Calmer sentiment

June 14, 2013 — Mitul Kotecha

Gains in US stocks overnight will help to calm sentiment. The fact that US equities were able to shake off the 6%+ plunge in the Nikkei yesterday reveals the different perspectives in both markets. US markets were helped by a bigger than expected increase in headline US retail sales in May and a bigger than expected decline in weekly jobless claims.

A WSJ story that Fed Chairman Bernanke would highlight at next week’s Fed FOMC meeting that a “considerable” amount of time would pass before ending QE and raising rates also likely contributed to firmer sentiment while pressurizing Treasury yields lower. Commodities’ markets also showed some sign of stabilization.

The data slate today consists of mostly US releases including May industrial production and June Michigan confidence both of which are likely to record positive outcomes. Markets are likely to digest the data well and after recent bouts of volatility a period of calm ahead of next week’s FOMC meeting will be welcome.

The USD index has suffered a dramatic reversal of fortunes since reaching a high just under 84.5 on 23 May dropping by around 4.3%. Its tumble has taken place despite higher US bond yields and risk aversion, both of which would usually be expected to boost the currency. Fed tapering nervousness has done nothing to support the USD despite prospects of reduced asset purchases.

The USD’s move should not be seen in isolation, however. In the wake of major position adjustments across many asset classes usually strong correlations have broken down. Given recent record long USD positioning over recent weeks the pull back in the USD versus major currencies may have further to run but we suspect that much of the decline has already taken place. Given that the USD appears to be more strongly correlated to equities at present it may find some support from the gain in US stocks overnight.

Assuming that the USD’s declines begin to slow and even reverse the EUR is unlikely to extend its gains much further. The overall backdrop for the EUR is not particularly positive, with growth data remaining weak, albeit less so than in previous months. Additionally there are renewed concerns about Greece due to protests over the shutdown of the state broadcaster highlighting the difficulty in implementing crucial deficit cutting measures.

Meanwhile, European Central Bank Board member Mersch once again highlighted the possibility of utilizing negative deposit rates, which ought to prove to be a negative influence on the EUR, while other members including President Draghi continue to defend the potential use of OMT. EUR/USD will run into strong resistance around 1.3434 and I expect the upside momentum to fade over coming sessions.

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Risk appetite continues to shrink

June 13, 2013 — Mitul Kotecha

Risk appetite continues to shrink as the ongoing nervousness over Fed tapering continues to provoke significant position adjustments across markets. Markets will have to wait for next week’s Fed FOMC meeting to find to find greater clarity over the timing and extent of Fed tapering although there will be some further input to the Fed decision from today’s US May retail sales release.

In the meantime US Treasury yields continue to move higher even as risk aversion also intensifies, revealing the extent of the shake out that is currently being felt in US bond markets. The USD which would usually be expected to rally on higher yields and elevated risk aversion, remains under pressure against most major currencies although it continues to run havoc against emerging market currencies.

USD/JPY’s decline is showing no sign of abating. The combination of elevated risk aversion and disappointment over recent policy announcements, in particular the lack of detail about Prime Minister Abe’s third arrow, has prompted ever more upside for the JPY. The impact of these factors is negating the impact of higher US Treasury yields, which would usually act to push USD/JPY higher.

As the rout in equity markets appears to be showing little sign of subsiding the JPY looks firmly supported in the near term, especially as the picture is unlikely to change ahead of next week’s FOMC meeting. Additionally, the options market looks to be expecting more JPY upside as reflected in risk reversal skews, with volatility overall continuing to look elevated.

The RBNZ policy decision overnight provided another blow to the NZD, with the central bank highlighting that economic growth is “uneven” and noting that the kiwi remains overvalued, acting as a burden on the tradables sector of the economy. Moreover, in the Q&A session governor Wheeler maintained the pressure on the currency, indicating once again the risks of FX intervention to weaken the NZD if needed.

After dropping by over 8% since its cyclical peak on early April the NZD looks set to remain under pressure in the short term amid elevated risk aversion although it was encouraging that the currency did not fall further following the RBNZ. Our valuation models show that the currency is oversold and if anything the selling pressure will abate over coming weeks.

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US dollar finding its feet

June 11, 2013 — Mitul Kotecha

Markets continue to second guess the Fed but the Fed’s Bullard did not provide much by way of clues overnight. Nonetheless, US Treasury yields continue to push higher. Taken together with an upgrade to US credit ratings by S&P ratings (in light of the better US fiscal outlook) provided some support to the USD. Data releases overnight provides little direction and a similarly lean data schedule today will leave markets without any major directional influences aside from reacting to the rise in US yields.

After dropping by around 3% the USD index looks to be showing greater stability and further gains are likely over coming weeks as the USD tracks US yields higher. Retail sales data on Thursday will provide more direction both to Treasuries and to the USD and a likely healthy reading expected ought to allow the USD to register further gains. Similarly June Michigan confidence data is likely to reveal that consumer sentiment remains at its strongest level since July 2007.

Conversely the EUR is unlikely to react well to the hearing in the German Constitutional court on a number of legal complaints in particular the ECB’s Outright Monetary Purchases (OMT) programme, with the German Bundesbank being of the most vociferous opponents of the programme. While the court is unlikely to rule against OMT, it will at the least highlight the divisions within the Eurozone over this and other policies.

The Bank of Japan’s inaction at its policy meeting today was met with disappointment. There was a significant minority expecting action especially the implementation of 2 year liquidity provisioning operations widely reported by the Japanese press. Consequently the JPY strengthened following the unchanged BoJ decision but its gains are likely to be limited. Relatively higher US yields suggest that the USD will renew its strength versus JPY.

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Risks to US payrolls / Japan disappointment

June 6, 2013 — Mitul Kotecha

US service sector confidence improved, with the ISM non manufacturing index revealing a stronger than forecast rise to 53.7 while the Fed’s Beige Book recorded “modest to moderate” growth across most Fed districts. However, any positive reaction was fully negated by a drop in the employment component of the ISM report and a weaker than expected ADP private sectro jobs report which revealed only a 135k increase in jobs. Consequently there will be a scramble to revise down forecasts for May US non farm payrolls released tomorrow.

Risk assets and in particular equities didn’t like what they saw even though on balance the data suggests less risk of the Fed beginning to taper its asset purchases this year. Added to the uncertainty revolving the around the Fed was disappointment on Japanese policy in the wake of Prime Minister Abe’s policy speech yesterday which failed to reveal details about his growth strategy or third arrow to reform business and deregulate parts of the economy. Central banks will remain in focus today although both are likely to be less volatile, with both the European Central Bank and Bank of England set to deliver unchanged policy outcomes.

USD/JPY’s pull back has continued unabated as disappointment over Japanese prime minister Abe’s ‘third arrow’ speech of structural reforms and a pull back in US Treasury yields taken together with firming risk aversion have all contributed to a firmer JPY. Clearly pressure will grow to limit the JPY’s bounce back but as long as Japanese equities continue to slide it will be difficult to do so.

Given that this is coinciding or perhaps spurring more Japanese selling of foreign assets as revealed in recent data, it is difficult to prevent a further drop in USD/JPY unless and until such flows reverse. Having dropped below its 50 day moving average level around 99.28 USD/JPY is vulnerable to more short term slippage.

EUR/USD is likely to struggle to make further headway and there will be plenty of caution around the ECB meeting today. While there is very little chance of a further easing in policy President Draghi is likely to keep the door open for further action which ought to take the wind out of the EUR’s sails.

While the EUR may be taking advantage of a softer USD tone as well as a narrowing in the US Treasury yield advantage over bunds (2 year) I don’t believe this will continue. It is only a matter of time before US yields renew their widening trend, with Friday’s US jobs data a possible trigger.

GBP is another currency taking advantage of a generally softer USD tone having made a solid recovery from its lows around 1.5008 at the end of last month. EUR/GBP has been more stable but we expect GBP outperformance here too.

While the BoE will offer little help given the likelihood of an unchanged policy decision firmer UK data in the form of better than expected manufacturing, construction and services purchasing managers’ indices revealed this week has provided a solid backstop for the currency. Given that positioning in GBP has been around record low levels it would appear that the potential for short covering remains significant.

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Changing dynamics

June 3, 2013 — Mitul Kotecha

A change in market dynamics appears to be taking place. Nervousness over a prospective paring back in US quantitative easing as the Fed ponders the timing of a tapering in asset purchases taken together with elevated volatility in Japanese markets is leading to a decrease in risk appetite, higher core bond yields and weaker equity markets. Consequently emerging market assets especially high beta currencies are coming under significant pressure under the weight of capital outflows and rising risk aversion.

Unsurprisingly the USD has been a major beneficiary although it did lose steam last week. In Japan “Abeconomics” is leading to a rise in inflation expectations and higher Japanese government bonds (JGB) yields which could in turn derail recovery unless the rise in yield is capped by the Bank of Japan’s policy actions. Overall, the background is set for a further increase in uncertainty and market volatility this week.

The lack of clarity over Fed policy in particular is fuelling market volatility and given the intense focus on the Fed and in turn the Fed’s focus on the jobs market, the US May jobs report at the end of the week will be crucial to determine the direction of activity over the coming weeks. The consensus forecast for May payrolls is 165k. Opportunity to refine the forecast will follow the release of ISM manufacturing confidence (today) and ADP private sector jobs data (Wed).

Other potentially market moving events include the European Central Bank (Thu), Bank of England (Thu) and Reserve Bank of Australia meetings (Thu). None of the central banks are likely to change policy settings although there is potential for a dovish statement from the ECB (possible discussion of negative deposit rates and/or liquidity provision).

Currencies are reacting to higher US yields, which have driven the USD to multi month highs. EUR/USD in particular has a high correlation with 2 year bond yield differentials. As noted last week was less positive for the USD, with both the EUR and JPY making up some ground, with further direction coming from relative yield movements. In the case of the JPY, reduced risk appetite is also playing for a firmer currency. Nonetheless, it will be difficult for EUR/USD to sustain any gain above 1.3000 and USD/JPY to sustain any drop below 100.

Better than forecast Chinese manufacturing confidence data over the weekend has helped give some support to AUD, NZD and Asian currencies although it may provide limited relief, especially to Asian currencies which are suffering from increased risk aversion and the impact of higher US yields. While Asia has recorded the strongest inflow into equity markets compared to past years concerns about capital outflows from the region are intensifying. Korea and Thailand have suffered in particular from equity outflows over recent weeks.

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