FX5: PBoC – A Step Ahead Of A Credit Blowout

Friday February 19: 5 Things the markets are talking about

The strong U.S equity rally at the beginning of this week pulled the S&P500 out of correction territory and delivered the first three-day DJIA winning streak since last fall. However, good things do not always last. North America’s equity winning steak came to an end yesterday as global investors continue to size up Central Bank’s rate differential arguments.

1. ECB minutes sounded ‘dovish’

In yesterday’s ECB monetary policy minutes, Euro policy makers agreed that the risks for the eurozone economy have increased amid financial market volatility and weakness in emerging markets.

This train of thought continues to support the markets bet that the Central Bank is ready to provide additional stimulus if needed next month (March 10). Draghi’s insinuated mantra to “do what it takes” once again has the EUR (€1.1083) on the back foot.

The likelihood of further easing by the ECB, coupled with the possibility of further tightening by the Fed is the fundamental reason why the EUR is finding it difficult to maintain traction. Expectations of expanded ECB stimulus include cutting interest rates further into negative territory, extending the term and/or ramping up the bank’s bond buying program.

Nevertheless, the interest rate differentials argument continues to be tested. St. Louis Fed President, James Bullard (a voter and a hawk in 2015), said this week that declining U.S inflation expectations and falling asset prices argue against further boosts in the Fed’s short-term interest rate target. The man just does not see the need for more rate rises anytime soon.

2. World’s awash with crude, no matter, prices keep rallying…for now

Crude prices remain “relatively” bid on optimism that Russia, Saudi Arabia and the other big OPEC nations are willing to proceed with a production cap despite Iran’s tepid reception of this week’s preliminary agreement. Iran officials were non-committal about the deal on Wednesday, and yesterday there a number of press reports that Iranian officials do not believe the production freeze deal would be enough to balance the global oil market.

Meanwhile, the U.S’s API weekly inventory numbers saw the first drawdown in stocks in five-weeks; while yesterday’s Department of Energy report featured a small-than-expected build in inventories.

Commodity sensitive currencies (CAD, NOK and AUD) continue to benefit from the uptick in oil prices. The loonie is 9 cents stronger from this years low (C$1.4689) and 4-cents stronger from this months USD high (C$1.4101).

Brent ($33.94) is off its earlier highs on the Iran reports, while WTI ($30.41) has failed to break above $32, but is still trading north of the its psychological $30 handle.

3. People’s Bank of China (PBoC) a step ahead of a credit blowout

Chinese authorities will hike the required reserve ratio (RRR) for a “select” number of banks that have lent too fast. PBoC are set to boost the amount of reserves some banks must set aside to mitigate risks after last months surge in credit by smaller lenders.

The targeted increase in the reserve requirement ratio will affect regional banks in particular. In January, a number of riskier banks drove new lending to a record ¥2.51 trillion ($385 billion). It’s certainly a bold move by Chinese authorities. They understand that a significant few could cause a major financial problem and have therefor geo-targeted the most vulnerable. This select proactive move is aimed at curbing financial-system risks and not considered monetary tightening by the PBoC – authorities guided interest rates lower this week by offering to reduce medium-term borrowing costs for banks.

Also, to avoid any pre-determined currency direction, the PBoC has set the overnight Yuan fix slightly weaker (6.5186 vs. 6.5152). Authorities certainly do not want speculators to get too comfortable. The offshore Yuan market has remained fairly stable, trading within the ¥6.52-53 range.

4. Cost of FX speculation jumps

A number of market benchmarks show that some of these currency moves are not for the faint hearted. 2016 thus far has recorded the highest currency-market volatility in more than four-years.

Volatility (vols.) helps determine the price of currency options and because of increased vols leads to higher prices; currency options are losing some of their appeal as a way to speculate in foreign exchange markets and none of this is expected to change anytime soon. For directional moves, the spot market seems more appealing.

Global markets have been subject to above-average swings on investor fears that a slowdown in China is going to have a massive global knock on effect. Even the OECD is concerned about currency swings. Yesterday they warned the markets of further “substantial” financial stability risks and exchange-rate volatility.

For example, due to the uncertainty, demand is spiking for contracts that protect investors from a big move in GBP (Brexit worries) this summer. Dealers note that the cost of some options have hit its most extreme levels since Europe’s sovereign debt crisis. Implied volatility (vols.) has rallied +12% this week vs. +8.4% cost recorded two-months ago. “Uncertainty” comes at a premium!

5. Risk aversion remains strong

The BoJ’s attempt to manipulate the value of its currency by introducing negative interest rates in late January has gone horrible wrong for Governor Kuroda. Initial reaction saw the yen fall against the dollar to ¥121.50, but ever since, JPY has appreciated.

The yen was stronger again overnight against its major rivals, printing its highest in more than two-years against the EUR (€125.39) and a one-week high outright (¥112.73) predominately on the back of safe-haven appeal.

With the lack of central bank guidance this month, the market has been somewhat scrambling looking for currency direction. With Tier 1 Central Banks (Fed, ECB, BoJ and BoE) back on line for monetary policy meeting announcements in March, next month is not expected to reign in market volatility anytime soon.

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