A volatile period of transition

June 4, 2013 — Mitul Kotecha

The drop in the US ISM manufacturing confidence index in May to close to 4 year low failed to have a sustained impact on equity markets. Perversely weaker data is leading to less fears of Fed tapering which in turn is boosting equity markets. Surely equities should fall as data comes in weak but clearly that is not the case. In any case the contraction in the ISM is highly unlikely to presage a new phase of economic weakness.

Markets continue to await central bank meetings and the US May jobs data at the end of the week for further direction but ahead of that volatility whether in the interest rate, FX or equity spectrum shows little sign of dissipating. During a period of policy transition as we appear to be in now, such volatility should be expected but could prove dangerous if prolonged.

The USD has lost ground even as risk aversion has moved higher, a factor that would normally be associated with a stronger USD. The USD received a blow from the weaker than forecast US ISM manufacturing index which led to Treasury yields slipping from their highs.

Hesitation ahead of Friday’s payrolls data may also explain some of the inability of the USD to strengthen and given that aggregate USD speculative positioning reached an all time high last week profit taking on USD longs is unsurprising. However, the move is unlikely to mark the start of a deeper pull back and assuming that the US jobs report continues on an improving trajectory the USD will likely resume its uptrend over coming weeks.

After reaching a high close to 104 USD/JPY has dropped all the way back to below the 100 level. Part of the explanation comes from elevated risk aversion but also heightened volatility in the local equity and bond markets which has prompted USD/JPY liquidation. Is this the end for JPY bears? More likely the pull back will prove temporary especially as yield differentials have actually widened in favour of the USD over recent days.

Meanwhile, capital flow data will continue to be watched carefully to determine whether Japanese lifers and the government pension fund are finally moving money offshore, something that has not happened yet. Strong support for USD/JPY is seen around the 50 day moving average level at 99.08.

AUD/USD has benefitted from a short squeeze and looks to have bottomed out just above 0.96 versus USD which ought to provide a solid base for the currency. AUD looks especially attractive relative to NZD. As I have been noting the AUD has already priced in a lot of bad news and our quantitative model points to upside versus USD. Reflecting this is the fact that speculative positioning has dropped to extreme levels leaving the AUD susceptible to further short covering.

One obstacle to AUD recovery is the RBA but perversely the drop in the AUD over recent weeks will have given the Bank further reason not to ease policy today, which in turn will play well for the currency.

Rather than facing more pressure as would be expected in the wake of weaker US manufacturing confidence data Asian currencies have actually benefitted as the USD has weakened overnight. The PHP has been a star performers and according to my quantitative models is set for further gains. I am wary of looking for much further upside for Asian currencies, however, especially as the USD pull back is likely to prove short lived.

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Changing dynamics

June 3, 2013 — Mitul Kotecha

A change in market dynamics appears to be taking place. Nervousness over a prospective paring back in US quantitative easing as the Fed ponders the timing of a tapering in asset purchases taken together with elevated volatility in Japanese markets is leading to a decrease in risk appetite, higher core bond yields and weaker equity markets. Consequently emerging market assets especially high beta currencies are coming under significant pressure under the weight of capital outflows and rising risk aversion.

Unsurprisingly the USD has been a major beneficiary although it did lose steam last week. In Japan “Abeconomics” is leading to a rise in inflation expectations and higher Japanese government bonds (JGB) yields which could in turn derail recovery unless the rise in yield is capped by the Bank of Japan’s policy actions. Overall, the background is set for a further increase in uncertainty and market volatility this week.

The lack of clarity over Fed policy in particular is fuelling market volatility and given the intense focus on the Fed and in turn the Fed’s focus on the jobs market, the US May jobs report at the end of the week will be crucial to determine the direction of activity over the coming weeks. The consensus forecast for May payrolls is 165k. Opportunity to refine the forecast will follow the release of ISM manufacturing confidence (today) and ADP private sector jobs data (Wed).

Other potentially market moving events include the European Central Bank (Thu), Bank of England (Thu) and Reserve Bank of Australia meetings (Thu). None of the central banks are likely to change policy settings although there is potential for a dovish statement from the ECB (possible discussion of negative deposit rates and/or liquidity provision).

Currencies are reacting to higher US yields, which have driven the USD to multi month highs. EUR/USD in particular has a high correlation with 2 year bond yield differentials. As noted last week was less positive for the USD, with both the EUR and JPY making up some ground, with further direction coming from relative yield movements. In the case of the JPY, reduced risk appetite is also playing for a firmer currency. Nonetheless, it will be difficult for EUR/USD to sustain any gain above 1.3000 and USD/JPY to sustain any drop below 100.

Better than forecast Chinese manufacturing confidence data over the weekend has helped give some support to AUD, NZD and Asian currencies although it may provide limited relief, especially to Asian currencies which are suffering from increased risk aversion and the impact of higher US yields. While Asia has recorded the strongest inflow into equity markets compared to past years concerns about capital outflows from the region are intensifying. Korea and Thailand have suffered in particular from equity outflows over recent weeks.

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After the storm

May 27, 2013 — Mitul Kotecha

As last week’s volatility in Japanese markets demonstrates central banks do not have it all their own way. Unfortunately for Japan the risk remains that policy makers spur higher yields without accompanying growth, an outcome that would be highly undesirable, especially if it hits economic activity. Equity markets and risk assets in general came under pressure and safe havens found long lost bids, with core bond yields moving lower and JPY and CHF strengthening.

The heightened volatility in markets was also partly triggered by concerns about the timing of the tapering off of Fed asset purchases, with Fed Chairman Bernanke setting the cat amongst the pigeons by with commenting about the possibility of reducing asset purchases over the next few meetings. Additionally weaker than forecast Chinese manufacturing confidence data came as another blow to markets. While the market reaction looked a tad overdone in it is notable that the dichotomy between growth and equity market performance has widened over recent weeks.

This week is likely to begin on a calmer note, with holidays in the US and UK today. Data releases in the US will remain encouraging , with May consumer confidence likely to move higher although US Q1 GDP is likely to be revised slightly lower to 2.4% due an inventories hit. In Europe, while the trajectory of recovery is starting from a much lower base there will be some improvement in business confidence in May while inflation will be well contained at 1.3% YoY in May, an outcome that will maintain room for more European Central Bank policy easing. In Japan a sixth straight negative CPI reading will highlight jus how difficult the job is for the Bank of Japan to meet its inflation target.

The JPY was a major beneficiary of last week’s volatility helped by short covering as speculative positioning in the currency reached its lowest level since July 2007. A calmer tone to markets ought to ensure that JPY upside will be limited and USD buyers are likely to emerge just below the USD/JPY 100 level. In contrast the EUR has been surprisingly well behaved despite the fact that speculative EUR positioning has also dropped sharply over recent weeks. While the overall trend is lower EUR/USD will find some support on any dip to around 1.2795 this week.

AUD and NZD have been particularly vulnerable in the wake of higher risk aversion and weak Chinese data. Some calm ought to ensue over coming days, with AUD prone to short covering given the sharp drop in speculative positioning in the currency over recent weeks. Asian currencies have similarly been under pressure. Some stabilisation in risk appetite will give relief to Asian currencies this week as will a relatively firm CNY.

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Bernanke hits Treasuries, boosts dollar

May 23, 2013 — Mitul Kotecha

Fed Chairman Bernanke’s prepared testimony expressed no hurry to scale back policy accommodation given the risks to economy recovery. However, in the Q&A session following the testimony he noted that the Fed is prepared to adjust the current flow rate of asset purchases in response to incoming data. Importantly in terms of timing Bernanke hinted that the Fed could “take a step down in the pace of purchases” in the next few FOMC meetings dependent on the data. While it is likely that many FOMC members want to see more evidence of recovery especially in the jobs market a reduction in asset purchases in Q4 is likely assuming this evidence if forthcoming. The FOMC minutes echoed this sentiment.

Bernanke’s comments and the minutes fuelled plenty of market volatility, with equities selling off after an initial rally and Treasury yields rising, with the 10 year US Treasury yield flying through the 2% level. Commodities dropped and the USD strengthened, with USD/JPY breaking through 103.00. This pattern is likely to be echoed in Asian trading today but much of the market reaction to the Fed has already occurred and it will need more evidence of either stronger US data or more hawkish Fed comments to extend yesterday’s moves. US jobless claims today will take on more prominence in this respect in the absence of other major data releases with the exception of a likely gain in April new home sales.

The USD is set to consolidate its gains over the short term firmly underpinned by higher US bond yields. Funding currencies (JPY and CHF), yielding and commodity currencies (AUD, NZD and CAD ) look most vulnerable to a firm USD although almost all currencies have felt some of the pressure. The net result is that the USD index has reached its highest level in close to 3 years. Given that the rise in US yields may only mark the beginning of a deeper reversal the upside for the USD over coming months could be significant.

Fortunately for Asian currencies they have not been particularly sensitive to USD strength over recent months as domestic factors have taken on more prominence although the KRW and SGD have been particularly sensitive to JPY weakness. Nonetheless, Asian currencies are set to remain under pressure over the short term as concerns of a slowing in capital flows to the region may grow. Singapore’s better than expected Q1 GDP reading (1.8% QoQ) released this morning will do little to stem the pressure. Meanwhile comments by Korean officials on the impact on the country’s exports from a stronger JPY will keep the KRW pressured.

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Catching a falling knife

May 21, 2013 — Mitul Kotecha

USD/JPY’s pull back is proving short lived as Japanese Economy Minister Amari attempted to backtrack from his earlier comments that warned about the negative impact of a weaker JPY on “people’s lives”. His comments today suggest that Japan’s stance on a weaker JPY has not changed.

Nonetheless, there may be some consolidation in the near term as likely inaction from the Bank of Japan at it policy meeting this week will mean no new stimulus. While no policy change ought to be unsurprising given recent aggressive actions it appears that the market has become addicted to stimulus.

In any case US Treasury yields will need to be eyed for further USD/JPY direction, with a break of the psychologically important 2% level in the 10 year Treasury a likely trigger for a further up move in the currency pair.

GBP has held up well on the crosses while like many other currencies has faced a resurgent USD. Little impact on GBP is expected from today’s April CPI inflation data especially given that any expected decline is set to prove temporary (Bloomberg consensus 2.6% YoY).

More importantly a likely more optimistic set of Bank of England MPC minutes on Wednesday and rebound in April UK April retail sales on Thursday will provide GBP will further support although we suggest looking for any upside on the crosses rather than versus USD.

Is it time to buy AUD? While I don’t want to be accused of catching a falling knife AUD looks reasonably good value especially against other commodity currencies, especially NZD and CAD. While there have been plenty of negative factors pressuring the currency including prospects for more RBA rate cuts, weaker commodity prices, and softer domestic and Chinese data, much of this is in the price.

My AUD/USD quantitative model estimate based shows that it is oversold relative to its short term fair value estimate. Moreover, speculative positioning according to the CFTC IMM data has turned negative for the first time in almost a year. The RBA May meeting minutes (the meeting during the RBA surprisingly cut its cash rate to 2.75) reelased today did not change this perspective given that markets have already priced in one more rate cut in the cycle.

Asian currencies will likely continue to retrace some of their recent losses in the near term. However, domestic factors and growth worries will provide an importance influence, with the IDR for instance failing to benefit from any USD pull back as the government continues to wrestle with a fuel subsidy cut. Meanwhile, weaker than expected growth in Thailand in Q1 2013 cast a shadow over many Asian currencies as concerns of a wider growth slowdown in Asian intensify.

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