Temporary Euro Relief

January 12, 2011 — Mitul Kotecha

Eurozone peripheral country travails continue to garner most market attention. There was at least a semblance of improvement on this front as peripheral bond spreads with German bunds narrowed on Tuesday but this was largely due to European Central Bank (ECB) bond buying than any improvement in sentiment. The fact that German bund yields also rose helped to narrow bund-peripheral spreads further.

A clearer test of sentiment will be today’s debt sales by Portugal followed by actions by Spain and Italy tomorrow. ECB buying of Portuguese bonds has given some relief to other debt, with Spanish and Italian debt spreads narrowing too. Even Greece managed to sell short term debt (EUR 1.95 bn of 26 week T-bills) but at a higher cost than the previous sale.

Perhaps a stronger boost to sentiment will come from the news that European Union (EU) governments are discussing an increase in the EUR 440 billion bailout fund in recognition of the fact that the fund may prove too small to cope if the crisis spreads to Spain. However, don’t expect a decision anytime soon, with next week’s meeting of EU finance ministers unlikely to agree to such a move. Support (or lack) of from Germany may prove to be a sticking point against the background of domestic political pressure.

Other options being considered include the possibility of the EFSF (European Financial Stability Facility) purchasing bonds in the secondary market and lowering interest rates on EFSF bailout loans. News that Japan will buy 20% of EFSF bonds this month as well as recent supportive comments from China suggest that an increase in the size of the EFSF may be easily funded by such investors. The EUR will gain some support against the background of such speculation but its upside may be restrained around its 200-day moving average at EUR/USD 1.3071.

In the US the economic news was not so positive for a change as the National Federation of Independent Business (NFIB) small business optimism survey came in weaker than expected in December, an outcome that will come as a blow given that it suggests some stuttering in the recovery process as well as hiring.

There is only secondary data scheduled today, with most attention on the Fed’s Beige Book later tonight. The survey of Federal Reserve districts will likely reveal a broad based but moderate improvement in economic conditions with the exception of housing activity. A speech by the Fed’s Fisher on Monetary policy will also be in focus. Like the Fed’s Plosser overnight he may highlight some caution about the impact of Fed quantitative easing (QE).

The AUD is increasingly feeling the impact of the flooding in Queensland Australia as the extent of economic damage is revealed. Reserve Bank of Australia (RBA) board member McKibbin estimated that it could knock off at least 1% from economic growth. This may prove too negative and although the flooding will result in a significantly negative impact on growth in Q1 rebuilding and reconstruction will mean that overall growth for 2011 will not be as significantly impacted. Nonetheless, a paring back in RBA policy tightening expectations will see the AUD come under further pressure, with a move down to around AUD/USD 0.9634 on the cards over the short-term.

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FX sensitivity to yield

December 9, 2010 — Mitul Kotecha

It’s all about yield. The back up in US bond yields in reaction to the US tax compromise from the Obama administration has been particularly sharp. US 10 year bond yields jumped around 35bps this week prior to a small correction in yields overnight whilst 2s were up 21bps. US bond yields are now back where they were in June, a fact that makes a mockery out of the Fed’s attempts to drive bond yields lower via quantitative easing (QE). Yields elsewhere increased too but by a smaller degree whilst equity market sentiment has been dampened by the rise in global yields although US stocks still ended higher overnight.

There is plenty of commentary discussing the impact on currencies of the move in bond yields so it’s worth looking in more detail how sensitive FX markets have been to yield. The most sensitive currencies i.e. those with the highest 3-month correlations with relative bond yield differentials (2 year) are the AUD/USD, EUR/USD, and of course USD/JPY. However, there is less sensitivity to gyrations in 10 year yields with no currency pair registering a statistically significant correlation with 10-year bond yield differentials over the past 3-months.

Assuming that US bond yields continue to push higher into 2011, with much lager increases in both nominal and yields expected, this means that AUD, EUR and JPY will face the most pressure relative to the USD. Moreover, the stimulus measures agreed by the US administration will likely lead to many analysts penciling in higher growth forecasts over 2011 whilst reducing the prospects of QE3 from taking place, all of which is USD positive. I still retain a degree of caution in Q1 2011, especially with regard to a potential bounce in EUR, especially if the ECB becomes more aggressive in its bond buying, but even so, any EUR rally is likely to prove termporary.

The impact of higher US yields on the AUD may be more limited however, despite the high correlation with relative bond yields, as Australian bond yields are also likely to rise somewhat given the resilience of its economy. This was clearly demonstrated by Australian November employment data released overnight revealing yet another consensus beating outcome of +54.6k, with all the gains coming from full time employment. Against the background of a generally firm USD, the best way to play AUD resilience is via the NZD, with the currency pair likely break through resistance around 1.3220 (21 October high).

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Peripheral debt concerns intensify

November 10, 2010 — Mitul Kotecha

European peripheral debt concerns have allowed the USD a semblance of support as the EUR/USD pullback appears to have gathered momentum following its post FOMC meeting peak of around 1.4282. The blow out in peripheral bond spreads has intensified, with Greek, Portuguese and Irish 10 year debt spreads against bonds widening by around 290bps, 136bps and 200bps, respectively from around mid October.

The EUR appears to have taken over from the USD, at least for now, as the weakest link in terms of currencies. EUR/USD looks vulnerable to a break below technical support around 1.3732. Aside from peripheral debt concerns US bonds yields have increased over recent days, with the spread between 10-year US and German bonds widening by around 17 basis points in favour of the USD since the beginning of the month.

The correlation between the bond spread and EUR/USD is significant at around 0.76 over the past 3-months, highlighting the importance of yield spreads in the recent move in the USD against some currencies. Similarly high correlations exist for AUD/USD, USD/JPY and USD/CHF.

Data today will offer little direction for markets suggesting that the risk off mood may continue. US data includes the September trade deficit. The data will be scrutinized for the balance with China, especially following the ongoing widening in the bilateral deficit over recent months, hitting a new record of $28 billion in August. Similarly an expected increase in China’s trade surplus will add to the currency tensions between the two countries. FX tensions will be highlighted at the Seoul G20 meeting beginning tomorrow, with criticism of US QE2 gathering steam.

Commodity and Asian currencies are looking somewhat precariously perched in the near term, with AUD/USD verging on a renewed decline through parity despite robust September home loan approvals data released this morning, which revealed a 1.3% gain, the third straight monthly increase.

However, the NZD looks even more vulnerable following comments by RBNZ governor Bollard that the strength of the Kiwi may reduce the need for higher interest rates. As a result, AUD/NZD has spiked and could see a renewed break above 1.3000 today. Asian currencies are also likely to remain on the backfoot today due both to a firmer USD in general but also nervousness ahead of the G20 meeting.

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Currencies At Pivotal Levels

November 3, 2010 — Mitul Kotecha

Ahead of today’s highly anticipated Fed FOMC meeting markets are holding their breath to determine exactly what the Fed will deliver. The consensus view is for the Fed to announce a programme of $500 billion in asset purchases spread over a period of 6-months. The reaction in currency markets will depend on the risks around this figure. Should the Fed deliver a bigger outcome, say in the region of $1 trillion or above, the US dollar will likely come under renewed pressure. However, a more cautious amount of asset purchases will be US dollar positive.

It has to be noted that the Fed will likely keep its options open and keep the program open ended depending on the evolution of economic data which it will use to calibrate its asset purchases. The USD will likely trade with a soft tone ahead of the Fed outcome, but with so much in the price, it may be wise to be wary of a sell on rumour, buy on fact outcome.

Whatever the outcome many currencies are at pivotal levels against the USD at present, with AUD/USD flirting around parity following yesterday’s surprise Australian rate hike, EUR/USD holding above 1.4000, GBP/USD resuming gains above 1.600 despite a knock back from weaker than forecast construction data, whilst USD/JPY continues to edge towards 80.00. Also, both AUD and CAD are trading close to parity with the USD. The Fed decision will be instrumental in determining whether the USD continues to remain on the weaker side of these important levels.

Going into the FOMC meeting the USD has remained under pressure especially against Asian currencies as noted by the renewed appreciation in the ADXY (a weighted index of Asian currencies) against the USD this week. Although it appears that the central banks in Asia have the green light to intervene at will following the recent G20 meeting the strength of capital inflows into the region is proving to be a growing headache for policy makers. One option is implementing measures to restrict “hot money” inflows but so far no central bank in the region has shown a willingness to implement measures that are deemed as particularly aggressive.

There has been some concern that Asia’s export momentum was beginning to fade as revealed in September exports and purchasing managers index (PMI) data in the region and this in turn could have acted as a disincentive to inflows of capital, resulting in renewed Asian currency weakness. The jury is still out on this front but its worth noting that Korean exports in October reversed a large part of the decline seen over previous months. Moreover, the export orders component of Korea’s PMI remained firm suggesting that exports will resume their recovery.

Nonetheless, manufacturing PMIs have registered some decline in October in much of Asia suggesting some loss of momentum, with weaker US and European growth likely to impact negatively. However, China’s robust PMI, suggests that this source of support for Asian trade will remain solid. Similarly a rise in India’s manufacturing PMI in October driven largely by domestic demand, highlights the resilience of its economy although with inflation peaking its unlikely that the Reserve Bank of India (RBI) will follow its rate hike on Tuesday with further tightening too quickly.

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Temporary relief for US Dollar

October 15, 2010 — Mitul Kotecha

Downbeat US economic news in the form of a widening US trade deficit, increase in jobless claims and bigger than expected increase in top line PPI inflation contrasted with upbeat earnings from Google. Google shares surged over 9% in after hours trading but US data tarnished the risk on mood of markets, leaving commodity prices and equities lower and the USD firmer. Higher US Treasury yields, especially in the longer end following a poor 30 year auction, helped the USD to push higher.

The USD’s trend is undoubtedly lower but profit taking may be the order of the day ahead of a speech by Fed Chairman Bernanke on monetary policy later today and the release of the highly anticipated US Treasury Report in which China may be named as a currency manipulator. A speech by the Minneapolis Fed’s Kocherlatoka (non voter) this morning sounded downbeat, even suggesting that “Fed asset purchases may have a muted effect”. Despite such comments the Fed appears likely to embark on QE2 at its 3 November meeting.

Today is also a key data for US data releases with September data on US retail sales, and CPI and October data on Michigan confidence and Empire manufacturing scheduled for release. Retail sales are likely to look reasonable, with headline sales expected to rise 0.5% and ex-autos sales expected up 0.4%. The gauges of both manufacturing and consumer confidence are also likely to show some recovery whilst inflation pressures will remain benign. Given the uncertainty about the magnitude of QE the Fed will undertake in November, the CPI data will have added importance.

The US trade will likely have resulted in an intensification of expectations that China will be labelled as a currency manipulator in the US Treasury report later today. The August trade deficit with China widened $28.04 billion, the largest on record. At the least it will give further ammunition to the US Congress who are spoiling for a fight ahead of mid-term congressional elections, whilst heightening tensions ahead of the November G20 meeting.

Indeed currency frictions continue to increase although “currency war” seems to be an extreme label for it. Nonetheless, Singapore’s move yesterday to widen the SGD band highlighted the pressure that many central banks in the region are coming under to combat local currency strength. Singapore’s move may be a monetary tightening but it is also a tacit recognition of the costs of intervening to weaken or at least limit the strength of currencies in the region. To have maintained the previous band would have required ongoing and aggressive FX intervention which has its own costs in terms of sterilization.

This problem will remain as long as the USD remains weak and this in turn will depend on US QE policy and bond yields. A lot of negativity is priced into the USD and market positioning has become quite extreme suggesting that it will not all be a downhill bet for the currency. Many currencies breached or came close to testing key psychological and technical levels yesterday, with EUR/USD breaching 1.4000, GBP/USD breaking 1.6000, USD/CAD breaking below parity and AUD/USD coming close to testing parity. Some reversal is likely today, but any relief for the USD is likely to prove temporary.

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