Markets in limbo ahead of policy rate decisions

April 6, 2011 — Mitul Kotecha

Markets are generally range-bound ahead of tomorrow’s Japan, Eurozone and UK interest rate decisions, as reflected in the flat performance of equity markets overnight. Risk appetite remains positive though still lower than the high levels seen during most of March. China’s interest rate hike did not change the market’s perspective, with markets reacting well.

Overnight the Fed FOMC minutes reflected a range of opinions on the timing of the end of QE2 and the Fed’s exit strategy but the majority view was to end QE2 as planned at the end of June leaving markets, with little new to digest. The USD was a little undermined by a weaker than expected US March ISM non-manufacturing survey but losses are likely to be limited.

Meanwhile there was more negative peripheral news in Europe, with Moody’s cutting Portugal’s sovereign credit ratings by one notch, with Moody’s highlighting the urgent need for financial support from the EU. Portuguese debt took a hit but eurozone markets in general including the EUR continue to take such news in their stride, with EUR/USD holding above 1.4200. Firm readings for the eurozone final services purchasing managers index (PMI) in March helped to support sentiment, outweighing the negative impact of a drop in eurozone retail sales.

GBP was a key outperformer, helped by a much stronger than expected services PMI, which helped GBP/USD breach 1.63 overnight. Today’s industrial and manufacturing production data will likely reveal firm readings too, helping GBP to consolidate its gains but the currency looks rather rich around current levels, with risks skewed to the downside.

JPY was another mover, having breached 85.00 versus the USD, with USD/JPY now some 6 big figures higher from its post earthquake lows. Japanese authorities will undoubtedly see a measure of success from their joint intervention but the reality is that the shift in bond yields (2-year US / Japan yield differentials have widened by close to 30 basis points since mid March, are finally having some impact on USD/JPY as reflected in the strengthening in short-term correlations.

EUR/USD remains resilient to negative peripheral news such as the Portugal credit ratings downgrade, with further direction from tomorrow’s European Central Bank (ECB) meeting and accompanying statement. The risk that the ECB is not as hawkish as the market has priced in holds some downside risks to EUR.

Asian currencies are holding up well though it looks as though the ADXY (Bloomberg-JP Morgan Asian currency index) may have hit a short term barrier. Range trading for EUR/USD suggests little directional influence for Asian currencies in the short-term. Nonetheless, portfolio capital inflows continue to support Asian FX with all Asian equity markets recording foreign inflows so far this month. In particular, KRW continues to outperform. Note that Korea has recorded a whopping inflow of $1.1bn in equity inflows month-to-date.

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China tightens policy

January 13, 2010 — Mitul Kotecha

Risk appetite has soured due to a combination of the rise in China’s reserve requirements, disappointing earnings including Alcoa and a profit warning by Chevron, setting the scene for a day in the red for Asian markets.  The turn in sentiment has hit commodities and commodity currencies particularly hard whilst the JPY has outperformed.  As would be expected against the background of higher risk aversion the US dollar made up some ground.

All eyes are on China and markets will now look to the implications for CNY policy.  Increasingly it seems that data and policy in China is driving global markets and aside from the hike in reserve requirements this was also evident in the fact that stronger trade data over the weekend helped to counter the impact of the soft US December payrolls report.  Further increases in the reserve ratio are likely over coming months followed by actual hikes in interest rates (likely the 1 year rate).  China’s move to tighten policy further over coming months will likely be accompanied by allowing greater appreciation of the CNY too.

The news worsened overnight as the ABC Consumer Confidence index dropped by 6 points to -47, the biggest one-week drop in the last 25 years.  US trade data also came in worse than expected, with the deficit widening to $36.4bn in November.  There is little on the data front today to keep markets occupied today, suggesting that direction will come from equity markets and with more earnings this week including Intel Corp and JPMorgan Chase & Co. there will be plenty to digest.  In the near term the tone of risk aversion is set to continue to dominate but any pull back in risk currencies is likely to prove short-lived.   

There will be more Fed speakers as well as the Fed’s Beige Book today to provide clues ahead of the January 26-27 FOMC meeting.   Aside from noting some improvements in the economy, weak labour market conditions as well as a lack of inflationary pressures will help support expectations that the Fed will hold off from raising interest rates this year.   Fed speakers include Fisher and Plosser both of whom give speeches on the US economy though neither are current voters on the FOMC.   Plosser’s comments so far have highlighted the need for a timely “exit strategy”.

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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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Key events for FX markets this week

September 21, 2009 — Mitul Kotecha

Key events this week include the Fed FOMC and G20 meetings .  The G20 meeting is likely to be a non-event as far as markets are concerned.  There will be plenty of discussion about co-ordinating exit strategies but officials are set to repeat the commitment to maintain stimulus policies until recovery proves sustainable.  

There is likely to be little emphasis on currencies despite the fact that the dollar is trading around its lowest level in a year, except perhaps at the fringes of the meeting, with focus in particular on Japan’s new government’s pro yen policy.  

Regulation will also figure high amongst the topics debated but this will have little impact on markets over the short term.  Another topic that could be debated is protectionism, especially in light of the US decision to impose tariffs on Chinese tyres.

Ahead of the G20 meeting the Fed FOMC meeting is unlikely to result in any change in interest rates but the statement is likely to be cautiously upbeat in line with Fed Chairman Bernanke’s recent comments that the recession is “very likely over”.  The statement will be scrutinised for clues to the timing of policy reversal, especially given recent speculation that a couple of FOMC members were advocating an early exit.  Given that the dollar has suffered due to its funding currency appeal, any hint that some Fed officials are turning more hawkish could give the currency some much needed relief but we doubt this will last long. 

In contrast to speculation of a hawkish shift in thinking by some Fed members the Bank of England appears to be moving in the opposite direction.  The MPC minutes on Wednesday will be viewed to determine just how close the BoE was to extending quantitative easing and reducing interest rates on bank reserves at its last meeting. 

Sterling (GBP) has been a clear underperformer over recent weeks and a dovish tint to the minutes will act as another factor weighing on the currency as speculation over further action intensifies ahead of the next meeting.  

Sterling is also struggling against the euro having hit a five month low.  A combination of factors have hit the currency including concerns about quantitative easing expansion, the health of the banking system, and the latest blow coming from a the Bank of England in its Quarterly Bulletin where it states that GBP’s long run sustainable exchange rate may have fallen due to the financial crisis.   

Against this background it is not surprising that sterling was the only major currency against in which speculative positioning actually deteriorated versus the dollar last week (according to the latest CFTC Commitment of Traders report).   It is difficult to see any sterling recovery over the short term against this background, with a re-test of the 9 July low just under GBP/USD 1.60 in focus.

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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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