Asian currencies under pressure

The close to 1% drop in the USD index over recent days is misleading in terms of the USD’s performance against emerging market currencies where it has registered strong gains. For example the ADXY (Asian USD index) has dropped to its lowest level since early September 2013 and looks set to decline further as Asian currencies face more pressure. The best performers in this environment are traditional safe havens, especially JPY and CHF while the EUR and Scandinavian currencies have also capitalised on the weaker USD.

The drop in the USD against many major currencies reflects the fact that positioning had reached extreme levels prior to the sharp moves at the end of last week. For instance, net long USD speculative positions (according to the CFTC IMM data) had risen to the highest level since June 2013 while in contrast EUR positioning had dropped to its lowest since July 2013. The subsequent position adjustment will have proved to be a healthy correction that will set the USD up for an eventual rebound and the EUR for a sell off.

The sharp drop in US Treasury yields will undermine the USD further in the near term, however, and the mixed slate of US data releases will offer the currency little assistance. Nonetheless, the USD is expected to stay firm against Asian currencies. Notably capital flows from Asian equity markets have increased over recent weeks, with Philippines, South Korea, and Thailand on track to register outflows for the first month of the year. Against this background it is unsurprising that both the KRW and PHP are the two worst performing Asian currencies so far this year. While I expect a reversal in both, the near term outlook is for further pressure.

US dollar pull back to prove short lived

Having spent the tail end of last week in Singapore and Phnom Penh presenting the Global outlook for 2014 to clients as part of our Asian roadshow it struck me that there is a strong consensus view about a number of market movements this year. In particular, most expect the USD to strengthen over 2014. Indeed just as it looked as though the USD was going to surge into the new year, along comes the US jobs report to spoil the party. Clearly, it’s not going to be a one way bet in 2014.

The surprisingly weak US December payrolls data in which only 74k jobs were added compared to consensus expectations of close to 200k helped to support expectations that Fed tapering would take place only gradually, lending a helping hand to risk assets at the turn of this week.

I don’t believe the jobs data materially changes the picture for the Fed. Adverse weather may have played a role in the weakness in jobs while complicating matters was the drop in the unemployment rate to 6.7% largely due to around 350,000 people leaving the labour force. The data resulted in a drop in US bond yields and a weaker USD although equity market reaction was more mixed. Meanwhile gold and other commodity prices rose.

While risk assets may find some support in the wake of the jobs report this week much of the US data slate will if anything highlight that economic growth is strengthening, suggesting a reversal of some of the price action in US Treasuries, USD and gold. Data releases include a likely healthy increase in core US retail sales in December together with gains in manufacturing confidence surveys (Empire and Philly Fed) and industrial output as well as a further increase in consumer confidence (Michigan sentiment survey).

Additionally several Fed speakers are on tap over coming days, which may give more colour on Fed thinking in the wake of the jobs report. However, it is doubtful that they will indicate that the Fed will not taper as expected in January.

Clearly markets were caught overly long USDs last week as reflected in CFTC IMM speculative positioning data as of 7th January which showed that net USD long positions had reached their highest since September 2013. The pull back in the USD is set to be short lived, however, especially if US data over coming days reveals further improvement as expected.

USD/JPY in particular bore the brunt of the pull back in US yields, as long positions were unwound. A Japanese holiday today may limit activity but much will depend on the propensity for US yields to bounce back, with 10 year US Treasury yields currently around 2.85% compared to around 2.97% on Friday.

Asian currencies have been the most sensitive to US Treasury yields gyrations over the past three months. In order of sensitivity to US 10 year Treasury yields the highest is the JPY, followed by MYR, THB, PHP and SGD. These currencies would be expected to benefit the most in the wake of the drop in yields at the end of last week although as noted any pull back in US yields is likely to prove temporary. While the THB may suffer from political concerns in the near term the other currencies are likely to see some short term gains.

Fed pulls the trigger

The guessing game is finally over as the US Federal Reserve took a major step away from the extremely easy policy conditions implemented since the financial crisis by tapering its asset purchases by USD 10 billion, split equally by reduced Treasury and mortgage backed securities purchases. Indeed the Fed finally put markets out of their misery but successfully massaged the market reaction.

The Fed is set to gradually reduce asset purchases over coming months, likely ending its QE program by late 2014. The decision was supported by most Fed officials but to soften the blow the Fed strengthened its forward guidance, helping equity markets to rally while encouraging the short end of the curve.

Conversely Treasuries came under pressure and yields rose, giving a boost to the USD. Markets are likely to digest the news well in the Asian session following the lead from US markets. Nonetheless, while the Fed decision was predicated on stronger growth, the decision will presage a competition for capital especially among emerging markets.

The biggest FX reaction unsurprisingly (given its greater sensitivity to US yields) came from USD/JPY, with the currency breezing past the 104 level. However, given that US yields have not pushed significantly higher in the wake of the Fed tapering decision the boost to the USD will be limited in the short term. Indeed, FX markets will likely digest the Fed news will little reaction both in major and emerging market currencies in the short term.

Further out, the prospects for contrasting policy stances between the Fed, ECB and BoJ imply that the USD will forge higher against the EUR and JPY as well as other major currencies. Meanwhile, highly correlated currencies with US Treasury yields, in particular in the emerging markets spectrum, including INR, TRY, and BRL, will be the most sensitive to an expected rise in US yields over the coming months.

Awaiting the Fed

Another positive day for US equities overnight reflected the ongoing gradual but steady improvement in risk sentiment. The USD also managed to shake off some of its malaise, rising against most major currencies although US Treasuries continued to flat line. Data in the US did little to change expectations for the Fed FOMC policy decision tonight; headline retail sales dropped (-0.1%) in September but core orders looked healthier (0.4%), while US consumer confidence slipped by more than expected in October (71.2) and US house prices rose (0.93%) in August.

Direction will be limited ahead of the Fed outcome where markets hope to garner some clues on the timing of the beginning of tapering. However, given that the consensus has clearly shifted to a March 2014 beginning of tapering it is difficult to see how the Fed could build on already dovish market expectations. Ahead of the Fed decision we will be able to assess further evidence on the state of the private sector jobs market, with October ADP jobs scheduled for release.

Given the risk / reward around today’s Fed meeting we remain constructive on the USD, with further albeit gradual recovery ahead. Indeed, it is encouraging that the EUR failed to hold onto gains even after ECB member Nowotny effectively gave the green light for further EUR strength when he noted that policy makers `have to live with` a strong EUR. EUR will continue to look a sell on rallies above 1.3800.

Nototny’s sanguine tone is not shared elsewhere as reflected in attempts by RBA Governor Stevens to talk down the AUD this week or by NZ’s central bank, noting that the strength of the NZD could give scope to delay interest rate hikes. GBP also seems to be failing to shake off the after effects of relative dovish comments by Bank of England MPC members over recent days. The overall winner appears to the USD especially as a lot of dovishness is already priced into the currency.

The USD is also set to take a firmer tone against Asian currencies over the short term. Asian currencies most sensitive to USD strength are SGD, MYR and PHP and these currencies will be most exposed in the short term to further downside risks. IDR also looks vulnerable given the continued outflows of equity portfolio capital from Indonesia over recent weeks (month to date outflows USD 175 million). KRW looks more stable although disappointing September industrial production data released this morning will put a firm cap on the currency.

Bernanke awaited, RBI stays on hold

Central banks are very much in the spotlight. Whether it’s poor communication or disappointment over the lack of fresh stimulus measures in Japan or opposition to the European Central Banks’ (ECB) OMT policy being debated in the German constitutional court there is much to focus on. Against the background of heightened volatility and elevated risk aversion the Fed FOMC meeting on Wednesday will garner even more attention than usual.

Although no change in policy settings is expected the ability of Fed Chairman Bernanke to communicate effectively the Fed’s strategy over ‘tapering’ will be crucial to determine whether market volatility persists or lessens. Ultimately markets are likely to successfully transition to a world of reduced Fed asset purchases but this may take a while. In the meantime market stress is set to remain elevated.

Aside from the Fed FOMC meeting US data releases are likely to continue to show encouraging signs of housing market recovery, with US May housing starts and April existing home set to reveal gains. Meanwhile, CPI inflation will remain benign in May while the June Empire manufacturing survey today will reveal a slight improvement.

In Europe, there will be attention on a Eurogroup meeting on Wednesday where banking union will be discussed while data releases include the June German ZEW investor confidence survey (slight drop likely) and the flash estimates of June purchasing managers’ indices. These are likely to look less negative although they are set to remain in contraction territory. In Japan, May trade data will likely show a widening in deficit as weaker external demand outweighs the impact of a weaker JPY.

In FX markets USD selling against major currencies is likely to slow. The 4.4% drop in the USD index from its highs in late May has been rapid but it has led to a major shift in positioning. Speculative USD long positions have been cut back significantly, while EUR positioning is almost back to flat after being extremely short in previous weeks. Similarly JPY short positions are beginning to be pared back. I suspect that the EUR in particular will struggle to make much more headway.

Weakness of the USD against major currencies has contrasted sharply with USD strength against emerging market currencies. The sell off in Asian currencies has been particularly sharp although there was some tentative recovery towards the end of last week. The INR followed by the most risk sensitive currencies including PHP and THB have suffered the most over recent weeks.

The INR’s vulnerability has been particular high due to its external funding requirements although it may show some tentative signs of recovery over coming days as its sell off has looked overdone. The Reserve Bank of India policy meeting today offered no help for the INR. Although it was a close call there was a significant minority looking for a rate cut to boost growth. The lack of action will weigh on the INR in the short term.

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