What QE2 means for currencies

November 5, 2010 — Mitul Kotecha

The sweeping gains for the Republican party in the US mid term elections has sharply changed the political dynamic in the US, with the prospects of further fiscal stimulus looking even slimmer than before although the chances of the Bush tax cuts being extended have likely increased.

The onus is on monetary policy to do the heavy lifting and the Fed delivered on its end of the bargain, with the announcement of $600 billion of purchases of long-term securities over 8-months through June 2011.

Given the likelihood that the economic impact of the asset purchases is likely to be limited and with little help on the fiscal front the Fed has got a major job on its hands and $600 billion may end up being a minimum amount of purchases necessary for the Fed to fulfil its mandate.

The decline in the USD following the Fed decision is unlikely to mark the beginning of a more rapid pace of USD decline though further weakness over coming months remains likely. The USD remains a sell on rallies for now and an overshoot on the downside is highly probable as the Fed begins its asset purchases.

The bottom line is that the Fed’s program of asset purchases implies more USD supply and in simple economic terms more supply without an increase in demand implies a lower price. The USD will remain weak for some months to come and the Fed’s actions will prevent any USD recovery as the USD solidifies its position as the ultimate funding currency.

Nonetheless, with market positioning close to extreme levels, US bond yields unlikely to drop much further, and the USD already having sold off sharply in anticipation of QE2, (USD index has dropped by around 14% since June) those looking for a further sharp drop in the USD to be sustained are likely to be disappointed.

It is difficult however, to fight the likely further weakness in the USD even if turns out not to be a rapid decline. The path of least resistance to some likely USD weakness will be via the likes of the commodity currencies, scandies and emerging market currencies. There will be less marked appreciation in GBP, CHF and JPY against the USD.

The Fed’s actions will continue to fuel a rush of liquidity into emerging markets, particularly into Asia. This means more upward pressure on Asian currencies but will likely prompt a variety of responses including stronger FX intervention as well as measures to restrict and control such flows.

There have been various comments from central banks in the region warning about the Fed’s actions prompting further “hot money” flows into the region and even talk of a coordinated response to combat such flows.

This suggests more tensions ahead of the upcoming G20 meeting in Seoul. Assuming that at least some part of the additional USD liquidity flows into Asia, the implications of potentially greater FX intervention by Asian central banks to prevent Asian currencies from strengthening, will have a significant impact on major currencies.

Already it is apparent that central banks in Asia have been strongly using the accumulated USDs from FX intervention to diversify into EUR and other currencies including AUD and even JPY. Perversely this could end up exacerbating USD weakness against major currencies.

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Currencies At Pivotal Levels

November 3, 2010 — Mitul Kotecha

Ahead of today’s highly anticipated Fed FOMC meeting markets are holding their breath to determine exactly what the Fed will deliver. The consensus view is for the Fed to announce a programme of $500 billion in asset purchases spread over a period of 6-months. The reaction in currency markets will depend on the risks around this figure. Should the Fed deliver a bigger outcome, say in the region of $1 trillion or above, the US dollar will likely come under renewed pressure. However, a more cautious amount of asset purchases will be US dollar positive.

It has to be noted that the Fed will likely keep its options open and keep the program open ended depending on the evolution of economic data which it will use to calibrate its asset purchases. The USD will likely trade with a soft tone ahead of the Fed outcome, but with so much in the price, it may be wise to be wary of a sell on rumour, buy on fact outcome.

Whatever the outcome many currencies are at pivotal levels against the USD at present, with AUD/USD flirting around parity following yesterday’s surprise Australian rate hike, EUR/USD holding above 1.4000, GBP/USD resuming gains above 1.600 despite a knock back from weaker than forecast construction data, whilst USD/JPY continues to edge towards 80.00. Also, both AUD and CAD are trading close to parity with the USD. The Fed decision will be instrumental in determining whether the USD continues to remain on the weaker side of these important levels.

Going into the FOMC meeting the USD has remained under pressure especially against Asian currencies as noted by the renewed appreciation in the ADXY (a weighted index of Asian currencies) against the USD this week. Although it appears that the central banks in Asia have the green light to intervene at will following the recent G20 meeting the strength of capital inflows into the region is proving to be a growing headache for policy makers. One option is implementing measures to restrict “hot money” inflows but so far no central bank in the region has shown a willingness to implement measures that are deemed as particularly aggressive.

There has been some concern that Asia’s export momentum was beginning to fade as revealed in September exports and purchasing managers index (PMI) data in the region and this in turn could have acted as a disincentive to inflows of capital, resulting in renewed Asian currency weakness. The jury is still out on this front but its worth noting that Korean exports in October reversed a large part of the decline seen over previous months. Moreover, the export orders component of Korea’s PMI remained firm suggesting that exports will resume their recovery.

Nonetheless, manufacturing PMIs have registered some decline in October in much of Asia suggesting some loss of momentum, with weaker US and European growth likely to impact negatively. However, China’s robust PMI, suggests that this source of support for Asian trade will remain solid. Similarly a rise in India’s manufacturing PMI in October driven largely by domestic demand, highlights the resilience of its economy although with inflation peaking its unlikely that the Reserve Bank of India (RBI) will follow its rate hike on Tuesday with further tightening too quickly.

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G20 Leaves The US Dollar Under Pressure

October 25, 2010 — Mitul Kotecha

The G20 meeting of Finance Ministers and Central bankers failed to establish any agreement on clear targets or guidelines. Perhaps the problem of trying to achieve consensus amongst a variety of sometimes conflicting views always pointed to an outcome of watered down compromise but in the event the G20 summit appears to pass the buck to November’s summit of G20 leaders in Seoul where more concrete targets may be outlined.

Officials pledged to “move towards more market determined exchange rate systems” and to “refrain from competitive devaluation of currencies”. What does this actually mean? The answer is not a great deal in terms of practical implications. The first part of the statement is the usual mantra from such meetings and the addition of the latter part will do little to stop central banks, especially in Asia from continuing to intervene given that no central bank is actually devaluing their currency but rather preventing their currencies from strengthening too rapidly.

The communiqué highlighted the need for advanced economies being “vigilant against excess volatility and disorderly movements in exchange rates”, but once again this is the mantra found in the repertoire of central bankers over past years and is unlikely to have the desired effect of reducing the “excessive volatility in capital flows facing some emerging countries”. In other words many emerging countries will continue to have an open door to impose limited restrictions on “hot money” flows.

Although the language on currencies was stronger than in previous summits it arguably changes very little in terms of the behaviour of central banks and governments with respect to currencies. The communiqué is wide open to varying interpretations by countries and is unlikely to prevent the ongoing trend of USD depreciation and emerging market country FX appreciation and interventions from continuing over coming weeks.

The onus has clearly shifted to the November summit of G20 leaders but once again it seems unlikely that substantial agreements will be found. In the interim the November 3 Fed FOMC meeting will be the next major focus and if the Fed embarks on renewed asset purchases as widely expected FX tensions will remain in place for some time yet.

So whilst a “currency war” was always unlikely “skirmishes” will continue. In the meantime the USD is set to remain under pressure although it’s worth noting that speculative positioning has recorded a reduction in net aggregate USD short positions over the last couple of weeks, suggesting that some of the USD selling pressure may have abated. Whether this reflected caution ahead of the G20 meeting (as the data predates the G20 meeting) or indicated the USD having priced in a lot of quantitative easing (QE2) expectations already, is debatable.

The path of least resistance to USD weakness remains via major currencies including AUD, CAD and NZD. Officials in Europe are also showing little resistance to EUR strength despite the premature tightening in financial conditions and negative impact on growth that it entails. Scandinavian currencies such as SEK and NOK have also posted strong gains against the USD and will likely continue to show further outperformance.

The JPY has been the best performing major currency this year followed not far behind by the CHF despite the FX interventions of the authorities in Japan and Switzerland. Although USD/JPY is fast approaching the 80.00 line in the sand level expected to result in fresh FX intervention by the Japanese authorities, the path of the JPY remains upwards. Japan is unlikely to go away from the G20 meeting with any change in policy path as indicated by officials following the weekend deliberations.

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Contrasting Stance

October 13, 2010 — Mitul Kotecha

Despite some recent Fed speakers putting doubts into the minds of the many now looking for the Fed to embark on QE2 in November, the minutes of the 21 September FOMC meeting gave the green light to the commencement of asset purchases next month. Although there is clearly no unanimity within the FOMC the majority favour further easing. Incremental data dependent asset purchases will be the most likely path.

The minutes leave the USD vulnerable to further declines but extreme short USD positioning suggest that there is plenty of risk of short covering and more likely we are probably set for a period of consolidation over coming weeks before the USD resumes its decline.

Unlike the Fed, BoJ and BoE, which remain in easing mode the ECB is already veering towards an exit strategy, albeit one that is unlikely to take effect for some time. Hawkish comments by the ECB’s Weber overnight managed to give a lift to the EUR in the wake of a further widening in interest rate differentials between the eurozone and US. Indeed, interest rate differentials (2nd contract futures) are at the widest since Feb 2009, a factor that is providing plenty of underlying support for the EUR.

Further out the follow through on the EUR will depend on whether markets believe Weber’s stance is credible. Germany’s economy is doing well but it is highly likely that Southern European officials would oppose any premature tightening in policy given the parlous state of their economies. The stronger EUR will also do some damage to growth, with its recent appreciation acting as a de facto monetary tightening.

Despite the positive influence of Weber’s comments short-term technical indicators show that the trend in EUR is vulnerable, with clear signs of negative divergence as the spot rate is still trending higher whilst the relative strength indices (RSI) are trending lower. Moreover, EUR speculative positioning is at its highest in a year, albeit still well of its all time highs. Speculators may be reluctant to build on longs in the near term. A clean and sustained break above EUR/USD 1.4000 level still looks like a stretch too far though any downside is likely to be limited to strong support around 1.3895.

Unlike the perception that the ECB is highly unlikely to follow the Fed in a path of QE2 the policy stance of the BoE is far more uncertain, a fact that continues to weigh on GBP, especially against the EUR. Recent data in the UK has played into the hands of the doves, with housing market activity and prices coming under renewed pressure, retail sales surveys revealing some deterioration and consumer confidence as revealed in the Nationwide survey overnight, weakening further.

BoE MPC member Miles summarized the situation by highlighting that the UK faces “some big risks” and even hinted that the BoE may “come to use QE”. UK jobs data today is unlikely to give any support to sentiment for GBP although as per its recent trend GBP is likely to remain resilient against the USD whilst remaining under pressure against the EUR, with a move to resistance around EUR/GBP 0.8946 on the cards in the short-term

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No FX co-operation

October 11, 2010 — Mitul Kotecha

Despite all the jawboning ahead of the IMF / World Bank meetings over the weekend the meeting ended with little agreement on how deal to with the prospects of a “currency war”. US officials continued to sling mud at China for not allowing its currency, the CNY, to appreciate quickly enough whilst China blamed the US for destabilizing emerging economies by flooding them with liquidity due to the Fed’s ultra loose monetary policy stance. Chinese trade data on Wednesday my throw more fuel on to the fire given another strong surplus expected, lending support to those in the US Congress who want to label China as a “currency manipulator”.

Although the IMF communiqué mentioned countries working co-operatively” on currencies there were no details on how such cooperation would take place. The scene is now set for plenty of friction and potential volatility ahead of the November G20 meeting in Seoul. Although many central banks are worrying about USD weakness when was the last time US Treasury Secretary Geithner talked about a strong USD? US officials are probably happy to see the USD falling and are unlikely to support any measure to arrest its decline unless the drop in the USD turns into a rout. In contrast, the strengthening EUR over recent weeks equates to around 50bps of monetary tightening, a fact that could put unwanted strain on Europe’s growth trajectory, especially in the periphery.

The outcome of the IMF meeting leaves things much as they left off at the end of last week. In other words there is little to stand in the way of further USD weakness apart from the fact that the market is already extremely short USDs. Indeed the latest CFTC IMM data revealed that aggregate net USD positioning came within a whisker of its all time low, with net positions at -241.2k contracts (USD -30 billion), the lowest USD positioning since November 2007. Interestingly and inconsistent with the sharp rise in the EUR, positioning in this currency remains well below its all time highs, supporting the view that rather than speculative investors it is central banks that are pushing the EUR higher.

The US jobs report at the end of last week proved disappointing, with total September payrolls dropping by 95k despite a 64k increase in private payrolls. The data will act to reinforce expectations that the Fed will begin a program of further asset purchases or quantitative easing (QE2) at its November meeting. Data and events this week will give further clues, especially the Fed FOMC minutes tomorrow and speeches from Fed Chairman Bernanke on Thursday and Friday as well as various other Fed speakers on tap.

Recent speeches by Fed officials have highlighted growing support for QE although some have tried to temper expectations. Questions about the timing and size of any new programme, as well as how it will be communicated remain unanswered. Although November seems likely for the Fed to start QE the Fed’s Bullard suggested that the Fed may wait until December. The minutes will be scrutinized for clues on these topics. The Fed is likely to embark on incremental asset purchases with the overall size being data dependent and the USD set to remain under pressure while this happens.

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