Australian Dollar Looking Stretched

April 7, 2011 — Mitul Kotecha

Central bank decisions in Japan, Europe and UK will dictate FX market direction today. No surprises are expected by the Bank of Japan (BoJ) and Bank of England (BoE) leaving the European Central Bank (ECB) decision and press conference to provide the main market impetus. Although a hawkish message from ECB President Trichet is likely the market has already priced in a total of 75 basis points of tightening this year. We retain some caution about whether the EUR will be able to make further headway following the ECB meeting unless the central bank is even more hawkish than already priced in.

EUR/USD easily breached the 1.4250 resistance level and will now eye resistance around 1.4500. News that Portugal formally requested European Union (EU) aid came as no surprise whilst strong German factory orders provided further support to the EUR. The data highlights upside risks to today’s February German industrial production data. The EUR will find further support versus the USD from comments by Atlanta Fed’s Lockhart who noted that he doesn’t expect the Fed to hike interest rates by year end.

USD/JPY is now around 7.5% higher than its post earthquake lows. Japanese authorities will undoubtedly see a measure of success from their joint FX intervention. To a large degree they have been helped by a shift in relative bond yields (2-year US / Japan yield differentials have widened by close to 30 basis points since mid March, and are finally having some impact on USD/JPY as reflected in the strengthening in short-term correlations. Whilst the BoJ is unlikely to alter its policy settings today the fact that it is providing plenty of liquidity to money markets, having injected around JPY 23 trillion or about 5% of nominal GDP since the earthquake, is likely playing a role in dampening JPY demand.

AUD/USD has appreciated by close to 6% since mid March and whilst I would not recommend selling as yet I would be cautious about adding to long positions. My quantitative model based on interest rate / yield differentials, commodity prices and risk aversion reveals a major divergence between AUD/USD and its regression estimate. Clearly the AUD has benefitted from diversification flows as Asian central banks intervene and recycle intervention USDs. However, at current levels I question the value of such diversification into AUD.

Speculative AUD/USD positioning as indicated by the CFTC IMM data reveals that net long positions are verging on all time highs, suggesting plenty of scope for profit taking / position squaring in the event of a turn in sentiment. Moreover, AUD gains do not match the performance of economic data, which have been coming in worse than expected over recent weeks. Consequently the risks of a correction have increased.

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Markets in limbo ahead of policy rate decisions

April 6, 2011 — Mitul Kotecha

Markets are generally range-bound ahead of tomorrow’s Japan, Eurozone and UK interest rate decisions, as reflected in the flat performance of equity markets overnight. Risk appetite remains positive though still lower than the high levels seen during most of March. China’s interest rate hike did not change the market’s perspective, with markets reacting well.

Overnight the Fed FOMC minutes reflected a range of opinions on the timing of the end of QE2 and the Fed’s exit strategy but the majority view was to end QE2 as planned at the end of June leaving markets, with little new to digest. The USD was a little undermined by a weaker than expected US March ISM non-manufacturing survey but losses are likely to be limited.

Meanwhile there was more negative peripheral news in Europe, with Moody’s cutting Portugal’s sovereign credit ratings by one notch, with Moody’s highlighting the urgent need for financial support from the EU. Portuguese debt took a hit but eurozone markets in general including the EUR continue to take such news in their stride, with EUR/USD holding above 1.4200. Firm readings for the eurozone final services purchasing managers index (PMI) in March helped to support sentiment, outweighing the negative impact of a drop in eurozone retail sales.

GBP was a key outperformer, helped by a much stronger than expected services PMI, which helped GBP/USD breach 1.63 overnight. Today’s industrial and manufacturing production data will likely reveal firm readings too, helping GBP to consolidate its gains but the currency looks rather rich around current levels, with risks skewed to the downside.

JPY was another mover, having breached 85.00 versus the USD, with USD/JPY now some 6 big figures higher from its post earthquake lows. Japanese authorities will undoubtedly see a measure of success from their joint intervention but the reality is that the shift in bond yields (2-year US / Japan yield differentials have widened by close to 30 basis points since mid March, are finally having some impact on USD/JPY as reflected in the strengthening in short-term correlations.

EUR/USD remains resilient to negative peripheral news such as the Portugal credit ratings downgrade, with further direction from tomorrow’s European Central Bank (ECB) meeting and accompanying statement. The risk that the ECB is not as hawkish as the market has priced in holds some downside risks to EUR.

Asian currencies are holding up well though it looks as though the ADXY (Bloomberg-JP Morgan Asian currency index) may have hit a short term barrier. Range trading for EUR/USD suggests little directional influence for Asian currencies in the short-term. Nonetheless, portfolio capital inflows continue to support Asian FX with all Asian equity markets recording foreign inflows so far this month. In particular, KRW continues to outperform. Note that Korea has recorded a whopping inflow of $1.1bn in equity inflows month-to-date.

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FX sensitivities to yield differentials

April 1, 2011 — Mitul Kotecha

A lot has been made about the hawkish language from a few Federal Reserve FOMC members over recent days and growing speculation about whether quantitative easing (QE2) will end earlier than initially planned. In turn, this has been noted as a positive factor for the USD. Undoubtedly there are a few in the Fed who are becoming more nervous about current policy settings but it is highly unlikely that the Fed will not complete its $600 billion in planned asset purchases by the end of June.

The biggest imponderable is how and when the Fed begins its exit policy and how effectively/efficiently it can be done. Whilst it is likely to be over a year before the Fed Funds rate is hiked, the USD will be sensitive to balance sheet reduction. Moreover, the way in which the Fed reduces the size of the balance will also be important given the likely active approach to liquidity withdrawal required.

For the present, it should be noted that even with the hawkish Fed rhetoric and increase in US bond yields (2 year yields have risen by close to 25bps over the last couple of weeks) the USD is actually lower versus EUR than where it was two weeks ago. The reality is that German bund yields have risen by even more than US yields ahead of the anticipated European Central Bank (ECB) rate hike on 7 April (the case for which appears to have been sealed by the above consensus 2.6% YoY reading for March eurozone CPI).

However, I would be cautious about ascribing general FX moves at present to yield / interest rate differentials given that it is only EUR crosses (including EUR/JPY, EUR/GBP, EUR/CAD, and EUR/USD) that hold a statistically significant relationship with yields. All of this implies EUR crosses look supported ahead of the upcoming ECB meeting, with EUR/USD unlikely to sustain a drop below 1.4000 ahead of the rate decision. What happens after depends on the press conference. Bearing in mind that markets have already priced in 75bps of rate hikes by the ECB it would take an even stronger tone from the ECB to push the EUR higher, something that looks unlikely

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Equity Flow Reversal Supports Asian FX

March 30, 2011 — Mitul Kotecha

Asian currencies have rebounded smartly from their post Japan earthquake lows on March 16. The ADXY (Bloomberg-JP Morgan Asia Currency index) is now at its highest level since September 1997 reflecting a sharp rebound in capital inflows to the region. The performance of Asian currencies continues to correspond closely with the movement in capital flows.

Although almost all Asian equity markets have registered outflows so far this year (total equity outflows -$6.2bn), the trend is reversing. Over the past month there has been a major slowing in capital outflows for most countries in Asia whilst India, Thailand and the Philippines have actually registered sizeable inflows. South Korea is notable in that there has been a sharp increase in equity capital inflows over the past week.

Although there has been much focus on a rotation of capital flows out of Asia and into developed economies this year, it is worth noting that the pattern of equity flows in Q1 2011 has not been too different from that witnessed in the past couple of years. In both 2009 and 2010 equity outflows were recorded over the two (2010) or three (2009) months of the year before a reversal took place. This pattern looks like it is repeating itself.

Clearly the environment for Asian equity markets is not as supportive as it was last year given the belated tightening in monetary policies being undertaken by many central banks and prospects of an end to QE2 in the US. Whilst this will result in some reduction in capital flows to the region compared to last year, the overall outlook is positive. Easing risk aversion (our risk aversion barometer has already reversed all of its post Japan earthquake spike and is trending lower), positive growth outlook and maintenance of low US rates point to more inflows.

One currency in particular that will benefit is KRW, with a further drop in USD/KRW likely over coming weeks. KRW has already strengthened by around by around 2.7% since its post Japan earthquake low making it the best performing currency since then. Further gains are likely; a test of USD/KRW 1100 is on the cards in the short-term, with the year end target standing at 1050.

Why buy KRW? 1) Korea has registered the biggest improvement in equity capital flows recently, 2) KRW has been the most sensitive Asian currency to risk over the past month and therefore benefits the most as risk appetite improves, 3) Estimated Price/Earnings ratio for Korean equities looks cheap compared to its historical z-score according to our estimates. As a result our quantitative model on USD/KRW based on commodity prices, risk aversion and equity performance highlights the potential for significantly more KRW strength.

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Risk on, US dollar pressure

March 22, 2011 — Mitul Kotecha

FX markets have plenty of different factors to digest these days and after a harrowing couple of weeks markets began this week on a firmer footing. The overall tone into this week is to load up on risk assets. News that the nuclear situation in Japan may closer to stabilising has helped, whilst markets easily shook off another hike in China’s reserve ratio and ongoing conflict in Libya as Allied forces step up their campaign in the face of continuing resistance from Gaddafi’s forces.

Improved risk appetite has helped to keep the JPY on the defensive along with the continued threat of FX intervention, with further official JPY selling likely in the days ahead. Interestingly the intervention last Friday was estimated at only JPY 530 billion ($6.2 billion), much lower than previously thought. USD/JPY 80 remains a major line in the sand and any sign of another breach of this level will likely be met with official JPY selling. I suspect that the Japanese authorities will not be content until USD/JPY is far higher. In this respect its worth noting an official report released earlier in March highlighting that Japanese companies are not profitable at a USD/JPY rate below 86.

The EUR looks overbought around the 1.42 level but seems to be a beneficiary of Japanese FX intervention (perhaps a recycling of USDs into EUR) as well as comments by European Central Bank (ECB) Council members reiterating their intention to hike the refi policy rate, likely at the April ECB meeting. In a similar vein to the recycling of intervention USDs into EUR, Middle East entities may also be recycling petrodollars into EUR whilst news that Russia has permitted one of its oil related funds to buy Spanish debt has given a lift to sentiment for the EUR. Over the near term EUR/USD may struggle to make much headway above 1.42, with further direction coming from the EU leaders meeting on 24/25 March.

GBP is also doing well, having jumped close to the 1.6400 level versus USD, with UK February CPI giving the currency a further lift. The outcome at 4.4% YoY, which was not as bad as rumoured but in any case worse than consensus will give the hawks in the Bank of England MPC further ammunition to push for a policy rate hike. The fact that core inflation also increased suggests that the jump in headline inflation cannot merely be brushed under the table. A BoE rate hike is increasingly looking like a done deal. Renewed inflation worries in the UK and the hawkish rhetoric from ECB officials is sufficient to keep the USD under pressure.

Posted in central banks, Currencies, ECB, Economics, Economy, Europe, eurozone, Federal Reserve, FX, Interest rates, Monetary Policy, UK, US. Tags: , , , , , , , , , , , , , , , , , , , , , , , , . Leave a Comment »
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