Where will interest rates go up next?

October 7, 2009 — Mitul Kotecha

Following the decision by the Reserve Bank of Australia to raise interest rates attention has swiftly turned to which central bank will move next. Indeed, there has been a reassessment of global interest rate decisions following Australia’s move. The hike in Australia is unlikely, however, to be quickly followed by the US, Japan, Europe or UK where policy is set to remain highly accommodative for long while.

Attention will however, turn to the Bank of Korea as well as the RBNZ and Norges Bank. In particular, the Norges Bank may be the next to hike when it meets on October 28. Norway has already appears to be priming markets for a rate hike. The RBNZ is likely to be slower to hike given the still slow pace of recovery in New Zealand and comfortable inflation backdrop.

The impact on currencies is not straightforward as the bigger influence on currency markets throughout the crisis has been risk appetite rather than interest rates. However, the influence of risk on currencies is beginning to wane and although interest rates have not been a major driver of currencies over recent months the move by the RBA likely accelerates the process of yield re-emerging as a key currency driver.

This is a big problem for the US dollar given that the Fed is unlikely to be quick to raise interest rates even if quantitative easing is withdrawn sooner. This means that the dollar will suffer from a growing yield disadvantage as interest rate hikes are priced in elsewhere. Taken together with improving risk appetite as reflected in the resilience of global equity markets, the main casualty will be the dollar, hit both from a yield and risk appetite perspective.

Risk currencies and those currencies with the greater prospect of higher rates will do well meaning further upside for the Australian dollar and New Zealand dollar as well as the Norwegian krone. Asian currencies look to continue to strengthen with the Korean won remaining an outperformer despite intervention threats by the Korean central bank. The euro will benefit from dollar weakness but is unlikely to benefit from anything euro specific given the likely slower pace of recovery in the eurozone. Meanwhile sterling is likely to remain under pressure, not helped by yield or risk appetite, and sentiment hit afresh by weak data.

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The best funding currency

September 13, 2009 — Mitul Kotecha

The dollar was beaten up over the past week, finally breaking through some key levels against many major currencies; the dollar index touched 76.457, the lowest since September 25, 2008.  The usual explanation for dollar weakness over recent months has been an improvement in risk appetite.  However, this explanation fails to adequately explain the drop in the currency over recent days.   

Although we have seen a multi month trend of improving risk appetite it is not clear that there was any further improvement last week.  On the one hand the ongoing rise in equity markets points to a continued improvement in risk appetite; the S&P 500 recorded its biggest weekly gain since July.  Equity volatility has also declined, reflected by the decline in the VIX index.   

On the other hand, other indicators reveal a different picture.  The ultimate safe haven and inflation hedge, namely gold, registered further gains above $1000 per troy ounce. That other safe haven, US Treasuries underwent the strongest demand in almost 2 years (bid-cover ratio 2.92) for the $12 billion 30-year note auction, whilst the earlier 10 year note auction also saw solid demand (bid-cover ratio 2.77) as well as strong interest from foreign investors.  

The massive increase in bond issuance to fund the burgeoning fiscal deficit continues to be well absorbed by the market for now, whilst the drop in the dollar does not appear to be putting foreign investors off US assets.  The strong demand for Treasuries could reflect a lack of inflation concerns but may also reflect worries about recovery, quite a contrast to the move in equities.

The fact that the Japanese yen and Swiss franc strengthened against the dollar also contrasts with the view that risk appetite is improving.  The yen was the biggest beneficiary currency during the economic and financial crisis but has continued to strengthen even as risk appetite improves.  USD/JPY dropped close to the psychologically important level of 90 last week which actually indicates a drop in risk appetite.  Perhaps the move is more of an indication of general dollar pressure rather than yen strength.  

A likely explanation for the drop in the dollar is that it is increasingly becoming a favoured funding currency, taking over the mantle from the Japanese yen; investors borrow dollars and then use it to take short positions against higher yielding currencies.  US dollar 3-month libor rates fell below those of the yen and Swiss franc for the first time since November, effectively making the dollar the cheapest funding currency and fuelling broad based weakness in the currency.

Although the historically strong relationship between currencies and interest rates has yet to establish itself to a significant degree, ultra low interest rates suggests that the dollar will remain under pressure for a while yet, especially as the Fed continues to highlight that US interest rates are not going to go up in a hurry.

Posted in Bond markets, central banks, Commodities, Currencies, Economics, Economy, equity markets, Financial crisis, Monetary Policy, US. Tags: , , , , , , , , , , , , , , , , , , , , , , , . 2 Comments »

Contrasting messages from bonds, gold and equities

September 8, 2009 — Mitul Kotecha

There is an interesting divergence developing between bond yields, gold prices and the trend in equity markets.  Whilst equities continue to go up, bond yields are falling and gold prices are rising.  Indeed the usually strong relationship between the S&P 500 and US 10 year yields has collapsed to an insignificant correlation around -0.09 over the past month compared to a high correlation of 0.84 in the month to 8 August.  

Rising equities appear to signify an improvement in risk appetite whilst bonds (US 10-year yield around 3.4%) and gold (around $1000 per troy ounce) are giving the opposite message.  So which indicator is correct and why the breakdown in the usually solid relationship?  

Growing optimism about economic recovery and the run of better than forecast data releases suggest that equities are correct but there is growing risk that so much good news is now priced in that we should pay attention to what bond yields and gold prices are telling us.  

Some of the move lower in bond yields can probably be attributed to the wall of liquidity sloshing around due to central banks’ unconventional policy measures.  However, it is still remarkable that despite the plethora of better than expected data releases, bond yields have actually declined.  This may reflect the success of quantitative easing but could also be associated with sustained economic and market fears.    

The commitment by G20 officials last weekend not to reverse stimulus policies prematurely may also have given more confidence in the view that interest rates will not be raised quickly.  Reflecting this 2 year German bund yields dropped to a record low level at the beginning of the week although longer term bond yield have pushed higher in the 30 year area.  The G20 commitment could turn out to be a double edged sword, however.  If there is no commitment to reduce burgeoning deficits, bonds could ultimately take fright.  

If bonds and gold prices are really reflecting safe haven demand then it will pose a risk to the sustainability of any equity rally over coming months.  As equity valuations begin to look increasingly stretched – the P/E ratio on the S&P 500 has reached 18.76 (according to Bloomberg calculations) compared to a low of around 10.00 at the beginning of March 2009 – it will need more to keep the rally going and high amongst the factors needed is some clarity about the pace and shape of growth once stimulus is reversed. 

For currency markets I think it will be difficult to see a trend until there is more clarity about the economic outlook and in the meantime currency markets will continue to stock watch for direction even if the influence of risk appetite is declining.  Even so, the dollar appears to be reacting more to equities than bond movements and is coming under growing pressure as equities rise.  

Many currencies are poised to break out of recent ranges to the topside versus the dollar led by risk currencies such as the AUD, NZD and CAD.  If it turns out that the equity story rather than the bond message is the correct one then the real message is a bullish one for risk appetite and given the dollar’s usually negative reaction to improved risk appetite, it could face further pressure over coming weeks.

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What goes up…

September 1, 2009 — Mitul Kotecha

…must come down. It was a soft end to August overall. Despite a 6.7% fall in Chinese stocks on the last day of the month, global equity markets for the most part registered gains over August. For example the S&P 500 registered a healthy 3.4% increase in August compared to close to a 15% drop in Chinese (Shanghai B) equities. The phrase, “the higher it goes, the harder it falls” looks appropriate in the case of Chinese stocks; at the time of writing, year-to-date the S&P 500 is up around 13% compared to a 68% gain for the Chinese stocks.

Looked at from another angle the S&P 500 is up an impressive 51% from its low in March 2009, whilst the Shanghai index is up a whopping 113% from its low in October 2008. Much of the selling in Chinese stocks as usual appears to be rumour based with talk of more lending curbs in China and a report that China’s state owned enterprises may terminate commodity contracts with foreign banks spurring the initial selling. The law of gravity suggests that Chinese stock may have further to fall.

The fact that the sharp sell off in Chinese stocks is having only a limited impact on other markets is an interesting development in itself. It suggests that investors in other markets and products are not getting too carried away with China stock watching. In particular, currencies appear calm despite the volatility in Chinese stocks and generally correlations between equity markets and currencies remain low according to my calculations (happy to provide correlation coefficients to anyone who is interested).

Posted in China, Commodities, Economics, Economy, equity markets, US. Tags: , , , , , , , , . Leave a Comment »

Saturated by good news

August 27, 2009 — Mitul Kotecha

We are currently moving into an environment where economic data is becoming less and less influential in moving markets and this could continue for some weeks.  The bottom line is that so much recovery news is in the price that the continuing run of better than forecast data are having only a limited impact.  Over recent days this run has included firmer than forecast readings on US manufacturing sentiment, consumer sentiment, housing activity and durable goods orders.  The market has become saturated with good news and is showing signs of fatigue.  

Just take a look at the reaction to the latest numbers. Equity markets barely flinched in reaction to positive data including a surge in new home sales and a jump in durable goods orders.  In Europe, the German IFO recorded its biggest increase since 1996.  Perhaps the subdued market reaction was due to the details of some of the reports which could have been considered as not as upbeat as the headlines suggested.  However, this explain is tenuous at best.  

News that China’s state council is studying restrictions on overcapacity in industries including steel and cement will not have helped market sentiment as concerns about Chinese growth are likely to resurface. Nonetheless, the most likely explanation for the lack of momentum in markets is fatigue.  There have been plenty of positive data surprises over recent weeks and markets have become increasingly desensitised to such news. 

Another explanation of the failure of positive data to boost sentiment is that risk appetite is almost back to pre-crisis levels according to many indicators I follow.  Indeed, further impetus for risk currencies will be more limited in the months ahead as the room for a further decline in risk aversion is becoming more limited.

This combined with growing fatigue will have interesting consequences. Firstly it suggests a degree of dollar and yen resilience over coming weeks and growing pressure on risk trades, especially commodity currencies which will suffer disproportionately to fears about Chinese growth and lower commodities demand. 

Nonetheless, consolidation in the weeks ahead rather than any sharp moves is the most likely path.  Although the overall trend of improving risk appetite will continue it is already becoming evident that it will take a lot more to drive risk appetite higher than a steady stream of data showing that the global economy is turning around. In any case, currencies have become less sensitive to the gyrations in risk suggesting that other influences will be sought in the months ahead.  In the meantime range trading will continue. 

The reduced swings in currencies have taken FX largely off the radar as far as policy makers are concerned and it is difficult to see the topic being a major issue at upcoming policy meetings. Lower currency volatility is clearly a boon for policy makers and reflects some “normalisaiton” in currency markets. It perhaps also reflects the fact that FX valuations are less of out synch than they were a few months back, with the USD far less overvalued against many currencies.

Posted in Asia, China, Commodities, Currencies, Economics, Economy, equity markets, Europe, Germany, US. Tags: , , , , , , , , , , , , , , , , . 1 Comment »
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