Commentary: Dissecting Banco De México Minutes, Mexican IP Numbers

Minutes from last the meeting which lead the Banco de México to cut its overnight target rate a record low of 3.50 percent were released last month on October 25th.  On November 8, September industrial production numbers were also released by the national statistics agency.  With these two highly significant releases, the time has come to examine the prospects for the Mexican economy, and more pertinently, the outlook for the the Mexican Peso. 

Bank Minutes

The Mexican economy slowed sharply in the first quarter of 2013, and registered a quarter on quarter contraction in Q2.  The Bank noted stressed two positive signs which it believes will drive a marked uptick in Q3 GDP.  First, public spending on by the national government should shore up internal demand.  A full reverse stop has been implemented by the government on its ambitious but overdone fiscal consolidation plan it rolled out last January.  The Bank is hopeful that public expenditures on infrastructure projects will help a devastated construction industry. (See Below)  

Secondly, exports to the US have driven a strong recovery in the manufacturing sector which had slumped earlier in the year.  In sum, the manufacturing sector is back on a positive growth trajectory.  

Finally, the bank has noted that subdued economic activity worldwide and well anchored inflation expectations will result in a era of low global inflation.  For Mexico, it expects that core inflation will remain below 3 percent.  Furthermore, the bank expects food and energy prices to ease up, bring the general bring index down to "very close" to the bank's three percent target.  The bank is also committing to watch for potential pass-through effects from Peso depreciation on food and energy prices.  Finally, the bank is not satisfied with meeting its target only on core inflation, and believes that achieving 3 percent general inflation is key to anchoring inflation expectations. 

Industrial Production 

One figure sums up the Mexican IP report.  

  Since the middle of 2012 construction has slowed, and more recently fallen off a cliff.  The entire industry, both public and private, is in a depression, falling a startling 8.3 percent in September on an annual basis.  On the other hand, manufacturing has continued its upward ascent after a brief hiccup at the end of 2012.  Finally, service sector growth has continued to be robust.  In sum, a tremendous slump in a highly important part of the economy, coupled with and in part driven by a decline in government spending, has hobbled Mexican growth.

Outlook for the Mexican Economy and the MXN 

Stable government finances and strong external accounts mean that Mexico continues  to enjoy sizable structural advantages over other emerging markets and some advanced economies.  Furthermore, structural reforms and liberalization of the energy market will help drive private sector investment.  The biggest downside risk for the domestic economy continues to be the development on a two speed economy, with construction slumping and service industries and manufacturing expanding.  On the MXN, the taper fears will abound, but Mexico should be less vulnerable to the kind of capital flight which hit South Africa and Turkey given its exposure to the US, reform minded government, stable financial system, and relatively low public and private debt levels. 

    

Commentary: Mexico Poised for Growth, But Uncertainty Remains

The Mexican Peso rose sharply this after the Bank of Mexico cut its overnight policy rate by 25 bps, but ruled out any reductions.  Growth in Mexico and the United States has been largely disappointing this year, which the Bank attributes to substantial fiscal tightening on both sides of the Rio Grande.  According the Bank, the sequester cuts and uncertainty surrounding broader fiscal and monetary policy has hurt growth in the US.  In Mexico, government spending has dropped by 2.5 percent so far this year since the new presidential administration took office last January.  The outgoing administration had run modest deficits to support the economic recovery for the previous four years.  Fiscal reforms earlier this year attempted to normalize fiscal policy by plugging the deficit with a combination of cuts and tax increases.  Furthermore, the plans ended the heavy investment in public infrastructure which had propped up the construction industry during the recovery.  This shock, combined with uncertainty regarding US economic policy, has stunted Mexican growth this year.  Given the slowdown, the Mexican government plans to run a deficit of 1.5 percent of GDP for fiscal 2014.  Demand for Mexican debt remains high, and public debt stands at a sustainable 43 percent of GDP.  

It is also important to highlight the significant structural reforms which have passed the Mexican Congress this year.  The Bank of Mexico has praised the liberalization of the telecommunications market, accountability reforms in public education, and a reduction in the bureaucracy involved with hiring and firing workers.  The bank has also urged reform to the energy sector to allow more private investment in oil and electricity production.  President Peña Nieto hopes to pass legislation through Congress before the year is out to address these issues.  

Financial markets and inflation have behaved in an "orderly way" according to various releases by the Bank.  While interest rates have risen in anticipation of a reduction in asset purchases by the Federal Reserve, rates appear to have stabilized since September.  The Mexican Peso has depreciated somewhat since May , but there appears to be limited pass through effects on inflation.  In general, the Bank expects inflation to remain subdued worldwide as growth remains held back by broader policy uncertainty in the US and Europe.  

In this context, the Bank cut its benchmark rate a further 25 bps, but stressed that further rate cuts would be inadvisable in the foreseeable future.  In general, the Bank hopes to the rise in interest rates which it believes has curtailed private investment.  Here's to a happy 2014.   
  

  

News:German Right Unified as CDU Recieves Record Total on Collapse of FDP

Germany's center right government, composed of the Christian Democratic Union and its sister party the Bavarian Christian Social Union, came close to securing an absolute majority in Bundestag in elections this Sunday.  Together, the two parties received 42 percent of the vote, up sharply from the 33 percent the duo garnered in 2009 federal elections.  Results for the main opposition party were largely disappointing, but    the Social Democratic Party, or SDP, got 25 percent of votes cast, up slightly from the 23 percent the party received in 2009.  While Ms. Merkel addressed ecstatic supporters Sunday night declaring "we did great," reality set in later in the night as in became clear that the rise in the CDU's vote total came largely as a result of an implosion of the Free Democrats, Germany's other right wing party which usually gets around ten percent of the vote. Support for the pro-business Free Democrats plunged from 14 percent in 2009 to a meager 4.7 percent in 2013, below the required five percent threshold to win seats in parliament.  Other minor parties faired a bit worse than four years ago.  Collectively the Greens and the Left, two minor leftist parties, received only 16.9 percent of the vote, compared to the near 23 percent these parties siphoned away from the more mainline parties in 2009.  The anti-Euro Alternative for Germany also failed to break above the five percent threshold.  

It appears unlikely that the CDU will win an absolute majority in the Bundestag.  Therefore, with the Free Democrats out of parliament, Ms. Merkel may be forced to form another "Grand Coalition" with the Social Democrats.  Such a partnership governed Germany from 2005 to 2009.   The CDU had governed with the Free Democrats since 2009, avoiding a costly alliance with the left which greatly curtailed Merkel's agenda when they were full coalition partners from 2005 to 2009.  

On FX, markets were mute to the election results, as participants were widely expecting a CDU victory.  On the other hand, if Merkel does indeed fall shy of an absolute majority, she will face tougher choices on coalition partners since all of the minor right wing parties have been voted out of office.  Markets have been calmed by the Merkel 'victory' but it is not clear at all that the prospect of a CDU-SDP coalition has been fully digested, especially since most English language news outlets are reporting a CDU landslide.  A more accurate characterization would be a coalescence of the German right around a single party, but a failure of the new unified movement to produce a parliamentary majority.  The silver lining the SDP is that it will a major player in the formation of the next German government.  Markets are calm for now, but prolonged coalition negotiations could inject some short-term volatility.    

Commentary: What Today's Decision Means

The FOMC voted 11-1 today to maintain its 85 billion dollars in monthly asset purchases.  The central bank justified its decision by highlighting its concern that rising market rates for debt ranging from corporate bonds to mortgages may threaten the still fragile recovery.  The committee also stated that further fiscal tightening by the Federal government continues to be a major downside risk for the economy.  Finally, the lack of robust data to indicate a broad recovery in labor markets also gave the Fed pause.  Particularly, the committee remains concerned about the recovery's "staying power," as highlighted by Chairman Bernanke's use of this term during the post-release press conference.    

On FX, the dollar was broadly weaker.  Falling substantially against all major currencies.  The dollar also sank against EM currencies.  The Mexican Peso soared nearly 3000 pips against the greenback, or 2.3 percent.  As of 11:26 GMT, one USD fetched 12.66 MXN, compared to 12.97 when morning trading started in New York.    This represented the biggest one day move in nearly two years.  TRY also had an incredible day, moving an amazing five big figures.  The lira, which has been under tremendous pressure due to taper fears moved to 1.95 against the USD, as compared to 2.00 yesterday. 

In general several key points can be taken Fed's statement and the market reaction.  First, the Fed still believes that quantitative easing can help fuel a stronger recovery.  Many voices, from outside the Fed and few on the inside such as Dallas Fed President Richard Fisher, had made clear their belief that QE had already done all it could to help jumpstart the economy and that further easing would have little to no effect.  The Fed's willingness to continue its asset purchases at the same 85 billion per month clip means that the FOMC  rejects the pessimistic "monetary policy has done all it can" view of some economists.  Crucially, we note that the Fed remains committed to weighing the downside risks of its easy money policies.  It therefore appears unlikely that the central bank would continue with its asset purchases if it did not believe they would have a tangible effect.  

Secondly, board's outlook on inflation remains subdued, and the Fed in general remains confident that it can exit without causing markets to panic or the real economy to suffer. 
The Fed remains acutely aware that bond traders are terrified by the potential dumping of trillions of dollars worth of securities onto the capital markets if the Fed unwinds too quickly.  The Fed therefore is likely to use other tools to tighten monetary policy, rather than selling securities.     When I spoke with one senior official at a regional Fed who was involved with preparing briefings for this month's meeting, they stressed the Fed's new authority to pay interest of reserves.  They also mentioned that while the central bank is confident that the capital markets are deep enough to absorb very large asset sales by the Fed, the central bank has no desire to be "a bull in a china shop."  Therefore, asset sales, if they occur will be slow and measured.  In general, my numerous discussions with Fed officials over the past year have centered around alternatives tools the Fed has at its disposable.  A mass dumping of Treasuries and MBS on the markets therefore seems unlikely unless inflation reached double digit levels.  

Finally, we note that communication and forward guidance remain  the most important factors in the outlook for rates and FX markets.  The Fed has already tightened policy in that last three months by signalling the possibility of a reduction in asset purchases this fall.  It is particularly troubling that the "tightening financial conditions" cited by the FOMC as threat to the recovery were essential created by the committee's own actions.  It is unclear whether or not the Fed intended for market rates to rise, but if it indeed believes that rising mortgage rates and bond yields have dampened the recovery, we've just gone through three months of volatility for nothing. 

In general, today's news is probably a green light to sell the greenback against EM currencies with strong fundamentals. Then again, the waiting game continues now for when the Fed will actually taper, so expect volatility to remain very high.     

News: Mexico Cuts, Markets Yawn

Mexico's central bank cut the overnight rate to by 25 basis points this morning to a record low of 3.75 percent.  The bank's statement cited subdued growth in both the EM countries and the US and Europe, as well as an environment of rising global rates in face of an expected shift in the stance of US monetary policy.  Given the weaker than expected growth this year, the bank seems especially concerned about the rise in medium and longterm rates, even in the Peso denominated money market, driven entirely by an "anticipation in of a reduction of asset purchases by the Federal Reserve," in the banks own words translated from the Spanish.  Mexico is not ready to raise rates, and  therefore felt compelled to do something on their end by easing conditions on the local money market with a rate cut. The bank also tried to calm the FX market, directly mentioning the volatility in EM currencies.  The bank cited that inflation expectations remain unaffected by swings in the exchange rate, but remains committed to monitoring the situation.  The bank also applauded strengthening public finances, and the low risk premiums Mexico pays to borrow money compared to other emerging markets. In general, the bank expects inflation to remain subdued and growth to strengthen in 2014.  However, it remains concerned that external factors, such as rising global rates may derail the local recovery.  Therefore, the bank ended its statement with a commitment to monitor "inflation, the evolution of economic activity, and its own policy stance vis a vis other central banks with the ultimate objective of continuing to achieve its inflation target of three percent."  Although the bank covered all the bases, including growth, inflation, and exchange rate volatility, the bank, inflation and price stability remained clearly in focus despite the fact that today's statement came with an easing of policy.  This mixing of a somewhat hawkish statement with an easing of policy left the MXN unchanged after the announcement of the cut.  Specifically, the USD/MXN spiked briefly up to 13.35 from around 13.24 in the minutes after the announcement, only to fall back down to around 13.1855 by 4:45 PM GMT.  For the day, the Peso is up despite the rate cut.     

As far as outlook for the MXN, the market seems directionless.  Weaker than expected NFP numbers sent the dollar down this morning against everything, as expectations of the Fed tapering this month weakened.  Again, the fundamentals of the Mexican economy, despite weakening substantially this year along with US, remain strong.  Both north and south of the border, growth has slowed as governments have tightened their belts, but consumer confidence remains at five year highs.  Major reforms to the energy sector are being debated this month in the Mexican Congress, and is widely expected to pass.  In light of recent developments, I am raising my year end target for USD/MXN to 12.70.  I expect the peso to regain its footing after tapering by the Fed becomes fully priced in.  The FOMC meeting later this month is the next big event and should set expectations for the rest of the year.  On the upside, 13.46, this year's high, remains as an area of critical resistance for USD/MXN.  The pair failed to breach this level a few days ago and today's rate cut ironically has it moving in the opposite direction.  In short, investor appetite remains strong for the peso, as evidenced by today's activity and the fact that this summer's second round of EM volatility was much kinder to Mexico than to other EM currencies such as INR, TRY, ZAR, BRL, and even smaller regional stars like the Thai Baht (THB) and Peru's Nuevo Sol (PEN).I continue to remain cautiously optimistic, for now.            

News: Syria Pushes TRY over the Edge, MXN Roller Coaster Continues

I did not think Syria would have much of an effect on the markets, but as one story on the wires put it, the market has "a good old fashion case of the geopolitical jitters."  Risk is being sold today, and the usual suspects are coming out on top.  JPY and CHF are both modestly up today, with USD/JPY falling off towards the 97 base.  USD/CHF was also dinged for a good 40 pips.  

EM space was mixed; USD/MXN pushed as high as 13.38 before falling sharply back toward 13.25.  This pair has been especially volatile of late.  Today marks the second time in a week that the Peso has fallen sharply only to regain its footing and then some.  Recent numbers in the Mexican trade account also present a puzzle.  Surging imports for in July in both consumer and capital goods contradicts the story that the Mexican economy is slowing, since weak sentiment ought to hurt both investment and consumer demand.  Exports to the US were also up, for both petroleum and non-petroleum products.  The fact that a currency under mild to moderate pressure from general EM turmoil also did not crimp Mexican demand for both capital and consumer broads from abroad further underscores the resilience of both consumer and business confidence.  Indeed, the former is approaching its one year high.  Business confidence is still subdue but is rising.  The X-factor is the Fed and the Bank of Mexico.  When and if tapering comes, and if the Bank of Mexico is willing cut further will dominate headlines in short term.  However, longterm, Mexico still appears to be poised to benefit from the US recovery.  

Turkey's Lira continued its free fall, with USD/TRY surging past the big 2.00 figure to reach highs of 2.04, before retreating to 2.03  These record lows for the Lira vis-a-vis the dollar expose underlying vulnerability of the lira and the overall performance of the Turkish economy.  Turkey remains highly dependent on exports to both the Middle East and Europe.  With the former in political upheaval and the latter still years away from full employment, Turkish growth prospects and diminishing and that is being reflected by the fall in the lira.  To make matters worse, a falling lira and rising energy prices brought on by Mid-East turmoil threaten to erase hard won gains in plugging Turkey's substantial current account deficit.  Finally, markets responded poorly to statements by the governor of the Turkish Central bank, indicating that the monetary authorities will use reserve sales in the FX market, rather than interest rate hikes, as its main tool to shore up the lira.  Perhaps markets are overdoing it as usual, but I must agree that in the medium to longterm, Turkey's outlook has weakened.          

Commentary: EM Blows Out, No Surprises from Fed Minutes

Today's Fed minutes held no surprises, but that didn't stop the market from selling EM currencies, and CAD and AUD in anticipation of a scale back of asset purchases next month.  After the minutes were release, the dollar extended gains against the above currencies.  The greenback also strengthened against EUR and CHF, but it was a subdued, with both pairs moving only about 30 pips in favor of the USD.  USD/JPY ground higher all day, moving up roughly 70 pips from 97.11 towards 98.  However, the real action happened in EM space.  USD/INR and USD/TRY hit all time highs today, and both the RBI and the Central Bank of the Republic of Turkey intervened in the FX market today.  The RBI sold USD 1.3 billion to satiate local demand for the greenback.  Turkey continues to tighten rates, and today announced that it will sell USD 100 million everyday until further notice.  Peru's central bank, which has in the past has intervened to calm FX markets in times of high volatility sold a record USD 600 million to prop up the Nuevo Sol.  Peru's economy, one of the most dynamic in South America has grown robustly over the previous few quarters though has slowed with the rest of the world economy in 2013.  Last year capital inflows pushed the Sol higher but uncertainty over US monetary policy has spooked investors causing a near 10 percent slide YTD.  Likewise, MXN and ZAR were both hit hard, sliding near nearly 3000 pips each against the dollar.  Neither the Bank of Mexico nor the South African Reserve Bank intervened in the FX market today.  

Today's developments has me reassessing my strategy somewhat.  While I still like Mexico's prospects in the year ahead, markets are obviously terrified of the abrupt end of QE.  Furthermore, MXN seems to be much more sensitive to taper fears than CHF, my funding currency.  The result is that hand wringing from the Fed causes CHF to weaken, but MXN to weaken more.  I have thus taken the step of become a net long USD by buying more USD/CHF than I sold of USD/MXN.  The result is that I can continue to be hedged against taper fears will still earning attractive carry of my MXN long position.  

Of final note is the dilemma facing Turkey, which is still coping with large current account deficit despite recent progress on this front.  Turkey, which must import nearly all of its energy for surface vehicles, will wind up with a higher gas bill if the Lira continues its downward slide.  However, unlike other imports such as consumer products, higher prices is unlikely to hurt demand for petrol.  Finally, Turkish consumer is likely to simply absorb the price spikes, especially since the economy has picked up steam in the last quarter. Turkey's already very high current account deficit is likely to increase with a stabilization of FX markets.  Rising inflation which is surging back up toward nine percent from 6.5 percent earlier this year also explains the very hawkish tone of the CBRT, which has now explicitly committed to stabilizing the lira and constraining credit growth.  Alas, while I feel Turkey's pain, it is unlikely that the European nation can do much without a coordinated effort from other world central banks.  Unless a crisis occurs and Turkey can convince the Fed to buy lira, TRY remains at the mercy of the markets.   

News: USD Continues to Struggle Along, but Fundamentals Still Look Good

The USD continues to struggle, down against both the Euro and the Japanese Yen.  EUR/USD is looking to break above 1.34, a point which over the last year has been an area of strong technical resistance.  It will be interesting to see if pair can find fresh sellers here or will grind higher.  On the Yen front, technical speculators are short USD/JPY with a target of 93.  These are interesting short term trades but appear to be quite risky.  The actions of the Federal Reserve other next few months will set the medium term trend for both these pairs.  If the US economy continues to pick up steam and the Fed does decide to taper this year, both these trades could be caught on the the wrong side of some powerful macroeconomic fundamentals.  Specifically, growth differentials between the advanced economies will likely remain in favor of the US.  Accordingly, the Fed is likely to tighten before both the BOJ and the ECB.  Should US joblessness fall below seven percent, a reduction in monthly asset purchases by the Fed seems likely. 

It is curious that EUR and CHF remain at such elevated levels, given that the Eurozone is still mired in recession and continues to face significant headwinds.  With unemployment near a record high of 12 percent, record low interest rates, and a fiscal crisis for several major national governments, it would appear as though Europe has run out of counter-cyclical treatments to apply.  John Taylor of FX concepts cites the Eurozone's modest current account surplus as grounds for being long the EUR.  But surely capital flows will overwhelm international payments registered in the current account.  And with rates set to rise Stateside, USD denominated assets are becoming more attractive.  Furthermore, the Swiss Franc continues to be 56 percent over valued in PPP terms.  The Swiss economy, though one of the healthiest in Europe also appears to be slowing, with the jobless rate moving up for the first time in five years.  Weak external demand for Swiss exports, and a sky high CHF with the associated deflation, finally seem to be taking their toll.  I expect the SNB to keep overnight rates at zero ad infinitum, and will stand prepared to purchase Euros in unlimited quantities to maintain its 1.20 floor on EUR/CHF . 

The biggest news in emerging markets continues to be Mexico.  While analysts continue to be largely bullish, Mexican economic performance has moderated this year, along with the US, its major trading partner.  A report today for the Bank of Mexico summarized trends in inflation and growth.  The national statistics agency reported annualized inflation at 3.47 percent for the second quarter, or 47 basis points above the central bank's target.  The Bank also lowered its 2013 growth forecast to between two and three percent, done from the 3-4 range it had estimated at the beginning of the year.  The bank cited weaker export demand and fiscal consolidation by the central government as the main headwinds to growth.  On the whole, given the inflation outlook, rates seem to be on hold for the medium term.  On FX specifically, the fact that foreigners have not fled Mexican fixed income is a promising sign.  Structural reforms by the new government continue to move along.  The widely anticipated energy reform proposal form the new administration is expected to be friendly to foreign direct investment.  In PPP terms, MXN is still close to 25 percent undervalued.  While USD/MXN is probably in for some Fed driven volatility, I target 12.30 by year end.  However, given the fact that I am both a USD and MXN bull, I prefer funding my long MXN carry trade with CHF or EUR.   

Commentary: Dollar Poised for Further Gains

My new favorite currency is the US dollar, which fundamentals suggest is poised for as the US data stream this week is likely to point towards divergent policy vis a vis the Fed and other world central banks.  US housing prices soared twelve percent since this month one year ago according to the Case-Shiller index, the gold standard for measuring home prices.  High consumer confidence and a healing labor market mean that the recovery should pick up steam in the second half of the year.  Of particular note is the fact that the drop in the gross number of home sales appears to be due to an inventory shortage, as evidenced by the high prices paid for homes which did sell.  More good news for the construction sector, although the last read on housing starts fell slightly short of expectations.  Finally, the US economy appears to be ready to absorb a slight increase in long term interest rates.  

The Euro and Japanese Yen continue to stay range bound.  Over the past few months EUR/USD and USD/JPY have bounced around in 1.33-1.28 and 103-95 ranges respectively.  The market seems to be awaiting further news from the Fed, but the general consensus is that asset purchases will be scaled back this year.  Furthermore, the market is also desperate for a growth currency outside of the EM space.  An advanced economy with favorable growth and interest rate differentials with the rest of the world would fill a large void and be highly desirable to many conservative investors who over the past few years have been forced to look to the developing world for both growth and income.  On this front, the USD looks like the dog with the least amount of fleas as Japan struggles to reboot and Europe muddles along.  The next step is for the ECB to join the QE club.  The core must accept higher inflation to give the periphery the stimulus it needs.  Finally, Persistent deflation in Switzerland means that the SNB will maintain its 1.20 floor on EUR/CHF. 

On the EM front, everything looks shaky as China slows down, Brazil and Turkey are unstable, and India and South Africa face major structural problems.  Mexican growth has slowed as well due to a US slowdown and budget cuts north and south of the border.  However, Mexico will benefit from a more robust US recovery an ambitious reform agenda from the new presidential administration, and a new five year infrastructure program.  Its still dangerous to be short the USD, so long MXN carry trade funded with Euros or Yen remains attractive.  I target EUR/USD at 1.23 and USD/JPY at 105 by year end.     

Commentary: Weighing the Impact of Mexico's Bold Infrastructure Plans

In 1994, Mexican President Carlos Salinas embarked on a pre-election spending spree which resulted in a collapse of the Peso and forced the new Zedillo administration to seek emergency loans from both the IMF and US. 20 years later, times have change.  Mexico no longer maintains an ill-advised peg to the US dollar, allowing the Peso to float freely.  Fiscal restraint was implemented, and the loans to the US were paid back early.  Today, the Bank of Mexico has nearly 150 billion USD of foreign reserves.  (Foreign reserves where depleted as the Bank desperately tried to defend the peg against speculators during the '94 crisis)  Debt to GDP stands at a stable 43 percent.  The budget deficit in 2012 was a 0.6 percent of GDP.  In short, Mexico excellent fiscal health compared to the rest of world puts in an excellent position to enact counter-cyclical fiscal policies to combat a manufacturing slump.  

Mexico  has prudently decided to spend USD 318 billion, roughly 25 percent of GDP, on new infrastructure projects over the next five years.  The goal is to both help Mexico cope with a short-term slowdown in exports, brought on mainly by US fiscal tightening, but also to boost overall competitiveness in the long term.  It will be interesting to see how the politics of this bold proposal play out.  Whether or not the PAN, a center right party which oversaw the repair of Mexican finances while in power from 2000 to 2012, supports the actions of new Peña Nieto administration.  The president's party, the PRI, does not hold a majority in Congress.  

On FX, the outlook for MXN has therefore improved.  Mexico's long overdue improvement to its infrastructure will support both short-term and longterm growth.  For the next year, I also expect the Banco de Mexico to maintain a neutral monetary policy so long as core inflation does not rise above its 3.00 percent target.  Furthermore, elevated levels in the general index should prevent any rate cuts, even if the bank judges them to be caused by transitory factors.  I target 12.30 MXN per USD by year end, but funding a long MXN trade with Euros or Swiss Francs may be even more attractive.       

Commentary: Taper Tandrum Continues, NFP Reaction Mixed

The jobs report surprised to upside today.  Non-farm payrolls grew by 195,000, versus the 165,000 consensus estimate.  The unemployment rate remained unchanged at 7.6 percent.  Stocks surged at first, then retreated off their highs.  Oil was up, copper was down.  Many traders say today's report is the death knell for gold.  Yields on the US ten year note surged 23.59 basis points.  On FX, the dollar was way up against everything, including MXN and CAD, two currencies which usually benefit from good US jobs numbers.  

The decline of the Peso and Canadian Dollar and inconsistent movement in industrial commodities are strong signs that markets remained perplexed by an opaque Federal Reserve.  Stronger than expected US jobs numbers have until today been highly supportive of both MXN and CAD, major US trading partners.  Furthermore, strong employment ought to lead to higher demand and therefore higher prices for industrial metals.  But today, Copper fell sharply.  

More evidence is emerging that conviction is low, and many investors are looking to sell on the slightest hint of the Fed winding down stimulus.   When good news is bad news because it may portend higher interest rates, a serious disconnect has occurred in the communicative channels through which the Fed is transmitting is monetary policy.  If the Fed tightens policy because of stronger fundamentals and a more robust job market, returns on stocks should be higher because corporate earnings are up.  Commodity prices should be higher because demand for oil and industrial metals is up.  

 Finally, markets seem to distrust the Fed on two fronts.  First, they do not believe that the Fed will know the appropriate time to tighten.  Investors are still nervous, and cannot imagine an economy where rates rise because business and consumers are willing to pay higher interest because of renewed confidence and higher incomes.   It seems that in today's world, economic growth only comes from stimulus, and higher rates must mean lower asset prices.  On a related note, the market cannot even agree on what tighter monetary will look like.  Despite substantial efforts by Chairman Bernanke himself, markets aren't buying the idea that the total size of the Fed's balance sheet is what is driving interest rates.  Therefore, as pointed out by many, it is becoming increasingly clear that any "tapering" of Fed asset purchases will cause a large rise in longer term rates.  A de facto tightening of monetary policy.   

In sum, today's mixed reaction to good NFP numbers reveals a persistent underlying fear that the Fed's exit strategy will slam markets. 

News: Egyptian Pound Steady Despite Constitutional Crisis

The ouster President Mohamed Morsi has failed to produce a decline in Egypt's monetary unit, the Egyptian Pound (EGP.)  USD/EGP remained remained largely unchanged Wednesday, trading at 7.0302, a mere fifty pip increase over Tuesday's close.  Egypt's Central bank conducts daily auctions for US dollars to satisfy exporter demands for foreign exchange.  Egypt's pound depreciated marked, sliding from six to seven to the dollar early this year.  

Despite today's political turmoil, the lack on movement in the currency is not surprising.  Unlike other emerging markets, Egypt's bond and equity markets had not been flooded with foreign money chasing yield.  Massive outflows remain unlikely unless wealthy Egyptians begin to move money abroad.  Given the turmoil of the past few year, many had presumably already done so.  

From this odd turn of events, we can draw two important lessons.  First, fundamentals quickly become priced into all asset classes.  Over the past few months, the EGP began to slide as Morsi's government lost credibility.  The Pound's decline based on political unrest was thus already reflected in market exchange rate.  Secondly, while Egypt's fundamentals may has worsened, its technicals have not.    With very few foreigners in the market, the outflows can only come from within.  Despite today's troubles, locals seem happy to hold onto their Pounds, for now.       

Commentary: What We Have Here is a Failure to Communicate

Perhaps one of the greatest consequences of the 2008 financial crisis has been the profound shift in the manner in which monetary policy implemented.  With policy rates pushed to their zero bound, central banks around the global have turned to large scale asset purchases and signaling to guide economies along the path to recovery. The move towards relying on communication is not surprising, given that QE and other large interventions blunt the Fed's ability to respond quickly to short-term shifts in the money market.  Specifically, under normal conditions, when bank reserves are in the billions and not the trillions, small purchases or sales of securities (on the order of 100 million USD) by the central bank can have a great impact on the money market.  However today, such trades would be a proverbial drops in the bucket when stacked up against the 1.9 trillion dollars in excess banking reserves created by QE.  The Fed is thus forced to do its best to guide the money market via forward guidance and other subjective communicative techniques. Suffice to say, unlike simply trading a few hundred million treasury bonds one way or the other, the response by the market to such actions is hard to predict.  

Judging by the Fed's own guidance and communication over the past few months, it is unlikely that it intended rates to rise sharply.  Chairman Bernanke has stressed repeatedly that a reduction in asset purchases does not portend a tightening of monetary policy.  Rather, it represents a slowing of further easing; therefore, measures to raise interests remain a long way off.  As evidenced by the sharp rise in bond yields globally, and the near 40 basis point rise in mortgage rates last month, the broader market remains largely unconvinced.  What we are seeing play out in financial markets around the world is the simple truth that no analyst, stock picker, and certainly not the Federal Reserve Board can accurately predict the collective reaction of millions of investors, bank managers, and speculators to specific news or information.  The Fed was able to successfully calm markets via forward guidance when it rolling out is aggressive easing policies.  However, despite visible efforts, the Fed has not been able to communicate or even discuss the particulars of its exit strategy without making markets swoon.       

While the Fed's dramatic injection of liquidity into the financial system over the past four years has undoubtedly succeeded in stabilizing credit markets and jump starting the economy, it has left the Fed in the unenviable position of having to used subjective measures to transmit monetary policy.  The Fed has shown its tremendous capacity to tackle a crisis, but ironically, it has clipped its own wings in terms of its ability to influence small changes in credit conditions.  Alas, the high volatility of both stocks, bonds and currencies over the past few weeks makes us yearn for days when the Fed could manage rates by simply telling its trading desk to buy or sell a few hundred million dollars of treasury bonds.  Markets didn't whip saw every time a Fed official opened their mouth, and central banking was boring. But for now, what we have here is a failure to communicate.      

Commentary: Opponents to Immigration Reform are Racists.

With this post, I take a small break from the exciting FX market to comment on the broader economics of immigration.  

Immigration reform is working its way through Congress.  While the consensus is that the bill in its current form will find broad bipartisan support in the Senate, its future in the US House of Representatives remains uncertain, despite polls showing that 75 percent of Americans support a path to citizenship for illegal immigrants.  The main cause of this disconnect is almost certainly a vocal and concentrated minority of voters with deep seated anxiety over potential changes in US demography.  At the same time, this minority tries to justifies its concerns over legalizing immigrants by spreading race based misconceptions and half-truths about the economics of immigration.  While it is good that overt racism is no longer an acceptable reason for opposing immigration, covert racism masked by economic myth and policy bunk is hardly a comforting alternative.  My purpose here is to expose this not so subtle racism which has manifested itself as hateful and dangerous rhetoric.  Upon examining the economics of immigration, we find that immigrants are a vital infusion of economic dynamism to the economy.  And in the end, we are left with the sad conclusion that those who oppose immigration, armed with faulty logical, flawed studies, and arguments which do not withstand scrutiny, are mainly motivated by racial anxiety and outright animus.    

 The economics of immigration are broadly misunderstood by opponents of immigration reform.  Some believe that immigration will cause an increase in unemployment.  The fact is that the consumption and other economic activities of immigratns will create many times the number of jobs that they fill.  Wage earners are ultimately consumers, and more consumers in the economy means more, not fewer jobs.  In a similar manner, the returning soldiers from the second world war were an economic boon.   Although many at the time predicted a return to 1933 unemployment rates, a huge cohort of young men needed homes, cars, education, and a host of other goods and services.  Industry rose to meet this demand, and took advantage of the increased labor force by hiring the vets themselves.  Investors made money, output rose, and jobs were created not just for the soldiers, but for everyone in the economy.  Indeed, despite a mild demobilization recession, between 1945 and 1949 nearly two and a half million jobs were created. 

Opponents also claim that immigrants come here to take advantage of social welfare programs while those who work avoid taxes.  They view immigrants as economic parasites and social misfits which came to the US because they could not succeed in their home countries.  But common sense and empirical data refute these spurious claims.  On taxes, the CBO estimates that immigrants pay more in taxes they receive in services. (Immigrants hurt local budgets by increasing education costs but make up for it by paying into federal coffers)  Common sense confirms this finding.  Immigrants are usually industrious and hard working.  It takes determination and grit to change cultures and languages as an adult, and it is also extremely disruptive to the social and family networks nearly all societies rely on.  The cost of this disruption is so great that most Mexicans prefer to stay in Mexico, even if moving to the US would mean higher wages.  In fact, net migration between the US and Mexico is currently zero.  

A final economic note is that remittances back to Mexico are not harmful to the economy.  Mexico is a major trading partner of the United States.  It sells eighty percent of its exports to the US, and the United Sates accounts for fifty percent of all goods and services imported to Mexico.  The broad economic integration ensures that money can flow freely between the two nations without acting as a "drain." Inevitably, the cash sent south finds its way north of the Rio Grande when Mexicans purchase foodstuffs or manufacturing equipment, two US export specialties.  

Finally, I wish to deconstruct the so-called "rule of law" argument brandished by many staunch opponents of immigration reform time.  This same groups also lauds our "generous" immigration system, which lets in many more legal immigrants than most other industrialized nations.  However, this kind of thinking fails to recognize the benefits immigrants bring, and only measure the cost some immigrants inevitable cause some local governments to incur.  We shouldn't reform the immigration system because we are nice or generous, on the contrary, failing to do so will continue to be a significant headwind for the economy for the reasons outlined above.  Failing to recognize the contributions of immigrants is just one further example of the underlying racism of those who oppose immigration reform.  Yes, many immigrants broke the law by coming here.  However, it is hypocritical to accept the benefits to the US economy brought to our shores by the "law breakers" via lax enforcement, and then to retroactively punish them with fines and long wait times to achieve full citizenship.  If the rule of law were really at stake, we never should have allowed this problem to fester for decades.  In short, we chose not to enforce our own immigration laws because they did not make economic sense.  Therefore, undocumented workers deserve to be treated with respect and deference, not like criminals.       

They will deny it up and down.  They will resort to code words like "rule of law" and "border security."  Others will invoke economic folklore.  Immigrants drive up unemployment.  Immigrants come here to collect food stamps.  Immigrants come here for a better life but drive down the quality of life for people already here.  Immigrant remittances home are a drain on the economy.  A more charitable man may give this vocal minority the benefit of the doubt.  Economic fallacy and myth often afflict even those who have spent a lifetime studying the dismal science.  However, misconceptions must come from somewhere, and all too often our errors reveal our underlying biases. The idea that the economy is essentially a competition between races for limited economic spoils is not only misguided view of how the economy works, it holds appeal for those with anxiety over the potential demographic changes immigration may bring.  Or put more pithily, most opponents of immigration reform are just a bunch of racist pigs.   

Commentary: Market is Desperate to Take USD Higher

In terms of news, yesterday's press conference was a non-event.  The FOMC kept policy unchanged and reiterated that a reduction in asset purchases would be 'data based.'  Specifically, the committee is looking for signs of a sustainable recovery in the labor market.  The committee also expects inflation to remain subdued, though it believes that 'transitory influences' are keeping inflation below the Fed's 2.0 percent objective.   Additionally, Chairman Bernanke once again drew the distinction between balance sheet policy and interest rate policy.  Though the Fed may reduce asset purchases and therefore slow the pace of the growth of its balance sheet, rises in the Federal Funds Rate are still years away.  A final note of interest is that the two dissenting votes on the committee were on opposite sides of the issue.  Kansas City Fed President Esther George raised concerned about risks to longterm financial stability associated with extremely accommodative monetary policy. At the same time however, Saint Louis Fed president James Bullard advocated an increase in the Fed's monthly asset purchase program, arguing that it is imperative that the Fed defend its inflation target from below, especially during times of economic recovery.  

Markets for their part have largely latched onto any hint of a possible tightening (or in this case a reduction of loosening) in monetary policy.  The fact the mere discussion of a possible reduction of QE, even one predicated on good economic data, has sent the dollar surging, bond yields soaring, and equity and commodity markets into a tailspin shows a fundamental lack of conviction on the part of many investors.  Alas, we are now in a world where the value of nearly all assets is based in large part on monetary policy and not underlying fundamentals.  More disturbingly, many seem to forget that monetary policy itself is guided by underlying economic fundamentals.  A rate hike from the Fed would be proceeded by a strengthening of the economic outlook, which coincide with increased corporate profits, and therefore higher and not lower stock prices. In short, the market seems to be groping for any excuse to take profits on stocks and unwind FX carry trades.   

On FX, I continue to look for growth differentials, underlying economic fundamentals, but also diverging monetary policy from central banks.  If perceptions continue to exist that the Federal Reserve is on the road to tightening policy, the USD can no longer safely be used as a funding currency.  I booked profits on my long USD/ZAR positions this morning, and look to get long again in the 10.05-10 range.  Weak South African fundamentals should push this pair higher even if this recent bout of dollar strength subsides.  I also expanded my long EUR/CHF bet, jumping in at 1.2260.  I target 1.2350 in the short term. 

    

Commentary: A Tale of Two Emerging Markets

The awesome volatility in EM space continues, this time with sharp swings in both directions.  Last week MXN and ZAR experienced wild rides up and down.  The peso  surged from 12.75 to 13.10 against USD last Wednesday morning, but managed to close  around 12.62.  ZAR traded in concert, with USD/ZAR spiking to 10.38 before retreating back below 10 late last week.  On fundamentals, Mexico appears to have weakened somewhat, but the medium to longterm outlook remains strong.  Mexico is likely to benefit from the US recover.  It is also worth noting that substantial fiscal drag has weighed heavily on both the US and Mexican economies as both Federal governments tighten their belts.  

South Africa on the other hand continues to suffer from twin current account and budget deficits, both around five percent of GDP.  Labor unrest ironically coupled with high unemployement, largely the result of a two speed economy, also remains a major concern.  South African capital markets have also been stressed by potential monetary tightening in the US.  Capital outflows have pushed up bond yields; the yield on the ten year government note has shot up 200 basis points in the last thirty days.  With weak growth and even weaker business and consumer confidence (consumer confidence is currently below 2009 levels), the South African economy is ill-equipped to support rising interest rates.  South African was downgraded earlier this year by Moody's and Fitch, largely due to South Africa's lack of room to maneuver on counter-cyclical policies.  Indeed, with a deficit at 4.6 percent of GDP, interest rates at historic lows, and inflation at the upper end of the central bank's target range, there appears to be space for fiscal or monetary stimulus.  In short, the government is running out of policy levers to pull.  More disturbingly, the capital outflows which are causing budget busting interest rate rises are the beginning of the vicious cycle we've seen hit so many emerging markets.  The central government loses credit worthiness, then rates rise, further stressing the government budget.  The endgame is a default followed by a collapse of the currency.  

To be sure, South Africa is still a long way off from that future.  And one important safety valve standing between the vagaries of the bond market and the real South African economy is the South African Reserve Bank. It is appearing likely that the bank will need to act to stop rates from rising to quickly.  Despite admonishments to contrary by Governor Gil Marcus, further rate cuts or asset purchases are still on the table. This, despite that fact that inflation sits at the top of the bank's 4-6 inflation target.  

Given these facts, I have adopted the strategy of cautiously buying USD/ZAR on dips, and maintaining a neutral stance towards MXN until a clearer picture emerges on US monetary policy and the reform agenda in Mexico.  For the week, the biggest events are South African current account figures due on Wednesday, and the post Fed press conference. 
 As always, and especially in times of high volatility, great care is required.       

News: Mexico Headline IP Pleases Market, But Bearish Trend Intact

I was foolish to think that I could make money in this market.  A bit harsh, but that's been the reality for the past month.  Mexican headline industrial production came in at 3.3 percent yoy.  I personally was looking for a bit higher number, along the lines of 5 percent, to confirm the seasonality of March's sharp decline.  Nonetheless, this number pleased the market, somewhat.  USD/MXN had spiked to 13.11 overnight, but retreated back down to 12.87 on the news.  Alas, the sharp rise in this pair during the Asian and European sessions assured that my short positions were already deep in the red, meaning that the post report bounce was more about recovering losses than making money.  Furthermore, its unclear whether the market was responding to the report or if the dip was caused by broader USD weakness.  Indeed, in the hours following the release, GPB/USD rallied, and USD/CAD fell from off its 1.0250 session peak to 1.0193.  

In general, the market remains chaotic.  USD/ZAR whipsawed up to 10.38 before plunging all the way back down to 10.03.  EUR/CHF was also unusually volatile, bouncing around between 1.2350 and 1.2230.  Earlier in the day, an SNB official called the 1.20 floor on maintained by the central bank "indispensable."  I can all but agree.  The specter of deflation still hangs over the small European nation as Swiss inflation struggles to register above 0. 

Given these facts, and keeping mind the market tone and fundamentals, I have decided to refocus my efforts toward getting long EUR/CHF at the most favorable spot.  I am also slowly building up a long USD/ZAR position.  The uptrend remains intact, largely in line with fundamentals.  Given the awesome volatility, much care is required.  I therefore plan to buy cautiously on dips.      

Commentary: Go Mex Go

Markets and market sentiment can turn on a dime.  A week ago, the future of the Mexican Peso looked to be in serious doubt.  Some short-term traders were actually looking to get long MXN on a weak jobs report, in hopes that slow job growth meant more Fed stimulus.  Sounds great on a monetary front, but what about Mexican fundamentals?  A weak US economy can't be good for Mexico, which sells eighty percent of its exports to the United States. 

This shift in thinking about USD/MXN coincided with last month's fears of the Fed tapering off its asset purchase program.  Rates rose globally, and especially in Mexico.  Indeed, the yield on 10-year peso bonds surged 92 basis points in May to 5.30.  The Peso for its part also retreated from its 2-year high of 11.93 per dollar to near 12.9.  Foreigners, especially US names, have been shedding Peso denominated holdings in anticipation of rates rising stateside.  

In the end, the steady US jobs report, which slightly exceeded analyst expectations, was largely  MXN positve.  USD/MXN dipped to 12.65 on the news, while the greenback strengthened against EUR, GBP, and JPY.  For now, what's good for the US continues to be good for Mexico. 

Further analysis of the fundamentals also warrant cautious optimism.  While Q1 GDP growth slowed to a paltry 0.8 percent,  the main culprits were a manufacturing slump and sharp reduction in government spending, which shrank 2.9 percent yoy.  Facing mild headwinds stemming from weak export demand, and significant fiscal tightening, the fact that the economy was able to grow at all shows its significant resiliency.  Some analysts were predicting GDP to shrink in Q1. 

Mexico's central bank has also turned hawkish in the release accompanying its most recent monetary policy decision.  Inflation continues to creep up towards five percent, well above the bank's three percent target.  While the bank expects inflation to slow by July, it raised concerns about disruptions to the process of price formation, and broader inflation expectations.  The bank reaffirmed its resolve to monitor "all causes of inflation," and its intention "to maintain its ability to respond to inflationary pressures in order to meet its signaled inflation objective."  Crucially, no possibility of a rate cut was signaled despite weak growth.  

On technicals, the speculators have cut back their MXN longs by nearly 31,000 futures contracts, while shorts increased by 6,500 contracts.  This strengthening from a technical perspective is also welcome news.  For much of April, massive net longs, which exposed MXN to a rapid sell off, had spooked some actors from entering the market despite the strong fundamentals.   The 2013 high of 12.97 remains the crucial point of technical resistance for USD/MXN.  Thus far, we've seen two topside failures, and news wires are a buzz with stories of traders looking to sell ahead of this key level.   

Finally,  Mexican industrial production numbers are due for release tomorrow, and this data read will give the market more information as to the nature of Mexico's manufacturing slump.  The massive 4.94 yoy drop registered in March was potentially caused by Semana Santa celebrations falling in late in the month rather than in early April.  Strong numbers tomorrow would confirm this.  I remain cautiously optimistic, for now.      

Commentary: For MXN, All News is Bad News

The private ADP employment survey came a bit lower than economists expected today, with private firms adding 135,000 jobs versus the 157,000 consensus estimate.  The dollar was weaker on the news, but then quickly recovered its losses.  Talks abound of the Fed tapering off its bond purchases, this has no doubt been a major factor in the sudden exodus from emerging market currencies.  Mexico's Peso, a long favorite of many investors for the past year, has been particularly hard hit.  The spread between US and Mexican treasury securities continues to widen as investor's flee MXN denominated assets.  Mexico and its central bank are in a tough spot when it comes to forming policy in the coming quarters.  Inflation continues to creep up, but a manufacturing slump continues to hurt growth.  Good economic data from US should help Mexican fundamentals, but strong US economic performance has been largely taken as a signal that the Fed will end its asset purchase program sooner.  Conversely, a poor NFP report this Friday may make MXN pop as some investors initiate Fed stimulus bets, but weaker US hiring also should hurt external demand for Mexican products.  The result is a directionless market where USD/MXN continues to drift higher.  I still like Mexico long term, but I prefer to sit on the sidelines until we get clearer signals from the Fed and the Bank of Japan on the future direction of monetary policy.  

This Friday, I intend to buy USD/ZAR on any dip post jobs.  I will also have a buy order a full 200 pips above the market level immediately before the release.  The plan will be to capture the move higher if NFP surprises to the upside.  ZAR remains my preferred choice taking advantage the EM currency sell-off, mainly because South Africa's weak fundamentals are also weighing heavily on the Rand.  Finally a word of caution.  Central bank opacity continues to cause jitters up and down all financial markets.  As such, I am keeping at least 40 percent of my holdings in cash, for now.   

Trade Idea: Sell SGD/INR

EM currencies have been slammed as of late, making it very difficult to advocate buying any exotic against any major, especially USD.  However, the idea of selling EM currencies against each other in search for "relative value" and fat carry is more attractive than ever, given EMs are moving in lockstep.  On this front, I have initiated small short position in SGD/INR.  Singapore is hardly an emerging market, with GDP per capital over 60,000 US dollars.  However, its export driven economy is tied closely to Asia and its emerging markets.  Indeed, SGD has been whacked with all Asian currencies as of late.  Therefore, given rock bottom Singaporean interest rates and relative high rates in India,   an odd but usually stable carry trade opportunity has emerged.  For the foreseeable future, these two currencies should move together.  Thus, while underlying value of the pair will continue to trade in a tight range, the shorting it should produce a steady stream of relatively low risk carry in the  coming weeks and months. 

Weekend Update: Strong USD, Nikkei Remain in Focus

Last week was not very fun for me, booking losses  on short USD/MXN positions and buying USD/JPY on weakness only to fall victim to a larger pullback.  Last week was all about profit taking for Japanese investors.  The Nikkei sold off to the tune of 7.5 percent on Thursday. (After being up over 3 percent the same session).  Japanese investors were also net sellers of foreign securities; more profit taking given the that the weak JPY makes overseas holdings very dear in Yen terms.  

In general we have a market that seems desperate to get long the USD.  This is understandable, given that among advanced economies, the US has clearly emerged as the dog with the least amount of fleas.  Indeed, the mere hint of a slowing of the Fed's QE programs has spooked equity markets and resulted in broad USD strength.   To be sure, doves outnumber hawks on the FOMC, and Bernanke has stressed repeatedly that a decision to slow asset purchases would be based on strong economic data. However, the fact that Mr. Bernanke is ready to talk specifics on the Fed's exit strategy has sent markets into a USD buying frenzy.  Strong economic data will now be even more USD positive, especially against JPY, EUR, and GBP.  CAD and MXN, which have continued to rise on good US data even after the calming of the Eurozone crisis will be key indicators of the market's mood on the greenback. A fall of either of these relative to the USD on strong non-farm payrolls would indicate a market highly bullish on the USD.  

Given these realities, last week I cut down my short USD/MXN position, and bought USD/JPY so that I would be net long the dollar.  I also initiate a small long EUR/CHF position.  This pair has found strong support at 1.24, and SNB policy assures limited downside.  I still like MXN, especially since I believe the recent slowdown is probably a delayed reaction to the Q4 contraction in the US.  However, being short USD in the face of a such bullish sentiment is a dangerous game.  

    

Commentary: MXN in for Pain Short Term

The party couldn't last forever, and USD/MXN has now established a firm uptrend.  Several factors are at work to keep MXN under pressure in the near term.  First, the market's interpretation of the Chairman Bernanke's comments have been largely dollar positive.  While Bernanke did not give a time line for the implementation of the Fed's exit strategy, the mere fact the the Chairman and other FOMC members are ready to discuss the operational specifics for the unwinding of the Fed's balance sheet has spooked markets.  Furthermore, general risk off sentiment has boosted the usual suspects.  Indeed, both JPY and CHF are both up on safe haven demand.  

More disconcerting, the internal strong internal fundamentals which helped MXN in the face of global headwinds have weakened somewhat.  Growth slowed in the first quarter to 0.8 percent yoy.  While stubbornly high inflation probably precludes a rate cut for the next couple of meetings, the Banco de Mexico may cut further in the fall should growth fail to recovery.  While a resilient consumer has helped Mexico maintain robust service sector growth, a manufacturing slump driven by weak export demand continues to weigh heavily on overall sentiment.  

Given these developments, I have revised up my year end target for USD/MXN to 11.8. I have cut down my short position at a loss, though I look to resell at a higher level.  I will take positive economic data out of Mexico as a sign to re-enter, with a particular bias towards strong industrial production data.  Lacking that, without strong signalling by the Fed of further easing, I see the pair climbing back up towards 12.8 in the near term.  

   

Commentary: Fed in the Driver Seat as Markets Await Bernanke Testimony

Conflicting signals from top Fed officials continues to drive equity and FX markets this week, although now in the opposite direction.  The last week and half have been all about rumors of the Fed 'tapering off' its bond purchase program before the end of the year, stoked by comments by San Fransisco president Williams.  Williams, who earlier in the year had affirmed his support for continued asset purchases, suggested last week that he was open to a winding down of Fed's 85 billion dollar monthly bond purchase program as early as the end of the summer. Such talk had sent stocks lower and the greenback higher during Friday trading, capping a week long dollar rally that had resulted in fresh highs for USD/JPY. 


On the other side of the table, Chicago Fed president Charles Evans was keen to reassert teh dovish tone at the Fed in what may or may not have been an attempt to walk back the Williams' speech.  Evans acknowledged that the US economy is performing 'quite well,' relative to other advanced economies, Evans, arguably the most dovish FOMC member, stated that bond purchases were here to stay given subdue inflation and historically high unemployment. Evans comments have been met with fading of the dollar rally, indiscriminate of local fundamentals.  Despite a slowing economy and lower intra-day stock market, USD/MXN traded lower on the news, sliding to 12.27. 

Fed Chairman Ben Bernanke is also set to testify before Congress this week.  While his testimony is always a significant market event, this week's two day affair before House and Senate committees appears to be of particular significance, especially for the FX market.  Specifically, market participants will be looking for a clear direction from the central bank's chief as to the pace of any winding down of asset purchases.  Markets will be hoping for Bernanke to 'break the tie' between the conflicting statements put out by FOMC members recently.  Bernanke, whom  Evans called a "spectacular chairman," may calm markets by reaffirming the Fed's intention to continue its QE program well into 2014.  More likely, Bernanke is will stick the thresholds set by the Fed in late 2012 and stress the Fed's dual mandate of maximum employment in a context of price stability.  Asset bubbles, a major downside risk to cheap credit, are likely to be a theme, but 1.2 percent headline inflation and 7.5 percent unemployment leaves the door wide open for more stimulus.   

News: Good Data From Abroad Fails to Crimp Dollar's Style

The USD has continues to climb higher today, rising against everything from JPY to MXN.  The Euro opened down nearly 50 points, despite better than expected car registrations, suggesting that auto-sales on the Continent may finally be picking up.    USD/MXN also extended its recent rally, pushing as higher even as Mexico posted higher than expected growth for Q1 or 2013.  Analysts had been expecting 0.3 percent YoY growth, in light of slowing manufacturing sector.  While a slowdown did occur in the industrial sector, Mexico's service sector grew fairly robustly, or 1.9 percent on a YoY basis. The manufacturing sector shrunk however, by 1.5 percent YoY, consistent with March's dismal IP data.  The primary sector grew at a 2.8 percent YoY pace, mainly due to increased crop yields.   The manufacturing sector, the engine behind Mexico's booming exports, seems to have been hurt somewhat by US fiscal consolidation.  Belt tightening occurred south of the boarder too.  The Mexican government has been diligently working to eliminate its small budget deficit.  Mexico's deficit in Q1 2013 was fifty percent smaller than its was this time one year ago. On the bright side, the Mexican consumer seems to have filled the spending gap somewhat, as evidenced by steady PCE data. 

Data is great, but the broader theme here is a buoyant dollar that appears to be overwhelming internal fundamentals of both major and exotic currencies.  Indeed, GBP, CHF, AUD, ZAR, INR, THB, TRY and a host of others are all way down for the week.  Some of these country's central banks have taken action of late, and some haven't.  The feeling in the air though, is the the Fed may be preparing to wind up its QE program while around the world other central banks are just getting starting.  

  

 

News: USD Pushes Higher, Mex Q1 GDP Looms

The US dollar has reasserted itself once again on the back of last week's surge in USD/JPY.  USD now appears to be firmly anchored above JPY 102, after bouncing off this key support level earlier this morning.  Buy the dip seems to by the story with pair, as USD/JPY sales are met with fresh buyers.  

But its not just the Yen which is the dollar's latest victim. While much talk is afoot about the 'realignment' of AUD, the Aussie dollar's dip below parity has coincided with broad dollar gains against majors and exotics alike. EUR/USD has dipped below 1.29 and its now settling into a 1.28-50 range.  Sterling is on the back foot again, but appears to have found short-term support at 1.52.  USD/CHF is trading in concert with EUR/USD.  Many expect a retest of .99 or even parity.  

On the EM front, USD/ZAR is pushing higher, and appears poised to test the crucial 9.30 level which was the peak of the last rally.  Further labor unrest and low commodity prices is also weighing heavily of ZAR.  Asians are down with the Yen and AUD.  USD/INR is trading higher in the 54.50-80 range.  USD/THB, which plunged earlier this year, is back near 30.  Finally, KRW has been under heavy pressure on speculation that the BOK, which cut rates along with the RBA last week, may intervene on FX markets to protect Korean exports against a weaker Yen.     Finally, USD/MXN is pressuring 12.30, especially in light of the low expectations for Q1 GDP due out Friday. The finance ministry expects annualized GDP to come in at a paltry 1 percent.    

In short, the greenback is consolidating its gains against everything.  While I am tempted to pat myself on the pat for buying USD/ZAR last week, it appears that the real theme is strong USD dollar.  Virtually any long USD is well in the green for the week.  A win is a win, but broad dollar strength, not internal fundamentals of individual currencies, appears to be setting the tone the FX market. 

Commentary: Talks of Tapering Probably a False Alarm

The Fed Rumors continue to swirl that the Federal Reserve may 'taper off' its bond purchase program before the end of the year. The market response has been soggy equity markets, a rally in Treasuries, and broad dollar strength. Specifically, the Fed is concerned that communicating the exact timing and nature of its implementation of its exit strategy may cause chaos in the Treasuries and MBS markets with participants rushing to front end any policy action by shorting these securities. This may make the Fed's promise to continue its open ended commitment to purchase 85 billion in Treasury and MBS, so long as unemployment remains over 6.5 percent and inflation under 3 percent, a tricky proposition. Should the BLS report high inflation or unemployment outside the Fed's stated targets, traders may begin to short Treasuries and MBS in anticipation of the winding down of the Fed's asset purchase program. 

One fact must be considered however. Even if the Fed decides to 'taper off' its purchases, such a move not represent a tightening of policy. Rather, it would only represent a reduction of the pace at which further liquidity is injected into the financial system. Hence, actual trades by the central bank won't come into play. Instead, the market will only have to rediscount the changed pace of liquidity injection. In other words, assuming that the price of the USD, stocks, bonds, or other securities already factors in the factor that the Fed will pump in 85 billion per month of fresh liquidity, how would actors re-adjust price expectations if the Fed cut its purchases by some modest figure, say 15 billion? 

I'm not sure, but I doubt a modest reduction in new liquidity being pumped into the economy will crush risk sentiment and result in falling stock prices and a resurgent USD. True, the USD may strengthen on the news, but knowing the Fed, any winding down of the Fed's QE program will be accompanied by good economic indicators which means that the broader economy can support higher rates. (Or rather, less accomadation, since rates are unlikely to rise until the Fed raises the rate paid on excess reserves or sells securities) In other words, expectations of higher returns will make risk takers willing to pay higher rates to obtain financing. For this reason, especially with rates near their zero bound, the unwinding of the Fed's balance sheet will probably be accompanied by increased loan demand, spurred on by a growing economy, and in spite of rising rates. A resumption of robust credit growth will be highly supportive of stock prices, housing prices, domestic consumption, and growth. 

 On FX, credit growth will affect the USD in two ways. Stronger growth in the US vis-a-vis other major economies will be highly USD supportive, even if this is obtained largely via increased leverage. However, as we saw in the 2000s, credit growth can also be USD negative, especially if US or foreign firms borrow in USD but invest abroad. However, this scenario seems unlikely to repeat itself. US firms will shift their focus towards North America, especially if the United States continues to lead the global recovery among advanced economies. Furthermore, firms abroad, especially in Europe, will be able to obtain cheaper financing in Euros, especially since it remains clear that the ECB has left the door for further easing wide open. True, European capital markets don't have the depth or liquidity of the US, but this will only be a factor for very small firms. Finally, we are seeing some US firms issuing Euro denominated bonds to obtain lower rates. DirectTV floated a five hundred million dollar eurobond today. In sum, whether the special place the US has in the world economy makes the USD the financing currency of choice as the credit cycle ramps up, despite higher rates than EUR or JPY, will be the key driver of the dollar in coming years.

Weekend Update: Opportunities Abound

It's been an exciting week and the time has come to prepare for the week ahead.  This week saw USD/JPY breach the 100 handle in dramatic fashion, surging up to 101.60 by New York close Friday afternoon.  Nearly all Asian currencies are down with the Yen.  USD/THB continues its rise, closing in New York at 29.77.  USD/INR is also up, closing at 54.65.  Two other movers have been AUD and KRW, whose central banks both cut rates this week.  AUD/USD breached parity, before popping back up to 1.0024.  USD/KRW, which had fallen back as low as 1082 as tensions cooled on the Korean peninsula, surged back above 1100 to 1110.7 after the BOK delivered a surprise rate cut.  

On the other side of the world, EUR/USD was soggy, as EUR has been unable to maintain is recent rally on strong German data.  I am still neutral on this pair. I still see a chance for a slow recovery back towards 1.40, but many commentators who I greatly respect have year end targets in the 1.20 to 1.25 range. 

USD/MXN gave up recent gains on profit taking and lower than expected industrial output for March.  Analysts had expected a drop, in light of the Easter holiday, which fell in March this year.  However, the 4.9 percent year on year drop was a big surprise to the downside which had some worried about a possible Mexico slowdown.  The rate outlook remains mixed, as Banxico struggles to manage capital flows and rising inflation.  I am looking to sell USD/MXN at 12.20. I remain cautiously optimistic.  The February's drop in IP was couple with weaker exports.  March saw robust export demand, with exports near all time highs.  Next month's data point should confirm whether or not the recent slowdown is indeed seasonal.  

Finally, USD/ZAR is probing higher, presumably on profit taking on any short USD/ZAR positions initiated on last week's post jobs euphoria.  The fundamentals remains weak, and the overall market tone is extremely gloomy.  I look to buy this pair on rallies. 

In short, opportunities abound. Asian currencies are getting cheap as the Yen continues to get hammered.  I may elook to get long THB or even INR should frantic yen selling push them even lower.  However, selling AUD and JPY as momentum trades or buying USD/ZAR on dips remain my preferred strategy for next week.  MXN is a mixed bag, right now, though I look to cautiously expand my position.  I will look to sell at 12.20, but more importantly, I will be laser focused on Mexican economic data for the foreseeable future. 

 

Commentary: Warren Student Loan Proposal is a Disaster

Senator Elizabeth Warren (D-MA) has proposed opening of the Fed's discount window to student borrowers, albeit indirectly.  The plan would mandate that the Federal Reserve lend to the Department of Education via the discount window so that it could charge students the same 0.75 percent rate that banks pay for emergency short term financing from the Federal Reserve.  To the uninitiated, this plan sounds great.  But it is nonsense, a disaster, and a disgrace that such a radical proposal would come from a sitting US Senator.    

Since my critics will no doubt accuse me of being a defender of the big banks, or a call me a fat-cat plutocrat, let's get some background out the way.  I voted for Barack Obama in 2008, and again in 2012.  Both times my support was enthusiastic.  I have generally supported Mr. Obama and his economic policies.  I am a strong supporter of a quick and easy path to citizenship for undocumented workers, and I believe in free universal healthcare.  But if my fellow democrats don't kill Ms. Warren's proposal immediately, I will be ashamed of the capital "D" after my name. 

 So what's wrong with the Students Loan Fairness Act.  In a word, everything.  But let's go through the details just so there isn't any doubt. 

The Fed lends money to banks against collateral, typically US government bonds or other highly rated securities, on a very short-term basis, usually overnight.  The purpose of such loans is not to enrich the banks or enable them to speculate.  It is a mechanism by which the banks can temporarily convert their loans into cash to meet withdrawal demands.  Without this safety valve, banks with a sudden surge in withdrawal requests would be unable to pay depositors, since it is not possible for them to "call" loans made to other customers.  

Furthermore, the Fed takes full custody of the pledged collateral, and earns all interest accrued during the term of the loan.  The bank is also still on the hook for the 0.75 percent for borrowing from the Fed.  So the bank is not only stuck paying interest on the loan, it also must forfeit the income generated by the collateral.  The result is a big net cost to the bank.  
 Banks would much prefer to borrow on the interbank market, where rates are lower and no collateral is pledged. 

Finally, the discount window is a boon, not a cost, to taxpayers.  Since 2008, the Fed has issued over 30,000 loans via the discount window, all fully repaid on time with interest.  The result has been over 300 billion in profits remitted directly to the US Treasury.  During its entire history, due to its ultra stringent lending standards, the Fed has never suffered a default.  

So where does this leave us with Ms. Warren's proposal?  

To start, because the Fed's awesome power to print money has great potential for abuse by politicians, the Fed was intentionally walled off from the rest of government.  The Fed never funds the government.  This sacrosanct rule of central banking is key to the Fed's credibility and that of the United States.  Countries which have resorted to money printing by the central bank to fund the government have suffered calamity after calamity.  Two recent examples include Zimbabwe in the 2000s and Argentina in the 1980s.  

Despite the lessons from history, Ms. Warren's proposal engages in overt money finance, or economist jargon for printing money to pay the government's bills.  She would direct the Fed to provide financing to the Department of Education to fund its Stafford student loan program.  While the goal of helping students is laudable, the means represent a dangerous crossing of the Rubicon which cannot be ignored. 

But perhaps worst of all, Ms. Warren's rhetoric in promoting her bill reminds of the cynical, rank, pandering usually employed by the Right.  Comparing central bank loans to banks, which are secured by firm collateral and usually last days, to student loans secured by nothing but the student's character and repaid over decades is the kind of despicable dumming down of issues that makes getting an education so important in the first place. 

Ms. Warren has made her career going after the excesses of Wall Street and helping to regulate the financial system.  She helped stand up the CFPB and assisted with overseeing the TARP bailout.  I therefore find it hard to believe that Senator Warren does not understand the basics of discount window loans or how it differs from loans made to consumers or students.  The fact that she would take advantage of the public's ignorance of an obscure but crucial function of government to score political points is shameful.  And ironic, since the objective of this whole exercise is supposedly to promote higher education.  Perhaps Ms. Warren should remember who exactly she is trying to help.          

News: USD/JPY Zooms Past 100, focus on 105

Sentiment on USD/JPY has turned firmly bullish as the pair surges over 100 for the first time in four years.  Techs and strategists alike are gearing up for a further leg upward in coming days and weeks.  News wires have talk of USD/JPY testing 102 as early as tomorrow.  Clearly from a technical perspective, 100 represented a major barrier, as evidenced by several failures to break above the 99.9 level in past few weeks.  Despite the take breach of this major level of technical resistance, don't look for a wave of short covering.  Per CTFC futures data, speculators were already long at about a five to one ratio.  Corporates continued to hedge their bets, piling up big Yen long positions.  Its unclear whether this is Japanese names "protecting" dollar denominated receivables, but this divergence in trader activity highlights the differing objectives of the participants on the FX market.  Corporates aren't concerned about the money they lose hedging on the futures market, so long as earnings from operations are "protected."  Furthermore, many companies always hedge, regardless of the fundamentals.  Therefore, corporates will stay long JPY for the foreseeable future, out of an unwillingness to take FX, or an inability to the work necessary to take said risk.  The as long as the specs continue to happily sell puts to the corporates, its up, up, and away for USD/JPY.