Is it Too Early To Talk about Annus Horribilis?

One might be forgiven for believing that nail-baiting start to the year is all China's fault. It has repeatedly for eight sessions fixed the yuan lower, including earlier today, at a seemingly accelerating pace. The new circuit breakers, introduced on Monday, appear to be adding to the volatility. Chinese share trading was stopped today after the first hour with the CSI 300 off 7%. It appears that the central bank through its agents intervened in the offshore (CNH) market.

The uncertainty over the intentions of Chinese policy makers, and the opaqueness of the decision-making process, rightfully spooks investors who recall the contagion effect last August. Yet while the China effect is important, it is not the only disruptive force at work, weigh on risk appetites.

The drop in oil prices is a significant and separate development. While some may link the drop in oil prices to China, it is a bit of a stretch. It seems widely understood that the Chinese stock market is only loosely connected to the underlying economy. Recall the spectacular run-up in Chinese share prices in the first part of last year. The economy slowed. Recall the dramatic decline in Q3 15, economic activity was little changed.

No the drop in oil prices cannot be solely laid at the feet of Chinese policy makers. The tensions between Saudi Arabia and Iran make it even more difficult to envision a cut in OPEC output in the middle of the year. Although US oil inventories fell last week, according to the US Department of Energy, the glut was simply shifted to the products. Gasoline inventories, for example, surged by the most in more than two decades. Stocks of distillates, which include diesel and heating oil, rose by the most in nearly five years.

The US rig count is at a five year low, about a third of its peak in late 2014. Output has continued to surprise in its resilience. Output rose to by 17k barrels a day last week, to 9.22 mln barrels a day. This is the most since August. OPEC output has been rising for two years and non-OPEC producers, such as Russia are reporting strong output. This does not yet include the new Iranian output that is expected to exacerbate the glut when sanctions are anticipated to be lifted later this month.

The price of oil fell about 30% last year. It is off another 12% so far this year. In the first four days of 2014, it fell nearly 8.5%. Investors are anticipating a policy response. The drop in oil prices, more than China's yuan and equity developments, have pushed the Canadian dollar to new multi-year lows and has sent the Norwegian krone to its weakest level against the euro since late-2014.

Sterling has been sold to new six-year lows today. The drop in oil prices, in the context of mostly disappointing UK data, reinforces ideas that the Bank of England will be unable to raise rates until much later in the year, at the earliest. To explain the heaviness of sterling, many observers are trying to make connections with the EU referendum later this year. We are not convinced that sterling would be trading much differently if there would be no referendum.

Consider this. From early 2013 through Q3 2015, sterling appreciated almost 22% on the Bank of England's broad trade-weighted index. The decline in sterling over the past 4-5 months has seen the trade-weighted index ease by around 4.5%. This is to say, sterling's weakness against the dollar masks its still elevated levels on a trade-weighted basis.

The price of oil has fallen by a little more than a quarter since the ECB met in early December. The ECB's staff forecast, which saw only minor adjustments from last June's iteration, did not anticipate such a decline. While it is too early to draw any hard conclusions, one can only assume that those forecasts will be adjusted in March to the downside.

After holding Tuesday's low (~$1.0710) yesterday, the euro recovered to almost $1.08, and extended those gains another 3/4 of a cent today. Unwinding positions, such as selling European shares, and buying back short euro hedges, may account for the euro's firmer tone. At the same time, the euro-sensitive two-year swap rates between the US and Germany has edged lower from 142 bp on December 29 to 134 bp today, the lowest since Christmas Eve.

Although the Fed's Vice Chairman Fischer reiterated yesterday that four rate hikes this year was still "in the ball park" failed to impress investors. His comments were understood to show that the Fed was not panicking over the tumultuous start to the year. Some saw the FOMC minutes as dovish in that it talked about the need to actual inflation to increase. The strength of the ADP estimate, which if anything, reduces the risks of a significant disappointment with tomorrow's national figures, also failed to sway the market. The market appears to be more comfortable anticipating two rate hikes this year, not the four that Fed's dot-plots indicated.

Lastly, the Japanese yen continues to shine. The dollar has been sold through JPY118, triggering stops and optionality on the way, to almost JPY117.30. It is the lowest level for the dollar since August 24 when it approached JPY116.20. The yen is up 2.2% this week against the dollar and 2.4% against the euro. The yen's strength has yet to draw a response from Japanese policy makers, but some response would not be surprising. The yen's strength, nearly 5% on a trade-weighted basis over the past month, if sustained, will hamper efforts to boost inflation.

We note that the yen buying has been particularly pronounced in the Asian session, with some consolidation often seen in North America. The intra-day technical warn that the pattern may continue today. The JPY118 level may acts as resistance now.