Risk and carry attraction increasing

July 4, 2012 — Mitul Kotecha

The outcome of the EU Summit together with hopes of monetary stimulus has definitely helped to put a floor under risk appetite. Indeed, such monetary stimulus expectations are reflected in the price of gold which continued to rise overnight. Risk assets in general have maintained a positive tone recently and even forward looking indicators of global activity such as the Baltic Dry Index have been trending higher.

Although it is difficult to become too positive given the still very significant downdraft to global growth officials in Europe have bought some time to get their collective house back in order. Whether they will use it wisely is another question entirely. It is difficult to see much of a market move ahead of the ECB Council meeting and US June jobs report this week. Moreover, the US Independence Day holiday will keep trading subdued today.

My Risk Barometer has moved back into ‘risk neutral’ territory following several weeks of remaining in ‘risk hating’ territory. Consequently the backdrop for risk currencies has turned positive. Although FX trading has become more subdued amid summer conditions and a US holiday today as reflected in the drop in implied volatilities, there is a clear sense that investors are increasingly moving into carry trades.

My Yield Appetite Index {YAI) has surged over recent weeks, now at its highest in several months. I remain concerned that markets are addicted to stimulus while underlying economic conditions remain weak as likely revealed in today’s releases of June service sector purchasing managers’ indices in Europe.

Nonetheless, it seems likely according to my risk measures that the current tone of risk / carry attraction will persist for some weeks to come. The currencies that will benefit in an environment of improving risk appetite / yield attraction are the ZAR, MXN, PLN, CAD & NOK by order of magnitude of correlation with our risk barometer.

However, the beneficiaries are by no means limited to these currencies. Almost every currency except the ARS and PHP has a statistically significant correlation with the risk barometer. The only currencies that come under pressure as risk appetite improves are the USD and JPY given their negative correlations.

Currencies with healthy carry such as the AUD, which broke above its 200 day moving average versus USD overnight, will be even bigger beneficiaries as investors pile into carry trades over coming weeks as indicated by the jump in our YAI.

Notably there is plenty of scope to build carry positions as our speculative measure of yield attraction (based on CFTC IMM data) remains relatively low, suggesting that leveraged investors have still not jumped on the carry bandwagon.

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USD and JPY remaining firm

June 27, 2012 — Mitul Kotecha

The USD has rebounded since 19 June in the wake of growing uncertainties and potential disappointment emanating from the EU Summit. As I previously highlighted a rally in the USD was to be expected in the wake of an extension of Operation Twist.

Looking ahead, as Bernanke and Co. also left open the option of more quantitative easing the USD is not out of the woods yet. The USD’s path will not only depend on risk but also on upcoming data releases. A further run of weak data will once again raise the spectre of more QE potentially leading to a softer USD.

Today’s US releases are unlikely to lend support to QE expectations, however. A bounce in May durable goods orders is expected while pending home sales are likely to recoup some of the sharp drop registered in April. However, markets will have to wait until next week for the release of the most important indicator, the June jobs report, before a clearer USD direction emerges.

USD/JPY remains well and truly constrained below the 80.00 level. Elevated risk aversion and a decline in the US yield advantage over Japan are acting as a restraint to any upside move in USD/JPY. Moreover, I do not expect any impact on the JPY from the passage of a bill to raise the consumption tax. Evidence that the Japanese economy is recovering may explain the lack of official enthusiasm to weaken the JPY but this assessment is prone to disappointment.

Increasingly, JPY bears are becoming frustrated by the lack of JPY downside traction. This has been reflected in the turnaround in speculative sentiment which turned positive for the first time in 15 weeks. Going forward, it will be difficult for USD/JPY to rise much unless US yields move higher. Eventually I think this will happen and look for USD/JPY to end the year around 83.00

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Chronology of a Crisis – endgame?

June 21, 2012 — Mitul Kotecha

Please see below an extract from my forthcoming book Chronology of a Crisis (Searching Finance 2012).

The departure of Greece from the Euro is by no means a forgone conclusion but if it happens it is not clear that global policy makers have much ammunition left to shield markets from the resulting fallout.

Stimulus after stimulus has only left governments increasingly indebted. The price of such largesse is now being paid in the form of higher borrowing costs. Even central banks do not have much ammunition left. Admittedly further rounds of quantitative easing, and central bank balance sheet expansion may help to shore up confidence but the efficacy of such policy actions is questionable. Moreover, policy support may only help to buy time but if underlying structural issues are not resolved pressure could resume quickly.

Against this background Europe is under intense pressure and there is little time left before it results in something catastrophic for global markets via a disorderly break up of the Eurozone. EU leaders and the European Central Bank (ECB) have to act to stem the crisis. However, at the time of writing the ECB under the helm of Mario Draghi is steadfastly refusing to provide further assistance to the Eurozone periphery either directly via lower interest rates or securities market purchases or indirectly via another Long term refinancing operation (LTRO). Any prospect of debt monetization as carried out already by other central banks including the Fed and Bank of England is a definite non-starter. The reason for this intransigence is that the ECB does not want to let Eurozone governments off the hook, worrying that any further assistance would allow governments to slow or even renege upon promised reforms.

Whether this is true or not it’s a dangerous game to play. The fact that the previously unthinkable could happen ie a country could exit the Eurozone should have by now prompted some major action by European officials. Instead the ECB is unwilling to give ground while Germany continues to stand in the way of any move towards debt mutualisation in the form of a common Eurobond and/or other measures such as awarding a banking license to the EFSF bailout fund which would effectively allow it to help recapitalize banks and purchase peripheral debt. Germany does not want to allow peripheral countries to be let off the hook either, arguing that they would benefit from Germany’s strong credit standing and lower yields without paying the costs.

To be frank, it’s too late for such brinkmanship. The situation in The Eurozone is rapidly spiraling out of control. While both the ECB and Germany may have valid arguments the bottom line is that the situation could get far worse if officials fail to act. As noted above there are various measures that could be enacted. Admittedly many of these will only buy time rather than fix the many and varied structural problems afflicting a group of countries tied together by a single currency and monetary policy and separate fiscal policies but at the moment time is what is needed the most. Buying time will allow policymakers to enact reforms, enhance productivity, reform labour markets, increase investment funds etc. Unfortunately European policy makers do not appear to have grasped this fact. Now more than at any time during the crisis much depends on the actions of policy makers. This is where the major uncertainty lies.

If officials do not act to stem the crisis, economic and market turmoil will reach proportions exceeding that of even the Lehmans bust.

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US dollar could stall as QE hopes rise

June 4, 2012 — Mitul Kotecha

Growth concerns are increasingly accompanying Eurozone tensions as major weights on market sentiment. US jobs data at the end of last week which revealed a disappointing 69k increase May payrolls added to other data including weaker than expected Chinese purchasing managers index (PMI) and even more disappointing Eurozone data highlighting intensifying downside risks to economic activity.

Combined with the lack of traction towards solutions to the Eurozone crisis it has led to an acceleration in the demand for safe haven assets. The weak US data has also reopened the debate about more US quantitative easing, with Fed Chairman Bernanke’s congressional testimony on the economic outlook on Thursday likely to garner plenty of attention.

Another central bank under pressure to act is the European Central Bank (ECB) but action such as restarting its Securities Market Purchases program and/or a third Long Term LTRO are unlikely to take place at least until after the Greek election on June 17 if at all. Until then investors will have to put up with more procrastination, prevarication and inaction from policy makers in Europe as the ECB continues its game of chess with European politicians.

Other central banks in focus this week include the Reserve Bank of India (RBA) and Bank of England (BoE) but while the ECB may still cut policy interest rates this week it is not obvious that the other central banks will follow suit despite growing pressure for easier policy. Against this background risk measures will remain highly elevated while core bond yields will remain suppressed and the USD will remain on the front foot.

The weaker than forecast US May jobs report has really set the cat among the pigeons. The prospects of more Fed quantitative easing is firmly back on the table and while Fed Chairman Bernanke is unlikely to countenance such action in his testimony this week, the market will still speculate on this option. Consequently the USDs one way bet is not longer so clear cut despite the elevated level of risk aversion providing some support for the currency.

Ahead of Bernanke’s testimony on Thursday the USD will struggle to make too much headway leaving the currency to consolidate its gains in the short term. Other US data releases this week are inconsequential for FX markets although the Fed’s Beige Book will be watched for clues ahead of the Fed’s 19-20 June FOMC meeting.

EUR/USD is well off its lows and will consolidate ahead of Thursday’s ECB meeting. Event risk is high and various rumours have resulted in a cautious tone for EUR bears. Talk of a ‘secret master plan’ consisting of structural reforms, banking union, fiscal union and political union to save the EUR as well as of the ECB buying sovereign bonds will keep markets wary of aggressively selling EUR from current levels. Attention is centred on Spain and its banking sector and debate about the country is next in line for a bailout.

Worries about Spain and of course the outcome of Greek elections on June 17 will limit any bounce in the EUR. Nonetheless, speculative positioning in EUR/USD reached another all time low in the latest week according to the CFTC IMM data, suggesting that scope for short covering is growing. EUR/USD will find technical support around its 2012 low around 1.2287 while upside potential will be restricted to resistance around 1.2505.

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Indian Rupee – How low can it go?

June 2, 2012 — Mitul Kotecha

Sentiment for the Indian rupee (INR) has gone from bad to worse. A number of concerns have hit the currency including weak economic data, deteriorating confidence in government policies, and intensifying risk aversion. The latest blow to the rupee came from data showing that economic growth in Q1 2012 slowed to 5.3% the slowest pace of growth in nine years. Worryingly high interest rates in the wake of persistent inflation pressures have damaged investment spending, a major weak point in the Q1 data. High inflation at over 7% means that the Reserve Bank of India has limited room to ease policy but the central bank has hinted at lower rates in the wake of lower oil prices.

These economic pressures have come at a time when the global environment has worsened. India was already more vulnerable compared to its Asian neighbours due it’s twin current account and fiscal deficits. Strong growth had put concerns about these deficits on the backburner but with growth slowing it only exposes India’s fragility. While less exposed to a global trade slowdown compared to other countries in the region India nonetheless is highly exposed to financial contagion. The INR is a high beta currency, sensitive to the vagaries of risk. The rise in risk aversion over recent weeks left the currency highly vulnerable as its sharp decline attests to.

Despite a host of regulation changes from the authorities the INR has continued to fall, with no let up in sight. While the RBI has suggested that it could sell USDs to oil companies to stem the decline in the rupee it may only result in slowing INR declines in the current environment. It’s decline against the USD has surpassed other Asian currencies. Interestingly there has not been a major exodus of portfolio capital from India, surprising given that other Asian countries such as Korea and Taiwan have seen significant outflows of equity capital. Nonetheless an escalation in the Euro crisis could quite easily change the picture for the worse.

It is not all bad news for the INR. While it will remain under pressure for some time yet from a valuation perspective the INR is looking increasingly cheap. I wouldn’t run out and buy it just yet but I would argue that a lot of bad news is already priced in to the currency. Investors will need to see some better news both externally and domestically and unfortunately this is lacking, but should risk appetite began to turn around the potential for rupee appreciation is significant for a currency that has lost close to around 20% of its value over the last 12 months. In the meantime, the best that could be hoped for is a slowing in the pace of depreciation, with a fall to around 57-58 versus USD on the cards over coming weeks.

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