Nervousness Creeping Back – US dollar firmer

Last week ended on a sour note as concerns over second round virus cases intensified; Apple’s decision to close some US stores in states where cases are escalating added to such concerns. This overshadowed earlier news that China would maintain its commitment to buying US agricultural goods.  Although on the whole, equity markets had a positive week there is no doubt that nervousness is creeping back into the market psyche.  Indeed it is notable that the VIX equity volatility “fear gauge” ticked back up and is still at levels higher than seen over most of May.

Economic recovery is continuing, as reflected in less negative data globally, but hopes of a “V” shape recovery continue to look unrealistic.  In this respect the battle between fundamentals and liquidity continues to rage.  Economic data has clearly turned around, but the pace of improvement is proving gradual.  For example, last week’s US jobless claims data continued to trend lower, but at a slower pace than hoped for.  A second round of virus cases in several US states including Florida, Arizona and the Carolinas also suggest that while renewed lockdowns are unlikely, a return to normality will be a very slow process, with social distancing measures likely to remain in place.  Geopolitical tensions add another layer of tension for markets.  Whether its tensions between US/China, North/South Korea, India/China or the many other hot spots globally, geopolitical risks to markets are rising.

The USD has benefitted from increased market nervousness, and from US data outperformance, with US data surprises (according to the Citi economic surprise index) at around the highest on record.  JPY has bucked the trend amid higher risk aversion as it has regained some of its safe haven status. GBP was badly beaten last week selling off from technically overbought levels, amid fresh economic concerns and a dawning reality that a Brexit trade deal with the EU may be unreachable by year end.  EUR looks as though it is increasingly joining the club on its way down. Asian currencies with the highest sensitivities to USD gyrations such as KRW are most vulnerable to further USD upside in Asia.

Data highlights this week include the May US PCE Report (Fri) which is likely to reveal a bounce in personal spending, Eurozone flash June purchasing managers indices (PMIs) (Tue) which are likely to record broad increases, European Central Bank meeting minutes (Thu), which are likely to reflect a dovish stance, and several central bank decisions including Hungary (Tue), Turkey (Thu), New Zealand (Wed),  Thailand (Wed), Philippines (Thu).   The room for central banks to ease policy is reducing but Turkey, Philippines and Mexico are likely to cut policy rates this week.

 

 

Central Banks Galore

It’s a big week for central banks.  Several central banks globally meet to decide upon monetary policy this week.  The biggest focus will be on the Fed FOMC but this week also sees Norges Bank, Bank of England, Bank of Japan and central banks in Indonesia, Philippines, Taiwan, and Brazil meet.

Markets are already aggressive in pricing in Fed rate cuts.  As US-China trade tensions have worsened markets have intensified their expectations of Fed easing, with around 75bps of easing already priced in.  Given how much is priced in in terms of Fed easing, if the Fed does not validate this with a dovish statement and/or shift in the dot plot there could be a significant risks of disappointment, which could weigh on equities, but leave the USD on a firmer footing.

Admittedly the Bank of Japan is more constrained than the Fed in terms of policy room, but their rhetoric has become more dovish.  I don’t expect easing anytime soon but the BoJ is likely to sound dovish and could offer some enhanced forward guidance.  BoJ governor Kuroda outlined four options in terms of more policy stimulus, with one being a further cut in the deposit rate.  However, BoJ would need to outline how they plan to alleviate the pressure on bank profits from such a move.

Bank of England is unlikely to move.  Data in the UK has been mixed, with softening in Q2 growth but ongoing pressure on inflation given the tightness of the labour market.  It’s also difficult for the BoE given the large amount of Brexit uncertainty. GBP risks remain to the downside over the short term especially given the heightening political noise in the UK.  The Norges Bank is likely to stand out amongst the crowd, with a rate hike expected, its second in just three months.

Elsewhere in Asia I expect no change from Bank Indonesia, BSP in the Philippines, and CBC in Taiwan. Bank Indonesia is edging towards a rate cut amid low inflation and slowing activity, but will likely want to see further signs of IDR stability before pulling the trigger to begin reversing the 175bp of hikes implemented in 2018.

Weaker activity in Taiwan calls for some sort of stimulus but the reality is that a rate cut will do little to alleviate the pain given that much of the problem is due to external factors.  Instead much of the adjustment may take place on the currency front.

I expect the BSP in the Philippines to maintain its overnight borrowing rate at 4.50% at this week’s meeting while signalling more RRR cuts ahead. Although CPI came in above expectations in May, at 3.2% y/y, it remains close to the midpoint of the BSP’s 2-4% band and I don’t expect it to stand in the way of further easing, but think BSP may wait until at least August to move again.

 

 

US dollar weakness providing relief

The US dollar index has weakened since mid-August 2018 although weakness in the broad trade weighted USD has become more apparent since the beginning of this month.  Despite a further increase in US yields, 10 year treasury yields have risen in recent weeks to close to 3.1%, the USD has surprisingly not benefited.  It is not clear what is driving USD weakness but improving risk appetite is likely to be a factor. Markets have been increasingly long USDs and this positioning overhang has also acted as a restraint on the USD.

Most G10 currencies have benefitted in September, with The Swedish krona (SEK), Norwegian Krone (NOK) and British pound (GBP) gaining most.  The Japanese yen (JPY) on the other hand has been the only G10 currency to weaken this month as an improvement in risk appetite has led to reduced safe haven demand for the currency.

In Asia most currencies are still weaker versus the dollar over September, with the Indian rupee leading the declines.  Once again Asia’s current account deficit countries (India, Indonesia, and Philippines) have underperformed most others though the authorities in all three countries have become more aggressive in terms of trying to defend their currencies.  Indeed, The Philippines and Indonesia are likely to raise policy interest rates tomorrow while the chance of a rate hike from India’s central bank next week has risen.

As the USD weakens it will increasingly help many emerging market currencies.   The likes of the Argentinian peso, Turkish lira and Brazilian real have been particularly badly beaten up, dropping 51.3%, 38.5% and 18.8%, respectively this year.  Although much of the reason for their declines have been idiosyncratic in nature, USD weakness would provide a major source of relief.  It’s too early to suggest that this drop in the USD is anything more than a correction especially given the proximity to the Fed FOMC decision later, but early signs are positive.

 

Asian currencies under pressure

The close to 1% drop in the USD index over recent days is misleading in terms of the USD’s performance against emerging market currencies where it has registered strong gains. For example the ADXY (Asian USD index) has dropped to its lowest level since early September 2013 and looks set to decline further as Asian currencies face more pressure. The best performers in this environment are traditional safe havens, especially JPY and CHF while the EUR and Scandinavian currencies have also capitalised on the weaker USD.

The drop in the USD against many major currencies reflects the fact that positioning had reached extreme levels prior to the sharp moves at the end of last week. For instance, net long USD speculative positions (according to the CFTC IMM data) had risen to the highest level since June 2013 while in contrast EUR positioning had dropped to its lowest since July 2013. The subsequent position adjustment will have proved to be a healthy correction that will set the USD up for an eventual rebound and the EUR for a sell off.

The sharp drop in US Treasury yields will undermine the USD further in the near term, however, and the mixed slate of US data releases will offer the currency little assistance. Nonetheless, the USD is expected to stay firm against Asian currencies. Notably capital flows from Asian equity markets have increased over recent weeks, with Philippines, South Korea, and Thailand on track to register outflows for the first month of the year. Against this background it is unsurprising that both the KRW and PHP are the two worst performing Asian currencies so far this year. While I expect a reversal in both, the near term outlook is for further pressure.

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