“Feral hogs” beware

June 25, 2013 — Mitul Kotecha

Bond and equity selling has been sustained as worries both about Federal Reserve tapering and liquidity in China’s banking sector continues to roil markets. Fed comments overnight did little to soothe market angst, with the Fed’s Fisher and Kocherlakota both revealing little concern about the market reaction to prospects of Fed tapering. However, both Fed officials were keen to point out that policy will remain accommodative even after the end of quantitative easing which helped to allay some of the pain on markets in overnight trading.

Reinforcing market volatility is the approach of month and quarter end. Several other Fed speakers will be on tap over coming days while 2, 5 and 7 year Treasury auctions will also be under scrutiny but ahead of the speeches and auctions markets will look to today’s US data releases including May durable goods orders, June consumer confidence and May new home sales for further direction.

EUR/USD failed to get much of lift from the rise in the German IFO business confidence survey in June and looks set to extend declines over coming sessions. Despite its drop from its high around 1.3420 EUR/USD has not been particularly sensitive to higher US yields over recent weeks but this may be changing. As revealed in the latest CFTC IMM report net speculative positioning in EUR/USD became positive for the first time in four months.

Now that the room for EUR short covering has disappeared EUR’s sensitivity to yield is likely to grow. The fact that the 10 year US Treasury yield differential with bunds has widened sharply will be difficult for EUR/USD to ignore, with attendant negative consequences for the currency. The lack of key Eurozone data releases over coming days will leave the EUR/USD increasingly at the mercy of US yield movements.

Another currency having to deal with a relatively thin data slate is GBP. Only the government’s Spending Review, Bank of England Financial Stability Report and second estimate of Q1 GDP are scheduled for release this week but none of these are likely to prove to be market movers. Having been hit by a firmer USD, GBP/USD has fallen well off its recent highs around 1.5752. On the crosses GBP looks a little healthier but is notably failing to make any headway against the EUR.

While the USD has rallied on higher US yields markets are not looking for a similar policy moves in the UK, especially given that some BoE MPC members are still inclined to increase asset purchases. Indeed, the recent rise in UK gilt yields may embolden the doves on the MPC. Although net speculative short GBP positions have not fully evaporated, the room for GBP upside is now very limited, with a firm USD in general set to continue to push GBP lower.

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It’s all about communication

June 18, 2013 — Mitul Kotecha

Calm has settled over markets as anticipation builds ahead of tomorrow’s Fed FOMC outcome. Equity markets registered broad based gains globally while US yields rose and the USD stabilized. It’s worth reiterating that effective Fed communication is the key to ensure that this calm continues otherwise market volatility will quite easily return.

Yesterday’s mixed data releases did not offer much to the debate on Fed policy as the Empire manufacturing survey rose more than expected but disappointed on the detail, while home builders’ confidence jumped. May CPI inflation data will perhaps offer more clues today, with a benign reading likely to ensure that markets do not get carried away in expecting any major shift in Fed policy. In Europe, a likely decline in the German ZEW investor confidence survey in June will do little to boost confidence in recovery.

GBP/USD has rallied impressively over recent weeks although much of its gain has been spurred largely by USD weakness rather than inherent GBP strength. Nonetheless, UK data has looked somewhat more encouraging, a fact that has played some role in reinforcing GBP gains. Whether this continues will depend on a slate of data releases this week including retail sales on Thursday. CPI inflation data (today) and Bank of England MPC minutes (tomorrow).

On balance, I look for UK data to continue to paint an encouraging picture of recovery, which ought to provide further support for GBP. However, the risk / reward does not favor shorting the USD at present and I suggest playing further GBP upside versus EUR.

CHF has strengthened as risk aversion has flared up. While I remain bearish CHF over the medium term the near term outlook will be driven by risk gyrations (given the strong correlation between CHF and our risk barometer). Both EUR/CHF and USD/CHF have already fallen sharply having priced in higher risk aversion.

Obviously much in terms of risk appetite will depend on the Fed FOMC outcome tomorrow and I would suggest caution about shorting the CHF just yet. Additionally Swiss data in the form of May trade data and more importantly the SNB policy decision this week will be watched closely, especially given the threat by SNB Jordan of implementing negative interest rates. I don’t expect any shift in policy on Thursday, however, leaving USD/CHF firmly supported around 0.9130.

Since Fed Chairman Bernanke highlighted the prospects of Fed “tapering” during his testimony on May 22 commodity currencies have performed poorly. The notable exception has been the CAD which has eked out gains over recent weeks. Like GBP, the CAD has been helped by relatively positive data releases, which in turn have prompted growing expectations of policy rates hikes from the Bank of Canada. Market positioning in CAD remains relatively short, suggesting more scope for gains over coming weeks. Meanwhile, data this week including May CPI and April retail sales will be scrutinized for clues as to the next move from the BoC and in turn whether gains in CAD are justified.

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Risks to US payrolls / Japan disappointment

June 6, 2013 — Mitul Kotecha

US service sector confidence improved, with the ISM non manufacturing index revealing a stronger than forecast rise to 53.7 while the Fed’s Beige Book recorded “modest to moderate” growth across most Fed districts. However, any positive reaction was fully negated by a drop in the employment component of the ISM report and a weaker than expected ADP private sectro jobs report which revealed only a 135k increase in jobs. Consequently there will be a scramble to revise down forecasts for May US non farm payrolls released tomorrow.

Risk assets and in particular equities didn’t like what they saw even though on balance the data suggests less risk of the Fed beginning to taper its asset purchases this year. Added to the uncertainty revolving the around the Fed was disappointment on Japanese policy in the wake of Prime Minister Abe’s policy speech yesterday which failed to reveal details about his growth strategy or third arrow to reform business and deregulate parts of the economy. Central banks will remain in focus today although both are likely to be less volatile, with both the European Central Bank and Bank of England set to deliver unchanged policy outcomes.

USD/JPY’s pull back has continued unabated as disappointment over Japanese prime minister Abe’s ‘third arrow’ speech of structural reforms and a pull back in US Treasury yields taken together with firming risk aversion have all contributed to a firmer JPY. Clearly pressure will grow to limit the JPY’s bounce back but as long as Japanese equities continue to slide it will be difficult to do so.

Given that this is coinciding or perhaps spurring more Japanese selling of foreign assets as revealed in recent data, it is difficult to prevent a further drop in USD/JPY unless and until such flows reverse. Having dropped below its 50 day moving average level around 99.28 USD/JPY is vulnerable to more short term slippage.

EUR/USD is likely to struggle to make further headway and there will be plenty of caution around the ECB meeting today. While there is very little chance of a further easing in policy President Draghi is likely to keep the door open for further action which ought to take the wind out of the EUR’s sails.

While the EUR may be taking advantage of a softer USD tone as well as a narrowing in the US Treasury yield advantage over bunds (2 year) I don’t believe this will continue. It is only a matter of time before US yields renew their widening trend, with Friday’s US jobs data a possible trigger.

GBP is another currency taking advantage of a generally softer USD tone having made a solid recovery from its lows around 1.5008 at the end of last month. EUR/GBP has been more stable but we expect GBP outperformance here too.

While the BoE will offer little help given the likelihood of an unchanged policy decision firmer UK data in the form of better than expected manufacturing, construction and services purchasing managers’ indices revealed this week has provided a solid backstop for the currency. Given that positioning in GBP has been around record low levels it would appear that the potential for short covering remains significant.

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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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