Dubai’s bolt out of the blue is hitting markets globally, with the aftershock made worse by the thin liquidity conditions in the wake of the US Thanksgiving holiday and Eid holidays in the Middle East. The sell off followed news by government owned Dubai Holdings of a six month debt freeze. Estimates of exposure to Dubai vary considerably, with European banks estimated to have around $40 billion in exposure though what part of this is at risk is another question.
The lack of information surrounding the Dubai announcement made matters worse. The aftermath is likely to continue to be felt over the short term, with further selling of risk assets likely. Indeed, there is still a lot of uncertainty surrounding international exposure to Dubai or what risk there is to this exposure and until there is further clarity stocks look likely to face another drubbing.
The most sensitive currencies with risk aversion over the past month have been the JPY, and USD index, which benefit from rising risk aversion whilst on the other side of the coin, most Asian currencies especially the THB and KRW as well as the ZAR, and AUD look vulnerable to any rise in risk aversion. JPY crosses look to be under most pressure, with the likes of AUD/JPY dropping sharply and these currencies are likely to drop further amidst rising risk aversion.
The rise in the JPY has been particularly dramatic and has prompted a wave of comments from Japanese officials attempting to talk the JPY lower including comments by Finance Minister Fujii that he “will contact US and Europe on currencies if needed”. So far, these comments have had little effect, with USD/JPY falling briefly through the key psychological level of 85.00, marking a major rally in the JPY from a high of 89.19 at the beginning of the week. Unless markets believe there is a real threat of FX intervention by Japan the official comments will continue to be ignored.
It’s not all about risk aversion for the JPY, with interest rate differential playing a key role in the downward move in USD/JPY over recent weeks. USD/JPY has had a high 0.79 correlation with interest rate differentials over the past month. The US / Japan rate differential narrowed sharply (ie lower US rate premium to Japan) to just around 4.5bps from around 100bps at the beginning of August. With both interest rate differentials and risk aversion playing for a stronger JPY the strong JPY bias is set to continue over the short term.
Is this the beginning of a new rout in global markets? It is more likely another bump on the road to recovery, with the impact all the larger due to the surprise factor of Duba’s announcement as it was widely thought that Dubai was on the road to recovery. The fact that the news took place on a US holiday made matters worse whilst the weight of long risk trades suggests an exaggerated fall out over the short term.