World Cup FX Positioning/Data Highlights

The market tone felt decidedly better over the course of the last week although it was difficult to tell if this was due to position squaring ahead of the World Cup football or a genuine improvement in sentiment. There was no particular event or data release that acted as a catalyst either, with the European Central Bank (ECB) and Bank of England (BoE) meetings passing with little fanfare.

US data ended the week mixed, with retail sales disappointing in May but in contrast June consumer confidence beating expectations. Although questions about the pace of recovery remain, other data such as the Fed’s Beige Book suggest that recovery remains on track, sentiment echoed, albeit cautiously by Fed Chairman Bernanke last week.

Attention this week will centre on inflation data. Expected benign CPI readings will support the view that the Fed will take its time to raise interest rates. Speeches by the Fed’s Bullard, Plosser and Bernanke this week will be eyed for further clues on Fed thinking.

Central banks in Brazil and New Zealand hiked rates last week but this is not likely to be echoed this week. No change is likely from both the Bank of Japan and Swiss National Bank although there will be plenty of attention on the SNB’s comments on the CHF following recent data showing a surge in FX reserves due to currency intervention. The BoJ is unlikely to announce anything new but perhaps some further detail on the loan support plan could be forthcoming.

Manufacturing data will also garner some attention, with the US June Empire and Philly Fed surveys and May industrial production on tap. All three reports will confirm the improving trend in manufacturing activity in the US. Housing data will look weaker, with starts set to pull back in starts in May following the expiry of government tax incentive programmes though permits are set to rise.

In Europe, the June German ZEW (econ sentiment) investor sentiment survey will likely slip slightly due to ongoing fiscal/debt worries but this will be countered by stronger domestic data. In any case the index remains at a high level and a slight drop is unlikely to derail markets.

GBP may find some support form upgrade of UK growth forecasts by the CBI to 1.3% for 2010 and relatively hawkish comments from the BoE’s Sentance in the weekend press warning that inflation is higher than expected, indicating that the Bank may need to hike rates sooner than expected.

Further GBP/USD direction will come from CPI and retail sales data this week as well as public borrowing figures and a report by the new Office of Budget Responsibility on the UK’s fiscal position ahead of the June 22 budget. A break above GBP/USD resistance around 1.4760 is unlikely to materialise.

Despite the many data releases this week, the overall tone is likely to be one of consolidation and reduced volatility in the days ahead. This may allow EUR/USD to gain some ground due to short covering, with the CFTC commitment of traders (IMM) report revealing a further increase in net short speculative positions last week, close to the record set a few weeks back, though we suspect that there will be strong resistance around 1.2227.

The fact that the IMM data revealed that net aggregate net USD long positions reached an all time high last week, highlights the potential for profit taking this week. USD/JPY will look to take out resistance around 92.55 but this looks unlikely unless the BoJ dishes up anything particularly dovish from its meeting.

Contemplating Rate Hikes

The market mood has definitely soured and risk appetite has faltered.  This is good for the USD but bad for relatively high yielding/commodity risk trades. The USD is set to retain a firm tone over the near term even if is temporary, which I believe it is.  

Whether it’s profit taking on crowded risk trades, a lot of good news having already been priced in, fears that other countries will follow Brazil’s example of taxing capital inflows to dampen currency strength, or a reaction to weaker economic data, it is clear that there are many reasons to be cautious. 

It is also unlikely to be coincidental that the rise in risk aversion and drop in equity markets is happening at a time when many central banks are contemplating exit strategies and when many investors are pondering the timing of interest rates hikes globally following the moves by Australia and Israel. 

One of the reasons for the worsening in market mood is that some parts of the global economy may not be ready for rate hikes.  Certainly there is little chance of a US rate hike on the horizon and perhaps not until 2011 given the prospects of a sub par economic recovery.  This projection was given support by the surprise drop in US consumer confidence in October.

It is not just the US that is unlikely to see a quick reversal in monetary policy.  As indicated by the bigger than expected decline in annual M3 money supply growth in the eurozone, which hit its lowest level since the series began in 1980, as well as the drop in bank loans to the private sector, the ECB will be in no hurry to wind down its non-standard monetary policy measures. 

The chances of any shift in policy at next week’s ECB meeting are minimal, with the ECB’s cautious stance emboldened by the subdued money supply and credit data.  As long as EUR/USD remains below 1.50 ECB President Trichet is also unlikely to step up his rhetoric on the strength of the EUR.  

Although the major economies of US, Eurozone, Japan and UK are likely to maintain current policies for a long while yet, the stance is not shared elsewhere.  The Reserve Bank of India did not raise interest rates following its meeting this week but edged in this direction by requiring banks to buy more T-bills. Other central banks in the region are set to move in this direction.

In terms of developed economies, Norway was the latest to join the club hiking rates by 25bps and adding to the growing list of countries starting the process of policy normalisation.   Australia is set to hike rates again at next week’s meeting although a 50bps hike looks unlikely, with a 25bps move more likely. 

Who’s going to follow in Brazil’s footsteps?

Last week saw a sell off in some emerging market currencies and whilst this may simply have been profit taking attributable to some large hedge funds it did coincide with the imposition of a tax on portfolio inflows in Brazil.  The tax dented sentiment as it quickly fuelled speculation that it would be followed elsewhere, especially in countries that had seen rapid FX appreciation.  

The BRL is one of the best performing currencies this year against the USD whilst the stock market has surged on strong capital inflows.  The huge increase in USD liquidity globally and substantial improvement in risk appetite has fuelled strong capital inflows into Brazil especially as the country has proven to be one of the most resilient during the crisis.

Although on the margin the tax will have a negative impact on speculative flows into Brazil it is unlikely to have a lasting impact.  Previous such measures have done little to prevent further appreciation.  The BRL is clearly overvalued by around 25-30 at present, but the tax in itself will not be sufficient to result in a move back to “fair value”. 

At best it may act a temporary break on currency appreciation and could limit the magnitude of further gains in the real but this could be at the cost of distorting resource allocation and market functioning.   The longer term solution is to enhance productivity but this will not help in the interim. The tax may make investors a little more reluctant to pile into Brazilian assets, which is what the authorities will desire but already the BRL is back on its appreciation path suggesting a short lived reaction. 

Other countries that could follow include South Africa, Turkey or South Korea but South Africa has already denied that it has any plans to move in this direction.  In South Korea’s case the central bank has chosen to intervene in currency markets to prevent the further strengthening in the won but that also has implications for sterilizing such flows limiting the extent that intervention can be carried out.    

The bottom line is that the broad based improvement in risk appetite is proving to be a strong driver of capital flows into emerging markets and the reality is that many emerging economies such as Brazil and many in Asia have been much more resilient than feared. 

Although there is clearly a limit on the extent that these countries want to allow their currencies to strengthen versus USD the upward pressure will continue, leading to more FX intervention and potential imposition of taxes or restrictions such as implemented in Brazil.   Despite this the outlook for most emerging currencies remains positive and the authorities will face an uphill struggle. 

%d bloggers like this: