Australian dollar unworried by political developments

June 27, 2013 — Mitul Kotecha

The USD remains firm but is struggling to make further headway against major crosses. Some improvement in risk appetite, firmer equity markets and slightly lower yields today may limit the ability of the USD to extend its gains in the near term (as the USD usually suffers when risk appetite improves and US yields drop) although we expect any setback to prove temporary, with US Treasury bond yields set to continue to move higher over the coming weeks, albeit at a more gradual pace.

USD/JPY’s rebound has stalled over recent days despite the fact that US bond yields have continue to rise relative to Japanese JGB yields. My analysis of JPY performance during the last thee periods of sharply higher US yields shows that the JPY weakened versus USD in the first two periods and is on the verge of doing so in the third period (since early May).

Additionally the JPY has maintained a strongly negative correlation with US yields over the past 12 months. All of this suggests that the JPY will resume a weaker trend over coming weeks although markets may wait until the Japanese Upper House elections on July 21 and subsequent news of further reforms before pushing the JPY much weaker.

It if wasn’t enough that the AUD was suffering from higher US yields and China concerns, the announcement of a leadership election for the Labor leadership will have done little to bolster confidence in the currency. That said, politics is not an important driver of the AUD and the currency managed to eek out some gains despite Prime Minister Gillard’s loss in the contest.

Some easing in funding tensions among China’s banks has helped the AUD, with the currency showing encouraging signs of stabilization over recent days. However, its limited progress is still a long way from becoming a sustained rally. AUD/USD has a very negative correlation with 10 year US Treasury yields over the past 3 months, and continues to remain susceptible to further US yield increases until the market finally becomes accustomed the prospects of Fed tapering.

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Risk appetite continues to shrink

June 13, 2013 — Mitul Kotecha

Risk appetite continues to shrink as the ongoing nervousness over Fed tapering continues to provoke significant position adjustments across markets. Markets will have to wait for next week’s Fed FOMC meeting to find to find greater clarity over the timing and extent of Fed tapering although there will be some further input to the Fed decision from today’s US May retail sales release.

In the meantime US Treasury yields continue to move higher even as risk aversion also intensifies, revealing the extent of the shake out that is currently being felt in US bond markets. The USD which would usually be expected to rally on higher yields and elevated risk aversion, remains under pressure against most major currencies although it continues to run havoc against emerging market currencies.

USD/JPY’s decline is showing no sign of abating. The combination of elevated risk aversion and disappointment over recent policy announcements, in particular the lack of detail about Prime Minister Abe’s third arrow, has prompted ever more upside for the JPY. The impact of these factors is negating the impact of higher US Treasury yields, which would usually act to push USD/JPY higher.

As the rout in equity markets appears to be showing little sign of subsiding the JPY looks firmly supported in the near term, especially as the picture is unlikely to change ahead of next week’s FOMC meeting. Additionally, the options market looks to be expecting more JPY upside as reflected in risk reversal skews, with volatility overall continuing to look elevated.

The RBNZ policy decision overnight provided another blow to the NZD, with the central bank highlighting that economic growth is “uneven” and noting that the kiwi remains overvalued, acting as a burden on the tradables sector of the economy. Moreover, in the Q&A session governor Wheeler maintained the pressure on the currency, indicating once again the risks of FX intervention to weaken the NZD if needed.

After dropping by over 8% since its cyclical peak on early April the NZD looks set to remain under pressure in the short term amid elevated risk aversion although it was encouraging that the currency did not fall further following the RBNZ. Our valuation models show that the currency is oversold and if anything the selling pressure will abate over coming weeks.

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A volatile period of transition

June 4, 2013 — Mitul Kotecha

The drop in the US ISM manufacturing confidence index in May to close to 4 year low failed to have a sustained impact on equity markets. Perversely weaker data is leading to less fears of Fed tapering which in turn is boosting equity markets. Surely equities should fall as data comes in weak but clearly that is not the case. In any case the contraction in the ISM is highly unlikely to presage a new phase of economic weakness.

Markets continue to await central bank meetings and the US May jobs data at the end of the week for further direction but ahead of that volatility whether in the interest rate, FX or equity spectrum shows little sign of dissipating. During a period of policy transition as we appear to be in now, such volatility should be expected but could prove dangerous if prolonged.

The USD has lost ground even as risk aversion has moved higher, a factor that would normally be associated with a stronger USD. The USD received a blow from the weaker than forecast US ISM manufacturing index which led to Treasury yields slipping from their highs.

Hesitation ahead of Friday’s payrolls data may also explain some of the inability of the USD to strengthen and given that aggregate USD speculative positioning reached an all time high last week profit taking on USD longs is unsurprising. However, the move is unlikely to mark the start of a deeper pull back and assuming that the US jobs report continues on an improving trajectory the USD will likely resume its uptrend over coming weeks.

After reaching a high close to 104 USD/JPY has dropped all the way back to below the 100 level. Part of the explanation comes from elevated risk aversion but also heightened volatility in the local equity and bond markets which has prompted USD/JPY liquidation. Is this the end for JPY bears? More likely the pull back will prove temporary especially as yield differentials have actually widened in favour of the USD over recent days.

Meanwhile, capital flow data will continue to be watched carefully to determine whether Japanese lifers and the government pension fund are finally moving money offshore, something that has not happened yet. Strong support for USD/JPY is seen around the 50 day moving average level at 99.08.

AUD/USD has benefitted from a short squeeze and looks to have bottomed out just above 0.96 versus USD which ought to provide a solid base for the currency. AUD looks especially attractive relative to NZD. As I have been noting the AUD has already priced in a lot of bad news and our quantitative model points to upside versus USD. Reflecting this is the fact that speculative positioning has dropped to extreme levels leaving the AUD susceptible to further short covering.

One obstacle to AUD recovery is the RBA but perversely the drop in the AUD over recent weeks will have given the Bank further reason not to ease policy today, which in turn will play well for the currency.

Rather than facing more pressure as would be expected in the wake of weaker US manufacturing confidence data Asian currencies have actually benefitted as the USD has weakened overnight. The PHP has been a star performers and according to my quantitative models is set for further gains. I am wary of looking for much further upside for Asian currencies, however, especially as the USD pull back is likely to prove short lived.

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After the storm

May 27, 2013 — Mitul Kotecha

As last week’s volatility in Japanese markets demonstrates central banks do not have it all their own way. Unfortunately for Japan the risk remains that policy makers spur higher yields without accompanying growth, an outcome that would be highly undesirable, especially if it hits economic activity. Equity markets and risk assets in general came under pressure and safe havens found long lost bids, with core bond yields moving lower and JPY and CHF strengthening.

The heightened volatility in markets was also partly triggered by concerns about the timing of the tapering off of Fed asset purchases, with Fed Chairman Bernanke setting the cat amongst the pigeons by with commenting about the possibility of reducing asset purchases over the next few meetings. Additionally weaker than forecast Chinese manufacturing confidence data came as another blow to markets. While the market reaction looked a tad overdone in it is notable that the dichotomy between growth and equity market performance has widened over recent weeks.

This week is likely to begin on a calmer note, with holidays in the US and UK today. Data releases in the US will remain encouraging , with May consumer confidence likely to move higher although US Q1 GDP is likely to be revised slightly lower to 2.4% due an inventories hit. In Europe, while the trajectory of recovery is starting from a much lower base there will be some improvement in business confidence in May while inflation will be well contained at 1.3% YoY in May, an outcome that will maintain room for more European Central Bank policy easing. In Japan a sixth straight negative CPI reading will highlight jus how difficult the job is for the Bank of Japan to meet its inflation target.

The JPY was a major beneficiary of last week’s volatility helped by short covering as speculative positioning in the currency reached its lowest level since July 2007. A calmer tone to markets ought to ensure that JPY upside will be limited and USD buyers are likely to emerge just below the USD/JPY 100 level. In contrast the EUR has been surprisingly well behaved despite the fact that speculative EUR positioning has also dropped sharply over recent weeks. While the overall trend is lower EUR/USD will find some support on any dip to around 1.2795 this week.

AUD and NZD have been particularly vulnerable in the wake of higher risk aversion and weak Chinese data. Some calm ought to ensue over coming days, with AUD prone to short covering given the sharp drop in speculative positioning in the currency over recent weeks. Asian currencies have similarly been under pressure. Some stabilisation in risk appetite will give relief to Asian currencies this week as will a relatively firm CNY.

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Taking the wind out of the EUR, JPY watching the flow, AUD watching RBA

May 7, 2013 — Mitul Kotecha

Market activity was limited yesterday due to holidays in the UK and Japan but will pick up today as both markets reopen. The positive reverberations from the US April jobs report continue to provide a fillip to markets but the impact is already fading.

Once again risk assets are relying on central banks to provide the steroids for further support. In this respect it was the turn of European Central Bank President Draghi to take up the baton yesterday as he noted that further interest rate cuts are possible. Today’s data slate is thin, with the Reserve Bank of Australia policy decision and German March factory orders the main highlights.

ECB President Draghi took the wind out of the EUR’s sails as he highlighted the possibility of further policy easing. Also helping to keep the EUR under pressure was the rise in US Treasury yields; the 10 year yield differential with bunds has widened to close to 52 bps, which due to the strong correlation with EUR/USD is likely to cap any gains in the currency pair.

As Draghi noted prospects for further easing will be highly data dependent which in turn means that the EUR will be more data sensitive in the weeks ahead. The prospects of negative deposit rates in particular will continue to send shivers down the spines of EUR bulls. Look for EUR/USD to be capped around 1.3168.

As Japan returns from holiday USD/JPY is verging once again on a test of psychologically important 100 level. The trigger for the renewed bounce in USD/JPY was a jump in US bond yields following the better than expected US jobs report. In the absence of major US data releases this week Fed speakers including Chairman Bernanke will give further direction to bonds and in turn USD/JPY.

A further widening in the US yield advantage over Japan will be required to push USD/JPY higher especially as recent flow data have shown both Japanese investor repatriation and net foreign buying of Japanese portfolio assets. Despite these inflows we expect a break of 100 to occur very soon, with appetite for foreign assets from Japanese lifers and government pension fund, providing much of the ammunition for a sustained move higher.

AUD has started the week badly having suffered in the wake of the weaker than expected Chinese service sector confidence data and the surprise drop in Australian retail sales in March. Reports that the Australian Treasury will lower growth forecasts for the next two years in part due to AUD strength does not bode well for the currency either.

The data has emboldened doves looking for a policy rate cut from the RBA today and while the decision is a very close call as reflected in market pricing and consensus expectations, the balance of risks suggests that the RBA will hold off this month. This may however, come as scant relief for AUD as markets will likely push back easing expectations to the next meeting on 4 June.

Nonetheless, downside for AUD is likely to be limited, with speculative positioning already at a relatively low level. Strong support for AUD/USD is likely around the 4 March low at 1.0115.

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