Catching a falling knife

After a very long absence and much to the neglect to Econometer.org I am pleased to write a new post and apologise to those that subscribed to my blog, for the very long delay since my last post.   There is so much to say about the market turmoil at present, it is almost hard not to write something.

For those of you with eyes only on the continued strength in US stocks, which have hit record high after record high in recent weeks, it may be shocking news to your ears that the rest of the world, especially the emerging markets (EM) world, is in decidedly worse shape.

Compounding the impact of Federal Reserve rate hikes and strengthening US dollar, EM assets took another blow as President Trump’s long threatened tariffs on China began to be implemented.  Investors in countries with major external vulnerabilities in the form of large USD debts and current account deficits took fright and panic ensued.

Argentina and Turkey have been at the forefront of pressure due the factors above and also to policy inaction though Argentina has at least bit the bullet. Even in Asia, it is no coincidence that markets in current account deficit countries in the region, namely India, Indonesia, underperformed especially FX.  Even China’s currency, the renminbi, went through a rapid period of weakness, before showing some relative stability over recent weeks though I suspect the weakness was largely engineered.

What next? The plethora of factors impacting market sentiment will not just go away.  The Fed is set to keep on hiking, with several more rate increases likely over the next year or so.  Meanwhile the ECB is on track to ending its quantitative easing program by year end; the ECB meeting this Thursday will likely spell out more detail on its plans.  The other major central bank that has not yet revealed plans to step back from its easing policy is the Bank of Japan, but even the BoJ has been reducing its bond buying over past months.

The trade war is also set to escalate further.  Following the $50bn of tariffs already imposed on China $200 billion more could go into effect “very soon” according to Mr Trump. Worryingly he also added that tariffs on a further $267bn of Chinese goods could are “ready to go on short notice”, effectively encompassing all of China’s imports to the US.  China has so far responded in kind. Meanwhile though a deal has been agreed between the US and Mexico, a deal encompassing Canada in the form a new NAFTA remains elusive.

Idiosyncratic issues in Argentina and Turkey remain a threat to other emerging markets, not because of economic or banking sector risks, but due increased contagion as investors shaken from losses in a particular country, pull capital out of other EM assets.  The weakness in many emerging market currencies, local currency bonds and equities, has however, exposed value.  Whether investors want to catch a falling knife, only to lose their fingers is another question. which I will explore in my next post.

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US dollar finding some support

Global growth concerns are contributing to undermine commodity prices, with most commodities dropping overnight. Gold was the biggest loser. Risk measures continue to creep higher as a host of worries especially the lack of traction in the Eurozone towards a Spanish agreement on a bailout and inability of Greece to agree on deficit cuts, afflicted markets.

The near term outlook is likely to remain one of caution until some progress in the Eurozone is in evidence. However, growth concerns suggest any improvement in sentiment will be tenuous at best.

On a more positive note, there at least appears to be some movement in the US towards finding a solution towards avoiding the fiscal cliff from taking effect as a bipartisan group of senators have agreed to formulate a deficit reduction plan.

The USD index has rallied over recent days despite expectations for weakness in the wake of the Fed;s announcement of QE3. It almost appears to be a case of sell on rumour, buy on fact. Admittedly the USD usually does weaken following QE with the USD index falling during the full periods of both QE1 and QE2 (-4.6% and -2.9%, respectively).

The counter argument in support of a firmer USD which we believe is supported by the massive deterioration in USD positioning over recent weeks and over 5% drop in the USD since 24 July is that the market has already priced in a lot of QE expectations into the currency.

Another factor that will likely play positive for the USD is the fact that the Fed is not alone in expanding its balance sheet. Many central banks are vying to maintain very easy monetary policy. The implication of this is that there is a battle of the balance sheets in progress that does not necessarily involve the USD being the loser.

EUR/USD has fallen well off its recent highs around 1.3173, with sentiment for the currency souring due to inaction by the authorities in Spain on requesting a bailout and disagreements over how to proceed on various issues including banking supervision. The drop in the September German IFO business climate survey, the fifth in a row, did little to help the EUR, with the survey adding to Eurozone growth worries.

Increasingly it looks as though EUR short covering is running its course and while there may yet be a further bounce in the EUR should the ECB begin its bond purchase programme, the near term outlook is more fragile. Business and consumer confidence surveys in Germany and France today will echo the weakness of the IFO in contrast to a likely firming in September US consumer confidence, contributing to a weaker EUR. A test of support around 1.2848 looms

Political pressures afflicts the euro

I’m in Dubai today presenting at a client seminar so am a little late on my blog post today. There is definitely lots going on however and all the talk is about politics. The mood is decidedly downbeat following the elections in France and Greece over the weekend. Risk assets have tanked while the USD looks firm except versus JPY. The elections over the weekend clearly dealt a blow to advocates of austerity resulting in a major increase in policy uncertainty.

Following the weaker the forecast US jobs report at the end of last week data over coming days will be less influential on the USD. In general I expect the USD to edge higher, helped by a decidedly more nervous market tone and higher risk aversion. The main interest for FX markets on the data front will be the April NFIB Small Business Optimism survey, March trade data and May Michigan confidence at the end of the week.

Although not a particular driver for the USD, the dip in the NFIB survey in March provoked concerns about the pace of US recovery and potential downturn in growth. This has been echoed in other data, which in turn has kept the door open to more Fed action restraining the USD in the meantime.

The ECB failed to rattle the EUR’s cage following its policy meeting last week although the lack of a dovish tone did help the EUR to rally briefly. We believe the market reacted prematurely and if anything the ECB may be setting the scene for a rate cut in June. Weak data has helped to undermine the EUR and I expect little or no improvement over coming days. Given that Germany has also succumbed to some weakness, the March German industrial production report will be monitored with interest on Tuesday.

The main driver for the EUR over coming days will be politics rather than the ECB or economic data however, with markets digesting the outcomes of the second round of the French Presidential election and Greek elections as well as the poor result for Chancellor Merkel in German state elections. Against this background and facing a bearish technical picture EUR/USD will struggle to recover, with 1.3060 providing a new resistance level.

Dollar still in a stupor

The increase in the International Monetary Fund’s (IMF) funding by $430 adds another layer of firepower to provide help to the Eurozone periphery should it be required. Nonetheless, many other worries continue to afflict markets suggesting that any positive boost will be short lived. There are plenty of data and events this week including central banks in the US, Japan and New Zealand. Additionally US corporate earnings will remain in focus while bond auctions in the Eurozone will also provide direction. I continue to see risk aversion creeping higher against this background.

It is unlikely that the FOMC meeting tomorrow and Wednesday will provoke any change in the currently low FX volatility environment given that policy settings will remain unchanged, with the majority of FOMC members likely to look for the first tightening at the earliest in 2014. The Fed is therefore unlikely to wake the USD out of its stupor and if anything a softening in durable goods orders, little change in new home sales and a pull back in consumer confidence will play in favour of USD bears over coming days. Even a relatively firm reading for Q1 GDP will be seen as backward looking given the slowing expected in Q2.

The EUR will have to contend with political events as it digests the aftermath of the first round of the French presidential elections. The fact that the political process will continue to a second round on 6 May could act as a constraint on the EUR. Various ‘flash’ purchasing managers indices (PMI) readings and economic sentiment gauges will offer some fundamental direction for the EUR but largely stable to softer readings suggest little excitement. Consequently EUR/USD will largely remain within its recent range although developments in Spain and Italy and their debt markets will have the potential to invoke larger moves in EUR.

The JPY is usually quite insensitive to Japanese data releases and this is unlikely to change this week. Key releases include March jobs data, CPI inflation, industrial production and retail trade. Although inflation has moved into barely positive territory the BoJ is still set to increase the size of its asset purchase programme. This will act as a negative factor for the JPY but unless US Treasury yield differentials renew their widening trend against Japanese JGB yields and drop in the JPY will be limited.

JPY pullback risks, GBP to slip versus USD

A combination of market friendly comments by Fed Chairman Bernanke, a better than expected outcome for the German IFO business confidence survey in March and hopes of a bolstering of the Eurozone bailout fund, have managed to lift risk assets while pressuring the USD. Markets appear to have shaken off, at least for now, growth worries emanating from weaker manufacturing confidence surveys in China and Europe last week.

Nonetheless, while Bernanke maintained that accommodative monetary policy is still required especially given concerns about the jobs market, he did not hint at more quantitative easing, suggesting that market optimism may be tempered in the days ahead. Data and events today include US and French consumer confidence as well as bill auctions in Spain and Italy. US consumer confidence is likely to slip slightly while the bill auctions are likely to be well received.

While I remain bearish on the JPY in the medium term (beyond 1 month), over the near term I believe there is scope for a pull back. The move in USD/JPY has gone beyond what would be expected by the shift in relative yields. This is corroborated by my short term quantitative model which shows that USD/JPY should be trading around 80.

The speculative market is positioned for JPY weakness but also points to some scope for short covering; both CFTC IMM data and Japanese TFX data (a gauge of local margin trading positioning) reveal significant short JPY positions. If as I expect, USD/JPY does pull back it will offer better levels for investors to initiate medium term JPY bearish trades.

Ultimately the JPY will regain its attraction as a funding currency for carry trades and the bigger the shift in relative yield with the US, the more the potential for capital outflows from Japan into higher yielding assets.

GBP has failed to sustain gains above 1.59 against the USD over recent weeks let alone manage to test the psychologically important 1.60 level. The current bounce above 1.59 is unlikely to last. It will require a renewed downtrend in the USD in general provoked by a sharp improvement in risk appetite and/or a drop in US bond yields for GBP to move much higher. Neither seems likely.

Indeed, GBP will be vulnerable to a general firmer USD over the remainder of the year. While I would not suggest playing a bullish call on GBP versus the USD I think there is much more juice in holding GBP versus EUR, with downside risks to this currency pair likely to open up. Indeed, my quantitative models reveal that GBP is mispriced against both EUR and AUD.

USD pressured by drop in yield

Risk sentiment starts the week in positive mode. Weekend reports that Germany will not stand in the way of allowing the (European Financial Stability Facility) EFSF and its successor the European Stability Mechanism (ESM) bailout funds to be combined to boost the ‘firewall’ against contagion in the Eurozone has helped to boost sentiment.

Market direction may be obscured by month end and quarter end window dressing this week and despite the likely positive start to the week there are still plenty of factors to dent risk appetite over coming days, not least of which is the gyrations in oil prices.

The USD has slipped over recent days in line with a pull back in US Treasury bond yields. Notably there has also been a pull back in speculative USD sentiment as recorded in the CFTC IMM data. The ‘risk on’ tone to market that appears to be developing today will likely result in renewed downside risks to the currency.

US economic data continues to outshine economic releases elsewhere although US housing data last week was notably mixed. It will be the turn of March consumer confidence and February durable goods orders to capture the market’s attention over coming days.

A slight decline in the former and a healthy increase in the latter are expected. However, it seems unlikely that either release will be particularly supportive for yields and in turn the USD, so it will require a further increase in risk aversion to push the USD higher over coming days.

EUR/USD appears to be settling into the middle of a 1.30-1.35 range. Direction has increasingly been led by economic factors rather than debt issues recently but the news on the former has not been particularly good.

The March German IFO today and EU Finance Ministers meeting will be the key events of the week while there will also be interest on Spain’s budget as well as Spanish and Italian debt auctions. The IFO will likely prove to be more positive for the EUR than the manufacturing surveys last week, with an uptrend in the data continuing.

Moreover, hopes that Finance Ministers will bolster the ‘firewall’ to prevent other peripheral countries from repeating Greece’s debacle, will also likely keep the EUR supported. Overall, this implies EUR/USD will likely continue to creep higher over the week, with a test of technical resistance around 1.3356 eyed.

JPY retracement, CHF pressure

Risk assets rallied overnight, the USD weakened and US Treasury yields rose. There was little new in terms of economic news, with only NAHB March homebuilders confidence of note, which came in slightly weaker than expected. The bigger driver for markets was the news that Apple Inc. will pay around USD 45 billion in dividends and share buybacks over the next 3-years.

Today sees a crop of second tier releases including housing starts and building permits in the US and inflation data in the UK while there will also be attention on a speech by Fed Chairman Bernanke. Risk assets will remain supported but I continue to see consolidation for markets in the near term.

USD/JPY has retraced lower as warned last week. My quantitative models suggest scope for even more of a correction lower, with a drop below 83.00 on the cards in the short term. While the upward move in the currency pair was built on a widening in the US yield advantage over Japan, the move looks overdone. Nonetheless, any pullback will offer better levels to initiate long USD/JPY medium term positions.

Clearly the market believes that the JPY will weaken further given the build up in JPY short positions over recent weeks, with shorts at their highest since April 2011. February trade data to be released on Thursday will provide further fuel for JPY bears given the persistence of a trade deficit and weakness in exports.

Following the bounce in EUR/CHF last week the currency pair has dropped back into its recent tight range around the 1.2050-1.2070 area. Strong warnings by the Swiss National Bank at its policy meeting did not lead to any follow through on the CHF. I expect a gradual drift higher in EUR/CHF over coming weeks in line with the incremental change in sentiment for the Eurozone as Greece slips from the radar.

Official pressure for CHF weakness will remain intense given the deterioration in economic data as likely to be revealed in today’s release of Q4 industrial production. Nonetheless, the SNB will be wary of confronting the market in terms of FX intervention to weaken the CHF despite its verbal warnings. Meanwhile USD/CHF remains highly sensitive to gyrations in the USD index given its strong correlation, suggesting some consolidation in the short term as the USD pulls back.

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