Waiting For The Fed To Come To The Rescue

COVID-2019 has in the mind of the market shifted from being a localized China and by extension Asia virus to a global phenomenon.  Asia went through fear and panic are few weeks ago while the world watched but did not react greatly as equities continued to rally to new highs outside Asia.  All this has changed dramatically over the last week or so, with markets initially spooked by the sharp rise in cases in Italy and Korea, and as the days have progressed, a sharp increase in the number of countries recording cases of infection.

The sell off in markets has been dramatic, even compared to previous routs in global equity markets.  It is unclear whether fading the declines is a good move given that the headline news flow continues to worsen, but investors are likely to try to look for opportunity in the malaise.   The fact that investors had become increasingly leveraged, positioning had increased significantly and valuations had become stretched, probably added more weight to the sell-off in equity markets and risk assets globally.  Conversely, G10 government bonds have rallied hard, especially US Treasuries as investors jump into safe havens.

Markets are attempting a tentative rally in risk assets today in the hope that major central banks and governments can come to the rescue.  The US Federal Reserve on Friday gave a strong signal that it is prepared to loosen policy if needed and markets have increasingly priced in easing , beginning with at least a 25bps rate cut this month (19 March).  The question is now not whether the Fed cuts, but will the cut be 25bp or 50bp.  Similarly, the Bank of Japan today indicated its readiness to support the economy if needed as have other central banks.

As the number of new infections outside of China is now increasing compared to new infections in China, and Chinese officials are promising both fiscal and monetary stimulus, China is no longer the main point of concern.  That said, there is no doubt that China’s economy is likely to tank this quarter; an early indication came from the sharp decline in China’s official manufacturing purchasing managers’ index, which fell to a record low of 35.7 in February, deep into contraction territory.  The imponderable is how quickly the Chinese economy will get back on its feet.  The potential for “V” shape recovery is looking increasingly slim.

Volatility has also risen across markets, though it is notable that FX volatility has risen by far less than equity or interest rate volatility, suggesting scope for catch up.  Heightened expectations of Fed rate cuts, and sharp decline in yields, alongside fears that the number of virus cases in the US will accelerate, have combined to weigh on the US dollar, helping many currencies including the euro and emerging market currencies to make up some lost ground.  This is likely to continue in the short term, especially if overall market risk appetite shows some improvement.

Markets will likely struggle this week to find their feet.  As we’re seeing today there are attempts to buy into the fall at least in Asia.  Buyers will continue to run into bad news in terms of headlines, suggesting that it will not be an easy rise. Aside from watching coronavirus headlines there will be plenty of attention on the race to be the Democrat Party presidential candidate in the US, with the Super Tuesday primaries in focus.  UK/Europe trade talks will also garner attention as both sides try to hammer out a deal, while OPEC will meet to deliberate whether to implement output cuts to arrest the slide in oil prices.  On the data front, US ISM manufacturing and jobs data will be in focus.

“Risk On”- Which Currencies Will Benefit?

It was a “risk on” beginning of the week as equity markets rallied, commodities prices rose, and G10 bonds and USD came under pressure. Stronger manufacturing PMIs helped to boost confidence in the global economic recovery, with solid PMIs revealed in China, and across the rest of Asia, UK, and the US. The US ISM manufacturing which rose to its highest since April 2006 also revealed a rise in the unemployment component, consistent with view of an unchanged reading for December payrolls.

In the Eurozone the PMI matched the flash release and remained in expansion territory though there was some slippage in Germany, Spain, and Italy, underscoring the likely underperformance of the Eurozone economy relative to expectations of faster recovery in the US. Nonetheless, the PMIs continued to show a picture of expansion, with the Eurozone PMI at its highest in 21-months.

The USD lost ground against the background of improved risk appetite and looks set to fall further abruptly ending its short covering rally. The USD appears to be finding little support from interest rate expectations, with the correlation between most currencies and relative interest rate differentials remaining relatively low for the most part (just -0.04 over the past 3-months between the USD index and US rate futures).  The correlation between the USD and US 10-year bond yields looks somewhat stronger however, and could offer some relief to the USD if yields continue to push higher.

Speculative (CFTC Commitment of Traders) data reveals just how massive the shift in USD positioning has been over recent weeks, with net aggregate USD positioning (vs EUR, JPY, GBP, AUD, NZD, CAD, CHF) registering its first net long USD position since May 2008. The swing in positioning has been dramatic, from -167k contracts on 15 September 2009 to +8.7k in the week ending 29th December 2009. The data also reveals the sharp deterioration in sentiment for the EUR to its lowest since September 2008. Likewise net JPY positions have shifted to their biggest net short since August 2008.

What does this imply? The market is very short EUR and JPY but the JPY has much further to go on the downside as it increasingly retakes the mantle of funding currency.  In any case compared to historical positioning JPY shorts are not so big suggesting more room to increase short positions.   

The EUR has moved into a short term uptrend, with the MACD (12,26,9) having crossed its signal line and positioning supports further upside. EUR/USD will need to take out strong resistance at 1.4459 (December 29) before it can embark on a more significant move higher. Asian currencies also look set to take more advantage of a resumption of USD weakness, especially in the wake of strong risk seeking capital flows into the region. KRW, TWD, IDR and PHP look bullish technically.

Economic reality check supports dollar

The US dollar appears to be making a tentative recovery of sorts at least when taking a look at the performance of the US dollar index.  Much of this can be attributable to a softer tone to equities. The S&P 500 registered its biggest back to back quarterly rally since 1975 over Q3 and either through profit taking or renewed economic doubts, stocks may be in for shakier ground into Q4. 

This increase in equity pressure/risk aversion is being triggered by weaker data. Since the Fed FOMC on 24th September the run of US data has generally disappointed expectations; in addition to the ISM survey, existing and new home sales, durable goods orders, consumer confidence and ADP jobs data all failed to match forecasts.   This list was joined by the September jobs data which revealed a bigger than expected 263k drop in payrolls.  Consequently doubts about the pace of recovery have intensified as markets face up to a reality check.

The dollar’s firmer tone is not just being helped by weaker stocks but also by plenty of official speakers discussing currency moves. Although this is potentially a dangerous game considering the recent turnaround in Japanese official comments on the Japanese yen the net effect is to support the dollar.  In particular, Treasury Secretary Geithner stressed the importance of a strong dollar, whilst European officials including Trichet, Almunia and Junker appear to have become more concerned with the strength of the euro. 

In the current environment such comments will contribute to putting further pressure on the euro which in any case has lagged the strengthening in other currencies against the dollar over recent months.   Although ECB President Trichet highlighted “excess volatility” in his comments about currencies overnight implied FX volatility is actually relatively low having dropped significantly over recent months.  The real reason for European official FX concerns is quite simply the fact that the eurozone remains highly export dependent and that recovery will be slower the stronger the euro becomes.  

It’s not just G10 officials that are becoming concerned about currency strength against the dollar as Asian central banks have not only been jawboning but also intervening to prevent their currencies from strengthening against the dollar.   A firmer dollar tone is likely to put Asian currencies on the back foot helping to alleviate some of the upward pressure over the short term but the overall direction for Asian FX is still upwards.

%d bloggers like this: