Changing dynamics

June 3, 2013 — Mitul Kotecha

A change in market dynamics appears to be taking place. Nervousness over a prospective paring back in US quantitative easing as the Fed ponders the timing of a tapering in asset purchases taken together with elevated volatility in Japanese markets is leading to a decrease in risk appetite, higher core bond yields and weaker equity markets. Consequently emerging market assets especially high beta currencies are coming under significant pressure under the weight of capital outflows and rising risk aversion.

Unsurprisingly the USD has been a major beneficiary although it did lose steam last week. In Japan “Abeconomics” is leading to a rise in inflation expectations and higher Japanese government bonds (JGB) yields which could in turn derail recovery unless the rise in yield is capped by the Bank of Japan’s policy actions. Overall, the background is set for a further increase in uncertainty and market volatility this week.

The lack of clarity over Fed policy in particular is fuelling market volatility and given the intense focus on the Fed and in turn the Fed’s focus on the jobs market, the US May jobs report at the end of the week will be crucial to determine the direction of activity over the coming weeks. The consensus forecast for May payrolls is 165k. Opportunity to refine the forecast will follow the release of ISM manufacturing confidence (today) and ADP private sector jobs data (Wed).

Other potentially market moving events include the European Central Bank (Thu), Bank of England (Thu) and Reserve Bank of Australia meetings (Thu). None of the central banks are likely to change policy settings although there is potential for a dovish statement from the ECB (possible discussion of negative deposit rates and/or liquidity provision).

Currencies are reacting to higher US yields, which have driven the USD to multi month highs. EUR/USD in particular has a high correlation with 2 year bond yield differentials. As noted last week was less positive for the USD, with both the EUR and JPY making up some ground, with further direction coming from relative yield movements. In the case of the JPY, reduced risk appetite is also playing for a firmer currency. Nonetheless, it will be difficult for EUR/USD to sustain any gain above 1.3000 and USD/JPY to sustain any drop below 100.

Better than forecast Chinese manufacturing confidence data over the weekend has helped give some support to AUD, NZD and Asian currencies although it may provide limited relief, especially to Asian currencies which are suffering from increased risk aversion and the impact of higher US yields. While Asia has recorded the strongest inflow into equity markets compared to past years concerns about capital outflows from the region are intensifying. Korea and Thailand have suffered in particular from equity outflows over recent weeks.

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US dollar slips as yields pull back

May 30, 2013 — Mitul Kotecha

Market sentiment deteriorated overnight as equity markets in the US and Europe declined while commodity prices also dropped. US yields slipped which undermined the USD. Growth downgrades by the IMF and OECD did not help especially given the weaker growth trajectory for some emerging market countries.

Meanwhile, two central banks did not follow the now usual pattern of easing, with the Bank of Canada leaving policy on hold and Brazil’s central bank hiking policy rates although Thailand cut interest rates. A lack of first tier data releases today will limit activity although the tone will likely remain relatively downbeat.

Having failed to take break through 1.3250 at the beginning of the month the EUR/USD will end the month on a softer note. EUR/USD in particular has been very sensitive to yield differentials and the widening in the US Treasury yield advantage over German bunds has been consistent with a drop in the currency pair. In this respect further direction will come from bond markets.

While Eurozone data releases are becoming less negative as reflected in manufacturing confidence data earlier this week and likely to be seen in various economic and business confidence indices today this is in stark contrast to US data releases which highlight strengthening in recovery notwithstanding a likely downward revision to US Q1 GDP today. Consequently it is difficult to envisage EUR/USD strengthening much from current levels, with 1.3030 seen as a strong resistance level.

A narrowing in Australia’s yield advantage, declining terms of trade, weaker China data and a relatively firm USD index have all contributed to AUD weakness. Additionally weak domestic data have fuelled expectations that the RBA will cut interest rates. However, a rate cut at next week’s policy meeting is unlikely especially as the drop in AUD will help ease financial conditions allowing the Reserve Bank of Australia to wait to examine further data before cutting rates again sometime in Q3 2013.

The AUD may find some short term stability around current levels, with support around AUD/USD 0.9528. While technical indicators remain bearish a lot of bad news is already in the price. Further out, I expect the AUD to rebound as reflected by the fact that my quantitative model shows that the AUD/USD is oversold relative to its short term fair value while short speculative positioning is reaching extreme levels.

GBP is another currency that has been battered by a strong USD but while it has lost ground versus the USD over recent weeks it has held up against other major currencies. GBP/USD has rallied overnight as US yields have pulled back but this may prove temporary, with the currency pair vulnerable to a drop below 1.5000 over coming days.

Against the EUR the picture looks more constructive. My quantitative model shows that GBP looks particularly good value against the EUR, with the model producing a “strong sell” signal for EUR/GBP. Limited data releases in the UK this week will mean that GBP takes its cue from gyrations in the USD and EUR while markets look ahead to next week’s manufacturing purchasing managers’ index and the Bank of England policy decision

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Firmer JPY and CNY fixings to support Asian FX

May 28, 2013 — Mitul Kotecha

The USD has lost steam as US yields appear to have temporarily topped out. The fact that aggregate (minus MXN) USD speculative positioning is marginally below its all time high also points to the risk of position squaring / profit taking on USD longs. However, any downside risks to the USD will be limited.

Consumer confidence data today will highlight the ongoing improvement in sentiment driven by both equity and housing wealth gains. In the debate about early Fed tapering the confidence data will err on the side reducing Fed asset purchases sooner rather than later. Consequently, it seems unlikely that the yields and the USD will drop much further.

Hopes of a calm start to the week were dashed as Japanese equity markets extended their slide and the JPY strengthened. Heightened volatility is frustrating policymaker’s efforts to contain the rise in Japanese bond yields. Although Bank of Japan governor Kuroda noted that Japan could cope with rising interest rates, higher yields could dampen growth at a time when the economy is finally showing signs of life.

Higher JGB yields have led to a narrowing in the US Treasury yield advantage over JGBs, which in turn has helped to push the JPY higher versus USD. Unless the BoJ succeeds in curtailing the rise in yield, USD/JPY is at risk of breaking back below 100.

Like the JPY, the CHF has strengthened in part due to increasing risk aversion. For a change the CHF may garner some direction from domestic news this week, with Q1 GDP, April trade data and the May KoF Swiss Leading Indicator scheduled for release later in the week. The data will likely show that Switzerland is escaping the downdraft from weak Eurozone activity, helped to some extent by the CHF cap.

Encouraging economic news will not imply any change in the CHF cap, however especially given the benign inflation outlook. Higher risk aversion will keep the CHF supported in the near term but any move in EUR/CHF back to 1.24 should be bought into.

The rebound in the JPY and strong CNY fixings have given Asian currencies some support although sideways trading is expected in the near term. Equity capital outflows over recent days in the wake of higher risk aversion suggest some caution, however. South Korea in particular has been a major casualty of equity portfolio outflows this year although a factor that prevented the KRW from strengthening. Our models show PHP and THB as likely outperformers over coming weeks.

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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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Bernanke hits Treasuries, boosts dollar

May 23, 2013 — Mitul Kotecha

Fed Chairman Bernanke’s prepared testimony expressed no hurry to scale back policy accommodation given the risks to economy recovery. However, in the Q&A session following the testimony he noted that the Fed is prepared to adjust the current flow rate of asset purchases in response to incoming data. Importantly in terms of timing Bernanke hinted that the Fed could “take a step down in the pace of purchases” in the next few FOMC meetings dependent on the data. While it is likely that many FOMC members want to see more evidence of recovery especially in the jobs market a reduction in asset purchases in Q4 is likely assuming this evidence if forthcoming. The FOMC minutes echoed this sentiment.

Bernanke’s comments and the minutes fuelled plenty of market volatility, with equities selling off after an initial rally and Treasury yields rising, with the 10 year US Treasury yield flying through the 2% level. Commodities dropped and the USD strengthened, with USD/JPY breaking through 103.00. This pattern is likely to be echoed in Asian trading today but much of the market reaction to the Fed has already occurred and it will need more evidence of either stronger US data or more hawkish Fed comments to extend yesterday’s moves. US jobless claims today will take on more prominence in this respect in the absence of other major data releases with the exception of a likely gain in April new home sales.

The USD is set to consolidate its gains over the short term firmly underpinned by higher US bond yields. Funding currencies (JPY and CHF), yielding and commodity currencies (AUD, NZD and CAD ) look most vulnerable to a firm USD although almost all currencies have felt some of the pressure. The net result is that the USD index has reached its highest level in close to 3 years. Given that the rise in US yields may only mark the beginning of a deeper reversal the upside for the USD over coming months could be significant.

Fortunately for Asian currencies they have not been particularly sensitive to USD strength over recent months as domestic factors have taken on more prominence although the KRW and SGD have been particularly sensitive to JPY weakness. Nonetheless, Asian currencies are set to remain under pressure over the short term as concerns of a slowing in capital flows to the region may grow. Singapore’s better than expected Q1 GDP reading (1.8% QoQ) released this morning will do little to stem the pressure. Meanwhile comments by Korean officials on the impact on the country’s exports from a stronger JPY will keep the KRW pressured.

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