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MARKET INSIGHT REPORT

Growth Wont Be Climbing Further This Year
By John R Taylor, Jr. Chief Investment Officer

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Back in the old days, when the Fed was not pegging the overnight rate at zero and putting most of the governments financings on its own balance sheet, we watched the Treasurys yield curve to decide what the economy would do. A tightening yield curve was a sign of growth and coming growth, something we could depend on until the curve became too flat and finally inverted. Inversions of the two-year and ten-year government rates took place before the 2000 and 2008 recession, and like clockwork as had happened many recessions in a row, the economy turned down soon afterward. We see tightening occurring now, but it is virtually impossible for the 2s-10s curve to invert as the yield on the 2-year paper is so low it could never surpass the 10-year rate unless the US went on a very long inflationary economic binge, growing and inflating faster than ever before, or if the opposite were to occur and the 10-year rates approached zero. Both these events are impossible, so the old signals are history. In years past these spread narrowings occurred because the 2-year yield rallied faster than the 10-year in most cases, but now we have seen spread tightening while both the two-year and ten-year yield declined. One is healthy and the other unhealthy. The recent picture is not good. As of today not one of the four yields involved are at their 12-month highs. Both the 2s-10s spread and the longer 5s-30s spread are flirting with tightenings in which both instruments have yields that are going either sideways or slightly lower. This gives us an uneasy feeling.!

! In the last few weeks, we have seen some G-10 equity markets make a significant move

lower. Our longer-term cycles have argued that global equity markets will peak this year. We think some have peaked but many others could rally into the fourth quarter. As equity markets tend to forecast economic conditions in the future, say 6 to 9 months from now, a decline or even a sideways trajectory over the next few months, like the spread argument above, would signal economic weakness before the end of the year. The Fed and most analysts, us included, have been looking for higher yields, and we expect to see them in the next three weeks, along with a rising equity market. If we see new equity highs and new high yields, at least in the under 5-year segment of the market, this would be the right thing to happen if the economy were in good shape. But even then our cycles do call for a high in yields in the first half of May, so the rally needs to be impressive for us to be happy. We hope it is. !

! Back in 2007, the equity markets peaked in October and made a series of erratic drops

into a major Societe Generale trading mishap in January and the Bear Stearns collapse in March. All that time the dollar continued to weaken and commodities climbed higher. It was only eight months later that the commodities began their decline and the dollar started its rally. Today, we have strong cyclical signs of a major equity high, similar to the one in January 2000, when the Dow peaked, and or in October 2007. The Yellen Fed could make this forecast a reality if the equity market weakness so unnerves them that US rates come off and we witness a sharp narrowing of the 2s-10s and 5s-30s spreads as the dots for the first hike are pushed back a year or so. We would see this change developing in May and a weakening, loosening US would support the developing world and much of the G-10 as well, pushing the dollar down and keeping the upward pressure on oil and base metals. That is now our base view.
To contact FX CONCEPTS New York: 1 (212) 554-6830; London: +44 20 7213 9600; Singapore: (65) 67352898; research@fx-concepts.com

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Reasons for Euro Strength
By Joseph Palmisano

INTEREST RATES

There have been a number of forces behind the dollar weakness against the European currencies. First, even if the March payroll data in the US looked broadly in line with expectations, it was a catalyst for a re-pricing of the US curve (lower rates), probably due to hopes for a breakout number and related short positioning (and long USD positions). Second, the FOMC minutes for the March meeting were more dovish than the market had expected, and to some degree watered down the message from the FOMC itself. This prompted a further retracement in US rates; the implied yield of December 2015 Eurodollars is now essentially back to pre-March 19 levels. Third, we have observed a strong performance of risk crosses in FX. That is, both commodity and emerging market currencies have performed well, along with the developed European currencies. In other words, there seems to be a carry component to recent asset performance, which fits with the lower interest rate environment and is a reversal of the underperformance of risk from when the tapering debate started. But it is unusual to see this in an environment where equity markets are trading lower. Perhaps the explanation comes from the fact that the equity selloff seemed technical and was driven by high momentum names, especially within the tech sector. Interest rate differentials have clearly moved against the dollar on a global basis, which is an important factor in explaining the dollar weakness. But it depends on the specific cross, whether rates can explain the bulk of the move. For the EUR, GBP, CHF, and even CZK which is tethered to the 27.00 area the moves seem broadly consistent with moves in interest rates. It is also worth observing that FX volatility still remains low, despite the strength in the dollar over the last week. This, together with less skew in favor of USD calls, points to a liquidation of USD call structures, which may be both a reduction in speculative positioning and a reduction in hedges. Lastly, the PBoC has been intervening aggressively in the FX market, buying dollars against CNY and pushing the daily fixing higher too. John Taylor has argued that the policy is aimed at reducing the attractiveness of the CNY from a carry perspective. As we have been used to very rapid reserve accumulation, a policy that is effective in reducing hot-money inflows may have implications beyond China through reserve diversification. If a sizable share of inflows is allocated into the EUR, it could partly explain the upward pressure on the single currency. Given the impulsive nature of the current decline in the dollar, it is hard to fight it too forcefully. Our cycles expect the dollar to bottom versus the euro in early May. There is a minor low due Friday, but we doubt it will fall below the 1.3750 to 1.3760 area. Following this low the EUR/ USD will turn higher and a break above 1.3845 will confirm further strength into the second half of the week of April 28 or the following week. Our target for this move is the 1.4025 area this will be a great place to enter short euro positions. Our longer-term cycles tell us that following this high the currency pair will turn lower to begin a downtrend. We expect a low in late May or early June and our target is the 1.3600 area. The 1.3750 to 1.3760 area should hold, but a close below it means the EUR has already peaked and is headed directly lower to June.
To contact FX CONCEPTS New York: 1 (212) 554-6830; London: +44 20 7213 9600; Singapore: (65) 67352898; research@fx-concepts.com