three themes that will rock forex markets in 2016

7/25/2019 Three Themes That Will Rock Forex Markets in 2016

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Three themes that will

rock markets in 2016

By Greg McKenna, Chief Market Strategist

www.axitrader.com


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Table of Contents

Looking back, looking forward ................................................................................................................ 4

Three big themes in the year ahead ....................................................................................................... 6

1. The Fed tightening cycle .............................................................................................................. 6

2. Yuan devaluation and the Chinese slowdown ........................................................................ 8

3. Lowflation ..................................................................................................................................... 11


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Greg McKennaChief Market Strategist, AxiTrader

Greg McKenna has been working in financial

markets since 1988. He is a trader and Behavioural

Finance & Economics guy who has run billions of

dollars as a fund manager at State Super, was

Australias first currency strategist at Westpac,NABs head of currency strategy and Treasurer of a

large building society.

For the past three years Greg has been running his

own economic, trading and banking consultancy at

gregmckenna.com.au and he is Contributing Editor

for Markets and Economics at Business Insider

Australia.

Greg holds a Bachelor of Business (Banking and

Finance) from Monash University and a Master of

Applied Finance from Macquarie University.

Hes also a nice guy who loves his family, his mastiff,

surfing and sharing his knowledge and love of

markets and trading.


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2016 3 Themes that will rock marketsAxiTrader Financial Services Pty Ltd | www.axitrader.com 4

Looking back, looking forwardAs ayear of volatility ends, another seems set to begin

Traders inhabit a world of uncertainty. They must be comfortable making decisions to buy, tosell, to hold or to pyramid positions without knowing the exact outcome. Traders understand

this and, for the most part, are comfortable with the world they inhabit.

But 2015 has been an uncommonly volatile year for traders and markets.

If they werent fretting about the chances of a Euro implosion and a Greek exit from the single

currency, it was fears about the slowing global economy, the weakness in China, the crashing

price of iron ore, crude oils continued meltdown, stocks red for the year, a Euro below 1.05,

perhaps parity and now a Chinese Yuan devaluation and a Fed tightening in the United States.

Greece may have been resolved but, as we look forward to 2016, the year ahead could be just

as volatile, or worse. Britain is contemplating an exit from the Euro; a Brexit. At the same time,

markets will have to grapple with a US Federal Reserve which looks set to tighten as many as

four times in 2016. Traders have to grapple with a crude oil market still heavily oversupplied,

with prices falling and broad-based commodity weakness. Then, of course, 2016 looks set to be

the year emerging markets may have to face their debt bomb, weaker economies and a clear

signal China wants a weaker Yuan.


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Elsewhere, a US dollar surge is expected. But could it already have been delivered with big falls

across many Forex pairs in 2015? Most pundits say no, but positioning says much is priced in.

Stocks look richly priced in the US and beyond, while bonds rallying as the Fed tightens could

throw a spanner in many predictions.

2016 looks like another torrid year of volatility with three themes set to dominatethe global

market backdrop: The Fed, China and the Yuan, and Lowflation. Almost all the trades of

2016 will in some way flow from these three drivers.

With volatility comes opportunity, at least when it comes to trading.


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Three big themes in the year aheadThe Fed, the Yuan and Lowflation

Sailing is a great analogy for markets and traders in the post-GFC environment. Weve hadplenty of perfect days broken by intermittent storms and rough weather, but 2015 felt like it

was more foul than fair. And it seems there are so many cross currents in the year ahead that

its a storm sail and battened hatches that will be de rigueur for 2016.

Amongst these many cross currents, three key themes stand out as being at the intersection of

all the volatility.

1. The Fed tightening cycleThe Fed is about to embark on its first tightening cycle for nine years. Many argue the US

economy is not ready for higher rates. Many argue that the junk bond selloff is the precursor of

a US recession, and many argue that inflation in the US will struggle to get back to 2% anytimesoon.

But what is clear is that the US jobs market is strong. Unemployment is heading back to pre-

GFC levels and, for all of the above objections, the current strength of the US economy is

simply incompatible with zero interest rates.


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The question of how far and how fast the Fed moves rates is important

because of the impact this tightening cycle, has on other markets.

The Feds move will impact the US dollar, Euro, Yen, Pound, commodities and commodity

currencies. In other words, currencies in general.

The pace and aggressiveness or not of the

Fed will also impact the US and global yield

curves. That drives stock valuations in developed

and emerging markets. It could put pressure on

the Chinese Yuan, which could appreciate, or it

could put more pressure on the Chinese to

devalue. A stronger US dollar could pressure the

emerging market debt load. It could hurt stocks

used to not having to worry about interest costs.

My expectation is for the Fed to alternate between official hawkish talk of action and private

talk of calm. Id expect them to hike in December 2015 and then every quarter in 2016 to end

the year at 1.25%.

Thats probably enough to be destabilizing, but not quite enough to crash global markets. But if

the Fed discussion moves to shrinking its balance sheet, all bets are off. That would bedestabilising.


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2. Yuan devaluation and the Chinese slowdown

Markets feared Chinas slowing growth rate at various times and in various degrees over the

course of 2015. They feared the rate of 7% was nowhere near the real rate of growth.

Australian billionaire fund manager Kerr Neilson even suggested the rate of growth, based on

the indicators he watches, was closer to a paltry 4%.

Certainly the economy is slowing. The OECD expects that Chinese growth is projected to

decline gradually to 6.2% by 2017." Manufacturing is slowing, industrial production has been in

decline, and urban fixed investment is at its lowest level in 15 years.

As a result of the slowdown the central bank,

the Peoples Bank of China (PBOC), has

dropped interest rates and released cash into

the economy by lowering the amount of

reserves that banks need to hold.

On a positive note, however, there are signs in

the reacceleration of retail sales growth to

11.2% in November (the fastest in a year) that

these measures are gaining traction.


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But as the government reforms the economy and tries to chase corruption out of business and

the markets, there are risks to Chinas economic performance. To mitigate these risks the

PBOC is seeking the comfort of a more competitive currency. It shocked the market with a

devaluation of the Yuan in August. That set markets across the globe afire with risk aversion

and uncertainty and lead to Augusts market rout in commodities, stocks, interest rates and

currencies.

More recently, after a period of stabilization, the

PBOC has been slowly weakening the Chinese

Yuan against the US dollar. Thats taken the

onshore rate, USDCNY, to the highest level

(weakest Yuan) since 2011. Thats also pushed

the offshore rate, USDCNH the one most

traded by offshore market participants to its

highest level since 2010.

This move to weaken the Yuan is critical to the global market outlook in 2016 because many

argue that it was the move in the Chinese currency in the 1990s which precipitated the Asian

market crisis. Thats important in 2016 because of the level of emerging market debt being held

at a corporate level and the potential, amid the current sell-off in junk bonds and high yield

generally, that the weakening of the Chinese Yuan puts more pressure on its competitor

countries and the companies within them. Of course, Chinese companies and local

governments are carrying their own heavy debt load and is another source of potential

instability in the year ahead.

In December the PBOC announced a basket peg including the US dollar, Euro, Yen and 10

other currencies as it tried to switch traders' focus away from the bilateral USDCNY and

USDCNH rates. Its clearly a strategy aimed at de-pegging the Yuan from any potential US

dollar buying (Yuan strength) when the Fed tightening cycle begins.

Its also a clear signal that as money flows out of

China, or as the PBOC continues to ease, it will

not be sterilized. Thats better for the efficacy of

policy, the traction of monetary easing, in

helping economic growth. Its also better for the

economy which can get a lift from a weaker

currency. But it's problematic for Chinascompetitors.


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But where exactly is the PBOC aiming the Yuan?

This is the big question for traders, and a big theme for markets in 2016. Too much weakness,

or too fast, and China risks both the ire of its neighbours and the international community

which just voted to include the Yuan, along with the US dollar, Japanese Yen, Euro and Pound,

in the International Monetary Funds central bank currency basket known as Special Drawing

Rights (SDR).

In the lead-up to this decision China promised to keep it currency stable, a strategy it might

appear to abandon if USDCNY slips too far.

The question is what is too far and what is a material move?

At approximately 6.47, USDCNY is only 2.4% weaker than the post-devaluation lows. Even

against the pre-devaluation level of 6.20/22 USDCNY is only around 4.3% weaker than it was

before the move. USDCNH has moved further as traders bet on a bigger devaluation but the

PBOC has sort to keep this spread under 10 points recently.

But whether its the onshore or offshore Yuan rate when contrasted with the moves we have

seen in the Australian dollar, Euro, Sterling and even Yen over the past couple of years and the

Chinese are on solid ground, and have a strong argument that the currency is the epitome of

stability. Certainly during the GFC and in the post-GFC era they have been an outstanding

global citizen when it comes to the management of Chinas foreign exchange rate

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So, Im looking for China to maneuver the USDCNY rate into the 6.8 to

7.0 region we saw before its appreciation began in 2010. Thats a not too

hot, not too cold zone.

3. Lowflation

Lowflation is what the world is suffering from in 2015 and what it looks set to suffer under forat least another year. That is, the inflation rate most of the developed world and parts of the

developing is experiencing in terms of consumer and producer price inflation are under the

central banks targets. Thus, we have lowflation as opposed to the outright deflation weve seen

in Chinese PPI for close to four years.

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As central bankers are fond of telling traders,

this is because the crash in the price of crude

oil, and commodities more broadly, has

depressed prices at the moment. They argue

that these forces are transitory and that

inflation will soon be back above 2%.

They may be right. But the trouble with this

thesis is the Japanese experience. Through a

cycle of depressed energy prices and the

boom that took oil well north of $100 a

barrel, Japan has steadfastly remained well

below the OECD average inflation rate except

for a period in 2014.

If Japan is a benchmark worth noting for central banks, something former Bank of JapanGovernor Shirakawa asked and answered in the affirmative at the BIS1in 2013 when delivering

a speech asking whether Milton Friedman was right about inflation being an always and

everywhere monetary phenomenon. Then the notion that inflation will swiftly, and sustainably,

revert above 2% around the world is questionable.

Shirakawa also argued, there is a technological element to lowflations persistence around the

globe. Shirakawa said the relationship between money and prices was broken in many

economies due to subsequent deregulation and technological change.

The basic premise of the technological

argument for lowflation is that technological

advances drive prices down. That can be

either through a lower cost of production, and

hence cheaper prices, or because

technological advancements mean you get

more for the same price. Think Smart TV for

the price of your old dumb TV. Thats

lowflationary.

Technology, Google, Baidu, E-bay, Amazon, smart phones. They are all lowflationary because

they are turning commerce, at a retail and business level, into almost perfectly competitivemarkets. How do they do that? Because all this technology drives transparency, gives pricing

power to the buyer and makes business more efficient.

1http://www.bis.org/publ/bppdf/bispap77e.pdf


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Thats important in understanding whats going on right here and now in economies and in

markets because it might mitigate the Fed tightening in 2016. It could certainly stop the Bank of

England from easing and it could even see the RBA ease rates. Crucially though, if lowflation

does not stay or slow the Fed, the divergence in policy between US interest rates and the restof the global central banking elite can drive some potentially huge moves in markets.

Higher rates in the US could drive the US

dollar higher. That can depress profits for US

companies and will continue to weigh on

commodity markets, most of which are

denominated in US dollars. It may also

accelerate the PBOCs push toward a weaker

Yuan. That will not be easily dealt with in

emerging markets and, as we saw in August,whatever the PBOCs protestations that it is

not pursuing a weaker currency, actions speak

louder than words and market ructions are

almost guaranteed.

Crucially, what lowflation has done over the past few years is undermine faith in central bankers.

Like the child brave enough to call the emperor naked, lowflation has exposed central bankers

as mere mortals and not the prescient gods of markets many observers thought them. As Bank

of Canada governor Poloz said in December, "2015 was another year in the series of serial

disappointments".


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The Trades of 2016

These three themes intersect across so many markets that even though 2016 looks set to be

another volatile year, a number of macro trade opportunities become obvious.

Whether in Forex, precious metals, oil or stock market indices, opportunities abound.

In my next report I will outline my top six macro

trades for 2016.

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three themes that will rock forex markets in 2016

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