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Where is the dollar heading to? A review of major catalysts for the next week


The weighted average dollar index DXY has been trending upwards from the end of September and a fair question is where the end of the rally is. I am not a big fan of technical patterns but applying a quick sketch of channel lines on the chart we can see a rather clear resistance point, at least from where bidding on further rally may be a mentally hard decision. Of course, it makes sense if we assume that the medium-term trend, we are talking about has some inertia. Such resistance could be expected at around 98.00 points.

What led the dollar here and what drivers are there for the American currency to grow further? Considering the situation with a “bird’s-eye view”, discrepancies in the fundamental picture of the market arise when assessing the three next points: the economic outlook for the United States abroad, the state of the American economy, and the Fed’s policies related to it. The collapse of oil prices by more than 20% from $80 per barrel to $50 steals the so-welcomed inflationary impulse from developed economies. This is especially clearly seen in the Eurozone and Japan and may contradict the commonplace view that lower oil will help firms to save up on costs.

If we chart together the yield on German 10-year bonds and the oil price, it is evident that energy prices somewhat lead the yield movement in the Europe’s fixed income market.

What led the dollar here and what drivers are there for the American currency to grow further? Considering the situation with a “bird’s-eye view”, discrepancies in the fundamental picture of the market arise when assessing the three next points: the economic outlook for the United States abroad, the state of the American economy, and the Fed’s policies related to it. The collapse of oil prices by more than 20% from $80 per barrel to $50 steals the so-welcomed inflationary impulse from developed economies. This is especially clearly seen in the Eurozone and Japan and may contradict the commonplace view that lower oil will help firms to save up on costs.

If we chart together the yield on German 10-year bonds and the oil price, it is evident that energy prices somewhat lead the yield movement in the Europe’s fixed income market.
 

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Fed-fueled rally fades as markets concentrate on Trump-Xi meeting

In continuation of my Thursday discussion about the stock market rally, volatility responded curiously to Powell’s speech on Wednesday. Usually, the VIX and S&P 500 move just the opposite (although with different amplitudes), but on Wednesday there was a moment when the 9-day expected volatility (VXST) rose despite the 2% gains of S&P 500 which is very unusual.


Usually, the VIX and the S&P 500 move in different directions, since, roughly speaking, panic and the accompanying increase in volatility is inherent in a rather bear market (“market goes up by stairs and down by elevator”). Interestingly, this movement has not been observed on the market since 2011.

The dots on the chart indicate the daily changes in VXST (9-day volatility), in those days when the S&P 500 grew by more than 2% per day. On average, VXST fell by -17%.


One of the possible explanations for what happened is that some market participants did not buy at the rally initiated by Powell, as they are waiting for the results of the Trump-Xi meeting, which I wrote about yesterday.


Despite the increase in fiscal and monetary support in recent months, the activity of the manufacturing sector in China fell to 2016 low and is on the verge of contraction. The main indicator was 50 points in November – the value of separating recovery and recession.


The service sector in China is also not yet able to take on the burden of growth – activity in it slowed to 53.4 points in November against expectations of 53.8 points.


The weakness of debt-addicted economy cannot be eradicated even after a fresh stimulus package- income tax cuts, credit support for financial organizations in order to pour this money into enterprises through stocks and bonds. The size and position in China in the global economy will guarantee the recession echoes will feed into the PMI data of other countries, primarily in the EU and the US. Their PMI gauges is expected to be released next week.


The minutes of the Fed meeting, which appeared yesterday, could seem irrelevant knowledge to the markets in the light of Powell’s communication on Wednesday, but the statement language convinces that concerns about growth in 2019 has been already gaining momentum at the beginning of this month.


First, the officials urged to be more attentive to the incoming economic data. They said that in the upcoming meetings, in the content of the statement and the wording, it may be appropriate to place more emphasis on economic data in economic assessments and policy forecasts.


That old and well-known “data dependence” narrative which pervaded Yellen’s comments and which Draghi cannot yet get rid of. This is the exact caution motive which may serve as fundamental ground for expectations of only one rate increase next year (in fact, to the lower limit of the neutral rate estimates by the Fed).


Secondly, after a series of previous statements about strong, robust growth, first signs of Fed concerns about the economy were concentrated around slowdown in “some rate-sensitive sectors” in the November statement. Most likely this is the real estate market and possibly the construction sector related to it, the data for which were absolutely not impressive this year. Since March 2016, the 30-year mortgage rate has risen from 3.6 to 5.2%.


Stock markets reacted slightly, the dollar changed was flat. Futures on the interest rate point to the same probability of a rate increase in December, while we are waiting for the results of the Trump-Xi meeting.


Please note that this material is provided for informational purposes only and should not be considered as investment advice. Trading in the financial markets is very risky.
 

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Huawei – the new bone of contention between China and US


Despite the catchy headlines of the reports covering the OPEC meeting, the oil market preferred to read between the lines, making frowning conclusion from the statements: the cartel members could not move further from the mere awareness that the threat of oversupply exists.

The meeting of Saudi Arabia, other members of the cartel and Russia ultimately produced only a recommendation to curb production, without a formal agreement on how much oil should leave the market.

Representatives of the OPEC countries hit the wires with comments on Wednesday on how important it is to cut production now, and the Russian representative confirmed that the meeting was constructive, but the result will be announced at a meeting in Vienna today. As a result, relying on positive rhetoric, oil prices may spend the day in positive territory, waiting for fruitful decisions.

Most likely the participants will agree on the extension of the existing production quotas. But some of the Russian producers have already expressed doubts about the possibility of cutting production due to seasonal difficulties, for example, Lukoil.

After the statements from Oman delegates that decline in production could be as low as 1 million barrels, prices fell. This may indicate that the market expects more serious concessions from OPEC.

The growth of commercial inventories in the United States so far effectively prevents the growth of positive sentiment in the oil market, which, moreover, is gradually accepting the hypothesis of a global slowdown in demand. In such conditions, output cut is an obvious necessity for OPEC, but the whole question is how much the members of the cartel are willing to sacrifice in order not to infringe upon their national economic interests.

Yesterday there were reports that Huawei CFO was detained in Canada on request of the US. The part of the market that has relied on the rapprochement of China and the United States after the meeting in Argentina is likely to start correcting its wrong hopes, this can now be seen from the fall of US stock futures. SPX, with ease, punctured the 2,700 mark down, Wall Street is likely to hold in sales today.

A top manager of a Chinese company is awaiting extradition to the US after being detained on the first of December, that is, before Trump and Xi meeting. Most likely, the reason for the arrest was the involvement in the sale of HP equipment, to the sanctioned Iran. It is unlikely that Trump did not know about this and did not authorize the detention, so he won’t be able to portray a surprise. And if he knew, the reaction of the markets was easy to predict, the fragile expectations due to the uncertainty with the tariffs only increases the amplitude of the negative reaction. The costs of creating additional tensions with China are high, so the reason is serious, and the dust will not be settled down quickly. The short trade of the S&P 500 now looks like an easy bet as the truce in a trade war can easily be broken.

The Fed released the Beige Book on Wednesday with pretty rich content for even polar interpretations. On the one hand, the number of references to the word “tariffs” decreased from a peak of 51 to 39 in December, on the other hand, the number of references to the word “slow” rose to the highest level in 2018. The frequency approach to analyzing the content of the Beige Book is justified by the fact that the Fed gathers anecdotal feedback of company managers, economists, market experts from different US districts about economy situation in the country. The citation of some actual words allows us to assess the general mood of the respondents.

Please note that this material is provided for informational purposes only and should not be considered as investment advice. Trading in the financial markets is very risky.
 

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A short guide: How to use data on the T-bills to estimate future Fed rate hikes?

Amid growing jittery that the Fed made a mistake picking up the quarterly pace of rate hikes and reluctantly admits its flaw, the US term structure of interest rates earns back the status of a “reliable predictor” of a looming slowdown. Recently, I wrote about how the spread between 10-year and two-year bonds portrayed extreme distrust of the Fed’s policy in the medium term, but today I would like to speculate about the even shorter timeframe of the Fed’s actions.

With the December meeting approaching and keeping in mind the quarterly pace of rate increases by the Fed, it is curious to see how the yield of 1-month and 3-month Treasury bonds behave together. If we assume that inflationary expectations in the short-term interval are roughly equal (i.e. only Fed decisions affect their yield then), comparing their yields, we can put forward a guess what the bond market thinks about the Fed meeting in March, which corresponds to the supposed quarterly increase in the rate.

The last auction of 3-month bonds in the amount of 39 billion was held this Monday, while the auction for the 1-month ones was held on Thursday. It is noteworthy that the yield to maturity of both terms was about the same.

Since the market is highly likely to expect a rate hike in December, convergence in yields of 1-month bonds with 3-month (which YTM basically focuses on the March decision) means that the expectations for a rate increase in March gradually leave the market. After all, if the opposite were true, the demand for three-month bonds would have to fall, which would be expressed in the increase in YTM (yield-to-maturity).

Of course, you may not bother with the details of yield movements and just look at the probability distribution of futures on the rate hike.

The chances of a rate increase in March to the level of 250-275 dropped to 33%, although only a month ago the probability of the increase was 50%.

And certainly, what will not leave the Fed indifferent is the inflation expectations (albeit measured through inflation-linked bonds), which did not last long at the desired level of 2% and began to dive.


The latest data shows that inflation expectations, measured “through the consumer” (for example, from W. Michigan), also slightly slowed down. The problem is that they are more likely to be lagging (considering that the consumer is less aware of the trend in economy) than the leading inflation expectations measured through the demand for bonds. On the other hand, we can’t rule out that the market reaction to what is happening in the economy can be irrational (for example, to the effects of tariffs), which then spreads to other agents (firms, consumers), and positive loop feedback only enhances the effect. The Fed is now trying to stabilize expectations and particularly illustrative for this are the comments of the President of the Federal Reserve Bank John Williams, who said recently that the Central Bank cannot react to every whim of the markets.

In general, the following situation arises: the market prices in one incomplete rate increase in 2019 and the beginning of a new easing program (QE4) in 2020. Then the Fed will have to begin to soften credit conditions in the economy, as expectations of a new wave of recession rise due to fading fiscal impulse, the effects of trade tensions and a seemingly deadlock state in the oil market.

In the short-run, hopes to remain for wage growth, data on which will be released today. The monthly wage change is expected to be at the level of 0.3%, the number of jobs – 198K, unemployment – at the level of 3.7%.

Please note that this material is provided for informational purposes only and should not be considered as investment advice. Trading in the financial markets is very risky.
 

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November US CPI may follow lackluster wages, Fed to call off March rate hike

The Asian and European markets rose on Wednesday thanks to positive comments from the US president regarding the trade deal, freeing Huawei top manager Meng on bail. The major source of gloom remains the risk of ousting British Prime Minister May, what threatens to thwart Brexit plans.

In an interview with Reuters, Trump said that the US government is conducting trade negotiations with China over the phone, and the new tariffs will not be introduced until certain results on the deal appear.

Trump decided to intervene in the Huawei case, under with the provision that non-intervention poses a threat to national security. This moment has yet to be clarified, but even now it allows the markets to downplay the risk of an escalation of the conflict with China.

A Canadian court decided to release Meng on bail, although, according to tentative information, he refused to do so, given severity of the charges and difficulty of determining the correct amount of bail. Keeping Meng in custody forced the markets to include the consequences of China’s “stern response” in the asset prices, but now it allows them to count on positive developments, in particular, on the trade deal.

The news background has improved enough to allow global markets to start trading on Wednesday with a correction, after a weak start at the beginning of the week. The MSCI broad Asia-Pacific index added 1.2% on Wednesday, while the positive attitude was clearly visible on the Chinese stock market.

China has already shown the will to cooperate, considering the reduction of tariffs on car imports from 40 to 15%. On the other hand, it can hardly be called a serious concession, given that the authorities are trying to boost consumer demand in the context of weakening the main driver of growth – production.

Negative expectations regarding the trade deal are fueled by news that several state agencies in the US are going to publish a report on China’s wrongdoings in commercial espionage and hacking. On the other hand, the government already has this information, so without specific consequences (for example, sanctions or indictments) the publication of evidence is unlikely to lead to an escalation of the conflict.

In the foreign exchange market, the pound sterling is down to the lowest level for 20 months against the dollar amid speculation that the conservative party may put forward a vote of no confidence in May. The likelihood of such an outcome increased after May moved the vote on Brexit, fearing its failure. In the event that May loses her seat, a supporter of hard Brexit will probably come to power, who may even initiate a second referendum. The pound is significantly oversold and barely holds above 1.25 on negative expectations, so any news about the trade-off will allow the British currency to materially strengthen.

Consumer inflation data for November are due later today. There is a significant risk of a negative surprise, considering that the data on wage for the past month did not meet expectations. Wage growth increased by 0.2% in November against the forecast of 0.3%. The early weakening of pressure in prices will strengthen speculation that the Fed will postpone rate hikes in 2019. The chances for the March rate hike are low, currently staying nearly 26%.

Oil prices rose after the API data pointed to a significant (-10M) decline in US commercial reserves, suggesting that a sharp decline in prices forced producers to slow down production pace. WTI rose cautiously on Wednesday by half a percent.
 

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BoE is likely to keep defense in the absence of political certainty

Non-farm payrolls released on Friday created a mixed impression about the state of the US labor market: demand for labor force grew significantly, which led to an increase in the number of new job openings by 304K in January (the biggest jump in almost a year), while the number of layoffs increased too, especially temporary, which left their footprints in the trend of jobless rate. The number of unemployed for the period surveyed increased to 6.5 million in January, or 4.0%.

In part, the unemployment was affected by the shutdown of federal government. Civil servants who were sent on unpaid leave at the time of the survey were temporarily out of work, but were included in the number of employed persons, because, albeit with a delay, they will receive a salary for the days of government holidays. It’s a bit more complicated with federal contractors, with whom the government has no hard-binding obligations: employees of the firm-contractors who lost their job were counted as unemployed. In general, the government shutdown as a factor affecting employment was worthy of mention in the BLS report. Therefore, with the government back into work we can observer positive impulse in employment in February.

Wages grew by only 0.1%, which is far from the market’s expectations and the Fed (0.3%), so the Fed’s balance of expectations may start to shift towards caution. However, only persistence of weakness in wages will be able to verify the assumption; accordingly, the pressure on the dollar after the data was very transient.

Meanwhile, the dollar has completely reverted the drop after the Fed statement in January:




The probability that the Fed will leave interest rate in the current range of 225-250 this year fell from 97% to 91% on Tuesday. Talking about reassessment may be still premature, but realization of this outcome could be very rewarding. You can read more about this here or here.

Consumer spending in the UK went on the mend in January after a season of modest spending in November and December. The rise in savings rate may be also promoted by the uncertainty associated with Brexit.

According to KPMG, retail sales increased by 2.2% last month, after lackluster December, the weakest for 10 years. Barclaycard figures also showed that card spending rose by 2.9%. According to the company report, buyers made holiday purchases in advance in November to take advantage of discounts. Sacrificing Christmas traditions to the desire of saving by conservative Britons speaks either of a drop in the income or greater risk aversion associated with leaving Britain from the EU. The second option is more likely, since the incomes of the British are growing at a pace higher than inflation:


In January, discounts continued to stimulate sales, but it is unclear whether the momentum will last without price support. The Barclaycard report showed that consumers are worried about rising prices and the purchasing power of money, so they changed their consumption profile so that it now characterizes the financial stress of the British. In particular, expenses in supermarkets have increased at the highest rates since April 2017, when there was a peak of the negative mood associated with Brexit.

The pound is defending the level of 1.30 while being caught in bearish trend for about a week. The local highest point was reached on January 27 at 1.32, the rally was ensured by the news indicating support and strengthening of May’s control over the government. There is only about two months left until the UK’s deadline for leaving the EU, and it is clear that the pressure on the pound will grow due to the lack of news indicating progress. A potential surprise that will allow the pound to advance will be the postponement of the Brexit deadline. In the short term, GBPUSD short position looks reasonable, after retracement from 1.30. The soft comments of Bank of England boss Mark Carney this week increase the likelihood of such a scenario, as the Bank is likely to make a classic move, preferring to take a defensive stance in the absence of political certainty.

Please note that this material is provided for informational purposes only and should not be considered as investment advice. Trading in the financial markets is very risky.
 

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Swiss franc flash crash – PBOC fills banks with liquidity

A month later, after various spikes ranging from tens to thousands pips in pairs with the yen, lira and sterling (and this happens on the most liquid foreign exchange market!), swiss franc joined the party on Monday. A collapse of the franc against dollar, yen and euro “surprisingly” coincided with the highly illiquid Asian session, and the day when Japan is closed for holidays. Dealers did not fail to take advantage of the opportunity to hunt for stop loss of the large bulls of the franc. They did succeed in this which, in fact, intensified the crash of franc:


As a result of the “raid on the franc buyers camp”, USDCHF jumped from 0.9% to 1.0096, but after having completely eliminated the effects of the movement, having gone below 1.000. CHFJPY was losing less, about 0.4%, EURCHF also reached 1.14081 for a very short period of time, before returning to the previous equilibrium range.

The recovery of the franc to the pre-crash trading range hints that the drop was not driven by some shift in fundamentals, i.e. it was not preceded by the release of any important news or events.

Asian markets started the week at minor loss, as in the last week they didn’t get favorable updates on the course of negotiations between the US and China. Trump tied market expectations to his own will, saying last week that only a personal meeting with Chinese leader Xi would be able to resolve major trade differences.

It is also curious to observe the movement of the mainland and offshore yuan today. Despite the sale of the mainland yuan to 6.78 per dollar (+ 0.55%), CNH, on the contrary, increased, although it is usually more sensitive to negative expectations, if any. The reference rate was set today at 6.7495. The Chinese are celebrating the lunar new year, which is traditionally associated with an increase in consumer spending, which means an increased demand for cash, so the PBOC probably is now taking appropriate measures to fill banks with liquidity. It is worth considering this as, the factor pushing the yuan lower, and behind it the gold. Recently, a correlation has reappeared between them:

This week, there should be data on monetary aggregates and lending rates in China, which will shed light on the implementation of plans to stimulate the economy in response to a fall in export and production growth rates. Global risk aversion may increase this week if export and import data for January does not meet expectations in China. I remind you that now, China’s trade with partners is experiencing a kind of “exhaustion” after Chinese firms rushed to ship goods in the third quarter of last year to avoid tariffs. Then, export grew amid reduced production volumes and it is clear that the business inventories were the “fuel” for export growth. The pace of their refilling is likely to have a negative impact on export statistics in January, as well as in the following months.

The European Commission last week sharply lowered growth forecasts for the Eurozone this year and next, Trump said he has no plans to meet with Xi before March 1, i.e. the date of introduction of new tariffs. That automatically makes relevant the scenario of a new round of tariffs. As a result, the dollar returns itself the status of the best safe heaven out of the worst that it is likely to use it this week.

Please note that this material is provided for informational purposes only and should not be considered as investment advice. Trading in the financial markets is very risky.
 

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When everybody sells, who buys? Who is supporting the US equities now?

The US stock market and the Chinese yuan soared on rumors that President Trump is considering the option to move the deadline in negotiations with China, presumably by 60 days.

In Twitter, Trump was deliberately reluctant to shift the deadline, saying that his decision is subject to the progress in negotiations. On the one hand, Trump’s announcement is a bullish signal, since in fact the new round of tariffs will be postponed, on the other hand the delay means that the progress of trade talks is basically in the same state as it was 2 months ago. Also, the effect of 10% tariffs will last more and the possibility of their early end (that is, the first of March) becomes a less realistic outcome.

One of the few leading indicators of sentiment in global trade is the Baltic Dry index. It is an aggregate estimate of the cost of transporting raw materials by sea. With the introduction of US tariffs last year, the index began to slide, reflecting the slowdown in global trade, and since January, the index decline has accelerated as the possibility of trade truce has remained extremely unclear, despite the flow of assurances from Chinese and American officials that they will make every effort to strike the deal.


The Index movement also depends on oil prices. If fuel costs are reduced, the freight is also getting cheaper. Therefore, part of the downward movement in the index is due to drop of prices in the oil market.

The US stock market finds itself in an interesting position. According to Bank of America, all three groups of investors – hedge funds, professional and private clients have been net sellers of stocks for the past two weeks. From a set of investment alternatives, stocks in the US stock market were considered the worst for all of January, while sovereign debt of emerging markets was the most preferable.



Nevertheless, the US stock market was not only able to recover from a fall but made unprecedented upturn since January 1987. Since the beginning of the year, the S&P 500 dynamics have become the second in terms of recovery rates since 1990, earning investors more than 10% of capital gains in less than a month and a half:



A reasonable question arises: who buys when everyone sells?

There is one driver which was in the lead last year and will probably be the basis for a stable (or even bullish) market in 2019 – share repurchase. Last year, the managers had been backing market caps of their firms burning almost $1 trillion (including money received through tax breaks). But since the beginning of this year, the companies have already spent 78% more funds to repurchase shares than they did in the same period last year.

Investors also prefer share buybacks instead of dividends, since capital gains are taxed less than dividend payments. Thus, US law encourages long-term investment in the stock market (after all, return on capital is “more deferred”), and for companies this is less stressful in decision-making because the dividend policy is a less flexible tool to reward investors than repurchase (usually, increasing dividends is a “commitment” to maintain them at a new level for a long time). Directing retained earnings to share repurchases also means the lack of investment prospects from companieswhat is another sign of the coming weakness in the future.

It seems that the return of the S&P 500 to the lows of 2018 and the QE4 from the Fed could only a matter of time.

Please note that this material is provided for informational purposes only and should not be considered as investment advice. Trading in the financial markets is very risky.
 

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Two ECB officials see bearish shift in the policy if weak growth persists

Several ECB policymakers made comments on Friday and Monday that were disappointing for the euro. On Friday, Benoit Coeure, a member of the ECB’s executive committee responsible for markets, said that the European banks may need additional money injections in the form of a fresh TLTRO round. In simple terms, these are long-term loans to banks at a preferential rate, which banks must then direct exclusively to lending to households and firms. The first round of TLTRO was held in 2016 with 4-year maturity loans, the money was received by banks that showed “distinguished” lending performance, instead of a search for arbitrage opportunities which ECB of course doesn’t appreciate. TLTRO is essentially a channel for the transmission of monetary policy, because a decrease in the ECB rate should be conveyed to the economy as lower loan rates, but banks are not always interested in this, since a shrinking interest margin forces them to hunt for yields and the economy with weak demand for loans or ability to repay loans (higher risks) is not profitable “point of delivery” of cheap money.

Earlier, Draghi complained that banks used “targeted” credit money for other needs, so they won’t be in a hurry with the new TLTRO. At the last meeting, he declined to discuss a new round of such funding, which disappointed the banking sector. Now, a turnaround is looming on this policy measure, and this may mean that the ECB will sacrifice with its efficiency as the growing slowdown in the economy and the deterioration of growth forecasts require additional easing actions.

The eurozone economy often upsets markets and policymakers, as can be seen from the growing number of negative economic surprises over the past six months.

Coeure also noted that the ECB’s economic slowdown is becoming “clearer and broader” and the inflation trajectory is also at risk. Monetary policy should “adapt” to new challenges, he said.

After Coeure’s comments on Friday, the euro went down sharply, touching on the 1.1250 mark against the dollar, but paring losses by Monday, bargaining around the 1.13 mark. The stock index of banks from Euro Stoxx also strengthened on Friday, bringing the weekly growth to 4%.

ECB Governing Council member Villeroy said on Monday that the slowdown in the eurozone economy is becoming significant, so the monetary policy guidance may change if it turns out that the nature of the downturn is persisting. The weakness of the economy came as a surprise to policymakers, since Italy was already entering recession, and Germany barely escaped this fate.

Responding to a question about whether weak economic reports would be a reason to reduce the rate, in an interview with the Spanish newspaper El Pais, Villeroy said that if the data indicates a steady recession without a rebound perspective, then a change in the rate is possible.

So, already two officials of the ECB expressed the opinion that economic challenges may require a U-turn in the policy. It should be noted that, according to previous statements, Coeure is distinguished by a hawk-like approach to politics, while Viléroi takes the position of a “centrist” with “dove” elements.

Based on the negative reaction of the euro to the statements of officials, its growth against the dollar is under threat and the downward movement is likely to resume this week.

Please note that this material is provided for informational purposes only and should not be considered as investment advice. Trading in the financial markets is very risky.
 

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“Secret buyer” of illiquid Chinese housing


With China’s economic transition from production to consumption rails, Chinese authorities are faced with the task to uphold consumer optimism, which, apart from current incomes also depends on the market value of their assets (wealth). Unlike in the US, where the stock market is a barometer of consumer confidence, economic decisions of Chinese households and firms are quite sensitive to real estate prices since for households it represents the biggest asset in their balance sheet:



Firstly, this is the result of the lack of other investment instruments and undeveloped financial markets. Secondly, the fiscal budget of China’s municipal authorities strongly relies on the proceeds from the sale of land and they use future revenues from land sale as collateral for financing by the government. Third, firms use real estate as collateral for loans, and therefore also prefer to keep it as an asset.



The government has realized the importance of stable house prices, therefore, they “inflate the bubble” from time to time, especially during the time of emergence of a strong imbalance between supply and demand. Such attempts were successful in 2011 and 2014, when another important driver of the economy, production, made up for the decline in such a component of GDP as residential investment. However, the last episode of weakness of Chinese economy which is characterized by a marked drop in production activity limits potential of past successful measures:



In the years when production activity was in the phase of expansion, the government could confidently pursue economic goals of the party by spending huge amounts of money on infrastructure and urbanization, which also supported the growth of capital investments of companies getting direct benefits from government expenditures. In the best traditions of the Keynesian idea of the government role state in maintaining growth, China built bridges, airports, roads and “ghost cities” which still miss their inhabitants:



But well, for Marxist-inspired Chinese officials, ghost cities can be simply a part of long-term government plan. The process of urbanization in China may not be fully based on market signals (i.e. prices), since the rapid increase of urban population can be a strategical goal for the government. Command methods can prevail in the block of macro-decisions, including regulation of the process of migration from villages to cities. The question is how long the state will be able to bear the burden of illiquid housing stocks.

In 2017, the number of vacant homes was 22% or 50 million, which is the highest among the major economies:



In mid-2016, the real estate bubble in China reached another peak, but then authorities managed to partially control the fall in prices, deflating the price bubble in Tier 1 cities and supporting a moderate price increase in other regions:



However, the calculation of house price inflation in China can be tricky. In addition to the notional regions’ taxonomy based on their administrative and economic importance (Tier 1, Tier 2, etc.), the urbanization process involves improvement of living conditions in a city, which creates a kind of “qualitative price inflation”. That is, if the price of a house rose 10% over the month, this does not always mean that inflation was 10%, since part of the price change fell on the growth of “intrinsic value” (improved infrastructure, newly created jobs near home etc.)



Taking into account the behavioral factors of the Chinese, investment needs, as well as speculation motive, the government attempts to stabilize real estate market which are accompanied by a strong amplitude of price fluctuations, as can be seen on the chart above. On the one hand, depriving the public of the fancy of endless price growth easily triggers a chain of panic sales, and demotivates potential buyers, including speculators (a sharp bias towards supply). On the other hand, the rise in prices as a result of artificial absorption of the supply by the government forces young buyers out of the market but begins to attract speculators. Recent decline in production activity, in turn, can be reflected in a decrease in the demand for rental housing, which can be an argument for potential rentiers to sell the house, increasing pressure on the market.



Attempts to withdraw excess supply by ordering municipal governments to buy surplus from developers lead to the price inflation outpacing other regions without government support:



Once a major buyer of housing in the province of Bengbu became the government, speculators were quick to jump in benefiting from state guarantees what drove prices up quickly. The program for buying out illiquid housing is planned to continue up to 2020 in 200 cities, but in cities with obvious speculative trends, such as in Shanghai, the right to determine prices is granted to the market.



Brief summary:

– More than 50 million uninhabited houses and apartments in China;

– The volume of mortgage loans increased 8 times in ten years;

– Government buys surplus real estate to support the market;

– Prices in developed cities are falling, the discount from developers reaches 30%.

It is obvious that China will have to continue to bear the burden of the “principal-agent” problem, which seems to be eternal for the command economy.



Please note that this material is provided for informational purposes only and should not be considered as investment advice. Trading in the financial markets is very risky.
 
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