Currency frictions

I would like to apologise for the lack of posts over the last couple of weeks. I have been on a client roadshow presenting our macro and markets outlook for 2013 to clients across Asia. Having returned the mood of the markets is clearly bullish as risk assets rally globally. Recovery hopes are intensifying as tail risk is diminishing while central banks continue to keep their monetary levers fully open.

A heavy slate of US data releases this week will keep markets busy but overall I see little to dent the positive tone to risk assets over coming sessions. The main events this week include the US January jobs report (forecast +160k) and Fed FOMC meeting (no change likely) while consumer and manufacturing confidence, Q4 GDP and December durable goods orders are also on tap.

In the Eurozone attention will focus less on data but more on Eurozone banks’ balance sheets, with further capital inflows likely to be revealed, marking another positive development following last week’s strong payback of LTRO funds. Elsewhere, industrial production in Japan is likely to reveal a healthy gain while an interest rate decision in New Zealand (no change likely) will prove to be a non event.

As fiscal and monetary stimulus measures are largely becoming exhausted or at least delivering diminishing returns the next policy push appears to be coming from the currency front. The issue of ‘currency war’ is once again doing the rounds in the wake of Japan’s more aggressive stance on the JPY leading to growing friction in currency markets.

In contrast the easing of Eurozone peripheral strains have boosted the EUR, in turn resulting in a sharp and politically sensitive move higher in EUR/JPY. Central banks globally are once again resisting unwanted gains in their currencies, a particular problem in emerging markets as yield and risk searching capital flows pick up. Expect the friction over currencies to gather more steam over the coming weeks and months.

In the near term likely positive news in the form of large capital inflows into Eurozone peripheral banks and sovereign bond markets will keep the EUR buoyed. The USD in contrast will be restrained as US politicians engage in battle over the looming budget debate and spending cuts despite the move to extend the debt ceiling until May.

GBP has slid further and was not helped by the bigger than expected drop in Q4 GDP revealed last week which in turn suggests growing prospects of a ‘triple dip’ recession. The lack of room on the fiscal front implies prospects for more aggressive Bank of England monetary policy especially under the helm of a new governor and in turn even greater GBP weakness.

JPY firmer ahead of Fed decision

The USD has come under growing pressure ahead of tommorow’s Fed FOMC decision. While by no means a done deal the majority of market participants are looking for the Fed to embark on a fresh round of quantitative easing or QE3. The Fed is also expected to shift its guidance to maintaining highly accommodative monetary policy into 2015 from 2014. There is a non-negligible risk of no action at the FOMC meeting which if correct will result in market disappointment, with an attendant sell off in risks assets.

Heading into the Fed meeting, comments by Republican House speaker Boehner that he was ‘not confident’ about reaching a deal with President Obama on avoiding the fiscal cliff as well as renewed warnings by Moodys ratings on the US AAA credit ratings, dealt the USD a further blow. It seems unlikely that the USD will be able to make much of a recovery if the Fed pulls the trigger for more QE. However, it should be noted that with so much in the price, should the Fed not deliver on expectations, the USD may actually bounce.

One currency that has felt the consequences of a weaker USD has been the JPY, which finally broke through the 78.00 level against the USD yesterday. A stronger JPY was greeted with plenty of disquiet in Japan (I’m in Tokyo this week) at a time when economic indicators are turning south. The fact that both the European Central Bank and the Fed are outpacing the Bank of Japan in terms of balance sheet expansion means that any JPY weakness is likely to be limited, with further upside risks to the currency prevailing.

Much will depend on the impact on US Treasury yields from Fed QE. Currently Japanese investors are disinclined to pour money overseas at a time when the yield advantage of US Treasuries or German bunds versus Japanese JGBs is limited. If US yields remain low, the prospects for further JPY weakness will also be limited while the pressure on the Japanese authorities to act to meet their 1% inflation goal and weaken the JPY will grow.

EUR to drift lower, AUD supported, JPY flatlines

EUR/USD has failed to retake the 1.2400 handle and as noted yesterday looks set to gradually make its way lower again. News that the German government lent its support to the European Central Bank (ECB) bond buying plan helped to limit losses overnight, but there is likely to be little news on the policy front over coming weeks as Europe moves into full blown summer holiday mode.

No news is perhaps good news, but market patience continues to run thin and the EUR will eventually be punished should policy makers fail to deliver which has been so often the case. With only German factory orders in terms of data releases of note today, EUR/USD is set to settle into a range, but with a downside bias.

The RBA meeting today is likely to prove relatively uneventful. Almost all analysts polled expect a no change outcome from the Reserve Bank. As this is the largely priced in, the main influence on AUD will be the accompanying statement. The market is overly aggressive in pricing in 75 basis points of policy rate cuts over the coming months and in this respect it will require a particularly dovish statement to validate these expectations.

More likely, the RBA will sound neutral reflecting on relatively firm data (except the June jobs report) releases since the last meeting and a better global environment. Combined with strong attraction to ‘carry’ trades and a firmer tone to risk appetite, AUD looks well supported, with technical support seen around 1.0437.

USD/JPY continues to flat line just above the 78.00 level ahead of this week’s Bank of Japan meeting. There is unlikely to be much excitement from the BoJ meeting but the pressure to take more aggressive steps to reach their 1% inflation goal as well as to weaken the JPY remains strong. The 78.00 level appears to be an uncomfortable equilibrium for markets and Japanese policymakers.

Although low implied FX volatility suggests that there is little expectation of a move in either direction Japanese officials continue to remain concerned about the strength of the JPY. Similarly, the US Treasury bond versus Japanese JGB yield differential (2 year) remains relatively steady, suggesting little directional impetus in the short term. Given hopes / expectations of more Fed quantitative easing it seems unlikely that USD/JPY will make much traction on the upside over coming weeks.

Risk currencies under pressure

Risk aversion continues to edge higher. This spells more bad news for risk/high beta currencies including many highly correlated currencies such as AUD, NZD and emerging market currencies.

Greece’s travails have come back to haunt markets and the inability to form a government puts at risk the whole bailout programme and possibly Greece’s ability to stay within the Eurozone. A failure to form a government will mean fresh elections in mid June and a delay in aid disbursements.

EUR/USD began the European session below the 1.30 level but I’m not convinced its heading much lower in the short term. The fact that the market is highly short (looking at the CFTC IMM data) means that positioning has already become very negative. Moreover, as in past months, there is plenty of inherent demand for EUR below this level. The better option is to play EUR weakness on the crosses.

UK economic news was soft overnight with the BRC retail sales survey plunging by 3.3%. GBP has acted as a semi safe haven against the background of the current Eurozone malaise but the data highlights that the job of the Bank of England is not particularly clear cut. No action is expected at tomorrow’s policy meeting leaving GBP reasonably well supported.

Safe haven currencies remain favoured, leaving the likes of the USD, JPY and CHF well supported. My quant models point to more short term downside for USD/JPY with a further decline below 80 remaining in place. One other currency that looks relatively attractive is the CAD. Relatively favourable fundamentals highlight the potential for CAD outperformance on the crosses

AUD downside remains intact and a drop below parity with the USD looms. A relatively austere budget after Prime Minister Gillard dropped a corporate tax cut has opened the door to potentially bigger easing from the RBA. While a lot of easing is already priced in the market will react by pricing in more cuts. Moreover, with a likely soft jobs report expected tomorrow and AUD’s susceptibility to risk aversion it all spells more weakness for AUD.

Dollar still in a stupor

The increase in the International Monetary Fund’s (IMF) funding by $430 adds another layer of firepower to provide help to the Eurozone periphery should it be required. Nonetheless, many other worries continue to afflict markets suggesting that any positive boost will be short lived. There are plenty of data and events this week including central banks in the US, Japan and New Zealand. Additionally US corporate earnings will remain in focus while bond auctions in the Eurozone will also provide direction. I continue to see risk aversion creeping higher against this background.

It is unlikely that the FOMC meeting tomorrow and Wednesday will provoke any change in the currently low FX volatility environment given that policy settings will remain unchanged, with the majority of FOMC members likely to look for the first tightening at the earliest in 2014. The Fed is therefore unlikely to wake the USD out of its stupor and if anything a softening in durable goods orders, little change in new home sales and a pull back in consumer confidence will play in favour of USD bears over coming days. Even a relatively firm reading for Q1 GDP will be seen as backward looking given the slowing expected in Q2.

The EUR will have to contend with political events as it digests the aftermath of the first round of the French presidential elections. The fact that the political process will continue to a second round on 6 May could act as a constraint on the EUR. Various ‘flash’ purchasing managers indices (PMI) readings and economic sentiment gauges will offer some fundamental direction for the EUR but largely stable to softer readings suggest little excitement. Consequently EUR/USD will largely remain within its recent range although developments in Spain and Italy and their debt markets will have the potential to invoke larger moves in EUR.

The JPY is usually quite insensitive to Japanese data releases and this is unlikely to change this week. Key releases include March jobs data, CPI inflation, industrial production and retail trade. Although inflation has moved into barely positive territory the BoJ is still set to increase the size of its asset purchase programme. This will act as a negative factor for the JPY but unless US Treasury yield differentials renew their widening trend against Japanese JGB yields and drop in the JPY will be limited.

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