Bracing for a world without steroids

June 21, 2013 — Mitul Kotecha

The sell off of risk assets in the wake of the Fed’s surprisingly direct FOMC communication continues unabated. Hopes that Fed chief Bernanke would attempt to assuage market concerns about tapering have been blown apart and instead the reality of forthcoming tapering continues to bite leading to higher US yields, weaker stocks and commodities and a firmer USD. In fact the USD appears to have finally re-established its positive relationship with yields and risk aversion.

The situation hasn’t been helped by the fact that data out of China has disappointed while local money market rates had risen sharply this week. Separately Japan’s reform momentum appears to have stalled ahead of Upper House elections as Prime Minister Abe’s third arrow missed target.

In combination these factors mean that markets are bracing for the day that they no longer have steroid injections to keep them going. Instead fundamentals will become important to sustain gains in risk assets. Why should anyone be surprised? US growth is recovering and at some point tapering has to occur. Unfortunately risk assets were just not ready for this revelation.

Ongoing volatility and uncertainty is likely to persist over the coming weeks as markets transition to an environment of Fed tapering, but this will give way to a renewed improvement in risk appetite and lower volatility later in the year.

The USD index continued to rise overnight having corrected around a third of its losses since 22 May. Gains remain broad based with gains registered against major and emerging market currencies. US Treasury yield differentials with other countries continue to widen across the board leaving the USD in strong form (10 year Treasury yield has risen by close to 80 basis points since early May).

Going forward firmer US data, taken together with higher US yields, will continue to drive the USD higher against major currencies, while some improvement in risk appetite as investors become accustomed to the prospects of Fed tapering will allow emerging market currencies to recover some, but not all lost ground against the USD.

Many currencies have become highly sensitive to US yields, with the TRY, NZD and INR the most sensitive over the past three months although notably most Asian currencies are near the top in terms of sensitivities.

Against this background unsurprisingly Asia continues to register capital outflows. All Asian countries have registered capital outflows this month, with total equity outflows of $10.2 billion registered, led by South Korea and Taiwan. Obviously the bigger concern is for deficit countries including India and Indonesia, with their currencies remaining particularly vulnerable to capital outflows.

Recent market volatility has meant that the prospects of Japanese investors stepping up their outflows have diminished over the near term. The latest data released yesterday showed that Japanese investors repatriated capital for a fifth straight week.

It is only a matter of time before outflows pick up as risk appetite improves as US yields move higher. The US 10Y Treasury yield advantage has widened versus Japanese JGBs to around 153bp and I expect this to widen further to around 185bp by the end of 2013. This will be consistent with a renewed slide in the JPY versus USD.

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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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Bernanke awaited, RBI stays on hold

June 17, 2013 — Mitul Kotecha

Central banks are very much in the spotlight. Whether it’s poor communication or disappointment over the lack of fresh stimulus measures in Japan or opposition to the European Central Banks’ (ECB) OMT policy being debated in the German constitutional court there is much to focus on. Against the background of heightened volatility and elevated risk aversion the Fed FOMC meeting on Wednesday will garner even more attention than usual.

Although no change in policy settings is expected the ability of Fed Chairman Bernanke to communicate effectively the Fed’s strategy over ‘tapering’ will be crucial to determine whether market volatility persists or lessens. Ultimately markets are likely to successfully transition to a world of reduced Fed asset purchases but this may take a while. In the meantime market stress is set to remain elevated.

Aside from the Fed FOMC meeting US data releases are likely to continue to show encouraging signs of housing market recovery, with US May housing starts and April existing home set to reveal gains. Meanwhile, CPI inflation will remain benign in May while the June Empire manufacturing survey today will reveal a slight improvement.

In Europe, there will be attention on a Eurogroup meeting on Wednesday where banking union will be discussed while data releases include the June German ZEW investor confidence survey (slight drop likely) and the flash estimates of June purchasing managers’ indices. These are likely to look less negative although they are set to remain in contraction territory. In Japan, May trade data will likely show a widening in deficit as weaker external demand outweighs the impact of a weaker JPY.

In FX markets USD selling against major currencies is likely to slow. The 4.4% drop in the USD index from its highs in late May has been rapid but it has led to a major shift in positioning. Speculative USD long positions have been cut back significantly, while EUR positioning is almost back to flat after being extremely short in previous weeks. Similarly JPY short positions are beginning to be pared back. I suspect that the EUR in particular will struggle to make much more headway.

Weakness of the USD against major currencies has contrasted sharply with USD strength against emerging market currencies. The sell off in Asian currencies has been particularly sharp although there was some tentative recovery towards the end of last week. The INR followed by the most risk sensitive currencies including PHP and THB have suffered the most over recent weeks.

The INR’s vulnerability has been particular high due to its external funding requirements although it may show some tentative signs of recovery over coming days as its sell off has looked overdone. The Reserve Bank of India policy meeting today offered no help for the INR. Although it was a close call there was a significant minority looking for a rate cut to boost growth. The lack of action will weigh on the INR in the short term.

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US dollar finding its feet

June 11, 2013 — Mitul Kotecha

Markets continue to second guess the Fed but the Fed’s Bullard did not provide much by way of clues overnight. Nonetheless, US Treasury yields continue to push higher. Taken together with an upgrade to US credit ratings by S&P ratings (in light of the better US fiscal outlook) provided some support to the USD. Data releases overnight provides little direction and a similarly lean data schedule today will leave markets without any major directional influences aside from reacting to the rise in US yields.

After dropping by around 3% the USD index looks to be showing greater stability and further gains are likely over coming weeks as the USD tracks US yields higher. Retail sales data on Thursday will provide more direction both to Treasuries and to the USD and a likely healthy reading expected ought to allow the USD to register further gains. Similarly June Michigan confidence data is likely to reveal that consumer sentiment remains at its strongest level since July 2007.

Conversely the EUR is unlikely to react well to the hearing in the German Constitutional court on a number of legal complaints in particular the ECB’s Outright Monetary Purchases (OMT) programme, with the German Bundesbank being of the most vociferous opponents of the programme. While the court is unlikely to rule against OMT, it will at the least highlight the divisions within the Eurozone over this and other policies.

The Bank of Japan’s inaction at its policy meeting today was met with disappointment. There was a significant minority expecting action especially the implementation of 2 year liquidity provisioning operations widely reported by the Japanese press. Consequently the JPY strengthened following the unchanged BoJ decision but its gains are likely to be limited. Relatively higher US yields suggest that the USD will renew its strength versus JPY.

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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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