Who’s going to follow in Brazil’s footsteps?

October 25, 2009 — Mitul Kotecha

Last week saw a sell off in some emerging market currencies and whilst this may simply have been profit taking attributable to some large hedge funds it did coincide with the imposition of a tax on portfolio inflows in Brazil.  The tax dented sentiment as it quickly fuelled speculation that it would be followed elsewhere, especially in countries that had seen rapid FX appreciation.  

The BRL is one of the best performing currencies this year against the USD whilst the stock market has surged on strong capital inflows.  The huge increase in USD liquidity globally and substantial improvement in risk appetite has fuelled strong capital inflows into Brazil especially as the country has proven to be one of the most resilient during the crisis.

Although on the margin the tax will have a negative impact on speculative flows into Brazil it is unlikely to have a lasting impact.  Previous such measures have done little to prevent further appreciation.  The BRL is clearly overvalued by around 25-30 at present, but the tax in itself will not be sufficient to result in a move back to “fair value”. 

At best it may act a temporary break on currency appreciation and could limit the magnitude of further gains in the real but this could be at the cost of distorting resource allocation and market functioning.   The longer term solution is to enhance productivity but this will not help in the interim. The tax may make investors a little more reluctant to pile into Brazilian assets, which is what the authorities will desire but already the BRL is back on its appreciation path suggesting a short lived reaction. 

Other countries that could follow include South Africa, Turkey or South Korea but South Africa has already denied that it has any plans to move in this direction.  In South Korea’s case the central bank has chosen to intervene in currency markets to prevent the further strengthening in the won but that also has implications for sterilizing such flows limiting the extent that intervention can be carried out.    

The bottom line is that the broad based improvement in risk appetite is proving to be a strong driver of capital flows into emerging markets and the reality is that many emerging economies such as Brazil and many in Asia have been much more resilient than feared. 

Although there is clearly a limit on the extent that these countries want to allow their currencies to strengthen versus USD the upward pressure will continue, leading to more FX intervention and potential imposition of taxes or restrictions such as implemented in Brazil.   Despite this the outlook for most emerging currencies remains positive and the authorities will face an uphill struggle. 

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EUR/USD takes a crack at 1.50, where now?

October 22, 2009 — Mitul Kotecha

It seemed inevitable and finally after flirting with the 1.50 level, EUR/USD managed to break through although there seems to be little momentum in the move, with the currency pair dipping back below 1.50 in the Asian trading session. Contrary to expectations the break above 1.50 did not lead to a sharp stop loss driven move higher. 

Even the break through 1.50 only provoked a limited reaction in the FX options market where implied EUR/USD volatility only moved slightly higher. In fact despite the warnings by ECB President Trichet about “excessive currency volatility” FX options volatility for most currency pairs has been on a downward trajectory over the past few months, implying that the move in EUR/USD and the USD itself has been quite orderly. 

Trichet’s warning is more likely a veiled threat on the level of EUR/USD rather than its volatility, unless of course the ECB chief is seeing something that the FX options market is not. Assuming that EUR/USD closes above 1.50 this week it technically has plenty of open ground on the run up to the record high of 1.6038 hit in July 2008 but there will also be plenty of official resistance to limit its appreciation. Such resistance is limited to rhetoric but it will not be long before markets begin discussing the prospects of actual FX intervention.  

Perhaps the reason that EUR/USD did not move sharply higher following the break of 1.50 was the late sell off in US stocks on Wednesday which helped to fuel some USD short covering.  The USD index is holding just above the 75.00 level but it’s not a big stretch from here to move down to the March 2008 low around 70.698, with the overall tone of broad USD weakness remaining intact and ongoing. 

GBP was helped by relief that the minutes of the BoE meeting showed no inclination to increase the level of quantitative easing despite the ongoing debate within the MPC.   The minutes even sounded slightly upbeat about economic prospects. GBP/USD hit a high of 1.6638 in the wake of these developments due in large part to more short covering whilst EUR/GBP briefly dipped below 0.90.  GBP/USD may find it tough going to make much headway above 1.66 as has been the case over recent months, with strong resistance seen around 1.6661.

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Earnings in focus

October 19, 2009 — Mitul Kotecha

The majority of US Q3 earnings have beaten market expectations resulting in a boost to risk appetite and further pressure on the US dollar. At the time of writing, 61 companies have reported earnings in the S&P 500 and an impressive 79% have beaten forecasts according to Thomson Reuters. This week there are plenty of earnings on tap and although a lot of positive news appears to be priced in the overall tone to risk appetite remains positive. This implies a weaker US dollar bias given the strong negative correlation between US equities and the USD index.

Aside from the plethora of earnings there are plenty of data releases on tap this week including housing data in the US in the form of building permits and starts as well as existing home sales. The data will likely maintain the message of housing market stabilisation and recovery in the US. There will also be plenty of Fed speakers this week and markets will once again scrutinize the speeches to determine the Fed’s exit strategy.

Highlights this week also include interest rate decisions in Canada and Sweden. Both the BoC and Riksbank to leave policy unchanged and expect a further improvement in the German IFO in October though at a more gradual pace than in recent months. There will be plenty of interest in the UK MPC minutes given conflicting comments from officials about extending quantitative easing. RBA minutes will be looked at for the opposite reason, to determine how quickly the Bank will raise interest rates again.

The USD index managed a slight rebound at the end of last week but is likely to remain under pressure unless earnings disappoint over coming days. US dollar Speculative sentiment became more bearish last week according to the CFTC IMM data, with dollar bloc currencies including the AUD, NZD and CAD benefiting the most in terms of an increase in speculative appetite. GBP short positions increased to a new record but the rally towards the end of last week may have seen some of these short positions being covered. Overall any recovery in the USD this week may just provide better levels to go short.

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Risk On / Risk Off

October 16, 2009 — Mitul Kotecha

Risk was firmly back on over the past few days as the majority of earnings came in stronger than expected; around 80% of S&P 500 companies have beaten expectations so far. Data releases in the US have also continued to beat forecasts, the latest of which was the September industrial production report. The dollar stood little chance of a recovering against this background and continues to languish around 14-month lows.

Sterling has been the star performer, perhaps a reflection of the fact that the market was extremely short (CTFC IMM data revealed record net short sterling positions last week) and some hints that the Bank of England may not extend quantitative easing was sufficient to provoke a short covering rally. Still the pound’s gains may prove short-lived until there are clearer signs of economic recovery and of a turn in the interest rate cycle.

There will be some key events and data over the coming week that will give further direction to sterling including a speech by BoE Governor King, MPC minutes, retail sales and preliminary Q3 GDP data. Overall, the data are unlikely to deliver much of a boost to the pound even though both retail sales and GDP are likely to deliver positive readings. Sentiment for the pound continues to swing in a wide range and though a lot of negativity was in the price a sustained recovery is far off. The risks remain that GBP/USD will push back towards support around 1.5902.

I still believe that there is little positive to be said for the euro too. The currency benefits from a weaker dollar but is hardly supported by fundamentals especially as a stronger euro damages one of the main engines of eurozone growth, namely exports. EUR/USD will struggle to make headway through 1.50 though once through here it could easily be carried higher. The most positive factor supporting the euro is the continued recycling of central bank intervention flows here in Asia and this may be sufficient to propel EUR/USD through 1.50 before hitting a wall of resistance around 1.5084.

The dollar itself may be given a lifeline from what looks like a softer tone to markets at the end of the week but overall sentiment remains very bearish despite attempts by various US officials to talk the dollar higher this week. The Fed’s Fisher hit the nail on the head when he said that the dollar’s long term value depends on policymakers “getting it right”. In the short term however, it’s all about risk and increasingly it will be about interest rate differentials, both of which will play negatively for the dollar.

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

No relief for Sterling

October 13, 2009 — Mitul Kotecha

Anybody in the UK thinking of taking a holiday overseas has had to think twice over recent months given the precipitous drop in the pound (GBP) that took place since the beginning of August 2008. At the lowest point around six months after the British pound began its decline it had lost around a third of its value against the US dollar. Against the euro, sterling has fared even more poorly over a longer period, with GBP losing around 45% of its value from the beginning of 2007.

Since then GBP has recovered but has given back some of its gains over recent weeks against the dollar but has continued to weaken against the EUR. The worsening in GBP sentiment has been particularly well reflected in CFTC data on speculative positioning which revealed a drop to an all time low in GBP speculative contracts in contrast to EUR speculative contracts reaching close to the year high.

GBP faces headwinds from expectations that the Bank of England will extend its quantitative easing especially in the wake of recent data whilst news that the Center for Economics and Business Research (CEBR) predicted that the Bank of England (BoE) will keep its base rate unchanged until at least the end of 2011 came as another blow.

Although currencies are not particularly sensitive to interest rate movements at present it is unlikely to be long before the historically strong FX/interest rate relationship re-exerts itself and if UK policy is likely to remain accommodative for a prolonged period this could be detrimental to GBP’s recovery prospects. It seems unlikely that the BoE will wait as long as the CEBR predict before raising interest rates although a rate hike anytime in 2010 also looks unlikely.

There is at least some hope that aggressive UK monetary policy will deliver a relatively quicker economic recovery than in the eurozone where policy has arguably been much less aggressive and this relatively more positive cyclical picture will eventually result in some strengthening in GBP.

Nonetheless, the interim outlook continues to look bleak and sentiment is likely to continue to deteriorate over the short term. EUR/GBP now looks on path to retest its high reached at the end of 2008 at just over 0.98 (or around 1.02 for those that prefer to look at GBP/EUR) whilst GBP/USD appears to be heading for a move back below 1.55 and back to around 1.50.

Perhaps one of the only positive things that GBP has going for it at present is that looks very undervalued and when recovery does happen it could bounce back quite quickly and aggressively as markets cover their short positions. In the meantime, the good news of low interest rates will at least benefit borrowers and mortgage holders holding GBP denominated loans but not anyone in the UK wanting to take a holiday overseas.

Posted in Currencies, Economics, Interest rates, Monetary Policy, UK. Tags: , , , , , , , , , , , , , , . 2 Comments »
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