FX Winners and Losers

There has been a sense of mean reversion in FX markets so far this year as some of last year’s winners have become losers. Namely NZD, CHF, JPY and AUD have all lost ground whilst EUR and GBP have gained ground. The odd one out is the SEK which has strengthened over 2010 and in 2011 versus USD. I expect this pattern to change and the likely winners over the next 3- months are NZD, AUD and CAD, with CHF and JPY the likely losers.

EUR held up reasonably well in the wake of slightly disappointing growth data, with eurozone GDP rising less than expected in Q4, and a smaller than expected gain in the February German ZEW investor confidence survey (economic sentiment component). My sense is that the net long EUR speculative position has already been pared back somewhat over recent days reducing the potential selling pressure on the currency in the near term.

Given that EUR/USD is one of the only major currency pairs being influenced by interest rate differentials, its direction will hinge more on policy expectations but in the near the announcement by the German Finance Minister this morning of a restructuring plan for WestLB may give the currency some support.

Perhaps one explanation for the stability of EUR/USD around the 1.3500 level is that US data was also disappointing yesterday. January retail sales rose less than forecast whilst revisions to back months suggest less momentum in Q4 consumer spending than previously envisaged. As with the eurozone data weather likely played a role in contributing to the outcome.

The net impact on currencies is that they are largely stuck within tight ranges. Further direction will come from the release of the Fed FOMC minutes for the January 26th meeting. The minutes may undermine the USD if a likely dovish slant continues to be expressed but given that the FOMC decision at that meeting to hold policy setting unchanged had no dissenters this should not come as a surprise.

Whilst the battle between the USD and EUR ended in a stalemate GBP outperformed in the wake of the increase in UK January CPI inflation and in particular the letter from the BoE governor to the Chancellor keeping open the door to a rate hike. The Quarterly Inflation Report (QIR) today will be particularly important to determine whether the bounce in GBP is justified.

I remain hesitant to build on long GBP positions given the net long speculative overhang in the currency. The risks following yesterday’s jump in GBP are asymmetric, with a hawkish QIR likely to have less impact on the currency than the negative impact from a more dovish than expected report.

Econometer.org has been nominated in FXstreet.com’s Forex Best Awards 2011 in the “Best Fundamental Analysis” category. The survey is available at http://www.surveymonkey.com/s/fx_awards_2011

Asian currencies on the up

The third quarter of 2009 has proven to be another negative one for the US dollar.  Over the period the dollar index fell by over 4%.  The only major currency to lose ground against the dollar over this period was the British pound.  Most other currencies, especially the so called “risk currencies” which had come under huge pressure at the height of the financial crisis, registered strong gains led by the New Zealand dollar, Swedish krona and Australian dollar.  Although the euro also strengthened against the dollar it lagged gains in other currencies over the quarter.

Asian currencies also registered gains against the dollar in Q3 but to a lesser extent than G10 currencies.  Asian currency appreciation was led by the Korean won, Indonesian rupiah and Singapore dollar, respectively.  The under performer over Q3 was the Indian rupee which actually depreciated against the US dollar slightly.  The reason for the smaller pace of appreciation for most Asian currencies was due mainly to intervention by Asian central banks to prevent their respective currencies from strengthening too rapidly, rather than due to any inherent weakness in sentiment.

In fact, Asian currencies would likely be much stronger if it wasn’t for such FX interventions.  A good indication of the upward pressure on Asian currencies can be found from looking at the strength of capital inflows into local stock markets over recent months.  South Korea has registered the most equity capital inflows so far this year, with close to $20 billion of flows into Korean equities year to date but in general most Asian stock markets have registered far stronger inflows compared with last year.   

For the most part, balance of payments positions are also strong.  For example, South Korea recorded a current account surplus of $28.15 billion so far this year, compared to a deficit of $12.58bn over the same period last year.  This is echoed across the region.  Although surpluses are expected to narrow over coming months due mainly to a deterioration in the terms of trade, the overall health of external positions across the region will remain strong and supportive of further currency appreciation.  

The outlook for the final quarter of 2009 is therefore likely to be positive for Asian currencies, with the US dollar set to weaken further against most currencies.  Some risk will come from a potential reversal in global equity market sentiment but overall, further improvements in risk appetite will support capital inflows into the region.  Capital will be attracted by the fact that growth in Asia will continue to out perform the rest of the world and yet again only interventions by central banks will prevent a more rapid appreciation of Asian currencies.

Contrasting messages from bonds, gold and equities

There is an interesting divergence developing between bond yields, gold prices and the trend in equity markets.  Whilst equities continue to go up, bond yields are falling and gold prices are rising.  Indeed the usually strong relationship between the S&P 500 and US 10 year yields has collapsed to an insignificant correlation around -0.09 over the past month compared to a high correlation of 0.84 in the month to 8 August.  

Rising equities appear to signify an improvement in risk appetite whilst bonds (US 10-year yield around 3.4%) and gold (around $1000 per troy ounce) are giving the opposite message.  So which indicator is correct and why the breakdown in the usually solid relationship?  

Growing optimism about economic recovery and the run of better than forecast data releases suggest that equities are correct but there is growing risk that so much good news is now priced in that we should pay attention to what bond yields and gold prices are telling us.  

Some of the move lower in bond yields can probably be attributed to the wall of liquidity sloshing around due to central banks’ unconventional policy measures.  However, it is still remarkable that despite the plethora of better than expected data releases, bond yields have actually declined.  This may reflect the success of quantitative easing but could also be associated with sustained economic and market fears.    

The commitment by G20 officials last weekend not to reverse stimulus policies prematurely may also have given more confidence in the view that interest rates will not be raised quickly.  Reflecting this 2 year German bund yields dropped to a record low level at the beginning of the week although longer term bond yield have pushed higher in the 30 year area.  The G20 commitment could turn out to be a double edged sword, however.  If there is no commitment to reduce burgeoning deficits, bonds could ultimately take fright.  

If bonds and gold prices are really reflecting safe haven demand then it will pose a risk to the sustainability of any equity rally over coming months.  As equity valuations begin to look increasingly stretched – the P/E ratio on the S&P 500 has reached 18.76 (according to Bloomberg calculations) compared to a low of around 10.00 at the beginning of March 2009 – it will need more to keep the rally going and high amongst the factors needed is some clarity about the pace and shape of growth once stimulus is reversed. 

For currency markets I think it will be difficult to see a trend until there is more clarity about the economic outlook and in the meantime currency markets will continue to stock watch for direction even if the influence of risk appetite is declining.  Even so, the dollar appears to be reacting more to equities than bond movements and is coming under growing pressure as equities rise.  

Many currencies are poised to break out of recent ranges to the topside versus the dollar led by risk currencies such as the AUD, NZD and CAD.  If it turns out that the equity story rather than the bond message is the correct one then the real message is a bullish one for risk appetite and given the dollar’s usually negative reaction to improved risk appetite, it could face further pressure over coming weeks.

Saturated by good news

We are currently moving into an environment where economic data is becoming less and less influential in moving markets and this could continue for some weeks.  The bottom line is that so much recovery news is in the price that the continuing run of better than forecast data are having only a limited impact.  Over recent days this run has included firmer than forecast readings on US manufacturing sentiment, consumer sentiment, housing activity and durable goods orders.  The market has become saturated with good news and is showing signs of fatigue.  

Just take a look at the reaction to the latest numbers. Equity markets barely flinched in reaction to positive data including a surge in new home sales and a jump in durable goods orders.  In Europe, the German IFO recorded its biggest increase since 1996.  Perhaps the subdued market reaction was due to the details of some of the reports which could have been considered as not as upbeat as the headlines suggested.  However, this explain is tenuous at best.  

News that China’s state council is studying restrictions on overcapacity in industries including steel and cement will not have helped market sentiment as concerns about Chinese growth are likely to resurface. Nonetheless, the most likely explanation for the lack of momentum in markets is fatigue.  There have been plenty of positive data surprises over recent weeks and markets have become increasingly desensitised to such news. 

Another explanation of the failure of positive data to boost sentiment is that risk appetite is almost back to pre-crisis levels according to many indicators I follow.  Indeed, further impetus for risk currencies will be more limited in the months ahead as the room for a further decline in risk aversion is becoming more limited.

This combined with growing fatigue will have interesting consequences. Firstly it suggests a degree of dollar and yen resilience over coming weeks and growing pressure on risk trades, especially commodity currencies which will suffer disproportionately to fears about Chinese growth and lower commodities demand. 

Nonetheless, consolidation in the weeks ahead rather than any sharp moves is the most likely path.  Although the overall trend of improving risk appetite will continue it is already becoming evident that it will take a lot more to drive risk appetite higher than a steady stream of data showing that the global economy is turning around. In any case, currencies have become less sensitive to the gyrations in risk suggesting that other influences will be sought in the months ahead.  In the meantime range trading will continue. 

The reduced swings in currencies have taken FX largely off the radar as far as policy makers are concerned and it is difficult to see the topic being a major issue at upcoming policy meetings. Lower currency volatility is clearly a boon for policy makers and reflects some “normalisaiton” in currency markets. It perhaps also reflects the fact that FX valuations are less of out synch than they were a few months back, with the USD far less overvalued against many currencies.

Risk gyrations and FX positioning

I must admit it has been quite tough to get a handle on the sharp moves in markets over recent days. Market sentiment shifted from positive to negative and back again in a matter of hours, meaning that anyone wanting to put on a long term trading position has had to have had a significant risk tolerance to hold onto their positions.

Attention was focused squarely on Chinese stocks last week but market fears over tighter regulation eased as the week progressed. Market sentiment was helped by strong existing home sales data in the US, continuing the run of better than forecast US economic data releases. Globally data releases mirrored this tone.

A cautiously upbeat tone from central bankers at the Jackson Hole symposium sets up a positive backdrop for markets. Although Fed Chairman Bernanke noted that the rebound in growth was likely to be slow and ECB President Trichet talked about a “bumpy road ahead” the overall tone was positive.

Importantly there was no indication that a reversal in monetary policy was in sight, with the Fed’s Kohn even indicating that there was no inconsistency between the Fed maintaining low rates for an “extended period” and keeping inflation low. The comments should help to ensure that markets do not misinterpret the signs of recovery as a cue to begin hiking interest rates.

This week’s data slate will maintain the run of good news. However, there are a few risks. Consensus forecasts look for US consumer confidence to improve in August but the weak labour market situation may hold some downside risks for the Conference Board measure of confidence just as it did for the Michigan reading.

US durable goods orders are set to bounce back and new home sales are likely to echo at least some of the gains in existing home sales last week. In the eurozone, attention will focus on the August German IFO survey and this release is likely to mirror the gains in the PMI, with a healthy gain in the headline reading expected.

Risk trades continue will be favoured after overcoming last week’s setbacks keeping the USD under downward pressure but within ranges and risk currencies including AUD, NZD, CAD and NOK under upward pressure. The USD index is verging on testing its 5th August low of 77.428, whist the JPY is also weaker though its moves may be more limited ahead of upcoming elections.

The IMM report shows that speculative investors have cut pared back USD short positions further, but the shift in positioning was relatively small from the previous week, with net aggregate USD short positions at -94.8k contracts compared to -96.1 in the previous week. Notable shifts in positioning over the week include a cut back in net EUR long positions to their lowest level since the week of 5th May 2009.

Commodity currencies suffered some pullback in net long positioning too with speculative AUD and NZD contracts being cut although net CAD long positions did increase slightly. Given the resumption in risk appetite into this week it seems highly likely that positioning will reverse and net USD short positions will increase.

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