Risk aversion spikes

Increased risk aversion overnight in the wake of escalating Middle East tensions gave the USD some support but overall the USD index is gradually drifting towards its early November low around 75.631. The antithesis of USD weakness is strength in most other major currencies.

The USD is being undermined by relatively dovish expectations for US interest rates relative to elsewhere and last night’s semi annual testimony by Fed Chairman Bernanke to the US Senate did nothing to alter this tone, with Bernanke maintaining the emphasis on subdued inflation and elevated unemployment.

The USD index itself has a high (0.82) 3-month correlation with US interest rate futures and over recent weeks as the implied yield has dropped, the USD has lost ground. The prospects of higher US bond yields may eventually provide the USD with support, especially given the prospect of substantial short-covering but in the near term the USD is likely to remain under pressure.

The upbeat run of US data highlights another source of USD support over the medium term, given the likely outperformance of the US economy over coming months. Yesterday’s ISM manufacturing survey and vehicle sales data lend support to this view. Moreover, the rise in employment component of the ISM supports the view of at least a 195k increase in February payrolls.

The Fed’s Beige Book tonight and February ADP jobs report will not alter the USD’s trajectory. The Beige Book is unlikely to reveal anything to worry the Fed in terms of inflation risks although will probably reveal further signs of improved activity. The ADP report will give important clues for Friday’s February non-farm payrolls data although it’s worth noting that last month’s report was way off the mark. In any case neither release is likely to prevent a further drop in the USD.

EUR is a clear beneficiary of expectations of tighter monetary policy by the ECB and the widening interest rate (futures implied yield) differential between the US and eurozone has given the EUR plenty of support recently as reflected in the high correlation with EUR/USD. Further support to the hawkish market stance was given by the upward revision to eurozone 2011 growth and inflation forecasts by the EU. The fact that eurozone inflation increased to 2.4% YoY in February also reinforced expectations of ECB tightening sooner than later.

The ECB press conference following the council meeting tomorrow will likely shape such expectations further, the EUR has already priced in a hawkish ECB stance, limiting the prospects of further appreciation. Notably EUR/USD has failed to break resistance at its year high around 1.3861, which will prove to be a formidable cap in the short-term.

In contrast, the RBA has poured cold water over expectations of further policy rate hikes in Australia. The policy statement following yesterday’s decision to keep the cash rate on hold pointed to an extended pause in the months ahead. Despite this and perhaps because markets have already pared back Australian interest rate expectations AUD rebounded quite smartly from its post meeting low and despite some overnight weakness due to increased risk aversion it will soon verge on a break of resistance at 1.0257.

AUD/NZD has continued to charge ahead having hit a multi-year high above 1.3600. NZD underperformance has been exacerbated by the impact of the recent earthquake, with growth expectations for this year having been sharply revised lower and growing speculation of an interest rate cut. Indeed, such speculation was given further fuel by comments by NZ Prime Minister Key who noted he would welcome a policy rate cut. Nonetheless, my quantitative AUD/NZD model suggests that the cross looks over-extended at current levels, whilst relative speculative positioning supports this view.


Japanese yen and FX sensitivity to interest rates

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.

An unusual dollar reaction

Although many market participants are on summer holidays this has not prevented some interesting market moves in the wake of yet more improvement in economic data and earnings.  The most noteworthy release was the July US jobs report which revealed a better than forecast 247,000 job losses and a surprise decline in the unemployment rate to 9.4%.  Moreover, past revisions added 43,000 to the tally.

Although it is difficult to get too optimistic given that job losses since December 2007 have totalled 6.7 million, the biggest drop since WW2, the direction is clearly one of improvement.  Nonetheless, markets were given a dose of reality by the drop in US consumer credit in June, which gives further reason to doubt the ability of the US consumer to contribute significantly to recovery.

The data spurred a further rally in stocks and a sell of in Treasuries.   Such a reaction was unsurprising but the more intriguing move was seen in the US dollar, which after some initial slippage managed a broad based appreciation in contrast to the usual sell off in the wake of better data and improved risk appetite.

It is too early to draw conclusions but the dollar reaction suggests that yield considerations are perhaps beginning to show renewed signs of influencing currencies following a long period where the FX/interest rate relationship was practically non-existent.  Indeed, the strengthening in the dollar corresponded with a hawkish move in interest rate futures as the market probability of a rate hike by the beginning of next year increased.

Since the crisis began the biggest driver of currencies has been risk aversion, a factor that relegated most other influences including the historically strong driver, interest rate differentials, to the background.  More specifically, much of the strengthening in the dollar during the crisis was driven by US investor repatriation from foreign asset markets as deleveraging intensified.   This repatriation far outweighed foreign selling of US assets and in turn boosted the dollar.

Over the past few months this reversed as risk appetite improved and the pace of deleveraging lessened.  Ultra easy US monetary policy also put the dollar in the unfamiliar position of becoming a funding currencies for higher yielding assets and currencies though admittedly this was all relative as yields globally dropped.   The dollar also suffered from concerns about its role as a reserve currency but failed to weaken dramatically as much of the concern expressed by central banks was mere rhetoric.

Where does this leave the dollar now?  Risk will remain a key driver of the dollar but already its influence is waning as reflected in the fact that the dollar has remained range bound over recent weeks despite an improvement in risk appetite.   As for interest rates their influence is set to grow as markets price in rate hikes and as in the past, more aggressive expectations of relative interest rate hikes will play the most positive for the respective currency.

It is still premature for interest rates to overtake risk as the principal FX driver.   Even if rates increase in importance I still believe interest rate markets are overly hawkish in the timing of rate hikes. A reversal in tightening expectations could yet push the dollar lower.  This is highly possible given the benign inflationary environment and massive excess capacity in the US economy.

Eventually the dollar will benefit from the shift in interest rate expectations as markets look for the Fed to be more aggressive than other central banks in reversing policy but this could take some time. Until then the dollar is a long way from a real recovery and will remain vulnerable for several months to come as risk appetite improves further.

Why the Fed should be in no hurry to hike rates

Equity markets struggled to gain traction last week and finally lost ground registering their first weekly decline in month.  It finally looks as though markets are succumbing to the inevitable; the realisation that the recovery is going to be a rocky ride but neither will it be rapid or aggressive.  Markets look as though they have just about run out of fuel and after registering major relief that the global economy was not falling into an endless whole and that financial markets were not going to implode, the equity rally has finally come to a point where it will need more than just news about “green shoots” to keep it going. 

One question that has been raised in particular in bond markets and in interest rate futures pricing is whether these “green shoots” have accelerated the timing of the end of quantitative easing and/or higher interest rates.  Although the markets have retraced some of the tightening expectations that had built in following the May US jobs report there will be a lot of attention on whether the Fed will attempt to allay market concerns that current policy settings will result in inflation running out of control and necessitate a hike in interest rates. 

The Fed’s job shouldn’t be too difficult. In usual circumstances the expansion of the money supply undertaken by the Fed would have had major implications for inflation.  However, the circulation of money (money multiplier) in the economy has collapsed during the recession as consumers have been increasingly reluctant to borrow and lenders have become increasingly reluctant to lend.  The end result has been to blunt the impact of Fed policy.  Of course, once the multiplier picks up the Fed will need to be quick to remove its massive policy accommodation without fuelling a rise in inflation.  If it didn’t it would be bad both for long term interest rates as well as the dollar. 

Although the current policy of quantitative easing is untested and therefore has a strong element of risk attached to it the reality is that the Fed is unlikely to have too much of a problem on its hands.  The explanation for this is that there will be plenty of slack in the economy for months if not years to come.  The labour market continues to loosen and as the US unemployment rate increases most probably well in excess of 10%, wage pressures will continue to be driven down.  

In addition there is plenty of excess capacity in the manufacturing sector and as the May industrial production report revealed the capacity utilisation rate dropped to 68.3%, a hefty 12.6% below its average for 1972-2008.  Inflation data continues to remain subdued as revealed by last week’s release core inflation remains comfortable at a 1.8% annual rate.   Weaker corporate pricing power suggests that core inflation will remain subdued over coming months and will even fall further, so there will be little threat to Fed policy.  

The output gap (difference between real GDP and potential GDP) remains wide and according to CBO estimates of potential GDP the economy will end the year growing at around 8% below its full capacity.  Even if the economy grows above potential for the next few years it may only just close the output gap and subsequently begin fuelling inflation pressures.  The bigger risk is that the economy grows slowly over coming years and takes several years to close the output gap. 

Taking a perspective of past Fed rate hikes following the last two recessions, interest rate markets should take some solace.  In 2001 the Fed begin to hike rates until around 2 ½ years after the end of the recession whilst in the 1990-91 recession rates did not go up until close to 3 years following the end of recession.  Arguably this recession is worse in terms of depth and breadth suggesting that it will take a long time before the Fed even contemplates reversing policy.

Are currency market dynamics shifting?

There has been a major shift in market pricing for US interest rates following the US jobs report and comments from Fed officials including Atlanta Fed president Lockhart, suggesting that the Fed should not wait too long before tightening monetary policy.  As a result the implied yield on the December 09 3-month eurodollar futures contract has spiked by around 50bps since the middle of last week and markets have now moved to pricing in a US rate hike by year.  This looks wildly premature given the likely absence of inflation pressures for many months to come. 

The most interesting reaction to the shift in interest rate expectations was exhibited by the dollar which has managed to register solid gains over the last couple of days indicative of the past relationship between the dollar and interest rate expectations.  The odd thing about the strengthening in the dollar is that it has come at a time when risk appetite has continued to improve, suggesting that the strong risk appetite/dollar relationship that has been in place for much of the past year could be diminishing in strength.  For instance, the correlation between various dollar crosses and the VIX volatility index has been higher over the last few months than it has been in previous years.   

Admittedly its early days and the bounce in the dollar may just have reflected a market that was positioned very short dollars.  There was already signs of some short covering prior to the release of the US May jobs report as reflected in the CFTC IMM commitment of traders’ report which showed that net aggregate dollar speculative positioning (vs. EUR, JPY, GBP, AUD, NZD, CAD and CHF) improved for the first time in five weeks.  It is not inconceivable that investors have continued to cover short positions over the last few days.  

Nonetheless, it is difficult to ignore the possibility that currency market dynamics may be shifting back towards interest rate differentials as a key FX driver.  Over recent months the interest rate / FX relationship had all but broken down as reflected in very low and insignificant correlations between interest rate differentials and various currency pairs.  This could be changing and as interest rate markets begin to price in higher rates the relationship with currency markets may once again be strengthening.  

The risk for the dollar is that this tightening in US interest rate expectations looks premature.   It seems highly unlikely that the Fed will raise rates this year which points to the risk of a turnaround in rate expectations at some point over coming weeks and months.  In turn this suggests that the dollar could come under renewed pressure in the event of a dovish shift in US interest rate markets.  Even so, this is a factor to consider further out.  Over the next few days such a shift is unlikely and the dollar is likely to hold onto and even extend its gains as markets continue to ponder the probability that the Fed tightens policy sooner rather than later.

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