All Eyes On Jackson Hole

August 26, 2011 — Mitul Kotecha

It’s all about Jackson Hole and ahead of the Fed symposium the USD index is likely to maintain its place in towards the middle end of its recent 73.47 – 75.12 range helped by weaker equity markets. Expectations or hopes that Fed Chairman Bernanke will announce or at least hint at a fresh round of quantitative easing have receded allowing the USD to escape further pressure. Bernanke will likely keep all options open but there are still some in the FOMC who do not want to embark on QE3.

Although the USD may be saved from a further drubbing the commitment to maintain exceptionally accommodative monetary policy through Q2 2013 has contributed to a relative reduction in US bond yields and in turn is acting to restrain the US currency. A likely revision lower to US Q2 GDP will not help the USD in this respect.

One currency in particular that is reactive to yield differentials is USD/JPY, which registers an impressively high correlation with US – Japan yield differentials. Attempts this week by the Japanese authorities to encourage capital outflows and a downgrade of Japan’s credit ratings by Moody’s have done little to weaken the JPY.

Even the usually bearish JPY Japanese margin traders have been scaling back their long USD/JPY positions over recent weeks while speculative investors remain overly long (well above the three-month average) JPY according to IMM data. The risk of a shake out of long JPY positions is high but unless yield differentials reverse renewed JPY weakening looks unlikely in the short-term.

Eurozone peripheral issues will be put on the backburner ahead of the Jackson Hole meeting but that doesn’t mean they have gone away. As the continued pressure on Greek bonds shows markets continue to be fixated on the country’s problems and there may be growing nervousness ahead of the decision to distribute the next IMF loan tranche at the end of September. Nervousness also extended to Germany, with ratings agencies having to confirm the country’s AAA rating.

So far this week EUR has shown impressive resilience despite weak data in the form the German August IFO business and ZEW investor confidence surveys. However, there is a risk of EUR weakness should Bernanke not hint at QE3, with the currency already trading around the bottom of its multi-day range.

AUD has failed to recoup its end July losses and is still some 5% below its high above 1.10 versus USD. There is scope for some AUD appreciation especially as AUD speculative positioning has dropped sharply over recent weeks reducing sharply the net long overhang in the currency.

Moreover, markets have become overly aggressive in pricing in interest rate cuts in Australia and as evidenced from the AUD bounce following RBA Governor Stevens comments this morning (in which he referred to inflation data as still being concerning) there is an asymmetric risk to the AUD on the upside.

Nonetheless, AUD has experienced an increase in sensitivity to risk over recent weeks and will continue to be driven by gyrations in risk appetite. In this respect it is too early to assume the worst is over, suggesting that any further gains in AUD will be limited.

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Euro resilient but for how long?

March 25, 2011 — Mitul Kotecha

The resilience of the EUR to bad news has been impressive but is unlikely to persist. The recent negatives include 1) the rejection of the Portuguese government’s austerity plan and the increased likelihood of a bailout, 2) a likely delay in the decision on increasing the size and scope of the EFSF EU bailout fund, 3) a drop in Eurozone purchasing managers indices in March, 4) downgrades to Portugal’ sovereign credit ratings by Fitch last night and S&P and 5) Moodys downgrades of 30 Spanish banks. Despite all of this, and after hitting a low of around EUR/USD 1.4054, EUR has bounced back close to the 1.4200 level.

Further direction will come from the outcome of the EU leaders’ summit today and the March German IFO business confidence survey. For the former there is unlikely to be a decisive result, with the optimism following the informal March 11 leaders’ summit likely to give way to delay due to wrangling over details. For the latter, a slight moderation in the IFO is expected following February’s upside surprise. However, there is a bigger risk of a downside surprise following the softer than forecast March German manufacturing PMI released. Against this background, EUR/USD is likely to struggle to break resistance around 1.249.

In general FX markets look somewhat more stable and even the pressure on the USD appears to have abated slightly despite a much weaker than expected outcome for US February durable goods orders yesterday, which revealed a drop in both headline and ex-transportation orders. My composite FX volatility measure has dropped sharply over recent days, led by short term implied JPY volatility which has dropped close to pre-crisis levels. Lower volatility has also likely reduced the prospects of further FX intervention although USD/JPY 80 will continue to be well defended.

Lower volatility as also reflected in the sharp drop in the VIX index has corresponded with a general easing in risk aversion as both Middle East and Japan tensions have eased slightly. US data today are unlikely to offer much direction, with a slight upward revision to US Q4 GDP and an unchanged outcome for the final reading of Michigan consumer confidence expected.

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Euro support unwinding

December 16, 2010 — Mitul Kotecha

The USD is set to end the year in firm form aided by rising US bond yields. Yesterday’s data supported this trend. The Empire manufacturing survey beat expectations rebounding nearly 22 points in December and industrial production rose 0.4% in November although there was a downward revision to the previous month. This was against the background of soft inflation, with headline and core CPI rising 0.1%, indicating that the Fed will remain committed to its $600 billion program of asset purchases.

EUR/USD dropped below support around 1.3280, weighed down by various pieces of negative news. Moodys downgrade of Spain’s credit ratings outlook dented sentiment but the bigger sell off in EUR followed the move in US bond yields. The prospect of EUR recovery over the short term looks limited. The issue of finding agreement on a permanent debt resolution fund continues to fuel uncertainty and will likely come to a head at the EU summit starting today.

Added to this Ireland’s main opposition party which will likely play a part in forming a new government early next year wants some of the debt burden shared with senior bank debt holders. The good news in Europe was few and far between but at least Ireland’s parliament backed the EU/IMF bailout for the country. Of course the backing could be derailed following elections in January. Perhaps the most surprising aspect of the move in EUR is that it’s not weaker. The next support level for EUR/USD is around 1.3160.

The divergence between the US and Europe on policy is stark, with loose fiscal and monetary policy in the US providing a significant prop to the US economy, whilst the much tighter fiscal stance and less loose monetary policy threatens to result in more pressure on eurozone growth especially against the background of an overvalued EUR. This divergence will manifest itself next year in the form of US growth outperformance and stronger USD vs. EUR.

The resilience of the UK consumer continues to surprise, with the CBI distributive trades survey coming in strong and rising further to +56 in December. The only problem with the survey data is that is has not tracked official data. November retail sales data today will give further clues to the strength of spending heading into Christmas. More worryingly from the Bank of England’s perspective is the fact that inflation continues to rise despite assurances that the increase in inflation is temporary. At the least the likelihood of more quantitative easing QE from the BoE has evaporated though it is still a long way off before interest rates are hiked. In the meantime GBP continues to underperform both EUR and USD though GBP/USD will find strong support around 1.5512.

Upward pressure on US yields and the USD us unlikely be derailed US data releases today. Housing starts are set to bounce back in November, with a 6% gain expected, whilst the trend in jobless claims will likely continue to move lower. The Philly Fed manufacturing survey is set to lose a little momentum reversing some of November’s sharp gain but will still remain at a healthy level.

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US bonds sell off, USD rallies

December 8, 2010 — Mitul Kotecha

US Treasuries didn’t like it but the compromise agreement to extend Bush era tax cuts, as well as a 13-month unfunded extension of long term unemployment benefits and a $120 billion payroll tax holiday will provide the US economy with further support and likely to lead to some upgrading of US growth forecasts. The agreement changes the dynamic of fiscal support for the US economy and means that the US is the only major country not tightening fiscal policy. It also implies less heavy lifting needed from the Federal Reserve.

Whilst some US taxpayers will not now face tax increases following the end of the year, the longer term question of fiscal adjustment and reform appears to have been postponed. US bond yields jumped on the news as the agreement effectively adds $1 trillion to US debt over the next couple of years. The contrasting fiscal stance with Europe could eventually haunt US markets as focus eventually return to US fiscal issues, with negative implications for the country’s credit ratings. However, at present, attention remains firmly fixed on European sovereign risk rather than US deficit fears.

There has been some relief to European debt markets, albeit temporarily, with debt markets ignoring the news that European Finance Ministers have not agreed to extend the size of the support fund (EFSF) and have also failed to agree on the introduction of recently touted “E-bonds”. ECB buying of peripheral bonds has given some support whilst the passage of the first votes of the Irish budget has eased tensions in its bond markets. Nonetheless as highlighted by the IMF, Europe’s ”piecemeal” response to the debt crisis in the region is insufficient to stem the crisis, suggesting that the current easing in pressure could prove short-lived.

The jump in US bond yields has given the USD some support but I wouldn’t overplay the impact on the USD of bond yields at present. Correlations reflecting the sensitivity of bond yields to various currencies remain relatively low suggesting that the influence of yield on FX is still limited. That said, the correlation is likely to increase over coming months as US yields move higher. The impact on USD/JPY is likely to be particularly sharp, with the currency pair likely to move higher over coming months. The USD has likely rallied due to the likelihood that the tax cut extensions will mean prospects of less quantitative easing by the Fed and prospects of relatively firmer US growth.

An ongoing concern for markets is the prospects of higher interest rates in China. As regular readers of Econometer many note, my blog posts have been a bit sporadic lately. This is not down to laziness but the fact that I have been on the road quite a bit travelling in Asia (and UK) visiting clients. One of the clear concerns that I have heard often repeated is the potential for China’s measures to curb real estate speculation, rising inflation, and lending, to slow China’s growth sharply and cause problems for the rest of the world. This is the topic of another post for another day, but against the background of such concerns the AUD and other high beta currencies are likely to fail to make much headway.

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Risk trade rally fizzles out

June 23, 2010 — Mitul Kotecha

The risk trade rally spurred by China’s decision to de-peg the CNY fizzled out. The realization that China will only move very gradually on the CNY brought a dose of reality back to markets after the initial euphoria. The fact that unlike in July 2005 China ruled out a one off revaluation adds support to the view that China will move cautiously ahead with CNY reform. In addition, renewed economic worries have crept back in, with particular attention on a potential double dip in the US housing market following a surprise 2% drop in existing home sales in May.

European banking sector woes have not disappeared either with S&P raising the estimate of writedowns on Spanish bank losses, whilst Fitch ratings agency noted that there is an increased chance of the eurozone suffering a double-dip recession. The net impact of all of these factors is to dampen risk appetite and the EUR in particular.

The UK’s announcement of strong belt tightening measures in its emergency budget did not fall far outside of market expectations. The budget outlined a 5-year plan of deficit reduction, from 11% of GDP in 2009-10 to 2.1% of GDP in 2014-15. The main imponderable was the response of ratings agency and so far it appears to have been sufficient not to warrant a downgrade of the UK’s credit ratings. Fitch noted that the “ambitious” plan ensured that the UK would keep its AAA credit rating. The emergency budget and reaction to it has been mildly positive for GBP, which has shown some resilience despite the pull back in risk currencies.

The recent rally in Asian currencies is looking somewhat overdone but direction will come from gyrations in risk appetite and the CNY rather than domestic data or events. Encouragingly equity capital flows into Asia have picked up again over recent weeks, with most countries with the exception of the Philippines registering capital inflows so far this month, led by India and South Korea.

China’s CNY move may attract more capital inflows into the region, suggesting that equity capital flows will continue to strengthen unless there is a relapse in terms of sovereign debt/fiscal concerns in Europe. Nonetheless, central banks in the region will continue to resist strong FX gains via FX interventions, preventing a rapid strengthening in local currencies.

Although India and Korea have registered the most equity inflows this month, both the INR and KRW have had a low correlation with local equity market performance over recent weeks. In fact the most highly sensitive currencies to their respective equity market performance have been the MYR and IDR both of which have reversed some of their gains from yesterday. USD/MYR will likely struggle to break below its 26th April low around 3.1825 whilst USD/IDR will find a break below 9000 a tough nut to crack.

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