27 August 2010 at 14:00 GMT
Market continues to tread water ahead of key Bernanke speech this morning, which will tell how much the market is leaning on the Fed for its next move. Will USDJPY be the big mover on his speech today?
Bernanke's speech today
Bernanke's speech is coming at a fairly interesting time for markets, as we have seen a consistent stream of very dismal data out of the US economy. Going forward, that data is unlikely to improve since three of the key props to the economy: public stimulus, an inventory rebuilding mini-boom, and tax incentivized home buying are now in steep retreat. Add to that the fact that Mr. Obama's healthcare package has made it drastically more expensive to buy health insurance and the most important job creators in the economy, small business, are far less willing to hire new workers, even if they wanted to. No growth is effectively baked into the cake in Q3 and growth might even turn negative by the end of the year.
The data and economy is on such a clearly negative path that the Fed has already been out twice recently with reduced forecasts for future growth and Mr. Bernanke must be getting worried enough to be already cooking up plans for renewed quantitative easing, even as the Wall Street Journal article suggested yesterday that he has few arrows left in the quiver (see the article with a great graphic here). But how easily can Mr. Bernanke move here and now with a large contingent of dissenters within the Fed and a juggernaut of a Tea-Party breathing Republican political movement providing significant headwinds. And how willing is the chairman to discuss his real thoughts right here and now? It's also interesting to consider that his host at the Jackson Hole event is the very Fed member who has officially dissented from the Fed's official monetary policy statement at the last several FOMC meetings.
So what do we get?
So what do we get from today's speech: a Bernanke that says "pass" and just talks about the risks to the economy and tries to reassure with general platitudes? Or do we get a Bernanke that affirms that we are precariously perched on a precipice here and gives an updated Helicopter Ben speech that strongly indicates - though the Fed has no "current plans" to do so - that the Fed will simply not stand by and let the economy dip into deflation. In extremis, this latter outcome could even include hints at the kind of out-of-the-box tools Mr. Bernanke would create to fight the deflation demons - free cash that expires if not used, etc.... The market reactions to these two extremes would be divergent, to say the least. Theoretically, the former could see bonds crushed at least temporarily and the USD probably rallying on the interest rate implications, as well as on a continued move lower in risk appetite since the risk market doesn't get a new liquidity fix. The latter would crush the USD as it confirms the market's worst fears that the Fed stands ready to destroy the USD to avoid deflation at all costs and could see another boost to bonds and more importantly to risk appetite. But what about the sovereign risk issue - if sovereign risk assessment deteriorates, this could defeat the Fed chairman's intentions. Gold going up is the only certainty with the latter outcome.
Potential market reactions
Almost regardless of what Mr. Bernanke says today, we have a key rule of thumb (or "old salty wisdom" as we like to think we've acquired over the years of observing the market) about these major event risks: Find the big trend that has been unfolding as the event approaches and judge the chances for the event serving as a major inflection point or end-point for that trend. Today feels like such a day if we look at the bond market and the Japanese JPY. While the bond market bull, and perhaps also the JPY bull, may not be over and done with in the longer term, it feels like it is the right time for some volatility to shake these complacent markets now that everyone is embracing the deflation theme. Below we take a look at a couple of JPY-related charts and ponder the market's reaction to today's speech.
Chart: USDJPY and US 10-year rates
Both the spreads at the short end and long end of the yield curve for the US and Japan have been tightening in favor of the JPY in recent months. The question here is how Mr. Bernanke's speech will affect the long end of the yield curve. If bond yields fall farther still, we'll likely need to see the BoJ on the offer to get a consolidation in the JPY rally.
Chart: Carry Trade Model
As we discussed in our most recent FX monthly, it is clear that the behavior of the JPY and the USD have diverged in recent months. As the declines in the US interest rates have been the fastest in the recent cycle and due to the expectations for Fed activism, the USD has been the preferred funding currency for carry trades, while the JPY has continued to strengthen as bond yield spreads have contracted in the JPY's favor.
Looking ahead
Outside of USDJPY, the reaction will depend to a great degree on the direction in risk appetite, as it is obvious from the carry trade model above that the USD continues to move in lock-step with risk. As we have pointed out, the likes of AUDUSD are at a key inflection point here. Sentiment surveys seem to show that equity traders are already very bearish, so though we talked up the risk of a crash/mini-crash today, we wonder if the marginal new sellers are there...
Also: is the CHF a different creature here or is it also likely to react strongly off Bernanke's speech? CHF and JPY have been moving in close correlation over the last couple of months and could be fellow travelers after the speech.
Next week is a very busy one for further event risks, with a raft of US data (both ISMs and the latest US employment report among other data), plenty of Australian data, and the Swedish Riksbank and ECB meetings as well.
Last second update: USD a bit weaker on the Fed's Bullard indicating that "disciplined QE" is necessary if the Fed does more. But the rest of his interview suggests that he is not at all expecting a double dip in the economy, so not particularly dovish overall. (The market is also reacting to a stronger revision on Q2 US GDP, a rather pointless exercise in studying the distant past...)
Strap on your helmets and stay careful out there, everyone.
Economic Data Highlights
- Japan Jul. Jobless Rate out at 5.2% vs. 5.3% expected and 5.3% in Jun.
- Japan Jul. Overall Household Spending rose 1.1% YoY vs. +1.5% expected an +0.5% last year
- Japan Jul. National CPI out at -0.9% YoY and -1.5% ex Food and Energy, both as expected
- China Aug. MNI Business Condition Survey out at 62.2 vs. 64.9 in Jul.
- Germany Jul. Import Price Index fell -0.2% MoM and rose 9.9% YoY vs. -0.4%/+9.7% expected, respectively
- Sweden Jul. Retail Sales rose +0.5% MoM and 2.0% YoY vs. +1.0%/1.1% expected, respectively
- UK Q2 GDP revised to +1.2% QoQ vs. +1.1% expected
- Switzerland Aug. KOF Swiss Leading Indicator out at 2.18 vs. 2.20 expected and 2.22 in Jul.
- US GDP Q2 GDP revised down to +1.6% annualized vs. +1.4% expected and +2.4% originally
Upcoming Economic Calendar Highlights
- US University of Michigan Confidence (1355)
- US Fed's Bernanke to Speak on Economic Outlook in Jackson Hole, Wyoming (1400)
- UK BoE's Bean to Speak (Sat 1400)
- New Zealand Jul. Trade Balance (Sun 2245)
- UK Aug. Hometrack Housing Survey (Sun 2301)
- Australia Jul. HIA New Home Sales (Mon 0100)
- Australia Q2 Inventories (Mon 0130)
- New Zealand Aug. NBNZ Business Confidence (Mon 0300)
- Japan BoJ Governor Yamaguchi to Speak (Mon 0430)