Catching up with reality

September 18, 2009 — Mitul Kotecha

Markets have had an exhilarating run up over recent weeks.  Since the start of the month the S&P 500 has risen by close to 7%,gaining around 58% from its March low, as the evidence of global economic turnaround has strengthened and the outlook for earnings improved.

Nonetheless, the rally in equities has meant that valuations are starting to look stretched again. For instance the price / earnings ratio on the S&P 500 has risen to its highest level since January 2004, perhaps hinting at the need for a degree of investor caution in the days and weeks ahead.

Other factors aside from the pace of the move also call for some restraint to market optimism such as the potential for escalation in trade tensions between the US and China, the imposition of regulations on banks and the timing of reversal of extreme stimulus measures. 

As the panic has left markets over recent months volatility has eased as reflected in the VIX index which has dropped to around its lowest level since September 2008, just before it spiked massively higher in a matter of weeks in the wake of the Lehman’s blow up. 

This has been almost perfectly echoed in the move in currency volatility, which has dropped to around the levels last seen a year ago for major currencies.  These levels are not quite pre-crisis levels but for the most part pre-date the collapse of Lehman Brothers, reversing almost all the spike in risk aversion that took place from a year ago. 

It is probably not too much of a stretch to state that having expunged the shock of Lehmans and the worst fears about the global economy from measures of risk and volatility the room for further improvements may be somewhat more limited.  This may be countered by the fact that economic data continues to deliver positive surprises relative to consensus, providing fuel for a further rally in risk appetite. 

However, a lot of good news must surely be in the price by now and it is likely that even the most bearish of forecasters has to acknowledge that an upswing in activity is underway. This ought to ensure that consensus forecasts catch up with reality, leaving less room for positive surprises and perversely less support for equity markets. 

The rally in risk appetite and equity markets has taken its toll on the US dollar which has had a gruelling few weeks during which the US dollar index (a basket of currencies versus USD including EUR, JPY, GBP, CAD, SEK and CHF) has hit new lows almost on daily basis.  Any pause in dollar selling driven by a softer tone to equities is likely to provide better opportunities for investors to take short positions in the currency given that little else has changed in terms of USD sentiment.   How far can the dollar drop?  Well for a start the April 2008 low around 71.329 for the USD index beckons and after that its into uncharted territory.

Posted in Asia, China, Currencies, Economics, Economy, equity markets, Financial crisis, US. Tags: , , , , , , , , , , , , , , , . Leave a Comment »

Japanese yen and FX sensitivity to interest rates

September 16, 2009 — Mitul Kotecha

Interest rates have some way to go before they take over from risk aversion as the key driver of currency markets but as noted in my previous post, low US interest rates have played negatively for the dollar. As markets have continued to pare back US tightening expectations and US interest rate futures have rallied, interest rate differentials have moved against the dollar. 

The most sensitive currency pair in this respect has been USD/JPY which has been the most highly correlated G10 currency pair with relative interest rate differentials over the past month. It has had a high 0.93 correlation with US/Japan interest rate differentials and a narrowing in the rate differential (mainly due to a rally in US rate futures) has resulted in USD/JPY moving lower and the yen becoming one of the best performing currencies over recent weeks.

Going forward the strong FX / interest rate correlation will leave USD/JPY largely at the whim of US interest rate markets (as Japanese rate futures have hardly moved). Fed officials if anything, are adding to the pressure on the dollar as they continue to highlight that US interest rates will not go up quickly. San Francisco Fed President Yellen was the latest official to do so, warning that the prospects for a “tepid” recovery could fuel inflation risks on the downside.

This echoes the sentiments of other Fed officials over recent weeks and suggests that the Fed wants to prevent the market pricing in a premature reversal in US monetary policy.   It looks increasingly likely that the Fed will maintain interest rates at current levels throughout 2010 given the massive amount of excess capacity and benign inflation outlook, suggesting that interest rate differentials will play negatively for the dollar for several months to come.

As for the yen its path will not only depend on relative interest rates but also on the policies of the new DPJ led government. If Japanese press speculation proves correct the new Finance Minister may favour a stronger yen which will benefit domestic consumers rather than a weaker yen that would benefit exporters. Against this background, markets will largely ignore comments by outgoing Finance Minister Yosano who said that further yen strength would be detrimental for exporters.

The market certainly believes that the yen will strengthen further as reflected by the sharp increase in speculative positioning over recent weeks; net CFTC IMM long yen positions have reached their highest since 10 February 2009. Although USD/JPY has pushed higher since it’s low around 90.21 the upside is likely to be limited against this background and a re-test and likely break back below the key 90.00 psychological level is likely soon.

Posted in central banks, Currencies, Economics, Economy, Interest rates, Japan, Monetary Policy, US. Tags: , , , , , , , , , , , , , , , , , , . Leave a Comment »

The best funding currency

September 13, 2009 — Mitul Kotecha

The dollar was beaten up over the past week, finally breaking through some key levels against many major currencies; the dollar index touched 76.457, the lowest since September 25, 2008.  The usual explanation for dollar weakness over recent months has been an improvement in risk appetite.  However, this explanation fails to adequately explain the drop in the currency over recent days.   

Although we have seen a multi month trend of improving risk appetite it is not clear that there was any further improvement last week.  On the one hand the ongoing rise in equity markets points to a continued improvement in risk appetite; the S&P 500 recorded its biggest weekly gain since July.  Equity volatility has also declined, reflected by the decline in the VIX index.   

On the other hand, other indicators reveal a different picture.  The ultimate safe haven and inflation hedge, namely gold, registered further gains above $1000 per troy ounce. That other safe haven, US Treasuries underwent the strongest demand in almost 2 years (bid-cover ratio 2.92) for the $12 billion 30-year note auction, whilst the earlier 10 year note auction also saw solid demand (bid-cover ratio 2.77) as well as strong interest from foreign investors.  

The massive increase in bond issuance to fund the burgeoning fiscal deficit continues to be well absorbed by the market for now, whilst the drop in the dollar does not appear to be putting foreign investors off US assets.  The strong demand for Treasuries could reflect a lack of inflation concerns but may also reflect worries about recovery, quite a contrast to the move in equities.

The fact that the Japanese yen and Swiss franc strengthened against the dollar also contrasts with the view that risk appetite is improving.  The yen was the biggest beneficiary currency during the economic and financial crisis but has continued to strengthen even as risk appetite improves.  USD/JPY dropped close to the psychologically important level of 90 last week which actually indicates a drop in risk appetite.  Perhaps the move is more of an indication of general dollar pressure rather than yen strength.  

A likely explanation for the drop in the dollar is that it is increasingly becoming a favoured funding currency, taking over the mantle from the Japanese yen; investors borrow dollars and then use it to take short positions against higher yielding currencies.  US dollar 3-month libor rates fell below those of the yen and Swiss franc for the first time since November, effectively making the dollar the cheapest funding currency and fuelling broad based weakness in the currency.

Although the historically strong relationship between currencies and interest rates has yet to establish itself to a significant degree, ultra low interest rates suggests that the dollar will remain under pressure for a while yet, especially as the Fed continues to highlight that US interest rates are not going to go up in a hurry.

Posted in Bond markets, central banks, Commodities, Currencies, Economics, Economy, equity markets, Financial crisis, Monetary Policy, US. Tags: , , , , , , , , , , , , , , , , , , , , , , , . 2 Comments »

Contrasting messages from bonds, gold and equities

September 8, 2009 — Mitul Kotecha

There is an interesting divergence developing between bond yields, gold prices and the trend in equity markets.  Whilst equities continue to go up, bond yields are falling and gold prices are rising.  Indeed the usually strong relationship between the S&P 500 and US 10 year yields has collapsed to an insignificant correlation around -0.09 over the past month compared to a high correlation of 0.84 in the month to 8 August.  

Rising equities appear to signify an improvement in risk appetite whilst bonds (US 10-year yield around 3.4%) and gold (around $1000 per troy ounce) are giving the opposite message.  So which indicator is correct and why the breakdown in the usually solid relationship?  

Growing optimism about economic recovery and the run of better than forecast data releases suggest that equities are correct but there is growing risk that so much good news is now priced in that we should pay attention to what bond yields and gold prices are telling us.  

Some of the move lower in bond yields can probably be attributed to the wall of liquidity sloshing around due to central banks’ unconventional policy measures.  However, it is still remarkable that despite the plethora of better than expected data releases, bond yields have actually declined.  This may reflect the success of quantitative easing but could also be associated with sustained economic and market fears.    

The commitment by G20 officials last weekend not to reverse stimulus policies prematurely may also have given more confidence in the view that interest rates will not be raised quickly.  Reflecting this 2 year German bund yields dropped to a record low level at the beginning of the week although longer term bond yield have pushed higher in the 30 year area.  The G20 commitment could turn out to be a double edged sword, however.  If there is no commitment to reduce burgeoning deficits, bonds could ultimately take fright.  

If bonds and gold prices are really reflecting safe haven demand then it will pose a risk to the sustainability of any equity rally over coming months.  As equity valuations begin to look increasingly stretched – the P/E ratio on the S&P 500 has reached 18.76 (according to Bloomberg calculations) compared to a low of around 10.00 at the beginning of March 2009 – it will need more to keep the rally going and high amongst the factors needed is some clarity about the pace and shape of growth once stimulus is reversed. 

For currency markets I think it will be difficult to see a trend until there is more clarity about the economic outlook and in the meantime currency markets will continue to stock watch for direction even if the influence of risk appetite is declining.  Even so, the dollar appears to be reacting more to equities than bond movements and is coming under growing pressure as equities rise.  

Many currencies are poised to break out of recent ranges to the topside versus the dollar led by risk currencies such as the AUD, NZD and CAD.  If it turns out that the equity story rather than the bond message is the correct one then the real message is a bullish one for risk appetite and given the dollar’s usually negative reaction to improved risk appetite, it could face further pressure over coming weeks.

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

Addicted to the medicine

September 7, 2009 — Mitul Kotecha

It comes as a relief to markets that G20 officials have agreed it is too early to begin withdrawing massive fiscal, monetary and financial support.   However, it is hardly surprising that officials are not formulating an early exit from emergency measures especially given the ongoing uncertainty about the pace and shape of global economic recovery.  

The latest US jobs report did not help clarify the outlook for markets as a smaller than forecast drop in employment in August (-216k) weighed against a surprise jump in the unemployment rate to a 26-year high of 9.7% and downward revisions to past months employment data.

There is a growing possibility that the Fed’s expectation the unemployment rate will breach 10% by the end of the year looks may be hit even earlier.  Fears about a “jobless recovery” will likely increase as a lack of hiring is set to persist for some time yet. 

The absence of any near term reversal of stimulus measures reduces the risk of a “double dip” recession but at some point there has to be a reckoning. Fiscal positions have blown out for many countries and will eventually require spending cuts, higher taxes and/or privatisation in addition to likely increases in the retirement ages for workers, to rectify them. It is questionable how sustainable recovery will be once such measures begin to be implemented.

In the meantime, it is not even evident that policy is working efficiently. Arguably yields on bonds and corporate debt are lower than they would otherwise have been had it not been for central bank actions but lenders are still not passing the additional liquidity to consumers and households against the background of fears about a rising tide of bad loans and delinquencies.

I would compare this to a patient who came close to death and has finally come off life support as the worst passed but has relied on support in the form of various strong medicines to keep him (or her) going.  The risk that the patient has become overly dependent on the drugs has grown but it is highly unclear how he will fare once he is weaned off.  

Fears about the ability of the patient to stand on his own two feet will increase.  The risk that the patient will relapse is intensifying but his ability to pay for more medicine is already diminishing and his options are running out quickly.

Posted in Bond markets, central banks, Economics, Economy, Financial crisis, Monetary Policy, US. Tags: , , , , , , , , , , , , , . 1 Comment »
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