Risk trades under pressure

July 11, 2009 — Mitul Kotecha

Having given presentations in Hong Kong, China and South Korea in the past week and preparing to do the same in Taiwan and Singapore this week it is clear that there is a lot of uncertainty and caution in the air.  

There can be no doubt now that risk aversion has forcibly made its way back into the markets psyche.  Government bonds, the US dollar and the Japanese yen have gained more ground against the background of higher risk aversion. 

Following a tough week in which global equity markets slumped, oil fell below $60 per barrel and risk currencies including many emerging market currencies weakened, the immediate outlook does not look particularly promising.

Data releases are not giving much for markets to be inspired about despite upgrades to economic growth forecasts by the IMF even if their outlook remains cautious.  US trade data revealed a bigger than expected narrowing in the deficit in May whilst US consumer confidence fell more than expected in July as rising unemployment took its toll on sentiment.   There was also some disappointment towards the end of the week as the Bank of England did not announce an increase in its asset purchase facility despite much speculation that it would do so.

Rising risk aversion is manifesting itself in the usual manner in currency markets.  The Japanese yen is grinding higher and having failed to weaken when risk appetite was improving it is exhibiting an asymmetric reaction to risk by strengthening when risk appetite is declining.  Its positive reaction to higher risk aversion should come as no surprise as it has been the most sensitive and positively correlated currency with risk aversion since the crisis began. 

Nonetheless, the Japanese authorities will likely step up their rhetoric attempting to direct the yen lower before it inflicts too much damage on recovery prospects.   The urgency to do so was made clear from another drop in domestic machinery orders last week as well as the poor performance of Japanese equities.  

The US dollar is also benefitting from higher risk aversion and is likely to continue to grind higher in the current environment.  Risk currencies such as the Canadian, Australian and New Zealand dollars, will be most vulnerable to a further sell off but will probably lose most ground against the yen over the coming days.   These currencies are facing a double whammy of pressure from both higher risk aversion and a sharp drop in commodity prices.    Sterling and the euro look less vulnerable but will remain under pressure too.   

There are some data releases that could provide direction this week in the US such as retail sales, housing starts, Empire and Philly Fed manufacturing surveys.  In addition there is an interest rate decision in Japan, and inflation data in various countries. The main direction for currencies will come from equity markets and Q2 earnings reports, however.  

So far the rise in risk aversion has not prompted big breaks out of recent ranges in FX markets.  However, unless earnings reports and perhaps more importantly guidance for the months ahead are very upbeat, there is likely to be more downside for risk currencies against the dollar but in particular against yen crosses where most of the FX action is set to take place.

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Dollar, Euro and Sterling Volatility Within Ranges

June 25, 2009 — Mitul Kotecha

Two steps forward, one step back appears to describe the movement of the US dollar over recent weeks.  Although the dollar is still off its lows registered at the beginning of June it has failed to make much of a recovery.  After a solid start to the week the dollar came under renewed pressure ahead of the FOMC decision but managed to register small gains following the lack of action from the Fed on Wednesday. Overall, the Fed showed slightly less concern about disinflation and became slightly less negative on the economic outlook but there was not much in the Fed statement to impact the dollar strongly.

Some comments by ECB officials noting that European interest rates are unlikely to be cut further and that further expansion of stimulus measures are not needed, likely explained some of the recent bounce in the euro versus dollar, but the massive ECB allocation of EUR 442 billion in its 1-year tender on Wednesday helped to push the euro lower once again.  The demand for funds from banks was extremely strong and the ECB responded by providing a huge amount of emergency credit.  The allocation drove down overnight and long term rates as well as weakening the euro. 

I still believe any gain in the euro will be limited especially as the Eurozone data flow continues to suggest that any recovery will be tepid.  Eurozone June PMIs this week revealed a small rise in the manufacturing index but a surprise fall in the services index. There was also some improvement in the French INSEE business confidence indicator but at most the data pointed to a slower pace of contraction and continue to lag the improvement in similar surveys in the US and UK.   EUR/USD appears to be trapped in a 1.38-1.43 range with little momentum to break either side of this. 

FX markets are set to remain volatile but within ranges.  The failure of the dollar to extend gains amidst thin data flow highlights the lack of direction in markets.  I am still biased towards some dollar upside over coming days but once again currencies will take their cue from equity markets.  The dollar may find some support if US equities continue to struggle; the S&P 500 is finding it difficult to sustain gains above its 200 day (897.2) and 50 day (900.54) moving averages, suggesting some scope for a downside move in US stocks an in turn a firmer dollar if the S&P 500 fails to hold above this level.   

GBP/USD looks resilient despite coming under pressure following comments by BoE Chief economist Spencer Dale that a weak currency was a “key channel” to spur growth.  Although GBP has recovered sharply from its low of 1.3549 touched on 26 January it is still looks undervalued and such comments do not necessarily justify a further drop in GBP.   Although GBP/USD is set to appreciate further over the coming months it could struggle to sustain a break above its 3 June high of 1.6663 over the near term.  The downgrade to UK growth forecasts by the OECD this week and comments by BoE governor King that UK recovery will be a “long, hard, slog” highlight the difficulties ahead.

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Why the Fed should be in no hurry to hike rates

June 21, 2009 — Mitul Kotecha

Equity markets struggled to gain traction last week and finally lost ground registering their first weekly decline in month.  It finally looks as though markets are succumbing to the inevitable; the realisation that the recovery is going to be a rocky ride but neither will it be rapid or aggressive.  Markets look as though they have just about run out of fuel and after registering major relief that the global economy was not falling into an endless whole and that financial markets were not going to implode, the equity rally has finally come to a point where it will need more than just news about “green shoots” to keep it going. 

One question that has been raised in particular in bond markets and in interest rate futures pricing is whether these “green shoots” have accelerated the timing of the end of quantitative easing and/or higher interest rates.  Although the markets have retraced some of the tightening expectations that had built in following the May US jobs report there will be a lot of attention on whether the Fed will attempt to allay market concerns that current policy settings will result in inflation running out of control and necessitate a hike in interest rates. 

The Fed’s job shouldn’t be too difficult. In usual circumstances the expansion of the money supply undertaken by the Fed would have had major implications for inflation.  However, the circulation of money (money multiplier) in the economy has collapsed during the recession as consumers have been increasingly reluctant to borrow and lenders have become increasingly reluctant to lend.  The end result has been to blunt the impact of Fed policy.  Of course, once the multiplier picks up the Fed will need to be quick to remove its massive policy accommodation without fuelling a rise in inflation.  If it didn’t it would be bad both for long term interest rates as well as the dollar. 

Although the current policy of quantitative easing is untested and therefore has a strong element of risk attached to it the reality is that the Fed is unlikely to have too much of a problem on its hands.  The explanation for this is that there will be plenty of slack in the economy for months if not years to come.  The labour market continues to loosen and as the US unemployment rate increases most probably well in excess of 10%, wage pressures will continue to be driven down.  

In addition there is plenty of excess capacity in the manufacturing sector and as the May industrial production report revealed the capacity utilisation rate dropped to 68.3%, a hefty 12.6% below its average for 1972-2008.  Inflation data continues to remain subdued as revealed by last week’s release core inflation remains comfortable at a 1.8% annual rate.   Weaker corporate pricing power suggests that core inflation will remain subdued over coming months and will even fall further, so there will be little threat to Fed policy.  

The output gap (difference between real GDP and potential GDP) remains wide and according to CBO estimates of potential GDP the economy will end the year growing at around 8% below its full capacity.  Even if the economy grows above potential for the next few years it may only just close the output gap and subsequently begin fuelling inflation pressures.  The bigger risk is that the economy grows slowly over coming years and takes several years to close the output gap. 

Taking a perspective of past Fed rate hikes following the last two recessions, interest rate markets should take some solace.  In 2001 the Fed begin to hike rates until around 2 ½ years after the end of the recession whilst in the 1990-91 recession rates did not go up until close to 3 years following the end of recession.  Arguably this recession is worse in terms of depth and breadth suggesting that it will take a long time before the Fed even contemplates reversing policy.

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What the G8 communiqué didn’t say

June 15, 2009 — Mitul Kotecha

There was a stark contrast between the outcome of the weekend’s G8 meeting in Lecce, Italy, and April’s G20 summit in London.  For a start, the tone was far more positive than in London, with Finance Minsters attending the meeting indicating that economic forecasts may need to be revised upwards rather than the steady stream of downward revisions seen over recent months.

The overall tone was one of cautious optimism.  The communiqué noted “there are signs of stabilization in our economies, including a recovery of stock markets, a decline in interest rate spreads, improved business and consumer confidence”.  However, at the behest of the UK the comments “but the situation remains uncertain and significant risks remain to economic and financial stability” was inserted into the final communiqué.   Such an inclusion is logical and at least suggests that officials are not getting to carried away with the improvement in recent data. 

Officials also began discussing “exit strategies” in terms of withdrawing massive global monetary and fiscal stimulus and even requested the IMF look at the issue in more detail.  Whilst it is premature to even discuss exit strategies the comments were clearly aimed at easing bond market concerns about widening fiscal deficits and inflation risks.  As Tim Geithner highlighted, recovery would be stronger if “if we make clear today how we get back to fiscal sustainability when the storm has fully passed”.   Nonetheless, a mere discussion about exit strategy is highly unlikely to remove the current angst that has built up in bond markets globally. 

Additionally, the communiqué included a commitment to develop standards governing the conduct of international business and finance, international regulatory reform, exchange of information for tax purposes and a commitment to refrain from protectionism.   None of these points will move markets this week and all were unsurprising discussion points. 

So what was missing?  The issue of stress tests on European banks was left out of the final communiqué even though it was discussed at the meeting. Reported disagreements with Germany and France over transparency over the publication of stress test results meant that an agreement could not be reached.  This is a big disappointment.  I have written about the issue in two previous posts “European economy in a whole lot of trouble” and “Stress testing European and UK banks” on my blog Econometer.   The fact that more wasn’t done will mean that uncertainty about the health of balance sheets in particular of banks in Germany will remain a constraint to European recovery.  At the least it will make it increasingly likely that in addition to a sharp decline in European growth this year GDP could also drop in 2010.

In addition, economic data continues to lag in the Eurozone compared to the improving signs in the US and elsewhere as highlighted by the huge 21% annual drop in April Eurozone industrial production at the end of last week.  This data even led to another omission with reference to “encouraging figures in the manufacturing sector” previously included in the draft dropped in the final communiqué.   It is clearly too early to talk about manufacturing recovery.

Also missing in the final communiqué was any reference to currencies. Although it was always unlikely that FX would be a major topic at the meeting due to the absence of central bankers attending, the drop in the dollar and concerns from foreign official investors (see a recent post on my blog “Are foreign investors really turning away from US debt”) raised the prospect that there would be some international backing of the US “strong dollar” policy led by the US. 

In the event there wasn’t any comment, but dollar positive comments on the sidelines of the meeting will likely limit any pressure on the dollar this week.  The dollar will be helped by comments on the sidelines of the G8 meeting as well as important comments from Russian Finance Minister Kudrin who stated that he has full confidence in the dollar with no immediate plans to move to a new reserve currency. Ahead of the meeting of BRIC countries this week the comments from Russia add further evidence that there will be no plan to move away from the dollar. Moreover, geopolitical tensions including the protests over the results of Iran’s elections as well as more jawboning from North Korea will work in favour of the dollar this week. 

The euro could look especially vulnerable this week. The lack of attention on European banks stress tests will be a disappointment for those hoping for more transparency and will act as a further drag on the euro.  This is likely to see the euro struggle to make much headway this week, with the recent high above 1.43 likely to provide tough resistance to any move higher in EUR/USD, with a bigger risk of a pull back towards the 1.37-1.38 levels.

Posted in bank rescue, Bond markets, central banks, Currencies, Economics, Economy, Europe, Financial crisis, Germany, Monetary Policy, US. Tags: , , , , , , , , , , , , , , , , , , , , , , , . 2 Comments »

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 »
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