Catching a falling knife

After a very long absence and much to the neglect to Econometer.org I am pleased to write a new post and apologise to those that subscribed to my blog, for the very long delay since my last post.   There is so much to say about the market turmoil at present, it is almost hard not to write something.

For those of you with eyes only on the continued strength in US stocks, which have hit record high after record high in recent weeks, it may be shocking news to your ears that the rest of the world, especially the emerging markets (EM) world, is in decidedly worse shape.

Compounding the impact of Federal Reserve rate hikes and strengthening US dollar, EM assets took another blow as President Trump’s long threatened tariffs on China began to be implemented.  Investors in countries with major external vulnerabilities in the form of large USD debts and current account deficits took fright and panic ensued.

Argentina and Turkey have been at the forefront of pressure due the factors above and also to policy inaction though Argentina has at least bit the bullet. Even in Asia, it is no coincidence that markets in current account deficit countries in the region, namely India, Indonesia, underperformed especially FX.  Even China’s currency, the renminbi, went through a rapid period of weakness, before showing some relative stability over recent weeks though I suspect the weakness was largely engineered.

What next? The plethora of factors impacting market sentiment will not just go away.  The Fed is set to keep on hiking, with several more rate increases likely over the next year or so.  Meanwhile the ECB is on track to ending its quantitative easing program by year end; the ECB meeting this Thursday will likely spell out more detail on its plans.  The other major central bank that has not yet revealed plans to step back from its easing policy is the Bank of Japan, but even the BoJ has been reducing its bond buying over past months.

The trade war is also set to escalate further.  Following the $50bn of tariffs already imposed on China $200 billion more could go into effect “very soon” according to Mr Trump. Worryingly he also added that tariffs on a further $267bn of Chinese goods could are “ready to go on short notice”, effectively encompassing all of China’s imports to the US.  China has so far responded in kind. Meanwhile though a deal has been agreed between the US and Mexico, a deal encompassing Canada in the form a new NAFTA remains elusive.

Idiosyncratic issues in Argentina and Turkey remain a threat to other emerging markets, not because of economic or banking sector risks, but due increased contagion as investors shaken from losses in a particular country, pull capital out of other EM assets.  The weakness in many emerging market currencies, local currency bonds and equities, has however, exposed value.  Whether investors want to catch a falling knife, only to lose their fingers is another question. which I will explore in my next post.

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More bad news in Europe, INR not impressed by new measures

Nervousness or simply just impatience is growing ahead of the EU Summit beginning on Thursday. The formal application by Spain for a banking bailout of up to EUR 100 billion has started the process while Greece is looking to renegotiate the terms of its bailout following the formation of a new government in the country.

European equities are not reacting well, however, with sharp declines registered yesterday following by drops in US stocks. Risk assets have come under pressure as noted by the sharp 12.5% jump in the VIX index overnight while the USD index continued to strengthen.

Interestingly despite the rise in risk aversion, many high beta currencies are holding up reasonably well. Indeed, those with the biggest sensitivities to risk such as ZAR, MXN, PLN and EUR have failed to drop while implied currency volatility has been falling over recent weeks. This may reflect the beginning of summer trading conditions rather than resilience in currency markets but nonetheless, it suggests a dose of FX calm ahead of the EU summit.

EUR/USD came under pressure hitting a low around 1.2471 failed to extend losses. The bad news intensified and included the formal Spanish bank aid request, Moody’s downgrade of 28 Spanish banks’ ratings, Fitch’s decision to cut Cyprus’ ratings to junk status, lack of concessions from German Chancellor Merkel who maintained her strong stance against common Eurobonds and inflexibility about the use of rescue funds. As a result it looks increasingly unlikely that a concrete plan will emerge from this week’s EU summit. EUR/USD will find technical support around 1.2442 and resistance around 1.2584.

One currency that has failed to perk up is the Indian rupee. New measures announced yesterday to shore up the INR including a $5 billion increase in the foreign investment cap in government bonds and an increase in the limit for domestic firms to borrow from overseas of up to $40 billion, failed to have more than a fleeting impact on the currency.

What were missing were measures to increase exports and cut excise duties. The measures left markets who had expected much more, with a taste of disappointment. While the measures are a decent starting point clearly much more will need to be done to appease markets and reverse the gloom among INR bears.

Indian Rupee – How low can it go?

Sentiment for the Indian rupee (INR) has gone from bad to worse. A number of concerns have hit the currency including weak economic data, deteriorating confidence in government policies, and intensifying risk aversion. The latest blow to the rupee came from data showing that economic growth in Q1 2012 slowed to 5.3% the slowest pace of growth in nine years. Worryingly high interest rates in the wake of persistent inflation pressures have damaged investment spending, a major weak point in the Q1 data. High inflation at over 7% means that the Reserve Bank of India has limited room to ease policy but the central bank has hinted at lower rates in the wake of lower oil prices.

These economic pressures have come at a time when the global environment has worsened. India was already more vulnerable compared to its Asian neighbours due it’s twin current account and fiscal deficits. Strong growth had put concerns about these deficits on the backburner but with growth slowing it only exposes India’s fragility. While less exposed to a global trade slowdown compared to other countries in the region India nonetheless is highly exposed to financial contagion. The INR is a high beta currency, sensitive to the vagaries of risk. The rise in risk aversion over recent weeks left the currency highly vulnerable as its sharp decline attests to.

Despite a host of regulation changes from the authorities the INR has continued to fall, with no let up in sight. While the RBI has suggested that it could sell USDs to oil companies to stem the decline in the rupee it may only result in slowing INR declines in the current environment. It’s decline against the USD has surpassed other Asian currencies. Interestingly there has not been a major exodus of portfolio capital from India, surprising given that other Asian countries such as Korea and Taiwan have seen significant outflows of equity capital. Nonetheless an escalation in the Euro crisis could quite easily change the picture for the worse.

It is not all bad news for the INR. While it will remain under pressure for some time yet from a valuation perspective the INR is looking increasingly cheap. I wouldn’t run out and buy it just yet but I would argue that a lot of bad news is already priced in to the currency. Investors will need to see some better news both externally and domestically and unfortunately this is lacking, but should risk appetite began to turn around the potential for rupee appreciation is significant for a currency that has lost close to around 20% of its value over the last 12 months. In the meantime, the best that could be hoped for is a slowing in the pace of depreciation, with a fall to around 57-58 versus USD on the cards over coming weeks.

RBA on hold, RBI hikes rates

News of the death of Osama Bin Laden gave the USD a lift and its gains have extended for a second day. Extreme short market positioning as well as increasing risk aversion (perhaps due to worries about retaliation following Bin Laden’s death) have helped the USD.

However, the boost to the USD could be short-lived in the current environment in which it remains the preferred global funding currency. Indeed, the fact that US bond yields have dropped sharply over recent weeks continues to undermine the USD against various currencies.

The USD firmed despite the US ISM manufacturing index dropping slightly, albeit from a high level. The survey provided some useful clues to Friday’s US jobs report, with the slight decline in the employment component of the ISM survey to 62.7 consistent with a 200k forecast for April payrolls.

Ahead of the European Central Bank (ECB) meeting on Thursday hawkish rhetoric from new Council member and Bundesbank chief Weidmann (replacing Weber) and more reassurances from Greek and EU officials that there will be no debt restructuring or haircut on the country’s debt has helped the EUR although it is notable that it could not sustain a foot hold above 1.49. Eurozone bond yields have risen by around 20bps compared to US yields over the past month, a fact that suggests that the EUR may not fall far in the short-term.

USD/JPY is trading dangerously close to levels that may provoke FX intervention by the Japanese authorities. General USD weakness fuelled a drop in USD/JPY which has been exacerbated by a rise in risk aversion over recent days (higher risk aversion usually plays in favour of a stronger JPY). The biggest determinant of the drop in USD/JPY appears to a narrowing in bond yields (2-year bond yields have narrowed by around 20bps over the past month) largely due to a rally in US bonds.

Unsurprisingly the Reserve Bank of Australia (RBA) left its cash rate on hold at 4.75%. The accompanying statement showed little inclination to hike rates anytime soon, with credit growth noted as modest, pressure from a stronger exchange rate on the traded sector and temporary prices shocks which are expected to dissipate. The only indication that rates will eventually increase is the view that longer term inflation is expected to move higher.

I look for further rate hikes over coming months even with the AUD at such a high level. AUD has lost a bit of ground after hitting a high just above 1.10 against the USD and on the margin the statement is slightly negative for AUD. A slightly firmer USD overall and stretched speculative positioning, with IMM AUD positions close to their all time high, points to some downside risks in the short-term.

In contrast India’s central bank the RBI hiked interest rates by more than many expected. Both the repo and reverse repo rates were raised by 50bps, with the central bank governor highlighting renewed inflation risks in his statement. The decision reveals a shift in RBI rhetoric to an even more hawkish bias in the wake of rising inflation pressures, which should be beneficial to the rupee.

Why Buy Asian FX (Part 2)

The strength of portfolio capital inflows into Asia reflects the outperformance of Asian economies relative to Western economies. Whilst the US, Europe, Japan and UK have struggled to recover from recession and are likely to register only sub-par recovery over the coming months, Asian economies led by China are recovering quickly and strongly. This pattern is set to continue, leading to a widening divergence between Asian and G7 economic growth.

As growth strengthens inflationary pressures are set to build up and Asian central banks will likely raise interest rates more quickly than their G7 counterparts. Already some central banks have moved in this direction, with India, Malaysia, Philippines and Vietnam, having tightened policy. This will be followed by many other central banks in Asia over Q2 2010 including China. Even countries with close trade links to Asia, in particular Australia will rate hikes further over coming months, with Australian interest rates likely to rise to a peak of 5% by year-end.

Given that the US is unlikely to raise interest rates in 2010 higher interest rates across Asia will result in a widening in the interest rate differential with the US leading to more upside potential for Asian currencies as their ‘carry’ attraction increases relative to the USD. The most sensitive Asian currencies to interest rate differentials at present are the Malaysian ringgit (MYR), Thai baht (THB) and Philippines peso (PHP) but I believe that as rates rise in Asia, the sensitivity will increase further for many more Asian currencies.

Most Asian currencies have registered positive performances versus the USD in 2010 led by the MYR and Indonesian rupiah (IDR) and closely followed by the Indian rupee (INR), THB and South Korean won (KRW). The notable exception is China which has been unyielding to pressure to allow the CNY to strengthen. Even China is set to allow some FX appreciation although if the US labels China as a “currency manipulator” it could prove counterproductive and even result in a delay in CNY appreciation.

Looking ahead, the trend of strengthening Asian FX will continue likely led by the likes of the KRW and INR but with the MYR, TWD and IDR not far behind. Stronger growth, higher interest rates, strengthening capital inflows and higher equity markets will contribute to appreciation in Asian currencies over the remainder of the year.

Asian currencies on the up

The third quarter of 2009 has proven to be another negative one for the US dollar.  Over the period the dollar index fell by over 4%.  The only major currency to lose ground against the dollar over this period was the British pound.  Most other currencies, especially the so called “risk currencies” which had come under huge pressure at the height of the financial crisis, registered strong gains led by the New Zealand dollar, Swedish krona and Australian dollar.  Although the euro also strengthened against the dollar it lagged gains in other currencies over the quarter.

Asian currencies also registered gains against the dollar in Q3 but to a lesser extent than G10 currencies.  Asian currency appreciation was led by the Korean won, Indonesian rupiah and Singapore dollar, respectively.  The under performer over Q3 was the Indian rupee which actually depreciated against the US dollar slightly.  The reason for the smaller pace of appreciation for most Asian currencies was due mainly to intervention by Asian central banks to prevent their respective currencies from strengthening too rapidly, rather than due to any inherent weakness in sentiment.

In fact, Asian currencies would likely be much stronger if it wasn’t for such FX interventions.  A good indication of the upward pressure on Asian currencies can be found from looking at the strength of capital inflows into local stock markets over recent months.  South Korea has registered the most equity capital inflows so far this year, with close to $20 billion of flows into Korean equities year to date but in general most Asian stock markets have registered far stronger inflows compared with last year.   

For the most part, balance of payments positions are also strong.  For example, South Korea recorded a current account surplus of $28.15 billion so far this year, compared to a deficit of $12.58bn over the same period last year.  This is echoed across the region.  Although surpluses are expected to narrow over coming months due mainly to a deterioration in the terms of trade, the overall health of external positions across the region will remain strong and supportive of further currency appreciation.  

The outlook for the final quarter of 2009 is therefore likely to be positive for Asian currencies, with the US dollar set to weaken further against most currencies.  Some risk will come from a potential reversal in global equity market sentiment but overall, further improvements in risk appetite will support capital inflows into the region.  Capital will be attracted by the fact that growth in Asia will continue to out perform the rest of the world and yet again only interventions by central banks will prevent a more rapid appreciation of Asian currencies.

Is the Asian FX rally losing steam?

Asian currencies appear to have lost some of their upward momentum over recent days.  Although the outlook remains positive further out, they are likely to struggle to make further gains over coming weeks.  One the one hand strong inflows into Asian equity markets have given support to currencies but on the other hand, data releases reveal only a gradual economic recovery is taking place, with continued pressure on the trade front as seen in the weakness in recent export data in the region.  Even China has been cautious about the prospects of recovery in the country.   

Almost all currencies in Asia have recouped their losses against the US dollar so far this year, with the Indonesian rupiah the star performer, having strengthened by over 11% since the start of the year.  More recently the Indian rupee has taken up the mantle of best performer, strengthening sharply following the positive outcome of recent elections.  The rupee has strengthened by around 3.5% since the beginning of the year and its appreciation has accelerated post elections.   

Much of the gain in the rupee can be attributable to the $4.4 billion of inflows into local equity markets over the last few months, a far superior performance to last year when India registered persistent outflows. Notably in this respect, the Philippines peso is set to struggle as foreign flows into local equities lag far behind other countries in the region.  Inflows into Phililipines stocks have been just $226 million year-to-date as fiscal concerns weigh on foreign investor sentiment.   

South Korea has been the clear winner in terms of equity capital inflows in 2009, with over $6 billion of foreign money entering into the Korean stock market.  Elsewhere, Taiwan has benefited from the prospects of growing investment flows from China and in turn equity market inflows have risen to around $4.3 billion supported by news such as the recent report  that Taiwan will allow mainland Chinese investors to invest in 100 industries.  Equity inflows into these currencies are far stronger than over the same period in 2008, highlighting the massive shift in sentiment towards Asia and emerging markets in general.

Unsurprisingly stock markets in Asia have been highly correlated with regional currencies over recent months, with almost all currencies in Asia registering a strong directional relationship with their respective equity markets.  Recent strong gains in equities have boosted currencies but this relationship reveals the vulnerability of currencies in the region to any set back in equities, which I believe could come from a reassessment of the market’s bullish expectations for Asian recovery.  

Central banks in the region have been acting to prevent a further rapid strengthening in Asian currencies by intervening in FX markets but a turn in equity markets and/or risk appetite could do the job for them and result in a quick shift in sentiment away from regional currencies. The Indonesian rupiah remains one to watch in terms of further upside potential, supported by the Asian Development Bank’s $1bn loan to Indonesia.   The outlook for the Indian rupee also looks favourable as post election euphoria continues.  Nonetheless, the gains in these and other Asian currencies have been significant and rapid and I believe there is scope for a pull back or at least consolidation in the weeks ahead.

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