European economy in a whole lot of trouble

June 11, 2009 — Mitul Kotecha

Concerns about the health of European banks, particularly German banks, and the pace of Eurozone economic recovery have intensified.  Warnings by the European Central Bank’s (ECB) about further financial sector weakness if there is not a “V” shaped recovery reveal the extent of such concerns.  Attention is increasingly focusing on a lack of transparency and the fact that European regulators are not releasing the results of industry wide stress tests in contrast to the recently released results of US bank stress tests.  Such problems have not gone unnoticed in Germany and even the bank regulator in the country said recently that toxic assets at German bank could blow up “like a grenade”. 

It’s worth noting that the IMF’s estimates for future writedowns and capital requirements in its financial stability report suggest that European banks have much more to do than their US counterparts. See an earlier post titled “Stress testing European and UK banks”.   The IMF repeated its warnings this week as it wrapped up its consultations with European officials, whilst US Treasury Secretary Geithner is set to pressure European authorities to carry out tougher stress tests at this week’s G8 meeting.   Germany has taken some steps towards resolving its banking sector problems and this week the German cabinet agreed to support a “bad bank” plan.  Nonetheless, the task will not be easy as Germany is estimated to have over $1 billion in toxic assets, with consolidation of the regionally owned Landesbanken a major concern. 

The prospect of a “V” shaped recovery in Europe is extremely limited.  Warnings about the pace of eurozone economic recovery should be taken seriously.  However, some officials such as the ECB’s Quaden are already talking about an exit strategy, which looks very premature given the likely slower recovery in the eurozone compared to the US over the coming months.  Whilst the US economy is set to see positive growth next year, albeit below trend, Europe is facing a second year of economic contraction.   Moreover, the drop in Eurozone growth in 2009 is likely to be far steeper than the US, with the economy set to decline by close to 5%.  The bigger than forecast 21.6% annual drop in German industrial production in April and the 29% annual drop in April exports released this week provided a timely reminder of the pressure on Eurozone’s biggest economy.  Given the fact that the German economy is still highly reliant on export growth the data were particularly worrying. 

Against this background and with inflation continuing to drop, the ECB is highly unlikely to raise interest rates until the beginning of 2011 at the earliest.  The fact that ECB officials are even talking about an exit strategy seems completely at odds with the reality of the situation.  As it is the ECB’s EUR 60 billion covered bond purchase plan will have a limited impact, and the policy can hardly be labeled as aggressive.  

Even so, there is no indication that the ECB is about to embark on more aggressive credit or quantitative easing.   The latest ECB monthly report predicts that growth in the eurozone will begin to pick up by the middle of next year but admits that inflation could turn negative over coming months.   Surely this will give the ECB further room to maintain easy monetary policy.   Once again disagreements within a 16 nation ECB council will result in compromise at a time when the eurozone economy is crying out for decisive policy actions.   Growth and banking sector concerns will also be a factor that helps to prevent the euro from fully capitalising on any weakness in the dollar.

Posted in central banks, Economics, Economy, Europe, Financial crisis, Germany, Interest rates, Monetary Policy. Tags: , , , , , , , , , , , , , , , , , , . 4 Comments »

Are currency market dynamics shifting?

June 8, 2009 — Mitul Kotecha

There has been a major shift in market pricing for US interest rates following the US jobs report and comments from Fed officials including Atlanta Fed president Lockhart, suggesting that the Fed should not wait too long before tightening monetary policy.  As a result the implied yield on the December 09 3-month eurodollar futures contract has spiked by around 50bps since the middle of last week and markets have now moved to pricing in a US rate hike by year.  This looks wildly premature given the likely absence of inflation pressures for many months to come. 

The most interesting reaction to the shift in interest rate expectations was exhibited by the dollar which has managed to register solid gains over the last couple of days indicative of the past relationship between the dollar and interest rate expectations.  The odd thing about the strengthening in the dollar is that it has come at a time when risk appetite has continued to improve, suggesting that the strong risk appetite/dollar relationship that has been in place for much of the past year could be diminishing in strength.  For instance, the correlation between various dollar crosses and the VIX volatility index has been higher over the last few months than it has been in previous years.   

Admittedly its early days and the bounce in the dollar may just have reflected a market that was positioned very short dollars.  There was already signs of some short covering prior to the release of the US May jobs report as reflected in the CFTC IMM commitment of traders’ report which showed that net aggregate dollar speculative positioning (vs. EUR, JPY, GBP, AUD, NZD, CAD and CHF) improved for the first time in five weeks.  It is not inconceivable that investors have continued to cover short positions over the last few days.  

Nonetheless, it is difficult to ignore the possibility that currency market dynamics may be shifting back towards interest rate differentials as a key FX driver.  Over recent months the interest rate / FX relationship had all but broken down as reflected in very low and insignificant correlations between interest rate differentials and various currency pairs.  This could be changing and as interest rate markets begin to price in higher rates the relationship with currency markets may once again be strengthening.  

The risk for the dollar is that this tightening in US interest rate expectations looks premature.   It seems highly unlikely that the Fed will raise rates this year which points to the risk of a turnaround in rate expectations at some point over coming weeks and months.  In turn this suggests that the dollar could come under renewed pressure in the event of a dovish shift in US interest rate markets.  Even so, this is a factor to consider further out.  Over the next few days such a shift is unlikely and the dollar is likely to hold onto and even extend its gains as markets continue to ponder the probability that the Fed tightens policy sooner rather than later.

Posted in central banks, Currencies, Economics, Economy, Financial crisis, Interest rates, US. Tags: , , , , , , , , , , , , , , , . Leave a Comment »

Is the Asian FX rally losing steam?

June 5, 2009 — Mitul Kotecha

Asian currencies appear to have lost some of their upward momentum over recent days.  Although the outlook remains positive further out, they are likely to struggle to make further gains over coming weeks.  One the one hand strong inflows into Asian equity markets have given support to currencies but on the other hand, data releases reveal only a gradual economic recovery is taking place, with continued pressure on the trade front as seen in the weakness in recent export data in the region.  Even China has been cautious about the prospects of recovery in the country.   

Almost all currencies in Asia have recouped their losses against the US dollar so far this year, with the Indonesian rupiah the star performer, having strengthened by over 11% since the start of the year.  More recently the Indian rupee has taken up the mantle of best performer, strengthening sharply following the positive outcome of recent elections.  The rupee has strengthened by around 3.5% since the beginning of the year and its appreciation has accelerated post elections.   

Much of the gain in the rupee can be attributable to the $4.4 billion of inflows into local equity markets over the last few months, a far superior performance to last year when India registered persistent outflows. Notably in this respect, the Philippines peso is set to struggle as foreign flows into local equities lag far behind other countries in the region.  Inflows into Phililipines stocks have been just $226 million year-to-date as fiscal concerns weigh on foreign investor sentiment.   

South Korea has been the clear winner in terms of equity capital inflows in 2009, with over $6 billion of foreign money entering into the Korean stock market.  Elsewhere, Taiwan has benefited from the prospects of growing investment flows from China and in turn equity market inflows have risen to around $4.3 billion supported by news such as the recent report  that Taiwan will allow mainland Chinese investors to invest in 100 industries.  Equity inflows into these currencies are far stronger than over the same period in 2008, highlighting the massive shift in sentiment towards Asia and emerging markets in general.

Unsurprisingly stock markets in Asia have been highly correlated with regional currencies over recent months, with almost all currencies in Asia registering a strong directional relationship with their respective equity markets.  Recent strong gains in equities have boosted currencies but this relationship reveals the vulnerability of currencies in the region to any set back in equities, which I believe could come from a reassessment of the market’s bullish expectations for Asian recovery.  

Central banks in the region have been acting to prevent a further rapid strengthening in Asian currencies by intervening in FX markets but a turn in equity markets and/or risk appetite could do the job for them and result in a quick shift in sentiment away from regional currencies. The Indonesian rupiah remains one to watch in terms of further upside potential, supported by the Asian Development Bank’s $1bn loan to Indonesia.   The outlook for the Indian rupee also looks favourable as post election euphoria continues.  Nonetheless, the gains in these and other Asian currencies have been significant and rapid and I believe there is scope for a pull back or at least consolidation in the weeks ahead.

Posted in Asia, central banks, China, Currencies, Economics, Economy, equity markets, India, Indian election. Tags: , , , , , , , , , , , , , , , , , , , . 1 Comment »

Backing the dollar

June 3, 2009 — Mitul Kotecha

There has been no let up in the bullish tone to markets over recent weeks. Optimism is dominating. Meanwhile, commodity prices continue to remain firmly supported, with the CRB commodities index up around 30% from its early March low. Bank funding has improved sharply, with indicators such as the Libor-OIS spread moving to its lowest spread since the beginning of February 2008 whilst the Ted spread is now close to where it was all the way back in August 2007.

Conversely, there is not much sign of a let up in pressure on the dollar despite assurances from US Treasury Secretary Geithner during his visit to China. Much of the move in the dollar continues to be driven by improvements in risk appetite but worries about the sustainability of foreign buying of US assets have increased too.

Russia’s proposal to create a new supranational currency has dealt the dollar another blow but it was notable that India, China and South Korea were reported to express confidence in the dollar, stating that there is no alternative to the dollar as a reserve currency. Such comments highlight that despite political motivation to move away from the dollar it is no easy process.

The comments from India, China and South Korea, three of the world’s biggest reserve holders reflect the growing concerns from official accounts about 1) dollar weakness getting out of control and 2) US bond yields pushing higher. Even though foreign central banks will continue to diversify the last thing they want to do is to destroy the value of their massive amounts of US asset holdings so don’t expect a quick move out of dollars from central banks despite the rhetoric from Russia and others.

Russia has said that a debate about the dominance of the USD will take place when BRIC (Brazil, Russia, India and China) countries meet on June 16. Although the rhetoric from Russia may add to dollar worries the reality is that it is highly unlikely that any form of concrete plan will be easily developed to shift away from the dollar. Political motivations aside, even Russian President Medvedev admits it’s an “idea for the future”.

Posted in Bond markets, central banks, China, Commodities, Currencies, Financial crisis, India, US. Tags: , , , , , , , , , , , , , , , . 1 Comment »
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