current terms of the bailout, Fannie and Freddie send nearly all profits to the U.S. Treasury. The companies have paid taxpayers $245.8 billion in dividends.

The terms allow the companies in 2016 to keep a capital buffer of $1.2 billion each but the buffer falls to zero by 2018. The buffer can absorb losses if either company posts one, but any losses greater than the remaining buffer would cause Fannie or Freddie to need a new taxpayer infusion.

When the terms went into effect in 2012, government officials thought legislators by now would have passed legislation replacing Fannie and Freddie with a new system. But Congress remains divided on how large the government’s role in the mortgage market should be.

A problem could arise because of how the companies account for derivatives they use to hedge the risk of losses when interest rates rise.

The companies seek not to lose or make money when rates rise or fall, and their hedging strategies eliminate that risk, said Jim Vogel, a strategist at FTN Financial.

Despite that, the accounting method that the companies use causes large, but illusory, losses or gains over short periods of time.

That’s because the rules require the companies to value the derivatives at the market price every quarter, while the value of the hedged assets doesn’t change.

If the volatility swings in the wrong direction when the companies have little capital, the resulting loss can trigger a bailout.

The accounting mismatch could eventually have a real-world impact. The companies have about $258 billion in remaining bailout money to draw on—a credit line that calms mortgage-backed securities investors.

But the credit line can’t be replenished, meaning that as the line is chipped away over time, investors could start to doubt the guarantee of their investments and drive mortgage rates up.

FHFA Director Melvin Watt in a February speech highlighted that concern. “It’s unclear where investors would draw that line, but certainly before these funds were drawn down in full,” he said.

The remaining funds available through the credit line are so large that many involved in efforts to overhaul the housing-finance system say the risk to the economy is far in the future.

They argue that requiring Fannie and Freddie to retain more capital to prevent a bailout is less beneficial to taxpayers than bailing out the companies when and if it is needed, since all profits go to the U.S. Treasury.

Some liberal advocacy groups and trade groups have called for Fannie and Freddie to keep capital to avoid the political risk. The fear is that if taxpayers sent another bailout to Fannie and Freddie, however small, lawmakers could pass a bill in haste that damages mortgage availability.

A couple of congressmen have also introduced bills that would retain capital, though political analysts say they have little chance of progressing soon.

But some housing watchers worry that building capital, without other changes, could set the stage for a return to a housing-finance system they say held too little capital and created too much incentive for risk taking.

“If you just let them earn money and retain capital without these other reforms, you’re taking a step toward going back to the old, evil Fannie and Freddie,” said Alex Pollock, a fellow with the R Street Institute, a conservative think tank.

Write to Joe Light at [email protected]

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Overnight Data Preview

May 24th, 2016 5:30 pm

Via Robert Sinche at Amherst Pierpont Securities:

CANADA: The Bberg consensus expects the Bank of Canada to keep its policy rate at 0.50% but likely scale back some of its optimistic rhetoric from last month’s review and forecasts.

S. KOREA: The May Consumer Confidence Index will follow a 101 reading in April and a relatively narrow 97-109 range for the last 5 years.

GERMANY: The Bberg consensus expects the June GfK Consumer Confidence Index to hold its gain to 9.7 in May, not far below the 10.2 cycle high reached last June. The consensus expects the May IFO Business Climate Index (BCI) to inch up to 106.8 in May from 106.6, with the Current Situation Index inching up to 113.3 from 113.2 while the Expectations index is expected to jump to 100.8 from 100.4. The BCI reached a 14-month low of 105.7 in February.

FRANCE: The BBerg consensus expects the number of Jobseekers to have inched up 4.5K after a shocking -60.0K fall in March.

ITALY: March data on Industrial Orders and Sales will be monitored to see if the recent modest YOY order gain in February (+3.8%) can be sustained.

BRAZIL: The Personal Loan Default Rate will be reported for April after holding at 6.2% for the prior 4 months.

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New Home Sales

May 24th, 2016 5:28 pm

I have been away from the markets for a good chunk of the day. This is a worthwhile read from Stephen Stanley on the new home sales data. This was the strongest report for this series since  January 2008. Mr Stanley describes today’s report as “spectacular”.

Via Stephen Stanley at Amherst Pierpont Securities:

New home sales exploded in April to 619,000 units at an annualized rate, the best reading since January 2008.  On top of that, the tallies from both February and March were revised upward by about 20K, so that the revised readings for both of those months are higher than virtually the entire range of economists’ forecasts for April!  Anecdotal reports from builders, realtors, etc. had been suggesting that the spring selling season would be the strongest of this expansion.  Up until today, the data had been solid but not spectacular.  Today’s number certainly qualifies as spectacular, as three of four regions in the country set cycle highs for new home sales.  In fact, the numbers are probably too good to be true, as I would be surprised if we continue higher from here.  Nonetheless, even if there is a bit of a pullback in May or June, the trend is undoubtedly upward and will almost certainly remain so.  Combined existing and new home sales broke the 6 million annualized pace mark in April for the first time since 2007.

As you would expect with a spike in sales, the months’ supply of new home inventories slid from 5.5 to 4.7.  However, the number of new homes on the market only fell by 1K to 243K, so builders have been ramping up their pipeline of new home construction by enough to largely cover the surge in sales in April.

The other striking element in this report is a spike in new home prices.  I do not generally focus on the price gauge in this report because the composition of homes sold in each month varies (i.e. prices can go up or down because more expensive or more modest homes were sold, not because the general trend in home prices is moving).  In April, the median price of new homes sold surged by nearly 8% on the month (not annualized) and the year-over-year gain was nearly 10%.  While I do not view this as an accurate read on the trend of home prices, I do think it tells us that the April jump in new home sales was not driven by a pop at the bottom end of the price spectrum.  If anything, the opposite would seem to be the case.

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Treasury Auctions Previewed

May 24th, 2016 8:29 am

Via TDSecurities:

Treasury will auction a total of $88bn this week, selling $26bn in 2s on Tuesday, $34bn in 5s on Wednesday, and $28bn in 7s on Thursday. With $70.6bn maturing at month-end settlement, net cash raised at the auction will total $17.4bn. Treasury will also auction $13bn in reopened FRNs on Wednesday for settlement on May 27. SOMA holdings maturing at month-end will total $25.2bn, with the Fed therefore adding on $7.5bn to 2s, $9.8bn to 5s, and $8.0bn to 7s (for more on add-ons see here). The FRNs will not see any add-ons this month. The rapid pulling forward of rate hike expectations over the past week has driven front-end yields sharply higher, potentially attracting additional demand at this week’s auctions. While some investors may remain cautious of a further backup in yields, it is worth highlighting that the “next meeting” phrase inserted into the October 2015 FOMC statement failed to dent demand at the November 2015 Treasury auctions. We believe this was a consequence of sharply higher outright yields, which helped attract additional demand.

•       2s: Last month’s 2yr auction saw its largest tail since August 2012 as foreign buyers stepped away, but broader trends for recent 2yr auctions remain positive. Just 3 of the past 12 auctions have tailed and 2s have cheapened on the curve. Averages point to a 0.3bp stop through the screens, with the highest WI yield in 5 months likely to draw additional demand. Auction statistics similarly suggest a 63% buy side award, with indirects taking 48% and directs getting 15%.

•       5s: The presence of a modest short base as well as higher yields should increase demand, though poor auction stats and relative richness of 5s on the curve continue to make us somewhat weary. Investment funds have remained strong buyers of recent 5yr auctions (taking an average of 50% over the past 3 auctions), but we see potential for a modest tail, which averages put at approximately 0.4bp. We expect the buy side to take 66% (59% to indirects and 8% to directs).

•       7s: The 7yr sector has seen mixed performance at recent auctions, with averages suggesting a 0.1bp tail and 71% buy side award (57% to indirects and 14% to directs). Investment funds have purchased an average of 51% of the past 3 auctions, and we believe the sale should benefit from this month’s larger 0.13yr index extension.

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When AAA Isn’t Really AAA

May 24th, 2016 8:26 am

Via Bloomberg:

Look Closer: 57% of China AAA Bond Issuers Have Junk-Like Risks
2016-05-24 08:19:07.842 GMT

By Bloomberg News
(Bloomberg) — So you bought a top-rated yuan bond in
China? Take a closer look. It may share characteristics with
junk notes in the rest of the world.
About 57 percent of bond issuers listed in China and whose
securities are rated AAA in the nation may have default risk
consistent with what Bloomberg’s quantitative, independent
default-risk model deems a below-investment-grade company. The
model tracks metrics including share performance, liabilities
and cash flow. It doesn’t take into consideration guarantees or
make assumptions about government support, regulations or future
earnings.
“We do not rely on onshore ratings from local rating
agencies when we make investment decisions,” said Edmund Goh,
Kuala Lumpur-based investment manager at Aberdeen Asset
Management Plc. “We apply our own internal ratings coming from
our own credit research. We are very careful with even AAA rated
papers in the onshore China market.”
Investors are pushing for more accurate ratings after at
least 10 companies defaulted so far this year, already exceeding
the tally for 2015. Dagong Global Credit Rating Co. didn’t cut
its grade for China Railway Materials Co. from a second-ranking
AA+ until three days after the company suspended trading on its
16.8 billion yuan ($2.6 billion) of notes on April 11 to study
debt repayment issues. Bonds rated AA- or lower are considered
as Junk in China’s onshore market.

Greater Scrutiny

The National Association of Financial Market Institutional
Investors will evaluate rating firms based on feedback given by
market players, the 21st Century Business Herald reported May
16.
The Bloomberg risk model data are based on ratings offered
by Dagong, China Chengxin International Credit Rating Co.,
Shanghai Brilliance Credit Rating & Investors Service Co. and
China Lianhe Credit Rating Co. Dagong, Chengxin and Lianhe
declined to comment on risks with AAA rated bonds.
“It’s normal that Chinese state-owned enterprises are AAA
or AA,” said Guo Jifeng, vice president at Shanghai Brilliance.
Even so, he added, “the possibility that some of the SOE ratings
are inflated can’t be excluded.”
Dagong said in an April 25 e-mail that its China Railway
Materials rating was based on the company’s financial situation
and external support, adding that a further adjustment would be
made if it weakened further. China Railway Materials paid off 1
billion yuan of bonds due May 17, according to Bloomberg data.

‘Dig Deeper’

Local rating agencies “need to dig deeper into the accounts
of state-owned enterprises and companies,” said Woon Khien Chia,
a senior portfolio manager in Singapore at Nikko Asset
Management Asia Ltd. “The differentiation in credit spreads from
sector to sector could be evaluated better.”
The China Securities Regulatory Commission, which said in
March it had issued warning letters to six rating firms on
violations, hasn’t responded to faxed questions seeking comment.
An official at the press office of the NAFMII, who wouldn’t be
identified, declined to comment on the report that there would
be an evaluation of rating firms.
Angang Steel Co. and property developer Gemdale Corp. are
among the AAA issuers that the Bloomberg default-risk model
deems as having high-yield traits. Angang Steel, rated AAA by
Chengxin, reported a 615 million yuan loss in the first quarter,
compared with a 19 million yuan net profit a year ago. The
state-owned steelmaker canceled a 3 billion yuan bond sale this
month, citing weak demand. Two calls to Angang’s board secretary
went unanswered Monday.
Moody’s Investors Service cut its Gemdale rating to Ba2
from Ba1 on April 27, predicting weakened credit metrics over
the next 12 to 18 months. In the onshore market, Lianhe rates it
AAA. Gemdale hasn’t responded to e-mailed questions seeking
comment.
Charlene Chu, a partner at Autonomous Research who made her
name warning of the risks from China’s credit binge, said a
bailout in the trillions of dollars is needed to tackle the bad-
debt burden dragging down the nation’s economy.
“Many local bond ratings are inflated,” said Qiu Xinhong, a
Shenzhen-based money manager at First State Cinda Fund
Management Co. “Some state-owned companies’ credit quality is
bad but they can still get high credit ratings.”

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FX

May 24th, 2016 6:19 am

Via Marc Chandler at Brown Brothers Harriman:

Dollar Regains Momentum, Sterling Resists

  • The US dollar lost momentum yesterday but has regained it today
  • The broader dollar gains have been driven by the shift in expectations of Fed policy
  • The news stream has been light and largely focused on Germany
  • The Eurogroup of finance ministers meets today with Greece front and center
  • Turkish central bank is expected to cut the overnight lending rate 50 bp to 9.5%; Hungarian central bank is expected to cut rates 15 bp to 0.90%

The dollar is mostly firmer against the majors.  Sterling and the Swedish krona are outperforming, while the Antipodeans are underperforming.  EM currencies are mostly weaker.  TRY, ZAR, and MXN are outperforming while MYR, KRW, and IDR are underperforming.  MSCI Asia Pacific was down 0.9%, with the Nikkei down 0.9%.  MSCI EM is down 0.35%, with Chinese markets down around 1%.  Euro Stoxx 600 is up 1.1% near midday, while S&P futures are pointing to a slightly higher open.  The 10-year UST yield is flat at 1.84%.  Commodity prices are mixed, with oil down slightly and copper up modestly.  

The US dollar lost momentum yesterday but has regained it today.  The euro has been pushed through last week’s lows near $1.1180.  The next immediate target is $1.1145, which corresponds to the lower Bollinger Band today, though the intraday technical readings suggest some modest upticks are likely first.  The $1.1200-1.1220 area may cap upticks.  

The greenback held above JPY109 and bounced to recoup 38.2% of its decline since the pre-weekend high near JPY110.60.  A move above this retracement (~JPY109.70) may yield minor gains, as it is likely to struggle to sustain gains above JPY110.  

The dollar-bloc currencies have been led lower by the Australian dollar.  When the US dollar momentum faltered yesterday, the Australian dollar resurfaced above $0.7200.  Unable to get above $0.7230 today, RBA Governor Stevens’ comments helped push it new lows since early March (~$0.7155).  Stevens noted that the Australian dollar, which has been falling since late-April, was moving in the right direction.  His observation that inflation was low and below target encourages speculation of an additional rate cut in the coming months.  

Sterling is recouping nearly everything it lost in the past two sessions and is back knocking on last week’s high above $1.46.  It appears to have been helped by a poll out late yesterday that found that not only are the undecideds in the UK referendum breaking toward the “remain” camp but that some of those that had favored leaving are now reversing.  

However, we are not fully satisfied with that explanation.  After all, sterling has been trending higher against the US dollar like many currencies did in the first part of the year.  Sterling rallied 6.7% from the late-February low through the May 3 high.  The polls only showed a shift in the last two weeks or so.  

Also, the options market is still reflecting anxiety, and given that the referendum poses contingent risk, the options market is where it ought to be expressed.  The referendum is within a month now so one-month volatility should be the focus.  It is firm today at around 11.2%.  This is the upper end of where it has traded since early March.  It finished last week near 10.4%.  

The increase in implied volatility suggests options are being bought.  The spread between the pricing of puts and calls equidistant out of the money (25 delta) can help determine what options are being bought.  The premium for puts over calls is the largest since last May.  This suggests that despite sterling’s gains in the spot market, some participants are still seeking protection in the options market by buying one-month sterling puts.  

The broader dollar gains have been driven by the shift in expectations of Fed policy.  For medium-term investors, it does not make much of a difference whether the Fed hikes in June or July.  The August Fed funds futures contract implies a yield of 54 bp.  We know that currently Fed funds have been averaging 37 bp.  If the Fed were to raise rates 25 bp at either the June or July meetings, fair value for the August contract is 62 bp.  The market is pricing in a 68% chance of a hike at one of the next two meetings (54-37)/25).  

 The US reports new homes sales today.  Sales in April are expected to bounce back after a 1.5% decline in March.  However, this report is not a typically a market mover.  Tomorrow’s advance look at April’s merchandise trade balance, durable goods orders the following day, and then personal income and consumption data before the weekend will allow economists to fine tune expectations for Q2 growth.  Meanwhile, Q1 growth is expected to be revised up from 0.5% toward 1.0%.      

Yellen’s speech at Harvard on May 27 is also a key.  We suspect that Dudley’s comments last week largely reflect that of the Fed’s leadership and we do not expect the Chair to pour cold water on the hawkish talk of many regional presidents as she did at the end of March.  

The news stream has been light and largely focused on Germany.  Its largest bank was downgraded by Moody’s.  The market largely shrugged it off.  The downgraded bank’s shares are trading higher.  Financials are the second strongest sector in Germany today and outperforming the overall DAX.  The ZEW survey showed an improvement in the assessment of existing conditions, but deterioration in expectations.  Is this the best it gets?  

Details of German Q1 GDP were published.  Private consumption and government spending were a bit softer than expected.  This was made up for by an increase in capital investment and construction.  Exports rose 1% on the quarter, twice what economists expected (and follows a 0.6% decline in Q4 15).  Imports rose 1.4%.  The median expectation was for a 1.0% increase after a 0.5% rise in Q4 15.  

The Eurogroup of finance ministers meets today with Greece front and center.  The Greek parliament approved various measures over the weekend, including contingency measures if its budget targets are not achieved in 2018.  This should be sufficient to free up another tranche of aid that will allow Greece to pay its official creditors and clear arrears.  

The important issue of debt relief remains at the center of the tension with the IMF.  Various schemes are being discussed while Germany is playing up the domestic politics card.  The problem though is not with Merkel’s coalition partner the SPD but with the CDU’s sister party the CSU and the farther-right AfD.  The AfD has been reinvigorated by Merkel’s immigration policy, not her handling of Greece.

Turkish central bank is expected to cut the overnight lending rate 50 bp to 9.5%.  However, the benchmark rate is seen remaining steady at 7.5%.  Price pressures are easing and so there is a case for easing policy.  However, the government should refrain from any sort of jawboning.  Economy Minister Simsek survived the cabinet shuffle and was named Deputy Prime Minister.  Markets had feared that this last surviving member of a market-friendly economic team would be replaced by new Prime Minister Yildirim.  

Hungarian central bank is expected to cut rates 15 bp to 0.90%.  While officials have been downplaying the likelihood of further easing, we think there will be one more 15 bp cut at the June 21 meeting to 0.75% before we see another pause.  Q1 GDP growth came in much weaker than expected, at 0.9% y/y.    

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