Not much good news

There are a plethora of issues weighing on asset markets though sentiment has improved slightly today.  Weak Chinese trade data over the weekend and a revision lower to Japanese GDP data yesterday added to growing global growth concerns, against the background of waning hopes of a resolution to the US-China trade war.

US administration comments that there was a hard deadline for trade talks have not helped sentiment either.  News today that Chinese Vice Premier Liu He spoke with US Treasury Secretary Mnuchin and US Trade Rep Lighthizer on a timetable and road map on trade talks provided some relief, however.

In the US, growth expectations are undergoing a shift and talk of a Fed pause is growing.  This would be considered as good news for EM if it wasn’t for the fact that a pause could be due to US growth concerns rather than any sense that the Fed was approaching its terminal rate.  US November CPI, retail sales, and industrial production data will give more clues, but I still think the Fed policy rates next week.

In the UK, Brexit worries have intensified following the decision by Prime Minister May to the delay the vote on a deal in parliament given she would most likely would have faced a defeat had it gone ahead.  May will now go on a tour of European capitals to try to improve the Brexit deal but prospects don’t look good, especially as European Council president Tusk has already ruled out any negotiation of the deal and in particular the Irish backstop.

GBP was pummeled as a result of the delay and will continue to struggle in the short term given the lack visibility.  A revised deal appears difficult while a hard Brexit and even a new referendum are all on the table.

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Catching a falling knife

After a very long absence and much to the neglect to Econometer.org I am pleased to write a new post and apologise to those that subscribed to my blog, for the very long delay since my last post.   There is so much to say about the market turmoil at present, it is almost hard not to write something.

For those of you with eyes only on the continued strength in US stocks, which have hit record high after record high in recent weeks, it may be shocking news to your ears that the rest of the world, especially the emerging markets (EM) world, is in decidedly worse shape.

Compounding the impact of Federal Reserve rate hikes and strengthening US dollar, EM assets took another blow as President Trump’s long threatened tariffs on China began to be implemented.  Investors in countries with major external vulnerabilities in the form of large USD debts and current account deficits took fright and panic ensued.

Argentina and Turkey have been at the forefront of pressure due the factors above and also to policy inaction though Argentina has at least bit the bullet. Even in Asia, it is no coincidence that markets in current account deficit countries in the region, namely India, Indonesia, underperformed especially FX.  Even China’s currency, the renminbi, went through a rapid period of weakness, before showing some relative stability over recent weeks though I suspect the weakness was largely engineered.

What next? The plethora of factors impacting market sentiment will not just go away.  The Fed is set to keep on hiking, with several more rate increases likely over the next year or so.  Meanwhile the ECB is on track to ending its quantitative easing program by year end; the ECB meeting this Thursday will likely spell out more detail on its plans.  The other major central bank that has not yet revealed plans to step back from its easing policy is the Bank of Japan, but even the BoJ has been reducing its bond buying over past months.

The trade war is also set to escalate further.  Following the $50bn of tariffs already imposed on China $200 billion more could go into effect “very soon” according to Mr Trump. Worryingly he also added that tariffs on a further $267bn of Chinese goods could are “ready to go on short notice”, effectively encompassing all of China’s imports to the US.  China has so far responded in kind. Meanwhile though a deal has been agreed between the US and Mexico, a deal encompassing Canada in the form a new NAFTA remains elusive.

Idiosyncratic issues in Argentina and Turkey remain a threat to other emerging markets, not because of economic or banking sector risks, but due increased contagion as investors shaken from losses in a particular country, pull capital out of other EM assets.  The weakness in many emerging market currencies, local currency bonds and equities, has however, exposed value.  Whether investors want to catch a falling knife, only to lose their fingers is another question. which I will explore in my next post.

USD/JPY volatility at an extreme low

USD/JPY will continue to struggle to break higher in the short term, with the currency pair restrained by capped US yields. Indeed US Treasury yields have slipped over recent days. The range bound trading pattern for USD/JPY has resulted in a declining trend in both implied and realized volatility. The drop in volatility has been particularly sharp, with 1 month volatility at an extreme level according to our z-score analysis.

The implication is that it is cheap to USD/JPY volatility although it may need a trigger from a further increase in US yields and / or major improvement in risk appetite to spur an increase in volatility. Comments by the Bank of Japan’s Iwata yesterday that its not necessarily good if the JPY keeps depreciating is not conducive for higher volatility in the currency pair but likely further stimulus from the BoJ alongside wider yield differentials with the US, will mean that downward JPY pressure will resume soon at a more rapid pace in the months ahead.

Why the JPY will weaken

While I continue to forecast JPY weakness over the coming months the JPY is currently being buffeted by various forces. Elevated risk aversion has limited the downside for JPY as the currency has once again found a safe haven bid although it has weakened as risk appetite improved slightly overnight.

Going forward, I expect US Treasury yields to move sharply higher as the US economy gains momentum and loses the shackles of bad weather, pressurising USD/JPY higher. Additionally likely further easing by the BoJ in April / May will contribute to downward pressure on the JPY.

Separately Japan has shifted from possessing a relatively strong broad basic balance surplus (current account + direct investment + portfolio flows) to a deficit, a factor that will undermine the JPY over the coming months.

JPY and Asian FX outlook

JPY is facing a double whammy of upward pressure related to both rising risk aversion and a narrowing US yield advantage over Japan. The latter influence has been significant, with 10 year US Treasury yields dropping by around 70bps since the end of last year, versus 10 year Japanese JGB yields. The net result is that the currency pair has fallen sharply over recent weeks and will remain constrained until US yields resume their ascent.

In the near term the escalation of tensions in the Ukraine will fuel increased safe haven demand for JPY potentially leading to a test of a test of technical support around USD/JPY 100.62 (11 September 13 high). However, strong demand around the 101.20-30 level suggests that it may require another leg lower for US yields to fuel a further sharp drop in USD/JPY.

Asian currencies are set to continue to show some relative resilience to events in Ukraine although a weaker bias is expected. Most currencies remain relatively insensitive to gyrations in risk appetite except KRW which registers the biggest correlation with our risk barometer.

Overall, lower US yields will help provide some support to Asian currencies and investors will continue to differentiate based on domestic factors rather than shifts in risk appetite. Additionally some relative stability in the CNY / CNH may also help to limit pressure on Asian currencies.

US dollar restrained further

The USD will continue to be restrained by poor weather conditions and lower US Treasury yields (around 2.6%), especially against the JPY which has also been supported by higher risk aversion and consequent safe haven demand. The USD index is at threat from dropping to its October 2013 lows around 78.998 (currently 79.828)

A similar story applies to the CHF, with USD/CHF hitting its lowest level since late 2011 around 0.8783. This pattern will not change in the short term, especially given the potential escalation in tensions in the Ukraine, keeping the CHF under upward pressure as safe haven inflows increase. EUR/CHF has dropped sharply as a result, with the resolve of the Swiss National Bank to support its line in the sand at 1.20 set to be tested shortly.

Risk currencies in contrast will likely come under growing short term pressure including AUD, NZD and many emerging market currencies. AUD/USD will likely trade with a heavy tone even though the RBA is unlikely to cut policy rates at its meeting tomorrow.

EUR benefitted from the upside surprise for Eurozone inflation but has run into resistance around 1.3800 versus USD. Speculative EUR positioning has continued to rise but the fact that CFTC IMM positioning has risen to above its 3 month average suggests that further EUR gains will be more limited.

Indeed although the USD continues to be restrained by weaker data and lower US yields, the potential for a dovish surprise from the ECB will limit the ability of the EUR to capitalise on USD weakness this week. Strong technical resistance for EUR/USD will be found around 1.3894 (2013 high).

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EUR and JPY outlook

EUR/USD took some advantage of a softer USD tone, with the currency pair breaking above 1.37 once again. However, the release of flash Eurozone HICP inflation readings today will take the shine off the EUR given that it will likely support the case for further policy easing at the 6 March European Central Bank policy meeting.

Benign readings for both headline and core inflation estimates are expected to be revealed today, consistent with small cuts in the ECB’s refi rate and strengthened forward guidance. EUR/USD will find strong resistance around its 2014 high at 1.3776.

Japan’s data slate released this morning came in better than expected. The jobless rate held at low level at 3.7% while the jobs to applicants’ ratio increased to 1.04 in a further sign of strengthening job conditions. CPI inflation marked its 8th straight month of gains while industrial production, retail sales and overall household spending beat expectations.

The main take away is that inflation is close to peaking and the risks of further Bank of Japan policy action is rising. This will limit the downside for USD/JPY but further slippage in US yields overnight mean that USD/JPY upside remains restrained. 101.67 – 102.85 is likely to hold as a near term range for the currency pair.

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