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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US dollar slips as yields pull back

May 30, 2013 — Mitul Kotecha

Market sentiment deteriorated overnight as equity markets in the US and Europe declined while commodity prices also dropped. US yields slipped which undermined the USD. Growth downgrades by the IMF and OECD did not help especially given the weaker growth trajectory for some emerging market countries.

Meanwhile, two central banks did not follow the now usual pattern of easing, with the Bank of Canada leaving policy on hold and Brazil’s central bank hiking policy rates although Thailand cut interest rates. A lack of first tier data releases today will limit activity although the tone will likely remain relatively downbeat.

Having failed to take break through 1.3250 at the beginning of the month the EUR/USD will end the month on a softer note. EUR/USD in particular has been very sensitive to yield differentials and the widening in the US Treasury yield advantage over German bunds has been consistent with a drop in the currency pair. In this respect further direction will come from bond markets.

While Eurozone data releases are becoming less negative as reflected in manufacturing confidence data earlier this week and likely to be seen in various economic and business confidence indices today this is in stark contrast to US data releases which highlight strengthening in recovery notwithstanding a likely downward revision to US Q1 GDP today. Consequently it is difficult to envisage EUR/USD strengthening much from current levels, with 1.3030 seen as a strong resistance level.

A narrowing in Australia’s yield advantage, declining terms of trade, weaker China data and a relatively firm USD index have all contributed to AUD weakness. Additionally weak domestic data have fuelled expectations that the RBA will cut interest rates. However, a rate cut at next week’s policy meeting is unlikely especially as the drop in AUD will help ease financial conditions allowing the Reserve Bank of Australia to wait to examine further data before cutting rates again sometime in Q3 2013.

The AUD may find some short term stability around current levels, with support around AUD/USD 0.9528. While technical indicators remain bearish a lot of bad news is already in the price. Further out, I expect the AUD to rebound as reflected by the fact that my quantitative model shows that the AUD/USD is oversold relative to its short term fair value while short speculative positioning is reaching extreme levels.

GBP is another currency that has been battered by a strong USD but while it has lost ground versus the USD over recent weeks it has held up against other major currencies. GBP/USD has rallied overnight as US yields have pulled back but this may prove temporary, with the currency pair vulnerable to a drop below 1.5000 over coming days.

Against the EUR the picture looks more constructive. My quantitative model shows that GBP looks particularly good value against the EUR, with the model producing a “strong sell” signal for EUR/GBP. Limited data releases in the UK this week will mean that GBP takes its cue from gyrations in the USD and EUR while markets look ahead to next week’s manufacturing purchasing managers’ index and the Bank of England policy decision

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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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Taking the wind out of the EUR, JPY watching the flow, AUD watching RBA

May 7, 2013 — Mitul Kotecha

Market activity was limited yesterday due to holidays in the UK and Japan but will pick up today as both markets reopen. The positive reverberations from the US April jobs report continue to provide a fillip to markets but the impact is already fading.

Once again risk assets are relying on central banks to provide the steroids for further support. In this respect it was the turn of European Central Bank President Draghi to take up the baton yesterday as he noted that further interest rate cuts are possible. Today’s data slate is thin, with the Reserve Bank of Australia policy decision and German March factory orders the main highlights.

ECB President Draghi took the wind out of the EUR’s sails as he highlighted the possibility of further policy easing. Also helping to keep the EUR under pressure was the rise in US Treasury yields; the 10 year yield differential with bunds has widened to close to 52 bps, which due to the strong correlation with EUR/USD is likely to cap any gains in the currency pair.

As Draghi noted prospects for further easing will be highly data dependent which in turn means that the EUR will be more data sensitive in the weeks ahead. The prospects of negative deposit rates in particular will continue to send shivers down the spines of EUR bulls. Look for EUR/USD to be capped around 1.3168.

As Japan returns from holiday USD/JPY is verging once again on a test of psychologically important 100 level. The trigger for the renewed bounce in USD/JPY was a jump in US bond yields following the better than expected US jobs report. In the absence of major US data releases this week Fed speakers including Chairman Bernanke will give further direction to bonds and in turn USD/JPY.

A further widening in the US yield advantage over Japan will be required to push USD/JPY higher especially as recent flow data have shown both Japanese investor repatriation and net foreign buying of Japanese portfolio assets. Despite these inflows we expect a break of 100 to occur very soon, with appetite for foreign assets from Japanese lifers and government pension fund, providing much of the ammunition for a sustained move higher.

AUD has started the week badly having suffered in the wake of the weaker than expected Chinese service sector confidence data and the surprise drop in Australian retail sales in March. Reports that the Australian Treasury will lower growth forecasts for the next two years in part due to AUD strength does not bode well for the currency either.

The data has emboldened doves looking for a policy rate cut from the RBA today and while the decision is a very close call as reflected in market pricing and consensus expectations, the balance of risks suggests that the RBA will hold off this month. This may however, come as scant relief for AUD as markets will likely push back easing expectations to the next meeting on 4 June.

Nonetheless, downside for AUD is likely to be limited, with speculative positioning already at a relatively low level. Strong support for AUD/USD is likely around the 4 March low at 1.0115.

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