Week Ahead: Re-Escalation of Tensions to Aid Greenback

Last week, we warned that the two main sources of tension that had arisen, the Russia's military action in Crimea and the relatively sharp depreciation of the Chinese yuan were going to stabilize. This week, investors should brace for a re-escalation of both.

This comes at a time when the US dollar's weakness appears from a technical analytic point of view, somewhat stretched. The re-escalation of tensions is likely to see the greenback recover against most of the major currencies. The Japanese yen and Swiss franc may also benefit from this shift.

There are four sources of heightened tensions with the Crimean crisis.  First, Russian forces have increased and are consolidating their control of Crimea, and this involves neutralizing Ukrainian bases in Crimea and getting control of communication and transportation, as well as securing borders.

Second, after the Crimean Parliament approved re-joining Russia, it will be presented to the people of Crimea next weekend.  The annexation of Crimea by Russia represents an important escalation of the crisis. Russia's other "near abroad" adventures have not led the absorption.

The US and Europe are also trying to integrate Ukraine more into the Atlantic economic community.  They will not wait for the May elections that will give legitimacy to the now un-elected government in Kiev, to have the Ukraine sign an Association Agreement, which brings the country a step closer to joining the EU.  It is the same agreement that the corrupt but democratically elected President Yanukovych had almost signed and instead, cut a deal with Russia at the last moment.

Third, Ukraine is in arrears to Gazprom by almost $2 bln according to reports.  The Russian company is threatening to raise prices and cut oil and gas deliveries to Ukraine. This highlights the fact that much of the US, EU and IMF monetary assistance to the Ukraine is likely to end up in Russia's coffers.

The fourth source of escalation is the tit-for-tat potential breakdown in cooperation between Russia, the United States and Europe.  Since the fall of the Soviet Union, Russia has been engaged in a wide range of diplomatic, treaty, economic and political agreements that entail varying degrees of cooperation, that survived Kosovo and Georgia, for example, and are now could be unwound.  For example, over the weekend the Russian Ministry of Defense warned that it stops international inspections of its nuclear weapons that are required under the START treaty and a separate agreement with the Organization for Cooperation and Security in Europe.

There are calls for the US to reactivate the ballistic missile defense program that was previously mothballed. Some advocate beefing up NATO forces and sending weapons to Ukraine.   These events are also boosting talk of easing restrictions on US LNG exports, as part of a larger attempt to dilute Russia's energy leverage.    It is the energy sector, broadly understood, to be one of the key industries that may be directly impacted by the geopolitical developments.

The China's yuan and equity markets stabilized last week.  The Shanghai Composite rose for the first time in three weeks, and the Chinese yuan appreciated by about 0.3%, the most in a week, in nearly five months.  However, the weekend news will likely play on fears that the yuan is over-valued and that the economic slowdown is more pronounced.  

Specifically, China reported a large February trade deficit (yes, deficit of $23 bln) and a larger than expected decline in inflation (February CPI 2.0% year-over-year vs 2.5% in January). Exports fell 8.1% from a year ago, whereas economists had expected a 7.5% increase.  Imports rose 10.1%.  The consensus had forecast a 7.6% increase.  The result was the largest deficit in two years.

At issue is the role of the lunar new year.  Some observers argue that it this was the real distortion; it would have impacted exports and imports more equally.  However, this is not necessarily so.  What appears to have happened is that exporters ramped up before the holiday, while importer boosted activity immediately afterwards.  This is consistent with China, not as the factory of the world, as some suggest, but the assembler of the world and its exports being import-intensive.  Yet, in any event, combining the January and February figures, exports fell 1.6%, which appear to be the largest decline since 2009.

Separately, the decline in the pace of consumer price increases brings the pace to its slowest in over a year. What is happening is that non-food prices are largely stable around 1.6%.  Food prices themselves are more divided.  Fruit, vegetables, and grain prices are rising, but meat prices, including pork, are easing.  Fruit prices, for example, rose almost 20% from a year ago, while the price of pork has fallen almost 9%.  China also reported that producer prices fell by 2%, which extends the streak to 24-months in which producer prices have fallen.  In fact, this is the largest decline since last July, and casts doubt the improvement some economists had played up.

The poor export showing and the softer CPI may encourage the view that the yuan is over-valued and that Chinese officials have scope to ease policy to help facilitate the transition it is trying to engineer.  The persistent yuan appreciation that helps take the edge of imported inflation may be less necessary now.  In turn, this is consistent with apparent efforts to introduce greater volatility to deter hot money inflows (which are often disguised Chinese flows themselves) and chip away at the larger moral hazard issues that permeates the financial sector.

During the week ahead, China is expected to report new yuan loans and aggregate social financing for February.  After out-sized increases in January (CNY1.32 trillion and CNY2.58 trillion, respectively), the February increase is expected to be half as much.   Perhaps, the level to watch in the dollar-yuan is CNY6.15.  This is the level of the yuan that some highly leveraged financial products begin incurring losses, according to reports.  Although the dollar had traded above there on an intra-day basis, it has not closed above it since last May.  

Otherwise, in terms of economic reports from the US and Europe, the week ahead if light.  The main US economic report will be retail sales report on March 13.  The headline is expected to have retraced half of January's 0.4% decline.  However, measure used for GDP calculations may show a greater rebound.  After falling 0.3% in January, retail sales, excluding autos, gasoline and building materials, is expected to have risen by 0.3%.

One of our interpretive points has been that, for most of January and February, US economic data was reported below market expectations.  Beginning in late February, but continuing last week, and including the nonfarm payrolls, economic data has begun coming in better than expected.  Two things appear to be happening.  First, economists have adjusted their forecast and now appreciate the extent of the slowdown in Q1.  Second, the impact from the weather is difficult to decipher, but may be in the details, rather than the headlines.  For example, the February nonfarm payrolls rose 177k, which is smack in line with the 6- and 12-month moving averages (177k and 179k respectively), but weather-effect could be seen in the decline in the work week and, perversely, in the increase in average hourly pay.

The main economic report from the euro area will be the January industrial output report.  After the 0.7% slump in December, the market looks for a healthy 0.5% rebound.  The 0.8% increase in the Germany figure bodes well for the regional report.   Separately, we note that the new Italian government is expecting to unveil its new employment initiative and a 2 bln euro plan to ease the lack of housing affordability.  I

Italian debt instruments under-performed Spain on a magnitude last week notable.  At the short-end of the coupon curve, at the end of February, Italy and Spain's 2-year yield was nearly identical, around 75 bp. Last week, the Italian premium, rose to 19 bp as Italian yields rose 12 bp and the Spanish yield fell 7 bp. At the 10-year sector, Italian yields were below Spain's and are now at a 6 bp premium.  

A continuation of this trend in the period ahead could be simply about what we had expected to be the under-performance of Italian assets.  We anticipated some profit-taking after a period of out-performance of Italian assets with the ascension of Florence Mayor Renzi to the prime minister's office by a vote of party, of which he was the leader.  However, the under-performance could also be an early signal of a change in the investment climate.

In the UK, there are two important economic reports, industrial production and trade balance.  The bottom line is that the UK economy continues to expand at a healthy clip.  There was likely a modest gain of 0.2-0.3% in UK industrial and manufacturing output.  The year-over-year rates should illustrate this with a 3.0% and 3.3% respectively.  Growth differentials and a strong exchange rate are forces that are expected to widen the trade deficit.  The growth differentials are obvious, as the euro area's recovery is faint.  In terms o the exchange rate, since last July, sterling has appreciated by 13.5% against the dollar and about have as much against the euro.  

The Bank of Japan and the Reserve Bank of New Zealand meet this week.  The RBNZ is widely expected to hike rates 25 bp.  It is fully discounted by the interest rate markets.  Another 2 hikes are expected this year.  Near $0.8500, the New Zealand dollar has approached the upper end of its ten-month trading range.  We suspect there is scope for "buy the rumor, sell the fact" type of activity.   This is consistent with our expectation of a firmer US dollar.  Technically, there is scope toward $0.8350.  

With the retail sales tax hike set to be implemented at the start of next month, the current real sector data is not very important.  The key is how the economy absorbs the tax hike.   In terms of the BOJ's inflation goal of 2%, the increase in energy prices at the same time the yen is weakening is a favorable development.  Remember, the BOJ's inflation target is on its core measure, which includes energy, but exclude fresh food. 

Separately, but not completely unrelated, the first thing Monday in Tokyo, Japan will report a record current account deficit for January.  The deterioration will be driven by the doubling of its trade deficit. Note that for the past ten years, the current account deficit has widened every January.   Japan will also report an updated estimate for Q4 GDP.  It may be tweaked lower from 0.3% quarterly rate and 1% annualized.  The deflator, though is likely to be confirmed at -0.4% and will be a timely reminder that deflationary forces are still evident.   

If our assessment of the re-escalation of tensions emanating from Russia/Ukraine and China is correct and this does help buoy the dollar and yen, there may also be knock-on effects on the equity markets. The price action warns that the S&P 500 may be losing momentum after setting new record highs.  The Nikkei has approached an important retracement level near 15340.  The DAX finished last week on an exceptionally poor note.  A break below 9320 now warns of scope for another 2-3% decline.  The price action in the FTSE is somewhat similar to the DAX, and key support is seen near 6670.   Core bond markets will likely be supported.