Is the Asian FX rally losing steam?

June 5, 2009 — Mitul Kotecha

Asian currencies appear to have lost some of their upward momentum over recent days.  Although the outlook remains positive further out, they are likely to struggle to make further gains over coming weeks.  One the one hand strong inflows into Asian equity markets have given support to currencies but on the other hand, data releases reveal only a gradual economic recovery is taking place, with continued pressure on the trade front as seen in the weakness in recent export data in the region.  Even China has been cautious about the prospects of recovery in the country.   

Almost all currencies in Asia have recouped their losses against the US dollar so far this year, with the Indonesian rupiah the star performer, having strengthened by over 11% since the start of the year.  More recently the Indian rupee has taken up the mantle of best performer, strengthening sharply following the positive outcome of recent elections.  The rupee has strengthened by around 3.5% since the beginning of the year and its appreciation has accelerated post elections.   

Much of the gain in the rupee can be attributable to the $4.4 billion of inflows into local equity markets over the last few months, a far superior performance to last year when India registered persistent outflows. Notably in this respect, the Philippines peso is set to struggle as foreign flows into local equities lag far behind other countries in the region.  Inflows into Phililipines stocks have been just $226 million year-to-date as fiscal concerns weigh on foreign investor sentiment.   

South Korea has been the clear winner in terms of equity capital inflows in 2009, with over $6 billion of foreign money entering into the Korean stock market.  Elsewhere, Taiwan has benefited from the prospects of growing investment flows from China and in turn equity market inflows have risen to around $4.3 billion supported by news such as the recent report  that Taiwan will allow mainland Chinese investors to invest in 100 industries.  Equity inflows into these currencies are far stronger than over the same period in 2008, highlighting the massive shift in sentiment towards Asia and emerging markets in general.

Unsurprisingly stock markets in Asia have been highly correlated with regional currencies over recent months, with almost all currencies in Asia registering a strong directional relationship with their respective equity markets.  Recent strong gains in equities have boosted currencies but this relationship reveals the vulnerability of currencies in the region to any set back in equities, which I believe could come from a reassessment of the market’s bullish expectations for Asian recovery.  

Central banks in the region have been acting to prevent a further rapid strengthening in Asian currencies by intervening in FX markets but a turn in equity markets and/or risk appetite could do the job for them and result in a quick shift in sentiment away from regional currencies. The Indonesian rupiah remains one to watch in terms of further upside potential, supported by the Asian Development Bank’s $1bn loan to Indonesia.   The outlook for the Indian rupee also looks favourable as post election euphoria continues.  Nonetheless, the gains in these and other Asian currencies have been significant and rapid and I believe there is scope for a pull back or at least consolidation in the weeks ahead.

Posted in Asia, central banks, China, Currencies, Economics, Economy, equity markets, India, Indian election. Tags: , , , , , , , , , , , , , , , , , , , . 1 Comment »

Backing the dollar

June 3, 2009 — Mitul Kotecha

There has been no let up in the bullish tone to markets over recent weeks. Optimism is dominating. Meanwhile, commodity prices continue to remain firmly supported, with the CRB commodities index up around 30% from its early March low. Bank funding has improved sharply, with indicators such as the Libor-OIS spread moving to its lowest spread since the beginning of February 2008 whilst the Ted spread is now close to where it was all the way back in August 2007.

Conversely, there is not much sign of a let up in pressure on the dollar despite assurances from US Treasury Secretary Geithner during his visit to China. Much of the move in the dollar continues to be driven by improvements in risk appetite but worries about the sustainability of foreign buying of US assets have increased too.

Russia’s proposal to create a new supranational currency has dealt the dollar another blow but it was notable that India, China and South Korea were reported to express confidence in the dollar, stating that there is no alternative to the dollar as a reserve currency. Such comments highlight that despite political motivation to move away from the dollar it is no easy process.

The comments from India, China and South Korea, three of the world’s biggest reserve holders reflect the growing concerns from official accounts about 1) dollar weakness getting out of control and 2) US bond yields pushing higher. Even though foreign central banks will continue to diversify the last thing they want to do is to destroy the value of their massive amounts of US asset holdings so don’t expect a quick move out of dollars from central banks despite the rhetoric from Russia and others.

Russia has said that a debate about the dominance of the USD will take place when BRIC (Brazil, Russia, India and China) countries meet on June 16. Although the rhetoric from Russia may add to dollar worries the reality is that it is highly unlikely that any form of concrete plan will be easily developed to shift away from the dollar. Political motivations aside, even Russian President Medvedev admits it’s an “idea for the future”.

Posted in Bond markets, central banks, China, Commodities, Currencies, Financial crisis, India, US. Tags: , , , , , , , , , , , , , , , . 1 Comment »

Are foreign investors really turning away from US debt?

May 29, 2009 — Mitul Kotecha

The press has been full of stories about the dangers to US credit ratings and growing concerns by foreign official investors about the value of their holdings of US Treasury bonds.   A combination of concerns about the rising US fiscal deficit, Fed quantitative easing and potential monetization of US debt, have accumulated to fuel such fears. Given the symbiotic relationship between China and the US it is perhaps unsurprising that China has been one of the most vocal critics. I have highlighted this in past posts, especially related to the risks to the US dollar. Please refer to US dolllar beaten by the bears and US dolllar under pressure. However, my concerns that foreign investors have been shunning US Treasuries recently may have proved somewhat premature.

Should China or other large reserves holders pull out of US asset markets, it would imply a sharp rise in US bond yields and a much weaker dollar.  However, it is not easy for China or any other central bank to act on such concerns.  China is faced with a “dollar trap” in that any decline in their buying of US Treasuries would undoubtedly reduce the value of their existing Treasury holdings as well as drive up the value of the Chinese yuan as the dollar weakens.  Such a self defeating policy would clearly be unwelcome. 

One solution that China has proposed to reduce the global reliance on the dollar and in turn US assets was to make greater use of Special Drawing Rights (SDRs) which I discussed in a previous post, but in reality this would be fraught with technical difficulties and would in any case take years to achieve.  Nor will it be quick or easy for China to persuade other countries to make more use of the yuan in the place of the dollar.  The first problem in doing so is that fact that the yuan is not a convertible currency and therefore foreign holders would have difficulties in doing much with the currency.  

Foreign official concerns are understandable but whether this translates into a major drop in buying of US Treasuries is another issue all together.  Foreign countries have been gradually reducing their share of dollars in foreign exchange reserves over a period of years.  This is supported by IMF data which shows that dollar holdings in the composition of foreign exchange reserves have fallen from over 70% in 1999 to around 64% at the end of last year.

In contrast the share of euro in global foreign exchange reserves has increased to 27% from 18% over the same period.  This process of diversification likely reflects the growing importance of other major currencies in terms of trade and capital flows, especially the euro, but the pace of diversification can hardly be labeled as rapid. 

Importantly, there is no sign that there has been an acceleration of diversification over recent weeks or months.  Fed custody holdings for foreign official investors have held up well.  In fact, these holdings have actually increased over recent weeks.  Moreover, the share of indirect bids (foreign official participation) in US Treasury auctions have been strong over recent weeks.  Taken together it provides yet more evidence that foreign official investors haven’t shifted away from US bonds despite all the rhetoric. 

Posted in Asia, Bond markets, central banks, China, Currencies, Economics, Economy, Europe, US, US administration. Tags: , , , , , , , , , , , , , , , , , , , , . 5 Comments »

Europe to recover at a snail’s pace

May 26, 2009 — Mitul Kotecha

There have been two pieces of data released over recent days which give us a good idea of the state of Europe’s biggest economy, Germany. The IFO survey – a crucial gauge of business confidence and an important forward looking indicator for the German economy, if not the whole eurozone economy – increased in May for the second straight month but came in lower than forecast. The second was the final reading of first quarter GDP, which confirmed the very steep 3.8% quarterly decline in growth, fuelled in large part by weaker exports.

Of course any improvement is encouraging but the fact that the rise in the IFO was less than expected highlights that the market has moved from excessive pessimism to being overly optimistic about recovery prospects. Moreover, at current levels the IFO remains at historically lows and still consistent with economic contraction. Admittedly it is at least consistent with a smaller pace of contraction in the economy in the months ahead but still way off indicating actual economic expansion.

The problem for Germany as highlighted by the GDP data is that the economy remains highly export dependent and given that global trade continues to shrink it points to very difficult times ahead. Moreover, the likelihood of a much bigger increase in unemployment and ongoing problems in the financial sector, points to the outlook for the consumer remaining very tough indeed for a long time to come.

Financial sector problems will only delay recovery.  A report in the UK’s Telegraph even carries a warning from the German bank regulator that toxic debts at German banks could blow up “like a grenade”. I won’t spend any more time on toxic debts at European banks but suggest reading a previous post titled “Stress testing European and UK banks” ,that highlights the lack of transparency and potential for much more writedowns in the months to come.

The problem is not just a German one. The eurozone economy is likely to recover much more slowly than the US despite the fact that the US was at the epicenter of the crisis. The major difference is that policy in the US is far more aggressive and rapid compared to Europe. European policymakers have struggled to put together any form of co-ordinated policy response and there is still an unwillingness from Germany to enact a fiscal stimulus package despite the fact the economy has weakened more rapidly than many other countries.

Moreover, conflict within the European Central Bank (ECB) council means that an aggressive move towards quantitative easing appears highly unlikely. The latest measure by the ECB to purchase EUR 60 billion in covered bonds hardly registered with markets. Faced with many opposing views from within the ECB representing many different countries this situation is unlikely to change anytime soon. As a result, Europe is destined for a snail’s pace of recovery, which could also stall the appreciation of the euro in the month ahead.

Posted in bank rescue, central banks, Economics, Economy, Europe, Financial crisis, Germany, Politics, US. Tags: , , , , , , , , , , , , , , , . 1 Comment »

US dollar beaten by the bears

May 22, 2009 — Mitul Kotecha

Since I wrote my last post on the US dollar a week ago, US dollar under pressure, the slide in the dollar has accelerated against most currencies. Rather than being driven by an improvement in risk appetite however, it appears that the dollar is being hit by a major shift in sentiment. Indeed currency market dynamics appear be changing rapidly.

In particular, there has been a major breakdown in the relationship between the dollar and equity markets, suggesting that the influence of risk on FX markets is waning. For example, rather than rallying on the back of weaker equity markets over recent days, dollar weakness has actually intensified.

More likely this is becoming a pure and clear slide in sentiment for the dollar. There was some indication of this from the latest CFTC IMM Commitment of traders’ report which is a good gauge to speculative market positioning, showing that net dollar positioning has become negative for the first time in several months.

More evidence of this is the fact that the dollar / yen exchange rate has fallen even as risk appetite has improved. This is at odds with the usual relationship between the Japanese yen and risk appetite. The yen benefited the most from higher risk aversion since the crisis began, strengthening sharply against many currencies. As risk appetite improves and equity markets rally the yen would be expected to weaken the most as risk appetite improves.

I had looked for dollar weakness to accelerate into the second half of 2009 but against some currencies the drop in the dollar has come earlier than anticipated. I also thought that the dollar may stand a chance at a bit of a recovery in the near term if equity markets slipped and risk aversion increased. I was wrong about this. Despite the drop in equities over recent days the USD has also lost ground. Nor has the USD benefited from higher bond yields in the US.

The evidence is clear; USD bearishness is becoming more entrenched and the likelihood of a risk related rebound is becoming more remote even as risk aversion picks up once again. There appears to be a general shift away from US assets in general particularly Treasuries and most likely by foreign official investors who appear to be accelerating their diversification away from the dollar over recent weeks.

The importance of foreign buying of US Treasuries should not be underestimated in terms of its influence on the USD. Foreign purchases of US Treasuries made up 77% of total foreign buying of US securities in 2008. If there is a growing chance of a downgrade to the US’s AAA credit rating in the wake of a budget deficit that will be around $1.85 trillion this year and a rising debt/GDP ratio, the drop in the dollar seen so far may prove to be small compared to downside risks in the months ahead.

Posted in Bond markets, central banks, Currencies, Economics, Economy, equity markets, Financial crisis, US. Tags: , , , , , , , , , , , , , , , , , , . 1 Comment »
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