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Yellen to hike rates despite lacklustre economic data
Fade politics buy China
The political circus that Washington has become continues to draw investors’ attention away from fundamentals. Just when the smoke cleared from Attorney General Sessions testimony, news broke that nearly 200 Democrat congressmen had filed a lawsuit against the Trump administration for alleged improper business interests. Political uncertainty and disappointment in Trump's failing pro-growth agenda will continue to weigh on USD sentiment. However, steady economic developments including China's solid data released today suggest a positive backdrop for risk-taking and potential for an overly bearish USD market to reverse.
In China, economic data indicated that despite decelerating pace of fixed asset and real estate investment (positively slowing rate of financial leverage buildup), industrial production and retail sales were strong. In our view the balanced results indicate higher level of economic stability in China than the market recognises. We remain constructive on China growth outlook and would materialise our view via long China technology stocks.
FOMC and long USDJPY
What needs to be said has already been said and now we wait. The markets have fully priced-in a 25bp to 1.0-1.25% range hike for this afternoon's FOMC rate decisions. We agree with the Fed that activity and inflation data has been stymied by transitional factors. We expected cyclical improvement in the 2H and anticipated another 25bp hike in December. Slightly less dovish commentary on economic outlook should see marginal repricing of US rate curve for 2017 and cause USD strength.
In regards to balance sheet reduction, we believe the Fed is not ready to announce their strategy for reducing its $4.5trn balance sheet (expectation for Sept). Yet that is really the rub, further Fed grinding movement towards normalisation either via balance sheet reduction or interest rate hikes are inherently hawkish.
In order to keep the USD weak, the Fed will attempt misdirection in order to keep the markets focused on Fed fund rates while they step away from supporting rates. We remain buyer of USDJPY given the pair’s high sensitive to US-JP interest rate differentials. The flattening of the yields curve indicated that markets are convinced of today’s hike (pushing short end higher) but uncertainty of futures hike (keeping long end low). Should our view prove correct, watch for US 10s yields to steadily climb well above 2.21% current levels towards 2.30% and USDJPY to 112.00. Elsewhere, US CPI and retail sales will be released likely adding general confusion heading into the FOMC.
RUB had a wild ride
It has been a wild ride for the Russian ruble over the last 18 months. USD/RUB fell as much as 35% between January 2016 and April 2017 before stabilising at between 56 and 58 ruble per US dollar. The sharp appreciation was mostly driven by the recovery in crude oil prices, easing political tensions on the geopolitical level and a tight monetary policy.
Over the same period, crude oil prices recovered from the massive debasement of 2014-2015 as a barrel of Brent rose from $27.10 to above $50, giving the ruble a boost. Indeed, the Russian currency has always been heavily correlated to crude oil prices as Russia stands amongst the main producers of black gold. However, this strong relation has weakened recently: crude oil price came under renewed downside pressures following supply glut fears and concerns over the sustainability of the OPEC output deal while the ruble held steady.
One of the reasons that could explain this deviation from this long-term relationship is the tight monetary policy adopted by the central bank. Elvira Nabiullina, the CBR’s president, held a restrictive monetary policy to bring inflation levels under control. Yet both the core and headline measures, currently standing at 3.8% y/y and 4.10% y/y respectively, are close to the institution’s target of 4%. Therefore, the CBR will accelerate the rate cut pace that will give a breath of fresh air to the economy but also allow the ruble to depreciate. Indeed, carry traders will lose interest in the ruble and continue to search for higher yields somewhere else.
All in all, we think that both the re-correlation with crude oil and a looser monetary policy will translate into a weaker ruble. We target the 60 resistance level in USD/RUB in the medium-term.