JPY selling momentum slows

Markets have few leads to trade off following yesterday’s President’s Day holiday in the US. Nonetheless, caution appears to be settling in ahead of this weekend’s Italian elections, especially in Europe.

European Central Bank President Draghi’s address to the EU parliament did little to stir markets as he didn’t elaborate much on his post ECB press conference in February. The most notable comment was that he urged the G20 to have very “strong verbal discipline” on talking about currency movements.

Despite the Italian election caution most risk measures appear to be well behaved. Equity volatility has continued to drop and gold prices have stabilised following the recent sharp decline. The highlight of the data calendar today is a likely gain in the February German ZEW survey.

Currency markets are rangebound but it is notable that USD/JPY has struggled to sustain gains above the 94.00 level, with upward momentum in the currency pair appearing to fade. Comments by Japan’s Finance Minister Aso that the government was not considering changing the central bank law at present or buying foreign bonds helped to dampen USD/JPY.

Although the G20 meeting effectively gave the green light for further JPY declines, a lot is in the price in terms of policy expectations and any further JPY weakness is likely to be much more gradual. USD/JPY 94.46 will offer strong resistance to further upside.

Asian currencies continue to deliver a mixed performance, with JPY sensitive currencies including SGD, KRW and TWD remaining on the back foot. The SGD is the most highly correlated Asian currency with JPY, with a high and significant correlation between the two. Any further drop in JPY will clearly bode badly for SGD but the inability of the JPY to weaken further may help to moderate pressure on the SGD in the near term.

Although the KRW has rebounded over recent days one risk to the currency is continued outflows of equity portfolio capital. South Korea is one of the only countries in Asia to have recorded outflows (around USD 1.2 billion year to date). However, this month the outflow appears to have reversed, with around USD 500 million in inflows registered month to date. In part the outflows of equity capital from South Korea in January reflected concerns about North Korea. Such concerns have receded but the risks remain of more sabre rattling and/or more nuclear tests from the North.

Sell USD / Asia FX on rallies

The biggest move this year appears to have come from the VIX ‘fear gauge’ which has dropped sharply contributing to an overall improvement in risk appetite. Although the VIX dropped further overnight equity sentiment overall continues to sour as fiscal cliff euphoria faded further and markets brace for the reality of likely protracted negotiations to raise the debt ceiling and avert huge spending cuts.

Caution over a plethora of fourth quarter earnings reports over coming weeks is also limiting upside for risk assets. Economic drivers were thin on the ground overnight but weak German exports data (which likely contributes to an overall decline in GDP in Q4) an increase in Eurozone unemployment and rumours of a French ratings downgrade did not help.

In the US the news was a little better as small business confidence reversed its sharp November drop. A limited data slate today will leave markets focussed on upcoming earnings, with consensus estimates for Q4 at a relatively low 2.9% QoQ.

Asian currencies have registered mixed performances so far this year. Resistance from some Asian central banks, notably Korea, has limited the appreciation of currencies. The incentive to prevent further strength has increased especially as a key competitor the JPY has weakened.

Maintaining its robust performance over 2012 the PHP has been the best Asian FX performer so far in 2013 followed by the THB. Similarly the IDR has maintained its negative performance registered last year. SGD is also likely to underperform further as the currency finds itself being increasingly used as a funding currency for taking long positions in other Asian FX.

We note that risk appetite has a limited correlation with Asian currencies at present but firm capital inflows will continue to provide support, with a sell USD / Asia FX on rallies environment set to persist.

CNY influence on Asian FX continues to grow

Asian currencies remain generally well supported both by a softer tone to the USD in general as well as a stronger Chinese currency, CNY. Since the USD/RMB high of 6.3964 on 25 July the RMB has appreciated by around 2.4% vs. USD. This equates to an annualized pace of appreciation of around 6.2%. The RMB is unlikely to continue to strengthen at such a rapid pace and could even be prone to a softer tone into year end.

Potential renewed weakness in the CNY could presage downside risks to Asian currencies. Also worth noting is the fact that equity portfolio capital inflows to Asian have slackened over recent weeks (Indonesia, Philippines and Taiwan registered outflows over October), a factor that could also pose risks to Asian currencies.

The influence of the RMB on Asian FX has continued to grow. Correlations or sensitivities between Asian currencies and the CNY remain are stronger than Asian FX sensitivities to USD movements. The implication is that USD index gyrations are having less influence on Asian currencies.

The most correlated currencies with the CNY are KRW, SGD and TWD although all Asian currencies with the exception of the INR register statistically significant correlations with the movements of USD/CNY. Notably our quantitative models show that the KRW, SGD and TWD are overbought relative to their short term fair value estimates.

While the USD is still influential in driving some Asian currencies several currencies including KRW, CNY and IDR do not possess a statistically significant sensitivity to the USD over the past 3-months. Should the CNY undergo renewed weakness it will mean that the currencies noted above namely KRW, SGD and TWD will be the most vulnerable to weakness given their high sensitivity to CNY.

Asian currencies at multi-year highs

Asian currencies are stronger in the wake of a sharp improvement in risk appetite following the approval of Greece’s austerity measures. The rally in Asian FX is revealed in the ADXY (an index of Asian currencies) index which is approaching a test of its 2nd May high around 119.26 around its highest level since August 1997. Technical indicators have turned more bullish, with the ADXY breaking above its key moving average levels (20, 50 & 100 day) and the 14-day relative strength index also turning higher.

The Asian FX rally has been led by the KRW, the Asian currency that has had the highest correlation with risk over the past few weeks. Given that risk aversion has dropped sharply since mid June it is no surprise that this currency has strengthened the most. USD/KRW is trading around its lowest level since August 2008. Strong equity capital outflows had kept the KRW on the back foot over much of June but there has been a bounce back in flows recently. However, USD/KRW is likely to find it tough to break below 1060 over the short-term, especially given likely resistance from the local authorities.

The THB, the worst performing Asian currency in June, has rapidly reversed some of its losses. The THB looks set to consolidate its gains following a decisive election result which saw the opposition Puea Thai Party gain control of parliament. The biggest relief for markets was the fact that the outcome was relatively clear cut, suggesting a potentially a smooth handover of power. Nonetheless, the currency has already jumped and after having dropped to around 30.40 from a high of around 31.01 USD/THB is likely to trade off gyrations in risk appetite.

The fact that the USD has lost some ground in the wake of firmer risk appetite and better news in Greece has also allowed Asian currencies to strengthen although it’s worth noting that amongst Asian currencies only the MYR has maintained a significant correlation with the USD index over the past 3-months. In other words, although USD weakness has helped to facilitate Asian currency strength, the recent strengthening in Asian FX is more likely to have been due to a rebound in capital inflows to the region.

Further Asian FX gains are likely over the near term especially as China continues to fix the CNY higher versus USD but given the recent rapid gains in some currencies, there is a risk of growing official resistance and intervention to slow or stem Asian FX gains. Moreover, the end of QE2 in the US suggests that the downside risks for the USD in general are not likely to be as prevalent, with a potential recovery in the USD over H2 likely to stand in the way of strong Asian FX gains over coming months.

Asian currencies vulnerable to equity outflows

Asian currencies are set to continue to trade cautiously. One big headwind to further appreciation is the fact that there has been a substantial outlook of equity capital over recent weeks. Over the last month to date Asian equity markets have registered an outflow of $3.3 billion in outflows. However, whilst Taiwan, South Korea, Thailand and India have seen outflows Indonesia, Philippines, and Vietnam have registered inflows.

The net result is that equity capital inflows to Asia so far this year are almost flat, a stark contrast from 2009 and 2010 when inflows were much higher at the same point in the year. The odds for further strong inflows do not look good, especially as the Fed ends QE2 by the end of June. While a sharp reversal in capital flows is unlikely, it also seems unlikely that Asia will register anywhere near as strong inflows as the last couple of years.

This will have a significant impact on Asian currencies, whose performance mirrors capital flows into the region. Almost all Asian currencies have dropped against the USD so far this month and could remain vulnerable if outflows continue. Given the relative stability of the USD over recent weeks and imminent end to QE2, the better way to play long Asia FX is very much against the increasingly vulnerable EUR.

The THB has been the worst performing currency this month but its weakness has been attributable to upcoming elections on July 3, which has kept foreign investor sentiment cautious. Thailand has seen an outflow of $812mn from its equity market this month. Polls show the PM Abhisit’s party trailing the opposition and nervousness is likely to persist up to the elections at least. THB weakness is not likely to persist over coming months, with USD/THB forecast at 29.2 by year end.

USD/KRW has been whipsawed over the past week but made up ground despite a continued outflow of equity capital over recent days. KRW has been particularly resilient despite a firmer USD environment and a drop in consumer sentiment in June. Next week the KRW will likely continue to trade positively, helped by a likely firm reading for May industrial production on Thursday. USD/KRW is set to trade in a 1070-1090 range, with direction likely to come from Greece’s parliament vote on its austerity measures.

TWD has traded weaker in June, having been one of the worst performing currencies over the month. USD/TWD does not have a particularly strongly correlation with movements in the USD or risk aversion at present but the currency has suffered from a very sharp outflow of equity capital over recent weeks (biggest outflow out of all Asian countries so far this month). Next week’s interest rate decision on Thursday by the central bank (CBC) will give some direction to the TWD but a 12.5bps increase in policy rates should not come as a big surprise. TWD is likely to trade with a weaker bias but its losses are likely to be capped around the 29.00 level versus USD.

Asian currencies – What’s correlated with what?

Asian currencies as reflected in the performance of the ADXY index have been on bit of a rollercoaster ride over recent weeks, dropping sharply in the face of a resurgent USD (note most Asian currencies have had a high correlation with the movements in the USD index over the past three-months) only to strengthen briefly before resuming weakness. Since the end of last month almost all Asian currencies are weaker, with the biggest falls led by MYR, KRW, SGD and INR.

Correlation analysis shows that Asian currencies are not particularly being influenced by yield differentials at present, with only USD/IDR and USD/PHP possessing a significant correlation with 2-year bond differentials. In the case of the IDR there has been a narrowing in the yield differential with the US over recent weeks as Indonesian yields have dropped, a factor that could be undermining the IDR at present.

Similarly risk aversion does not appear to be playing a major role in influencing Asian currencies, with a low correlation registered between my Risk Aversion Barometer and all Asian currencies over the past three-months. However, equity performance is more important for some currencies, with the SGD, THB, PHP, IDR and TWD all having a high sensitivity to the performance of their local equity market. Interestingly the INR is less sensitive to equity performance even though India has recorded heavy outflows of equity capital over recent weeks.

Asian currencies are likely to continue to track the gyrations of the USD in general over the short-term as has been the case over recent weeks but it will not be a one way bet for the USD. Whilst I remain bullish on the USD’s prospects over the medium term I am cautious about the ability of the USD to sustain its currency bounce given that there has not been any back up in US bond yields or any clarification on what the Fed will do after QE2 has been completed.

Against this background I do not expect Asian currency weakness to extend much further. Top picks for the year are KRW and PHP as well as the CNY. In any case given the strong influence of general USD direction on Asian currencies, I suggest playing long Asian FX positions versus EUR over coming months, especially given that the EUR is likely to slide much further against the USD by year end, with 1.30 remaining my target.

Equity Flow Reversal Supports Asian FX

Asian currencies have rebounded smartly from their post Japan earthquake lows on March 16. The ADXY (Bloomberg-JP Morgan Asia Currency index) is now at its highest level since September 1997 reflecting a sharp rebound in capital inflows to the region. The performance of Asian currencies continues to correspond closely with the movement in capital flows.

Although almost all Asian equity markets have registered outflows so far this year (total equity outflows -$6.2bn), the trend is reversing. Over the past month there has been a major slowing in capital outflows for most countries in Asia whilst India, Thailand and the Philippines have actually registered sizeable inflows. South Korea is notable in that there has been a sharp increase in equity capital inflows over the past week.

Although there has been much focus on a rotation of capital flows out of Asia and into developed economies this year, it is worth noting that the pattern of equity flows in Q1 2011 has not been too different from that witnessed in the past couple of years. In both 2009 and 2010 equity outflows were recorded over the two (2010) or three (2009) months of the year before a reversal took place. This pattern looks like it is repeating itself.

Clearly the environment for Asian equity markets is not as supportive as it was last year given the belated tightening in monetary policies being undertaken by many central banks and prospects of an end to QE2 in the US. Whilst this will result in some reduction in capital flows to the region compared to last year, the overall outlook is positive. Easing risk aversion (our risk aversion barometer has already reversed all of its post Japan earthquake spike and is trending lower), positive growth outlook and maintenance of low US rates point to more inflows.

One currency in particular that will benefit is KRW, with a further drop in USD/KRW likely over coming weeks. KRW has already strengthened by around by around 2.7% since its post Japan earthquake low making it the best performing currency since then. Further gains are likely; a test of USD/KRW 1100 is on the cards in the short-term, with the year end target standing at 1050.

Why buy KRW? 1) Korea has registered the biggest improvement in equity capital flows recently, 2) KRW has been the most sensitive Asian currency to risk over the past month and therefore benefits the most as risk appetite improves, 3) Estimated Price/Earnings ratio for Korean equities looks cheap compared to its historical z-score according to our estimates. As a result our quantitative model on USD/KRW based on commodity prices, risk aversion and equity performance highlights the potential for significantly more KRW strength.

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