Ready for Fed QE2

September 22, 2010 — Mitul Kotecha

The USD was already under pressure ahead of the Fed FOMC decision last night, with the EUR benefiting in particular from successful debt auctions in Ireland and Spain. The Fed statement resulted in a further lurch lower for the USD index as it fell through the 81.00 level on its way to testing the August low of 80.09. EUR/USD broke important technical resistance levels moving above its 200-day moving average (1.3215). In contrast, gold prices continued to surge hitting a new record high whilst 2-year Treasury yields fell to an all-time low.

The US Federal Reserve confirmed that it was ready to ease if needed. Although the decision to leave the Fed funds target rate at 0% to 0.25% unchanged and commitment to maintain exceptionally low levels of the rate for an “extended period” came as no surprise there was a subtle change in the language of the statement regarding further easing. The Fed noted that it was “prepared to provide additional accommodation if needed” a shift from the previous wording that it “will employ its tools as necessary”.

It appears to be a case of not if but when the Fed embarks on further quantitative easing and/or other policy accommodation. Once again the Fed offered no guideposts to determine the timing of easing and the decision will ultimately be data dependent. Nonetheless, the bias has clearly shifted towards more balance sheet expansion.

We expect core inflation to decline further over the coming months although we do not forecast a drop to as low as 0.5%. Nonetheless, declining core CPI could lead to the Fed’s disinflation concerns intensifying. Indeed, providing further rationale for the Fed’s conditional easing bias was the particularly dovish stance on inflation in the FOMC statement.

If it wasn’t obvious before it has become increasingly clear now that the USD will not relinquish its role as the ultimate funding currency for a long time to come. Although interest rate differentials are not yet the main driver for most currency pairs, with risk aversion retaining this role for now, there is a very high correlation between certain high yielding currencies and their respective interest rate differentials against the USD.

For instance, there is a high and significant correlation between interest rate differentials between Japan, Australia, Canada and the US and their respective currency pairs. AUD/USD is one to watch as the currency hit a fresh 25 month high overnight. Although the AUD looks rich at current levels, the shift in relative yield with the US overnight provides a further underpinning to the currency, with parity being talked about once again.

Even USD/JPY moved lower in the wake of the Fed statement dropping just below 85.00 although the threat of further official Japanese FX intervention will likely prevent a sharp drop in the currency pair. It will be interesting to see how far the market is prepared to go, with further threats of FX intervention by Prime Minister Kan overnight. Despite the threats the narrowing in US / Japan bond yields overnight suggests more downside pressure on USD/JPY and a fresh challenge for the Japanese authorities.

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The Week Ahead

September 20, 2010 — Mitul Kotecha

Equity markets and risk trades have generally performed well over the last couple of weeks, with for example the S&P 500 around 7.5% higher since its late August low, whilst equity and currency volatility have been generally low, the latter despite some hefty FX intervention by the Japanese authorities which did provoke a spike in USD/JPY volatility last week.

Risk appetite took a knock at the end of last week in the wake of worries that Ireland may seek EU / IMF assistance although this was denied by Irish officials. A similar worry inflicted Portugal, and as a result peripheral bond spreads were hit. Sovereign worries in Europe have not faded quickly and bond auctions in Greece, Spain and Portugal will garner plenty of attention this week. Renewed worries ahead of the auctions suggest that the market reception could be difficult.

Attention will swiftly turn to the outcome of the Fed FOMC meeting tomorrow and in particular at any shift in Fed stance towards additional quantitative easing following the decision at the August FOMC meeting to maintain the size of the Fed’s balance sheet. Given the recent improvement in US economic data the Fed is set to assess incoming data before deciding if further measures are needed.

Housing data in the US will also garner plenty of attention, with several releases scheduled this week. Increases in August housing starts, building permits, existing and new home sales are also expected. Whilst this may give the impression of housing market improvement, for the most part the gains will follow sharp declines previously, with overall housing market activity remaining weak following the expiry of the government tax credit.

Weakness in house prices taken together with a drop in equity markets over the quarter contributed to a $1.5 trillion drop in US household net wealth in Q2. Wealth had been recovering after its decline from Q2 2007 but renewed weakness over the last quarter will not bode well for consumer spending. Household wealth is around $12.4 trillion lower than its peak at the end of Q2 2007.

Aside from the impact of renewed sovereign concerns, European data will not give the EUR much assistance this week either, with Eurozone September flash PMIs and the German IFO survey of business confidence set to weaken as business and manufacturing confidence comes off the boil. If the Fed maintains its policy stance whilst risk aversion increases over coming days the USD may find itself in a firmer position to recoup some of its losses both against the EUR and other currencies.

This will leave EUR/USD vulnerable to drop back down to around support in 1.2955 in the very short-term. As indicated by the CTFC IMM data there has been further short EUR position covering last week whilst sentiment for the USD deteriorated, suggesting increased room for short-USD covering in the event of higher risk aversion.

The impact of Sweden’s election outcome over the weekend is unlikely to do much damage to the SEK despite the fact that the coalition government failed to gain an outright majority. EUR/SEK has edged higher over recent days from its low around 9.1528 but SEK selling pressure is unlikely to intensify following the election, with EUR/SEK 9.3070 providing tough technical resistance.

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No Let Up in USD Pressure

September 17, 2010 — Mitul Kotecha

At the end of a momentous week for currency markets it’s worth taking stock of how things stand. Much uncertainty remains about the global growth outlook, especially with regard to the US economy, potential for a double-dip and further Fed quantitative easing. Although there is little chance of QE2 being implemented at next week’s Fed FOMC meeting speculation will likely remain rife until there is clearer direction about the path of the US economy.

In Europe, sovereign debt concerns have eased as reflected in the positive reception to debt auctions this week. Nonetheless, after a strong H1 2010 in terms of eurozone economic growth the outlook over the rest of the year is clouded. Such uncertainty means that markets will also find it difficult to find a clear direction leaving asset markets at the whim of day to day data releases and official comments.

The added element of uncertainty has been provided by Japan following its FX intervention this week. Whilst Japanese officials continue to threaten more intervention this will not only keep the JPY on the back foot but will provide a much needed prop for the USD in general. Indeed Japan’s intervention has had the inadvertent effect of slowing but not quite stopping the decline in the USD, at least for the present.

The fact that Japanese officials continue to threaten more intervention suggests that markets will be wary of selling the USD aggressively in the short term. The headwinds on the USD are likely to persist for sometime however, regardless of intervention by Japan and/or other Asian central banks across Asia, until the uncertainty over the economy and QE2 clears.

Japan’s intervention has not gone down well with the US or European authorities judging by comments made by various officials. In particular, the FX intervention comes at a rather sensitive time just as the US is piling on pressure on China to allow its currency the CNY to strengthen further. Although US Treasury Secretary Geithner didn’t go as far as proposing trade and legal measures in his appearance before Congress yesterday there is plenty of pressure from US lawmakers for the administration to take a more aggressive stance, especially ahead of mid-term Congressional elections in November. Ironically, the pressure has intensified just as China has allowed a more rapid pace of CNY nominal appreciation over recent days although it is still weaker against its basket according to our calculations.

Another country that has seen its central bank intervening over many months is Switzerland, with the SNB having been aggressively intervening to prevent the CHF climbing too rapidly. However, in contrast to Japan the SNB is gradually stepping back from its intervention policy stating yesterday that it would only intervene if the risk of deflation increased. Even so, Japan may have lent the Swiss authorities a hand, with EUR/CHF climbing over recent days following Japan’s intervention.

The move in EUR/CHF accelerated following yesterday’s SNB policy meeting in which the Bank cut its inflation forecasts through 2013, whilst stating that the current policy stance in “appropriate”. Moreover, forecasts of “marked” slowdown in growth over the rest of the year highlight the now slim chance of policy rates rising anytime soon. Markets will eye technical resistance around 1.3459 as a near term target but eventually the CHF will likely resume its appreciation trend, with a move back below EUR/CHF 1.3000 on the cards.

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Resisting Asian FX Appreciation

September 7, 2010 — Mitul Kotecha

The upward momentum in Asian currencies has continued unabated over recent weeks the gyrations in risk appetite. Most Asian currencies have registered gains against the USD over 2010 with the notable exception of one of last year’s star performers, KRW which after gaining by close to 9% last year has weakened slightly this year. Last year’s best performer the IDR which raked in close to 20% gains over 2009 versus USD has continued to strengthen this year, albeit to a smaller degree. Another currency that has extended gains this year has been the THB, which is on track to beat last year’s 4% appreciation against the USD.

The strength in Asian currencies has in part reflected robust inflows into Asian equity markets. For example Indonesia has been the recipient of around $1.7 billion in equity inflows so far this year. However, India and Korea have registered even larger inflows into their respective equity markets, at around $13 billion and $7.7, respectively, yet both the INR and KRW have underperformed other Asian currencies. The explanation for this is largely due to deteriorating current account positions in both countries. Further deterioration is likely.

The fact that equity flows have had only a small impact on the INR and KRW is reflected in their low correlations with their respective equity market performance. For most other Asian currencies the correlation with equity performance has been quite high, with the THB and MYR having the strongest correlations with their respective equity market indices over the past 3-months although the SGD, PHP and IDR have also maintained statistically significant correlations.

Clearly, for many but not all Asian currencies equity market gyrations are important drivers but at a time when growth is slowing more than many had expected in the US and governments in the eurozone are implementing austerity measures which will likely result in slowing growth and a worsening trade picture in the region, central banks in Asia will become increasingly wary of allowing their currencies from strengthening too quickly.

Increasingly Asian currency strength is being met with intervention by central banks in the region buying USDs against a host of Asian currencies. Over recent weeks this intervention appears to have become more aggressive. Nonetheless, any FX intervention led weakness in Asian FX is likely to prove short lived, with renewed appreciation likely over the coming months unless risk aversion increases dramatically. In other words a drop in Asian currencies will provide better opportunities to go long.

The CNY will play an important role on the pace and pattern of Asian currency movements. Investors in the region will also have one eye on developments on the visit of US National Economic Council director Larry Summers to Beijing. The CNY has firmed over recent days but this appears to be the usual pattern when a senior US official is in town and ahead of a G20 meeting. The fact is however, that the lack of CNY appreciation since the June CNY de-pegging remains a highly sensitive issue.

China is unlikely to yield to US pressure and is set to continue to act at its own pace and comments from officials in China over the past couple of days suggest no shift in FX stance. Although the CNY has not appreciated by as much as many had hoped for or expected since the June de-pegging the path is likely to be upwards, albeit at a gradual pace. For Asian currencies a slow pace of CNY appreciation implies further reluctance to allow a fast pace of appreciation so expect plenty of FX intervention in the weeks and months ahead.

Posted in Asia, Bond markets, central banks, China, Currencies, Economics, Economy, emerging markets, equity markets, Europe, eurozone, India, Interest rates, Monetary Policy, Singapore, South Korea, US, US administration. Tags: , , , , , , , , , , , , , , , , , , , , , , , . Leave a Comment »

Two-way FX risk returns

August 18, 2010 — Mitul Kotecha

It appears that there is a bit of a sea change taking place in currency markets. Since early June the trend in currency markets would have looked like a one way bet to most casual observers. For instance, the USD index was declining fairly steadily and predictability as US growth worries intensified and markets anticipated a resumption of quantitative easing by the Fed. This changed quite dramatically over recent days, with a significant degree of two-way risk re-entering the market as the USD shook off worries about Fed quantitative easing and instead rallied in the wake of higher risk aversion.

The introduction of two-way risk into the market will cause a rethink of the increasingly fashionable view that the USD was about to embark on a renewed negative trend. This change in market perspective has coincided with renewed concerns about European sovereign risks, even as European growth has come in much stronger than expected over Q2. Other currencies have also lost ground against the USD more recently, with the notable exception of the JPY which remains close to the psychological level of 85.00.

Until recently the move in FX markets since early June contrasted with my view that Q3 would be a period of uncertainty and volatility. Improved risk appetite reflected a decline in uncertainty but whilst I now believe that Q3 will see less of an increase in risk aversion than previously anticipated, my core views remain unchanged. I see the USD resuming an appreciation trend against the EUR and funding currencies (JPY and CHF) whilst weakening against higher yielding risk currencies (AUD, NZD and CAD) over the medium term.

Although FX markets will likely gyrate between the influences of risk aversion on the one hand and growth/interest rates on the other, risk is likely to take the upper hand over the coming weeks. The influence of risk aversion has jumped sharply over the last few weeks for almost all currencies. As risk appetite was improving as it has done for much of the period since early June, it played negatively for the USD but the recent increase in risk aversion – brought about by renewed growth concerns, sovereign worries in the eurozone, with Ireland in particular coming under scrutiny – has managed to reverse this trend. The one-way bet for investors now appears to be over.

Only time will tell if the EUR’s recent bull run has come to an end but there is sufficient evidence to suggest that plenty of good news has now been priced in and that further upside will be much more difficult to achieve. Even the recently strong growth data in the eurozone has thrown up potential problems including growing divergence as well as the potential for a slowdown over coming quarters. Further strengthening of the EUR will be a particular problem for eurozone growth, especially for exporting countries such as Germany. In any case, even the recent drop in the EUR leaves the currency at an overvalued level and susceptible to further falls. Over the coming weeks a period of consolidation is likely, with the EUR set to take a weaker tone.

The JPY in contrast has shown little sign of weakening and continues to flirt with the key psychological level of 85.00 much to the detriment of the Japanese economy, leading to growing frustration from Japanese officials. Much weaker than expected Q2 GDP data has given even more reason to engineer a weaker JPY but as yet the only intervention has come verbally and even this has not been particularly strong. In the absence of FX intervention, the Japanese authorities may be forced to consider other options such as increasing outright JGB purchases.

Like the EUR and JPY, GBP will find it tough to extend gains against the USD especially given that the doves at the Bank of England will likely remain in the ascendancy as growth moderates. GBP is also less undervalued than it was just a few weeks back suggesting that the argument for GBP strength has weakened. Nonetheless, GBP is likely to outperform against a generally weaker EUR ending 2010 around 0.78.

Similarly, CHF will likely maintain its strength against the EUR in the short term but unlike GBP this will likely give way to weakness and a gradual move higher in EUR/CHF to around 1.37 by year end. An eventual improvement in risk appetite and some relative economic underperformance will undermine the case for holding CHF.

Scandinavian currencies are likely to struggle in the short term due to market nervousness about a US double dip in an environment of elevated risk aversion. Interest rates will also play an important role in driving NOK and SEK as will be the case for most currencies eventually. Divergence in rate views for Norway and Sweden suggests holding a short SEK long NOK position. Overall, with two-way risk now much more evident as many investors return from their summer break the FX market will look far less predictable than it did before they left.

Posted in Australia, Bond markets, central banks, Commodities, Currencies, Economics, Economy, equity markets, Europe, eurozone, Federal Reserve, Financial crisis, Fiscal/Budget, FX, Germany, Interest rates, Japan, Monetary Policy, Politics, UK, US, US administration. Tags: , , , , , , , , , , , , , , , , , , , , , , . Leave a Comment »
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