A Better Start To The Week

November 30, 2009 — Mitul Kotecha

The start of this week looks somewhat better compared to the end of last week. Although nervousness will remain amidst thinning liquidity, news that the UAE central bank “stands behind” local and foreign banks and will lend, albeit at a rate of 0.5% above the 3-month benchmark rate, will reassure investors that banks have sufficient liquidity in the wake of any losses suffered due to the Dubai Holdings debacle. This will see some improvement in risk appetite.

The news will unlikely prevent stock markets in the UAE, which open today following Eid holidays, from sliding, however. Attention will turn to the suspended Sukuk bonds and also to the extent of support (and any strings attached) provided by Abu Dhabi to Dubai. The support from the central bank will help markets outside of the UAE regain a little composure and limit demand for safe haven assets but the rally may prove limited until there is greater transparency.

Nonetheless, even if there is some relief at the beginning of this week due to some containment of the problems in Dubai nerves are likely to fray going into the end of the year, with the multi-month trend of improving risk appetite faltering. There have been plenty of reasons for markets to worry lately including concerns about the shape of economic recovery in the months to come as well as renewed banking sector concerns and these will not be allayed quickly.

Data this week in the US is unlikely to help to dampen growth concerns. The main event is the US November jobs report and although the magnitude of job losses is set to decrease the unemployment rate is set to remain stubbornly high around 10.2%. In addition to an expected decline in the November ISM manufacturing index suggests that growth concerns will intensify rather than lessen. This in turn highlights that any improvement in risk appetite this week will prove limited.

The other key events this week include interest rate decisions in Europe and Australia. Although the ECB is widely expected to leave rates on hold on Thursday, there will be plenty of attention on any details of the Bank’s “gradual” exit strategy. Whether the ECB offers new loans to banks at a variable interest relative to the current fixed rate will be taken as an important sign on the path of liquidity withdrawal. We believe the Bank will stick with a fixed rate. The RBA will take a step further and announce a 25bps interest rate hike tomorrow.

FX markets are likely to be buffeted by the gyrations in risk appetite but at least at the beginning of the week the USD is set to give up its recent gains, with EUR/USD likely to try and hold above 1.5000 as markets digest the better news coming from the UAE. The JPY will be a particular focus given the growing attention of the authorities in Japan. Finance Minister Fujii is quoted in the Japanese press that they won’t intervene in the FX market, which appears to give the green light to further JPY strength though I suspect that if USD/JPY drops below 85.00 again there will plenty of FX intervention speculation and in any case these comments have since been denied.

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US rates “low for long”

November 19, 2009 — Mitul Kotecha

Risk appetite is failing to show much improvement this week and sharply weaker than forecast US housing data dampened sentiment further following other soft data over recent days including the Empire manufacturing survey, industrial production and retail sales less autos. The data will add to concerns about the pace and magnitude of growth in the months ahead.

A sub-par recovery and benign inflation outlook are the two main reasons why the Fed will not hike rates for a long while yet. This was echoed by St. Louis Fed President Bullard – a voting member of the FOMC – who gave a little more colour on the Fed’s “extended period” statement. He highlighted the probability that US interest rates will not be raised until the first half of 2012.

Bullard noted that following the past two recessions the Fed did not raise rates until two and half to three years after recession ended. This is accurate given that in 2001 the Fed did not begin to hike rates until around 2 ½ years after the end of the recession whilst in 1990-91 rates did not go up until close to 3 years after recession ended. This recession just passed was arguably worse than both of the past two, so why should rates rise any earlier?

One factor that could trigger an earlier rate hike is the risks from the massive global liquidity fuelled carry trade fuelled by Fed policy. Bullard highlighted that the risks of creating an asset bubble from keeping rates “too low for too long” may prompt an earlier tightening. What will be important is that the Fed gets the exit strategy right and the risk that delaying any reduction in the Fed’s balance sheet and asset purchases could turn out to be inflationary which in turn would be negative for the USD and hit confidence in US assets.

The Fed is very likely to adjust the level of quantitative easing well before contemplating raising interest rates. The market is pricing in around 50bps of rate hikes in the next 12 months but even this looks to aggressive and as has been the case of recent months the market is likely to push back the timing of expected rate hikes. The consequences for the USD are negative at least until the market becomes more aggressive in pricing in US interest rate hikes or believes the Fed is serious about its exit strategy.

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Fed keeps the risk trade party going

November 17, 2009 — Mitul Kotecha

Risk is back on and the liquidity taps are flowing. Fed Chairman Bernanke noted that it is “not obvious” that US asset prices are out of line with underlying values, comments that were echoed by Fed Vice Chairman Kohn, effectively giving the green light to a further run up in risk trades. The last thing the Fed wants to do is ruin a good party and the comments indicate that the surge in equities over recent months will not be hit by a reversal in monetary policy any time soon.  

Aside from comments by Fed officials risk appetite was also boosted by a stronger than forecast rise in US October retail sales, with US markets choosing to ignore the sharp downward revision to the previous month’s sales, the weaker than forecast ex-autos reading and a surprisingly large drop in the Empire manufacturing survey in November.

Fed comments were not just focussed on the economy and equity markets as Bernanke also tried to boost confidence in the beleaguered USD, highlighting that the Fed is “attentive” to developments in the currency.  He added that the Fed will help ensure that the USD is “strong and a source of global financial stability”.  The comments had a brief impact on the USD and may have given it some support but this is likely to prove short lived. 

The reality is that the Fed is probably quite comfortable with a weak USD given the positive impact on the economy and lack of associated inflation pressures and markets are unlikely to take the Fed’s USD comments too seriously unless there is a real threat of the US authorities doing something to arrest the decline in the USD, a threat which has an extremely low probability.

It is perhaps no coincidence that the Fed is attempting to talk up the USD at the same time that US President Obama meets with Chinese officials.  The comments pre-empt a likely push by China for the US not to implement policies that will undermine the value of the USD but comments by Obama appear to be fairly benign, with the President noting that the US welcomes China’s move to a “more market based currency over time”. The relatively soft tone of these comments will further dampen expectations of an imminent revaluation of the CNY.

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Searching for inspiration

November 9, 2009 — Mitul Kotecha

After an eventful week which included several central bank meetings and the US Jobs report there is less for markets to get their teeth into this week.  Despite the weak US jobs report risk appetite looks relatively resilient suggesting that the USD will struggle to make much headway over coming days.  

Despite all of the events last week markets have been uninspired.  Even the G20 meeting delivered little to be excited about with no further developments on how to rebalance the global economy and the USD’s role in the process.  The lack of attention on the USD will leave it with little directional influence this week, with equity markets likely to the main driver once again.

One currency that may look a little better supported over coming days is the EUR.  GDP data later in the week is likely to reveal an expansion over Q3 after several quarters of contraction as indicated by various PMI data. Although it will likely be led by inventories and exports rather than domestic demand it will nonetheless come as good news, albeit backward looking.  Going forward growth in Europe is unlikely to match the pace of recovery in the US but for now the GDP data will be EUR supportive helping EUR/USD to gravitate around 1.50 and beyond. 

Meanwhile, central banks may also do their part in influencing currencies given their differing stances on monetary policy.  Although the Fed did not deliver any big surprises last week the FOMC statement will play for a softer USD as the currency looks to maintain its funding currency status for an “extended period”.   In contrast the RBA hiked rates as expected and despite hinting at more gradual rate increases in the months ahead the AUD continues to stand to benefit.   Going in the opposite direction the BoE increased its asset purchases but GBP avoided a significant negative fall out as the move is likely to be seen as the final step in the BoE’s asset purchase programme.

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US dollar remains funding currency of choice

November 5, 2009 — Mitul Kotecha

Rate hikes in some countries including Australia and Norway and a general improvement in economic data had led to some expectations that the Fed would shift its rhetoric on monetary policy but in the event this was not to be the case.  The key comment in the FOMC statement following the interest rate decision was that rates would be kept low for an “extended period”. The Fed added that its policy stance was contingent on “low rates of resource utilization, subdued inflation trends and stable inflation expectations.”  

The fact that the Fed maintained its relatively dovish stance contrary to some expectations ahead of the FOMC meeting resulted in interest rate markets paring back expectations for future rate hikes though I still believe that a rate hike anytime in 2010 will prove premature.  The Fed’s new conditions mean however, that the Fed will be more restricted when it does come to timing rate hikes and markets will watch closely, the unemployment rate and inflation expectations to determine this timing. 

Given that the unemployment rate is still rising and is expected to decline only slowly over coming months whilst core inflation is set to decline further, and excess slack in the economy is only likely to be reduced gradually, markets are still too aggressive in looking for increases in interest rates next year.  The Fed did not remove the reference to an “extended period” of low rates despite speculation ahead of the meeting and whilst many in the market continue to debate how long this will be, the Fed will not feel any need to rush to reverse policy. 

The USD weakened following the FOMC meeting but did not suffer a particularly hard blow.  Going forward the USD will not recover until there is clearer evidence that the Fed is ready to reverse policy and in the near term this means that the USD will remain under pressure, especially if markets push back expectations of rate hikes.  This will mean that the USD will continue to be the funding currency of choice for several months yet.  Cyclical USD recovery is still some way off but eventually the Fed’s actions will pay off and the USD will recover by around mid 2010 as the market becomes more aggressive in pricing in rate hikes in the US.

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