Japanese yen and FX sensitivity to interest rates

September 16, 2009 — Mitul Kotecha

Interest rates have some way to go before they take over from risk aversion as the key driver of currency markets but as noted in my previous post, low US interest rates have played negatively for the dollar. As markets have continued to pare back US tightening expectations and US interest rate futures have rallied, interest rate differentials have moved against the dollar. 

The most sensitive currency pair in this respect has been USD/JPY which has been the most highly correlated G10 currency pair with relative interest rate differentials over the past month. It has had a high 0.93 correlation with US/Japan interest rate differentials and a narrowing in the rate differential (mainly due to a rally in US rate futures) has resulted in USD/JPY moving lower and the yen becoming one of the best performing currencies over recent weeks.

Going forward the strong FX / interest rate correlation will leave USD/JPY largely at the whim of US interest rate markets (as Japanese rate futures have hardly moved). Fed officials if anything, are adding to the pressure on the dollar as they continue to highlight that US interest rates will not go up quickly. San Francisco Fed President Yellen was the latest official to do so, warning that the prospects for a “tepid” recovery could fuel inflation risks on the downside.

This echoes the sentiments of other Fed officials over recent weeks and suggests that the Fed wants to prevent the market pricing in a premature reversal in US monetary policy.   It looks increasingly likely that the Fed will maintain interest rates at current levels throughout 2010 given the massive amount of excess capacity and benign inflation outlook, suggesting that interest rate differentials will play negatively for the dollar for several months to come.

As for the yen its path will not only depend on relative interest rates but also on the policies of the new DPJ led government. If Japanese press speculation proves correct the new Finance Minister may favour a stronger yen which will benefit domestic consumers rather than a weaker yen that would benefit exporters. Against this background, markets will largely ignore comments by outgoing Finance Minister Yosano who said that further yen strength would be detrimental for exporters.

The market certainly believes that the yen will strengthen further as reflected by the sharp increase in speculative positioning over recent weeks; net CFTC IMM long yen positions have reached their highest since 10 February 2009. Although USD/JPY has pushed higher since it’s low around 90.21 the upside is likely to be limited against this background and a re-test and likely break back below the key 90.00 psychological level is likely soon.

Posted in central banks, Currencies, Economics, Economy, Interest rates, Japan, Monetary Policy, US. Tags: , , , , , , , , , , , , , , , , , , . Leave a Comment »

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.

Posted in Bond markets, central banks, Currencies, Economics, Economy, equity markets, Financial crisis, Interest rates, Monetary Policy, US. Tags: , , , , , , , , , , , , , , , , , , , , , . Leave a Comment »

Speculative dollar sentiment worsens

September 2, 2009 — Mitul Kotecha

Data releases continue to fail to inspire markets despite the continuing run of better than expected numbers. In the US the Chicago PMI reached the critical boom/bust level of 50.0 in August whilst the less closely followed Milwaukee PMI surged into expansion territory at 56.0.  This revealed some upside risk to the ISM manufacturing index which duly beat consensus coming at 52.9 in August.  The fact that positive data is failing to lift markets is a sign of fatigue and stock markets appear to be running out of fuel.

From an FX perspective these developments will not be sufficient to provoke a break out of well worn ranges. Risk trades remain in favour but the momentum is limited. The prognosis does not look as positive for the dollar as the generally improving environment for risk will play negatively. Speculative sentiment (CFTC Commitment of Traders IMM data) has indeed worsened for the dollar; IMM data revealed net dollar short positions increasing sharply in the latest week, with market positioning worse than the 3-month average.

Much will depend on the US jobs report on Friday but until then the dollar is likely to cling to the weaker end of ranges. I believe that the dollar index will avoid dropping below its August 5th low of 77.428. The main exception to dollar weakness appears to be sterling where sentiment has become more bearish recently. This was reflected in the IMM report in which aside from the dollar, the pound has also been a loser and the only other currency for which speculative appetite worsened.

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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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