JPY firmer ahead of Fed decision

September 12, 2012 — Mitul Kotecha

The USD has come under growing pressure ahead of tommorow’s Fed FOMC decision. While by no means a done deal the majority of market participants are looking for the Fed to embark on a fresh round of quantitative easing or QE3. The Fed is also expected to shift its guidance to maintaining highly accommodative monetary policy into 2015 from 2014. There is a non-negligible risk of no action at the FOMC meeting which if correct will result in market disappointment, with an attendant sell off in risks assets.

Heading into the Fed meeting, comments by Republican House speaker Boehner that he was ‘not confident’ about reaching a deal with President Obama on avoiding the fiscal cliff as well as renewed warnings by Moodys ratings on the US AAA credit ratings, dealt the USD a further blow. It seems unlikely that the USD will be able to make much of a recovery if the Fed pulls the trigger for more QE. However, it should be noted that with so much in the price, should the Fed not deliver on expectations, the USD may actually bounce.

One currency that has felt the consequences of a weaker USD has been the JPY, which finally broke through the 78.00 level against the USD yesterday. A stronger JPY was greeted with plenty of disquiet in Japan (I’m in Tokyo this week) at a time when economic indicators are turning south. The fact that both the European Central Bank and the Fed are outpacing the Bank of Japan in terms of balance sheet expansion means that any JPY weakness is likely to be limited, with further upside risks to the currency prevailing.

Much will depend on the impact on US Treasury yields from Fed QE. Currently Japanese investors are disinclined to pour money overseas at a time when the yield advantage of US Treasuries or German bunds versus Japanese JGBs is limited. If US yields remain low, the prospects for further JPY weakness will also be limited while the pressure on the Japanese authorities to act to meet their 1% inflation goal and weaken the JPY will grow.

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Euro firmer, AUD vulnerable to risk gyrations

August 29, 2012 — Mitul Kotecha

A surprise drop in US August consumer confidence which dropped to its lowest since November last year put a dampener on markets and notably the VIX index edged higher. Consequently treasuries rose and equities slipped despite a firmer than expected increase in US house prices in June. The confidence data adds the pressure on Fed Chairman Bernanke to give some indication of a further round of quantitative easing during his speech at Jackson Hole on Friday.

An upward revision to US Q2 GDP and a bounce in July pending home sales today are unlikely to change this perspective although the Fed’s Beige Book will likely show some moderate improvement providing the Fed with useful information.

Separately decent debt auctions in Spain and Italy helped to calm Eurozone market nerves further amid hopes of European Central Bank (ECB) action next week despite the news that Spanish region Catalonia formally asked for EUR 5 billion in funding. As a result the EUR retained a firmer tone.

Contrary to expectations, EUR/USD continued to push higher. Just why the currency is strengthening given the significant event risk in the days and weeks ahead is questionable although in part the move is attributable to an ongoing short squeeze. Hopes of constructive ECB action next week taken together with Fed quantitative easing expectations have helped to put the USD on the back foot, allowing the EUR to take advantage.

Admittedly the drop in Eurozone peripheral bond yields is certainly helpful for the EUR, while my short term quantitative ‘fair value’ estimate for EUR/USD suggests more upside too. Nonetheless, given the risk that so much could go wrong in the weeks ahead I am loathe to get on the bullish EUR bandwagon. While EUR/USD and EUR on the crosses will likely remain firm ahead of Jackson Hole I expect the EUR to struggle to hold onto gains into next week.

AUD has lost ground since around 10 August. This has roughly coincided with a rise in risk aversion over recent weeks. Indeed, AUD maintains a strong correlation with risk aversion and is therefore highly susceptible to swings in risk appetite. Additionally renewed China worries have also dampened the attraction of the AUD given the increasing dependency of Australia’s economy to China both directly through trade and indirectly via commodity prices.

While I remain positive on the AUD over the medium term, the high level of speculative positioning in the currency suggests some vulnerability to profit taking over the short term, with AUD/USD vulnerable to a drop to technical support around 1.0282. Much will depend on news out of China in terms of AUD direction, with Chinese stock market gyrations also providing some influence.

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Market fear rising

August 28, 2012 — Mitul Kotecha

In what was fairly subdued trading conditions in the wake of a UK holiday the most interesting market move was the jump in the VIX ‘fear gauge’ which has been on a steady increase since 17 August. The rise in equity volatility suggests that the relative calm experienced over the summer may be ending.

Major events over coming days and weeks including the Jackson Hole Fed symposium on Friday, IMF/EU review of Portugal today, ECB meeting on September 6, Dutch general election on 12 September, German constitutional court decision on the ESM permanent bailout fund on the same day, as well as the Fed FOMC meeting on September 12-13, highlight the potential for more volatility and uncertainty.

Yesterday’s fourth consecutive drop in the German IFO index was all but ignored as attention turns to Jackson Hole. Nonetheless, the announcement of the formation of a working group between France and Germany suggests some improvement in coordination towards finding a solution to the Eurozone crisis, while the ECB’s Asmussen further heightened speculation that the upcoming ECB meeting would detail the ECB’s proposed bond buying program.

Meanwhile, although the Fed’s Evans (non voter) highlighted his preference for more Fed quantitative easing an improvement in consumer confidence in August expected to be revealed today, will add to data playing against imminent QE.

All of the above leaves FX markets in limbo. The USD remains restrained by expectations of Fed QE but relatively better economic data compared to the Eurozone, suggests that any USD decline will be limited. Moreover, the fact that aggregate speculative USD positioning turned negative for the first time since September 2011, suggests that there is now some scope for short covering.

Conversely, hopes of ECB bond buying offer the EUR some solace but as noted, the many events over coming weeks in Europe, highlight the risks to the currency and we suspect that EUR/USD has topped out around 1.2500.

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Fed passes the baton to the ECB. EUR and GBP downside risks

August 2, 2012 — Mitul Kotecha

Although the Fed’s inaction overnight was perhaps a little disappointing for markets the FOMC did note that it “will” provide further stimulus to the economy if needed. The USD rallied but risk currencies came under pressure. However, any sell off in risk assets will be limited as markets look to the FOMC meeting on September 13 for more action. This will also coincide with updates of the Fed’s economic forecasts. The below consensus reading for the ISM manufacturing index in July which came in at 49.8 added to the slight disappointment, with the data consistent with flat growth in manufacturing.

Attention now turns to the European Central Bank (ECB). Warnings by the Bundesbank President Weidmann for the ECB not to overstep its remit sets the scene for a stressful policy meeting today. Although markets have pared back their overly bullish expectations from the end of last week a lack of action by the ECB to reduce peripheral bond yields will disappoint and lead to a sell of in risk assets and EUR/USD but support around 1.2150 is likely to hold. Even a restart of Securities Market Purchases on its own would not be a game changer.

The Bank of England also decides on policy today but unlike the ECB there is little expectation of any action from the MPC. Inaction by the BoE today will highlight that after a GBP 375 billion in asset purchases there is limited room in the tool kit aside from lowering interest rates further. A weaker than expected reading for UK July manufacturing confidence weighed on GBP, with the data following a rash of disappointing data releases over recent weeks. I continue to see downside risks to GBP both against the EUR and USD, however. Indeed, my quantitative models reveal that GBP/USD should be trading around 1.5144 while EUR/GBP should be around 0.8242.

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USD under pressure, AUD well supported

August 1, 2012 — Mitul Kotecha

Despite comments by the German Finance Ministry that it sees no need to give the ESM bail out fund a banking license, market hopes of European Central Bank (ECB) action tomorrow remain in place, helping to give some support to markets and the EUR. However, the Fed is unlikely to deliver fresh stimulus measures following the conclusion of its two day meeting today.

Sentiment slipped slightly overnight although any weakness was limited by stronger than expected data releases in the US in the form of July consumer confidence and Chicago PMI. US and European equities ended lower but overall its appears to be a case of treading water until the policy decisions over coming days as well as Friday’s US jobs report.

There is perhaps less expectation of Fed action than the ECB but nonetheless, recent press reports suggest that the Fed is shifting closer to pulling the trigger for more balance sheet expansion. This in turn has put some restraint on the USD.

Although it is more likely that the Fed will want to wait to assess more economic data (the Fed will not be privy to the July jobs report before its release on Friday) there is a chance that the Fed could extend its guidance tonight. This will be less important from a USD perspective but if the Fed opens the door even wider to a third round of quantitative easing the USD will find little solace from a lack of QE today as the Fed will merely be seen to delay such a move until September.

Combined with the impact of firmer risk appetite over recent days and consequently reduced safe haven demand the USD will struggle to make any headway in the near term, with the USD index to find it difficult to break above 83.000.

AUD has been the best performing major currency in July. Yield attraction has increased and the AUD has been a key beneficiary. While my forecasts remain among the most bullish this year (1.08 by year end) I am cognisant of the risks of a pull back in the interim.

AUD has benefited to some extent from expectations of further policy stimulus in China as well as a generally more favourable tone to risk appetite. Reports that China is interested in buying Australian regional government bonds will also help buoy AUD.

While external conditions hold various risks to the AUD the domestic picture does not look too adverse and various domestic economic indicators have beaten expectations. Consequently I believe that market expectations for a bigger 75bp of Reserve Bank of Australia (RBA) policy easing are overdone and an eventual correction in the markets’ overly dovish stance will help to support the AUD.

Meanwhile, speculative AUD positioning is well below the all time high reached in April 2011, suggesting scope for more gains. AUD/USD looks well supported around 1.0374.

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