Risk gyrations and FX positioning

I must admit it has been quite tough to get a handle on the sharp moves in markets over recent days. Market sentiment shifted from positive to negative and back again in a matter of hours, meaning that anyone wanting to put on a long term trading position has had to have had a significant risk tolerance to hold onto their positions.

Attention was focused squarely on Chinese stocks last week but market fears over tighter regulation eased as the week progressed. Market sentiment was helped by strong existing home sales data in the US, continuing the run of better than forecast US economic data releases. Globally data releases mirrored this tone.

A cautiously upbeat tone from central bankers at the Jackson Hole symposium sets up a positive backdrop for markets. Although Fed Chairman Bernanke noted that the rebound in growth was likely to be slow and ECB President Trichet talked about a “bumpy road ahead” the overall tone was positive.

Importantly there was no indication that a reversal in monetary policy was in sight, with the Fed’s Kohn even indicating that there was no inconsistency between the Fed maintaining low rates for an “extended period” and keeping inflation low. The comments should help to ensure that markets do not misinterpret the signs of recovery as a cue to begin hiking interest rates.

This week’s data slate will maintain the run of good news. However, there are a few risks. Consensus forecasts look for US consumer confidence to improve in August but the weak labour market situation may hold some downside risks for the Conference Board measure of confidence just as it did for the Michigan reading.

US durable goods orders are set to bounce back and new home sales are likely to echo at least some of the gains in existing home sales last week. In the eurozone, attention will focus on the August German IFO survey and this release is likely to mirror the gains in the PMI, with a healthy gain in the headline reading expected.

Risk trades continue will be favoured after overcoming last week’s setbacks keeping the USD under downward pressure but within ranges and risk currencies including AUD, NZD, CAD and NOK under upward pressure. The USD index is verging on testing its 5th August low of 77.428, whist the JPY is also weaker though its moves may be more limited ahead of upcoming elections.

The IMM report shows that speculative investors have cut pared back USD short positions further, but the shift in positioning was relatively small from the previous week, with net aggregate USD short positions at -94.8k contracts compared to -96.1 in the previous week. Notable shifts in positioning over the week include a cut back in net EUR long positions to their lowest level since the week of 5th May 2009.

Commodity currencies suffered some pullback in net long positioning too with speculative AUD and NZD contracts being cut although net CAD long positions did increase slightly. Given the resumption in risk appetite into this week it seems highly likely that positioning will reverse and net USD short positions will increase.

Risk trades under pressure

Having given presentations in Hong Kong, China and South Korea in the past week and preparing to do the same in Taiwan and Singapore this week it is clear that there is a lot of uncertainty and caution in the air.  

There can be no doubt now that risk aversion has forcibly made its way back into the markets psyche.  Government bonds, the US dollar and the Japanese yen have gained more ground against the background of higher risk aversion. 

Following a tough week in which global equity markets slumped, oil fell below $60 per barrel and risk currencies including many emerging market currencies weakened, the immediate outlook does not look particularly promising.

Data releases are not giving much for markets to be inspired about despite upgrades to economic growth forecasts by the IMF even if their outlook remains cautious.  US trade data revealed a bigger than expected narrowing in the deficit in May whilst US consumer confidence fell more than expected in July as rising unemployment took its toll on sentiment.   There was also some disappointment towards the end of the week as the Bank of England did not announce an increase in its asset purchase facility despite much speculation that it would do so.

Rising risk aversion is manifesting itself in the usual manner in currency markets.  The Japanese yen is grinding higher and having failed to weaken when risk appetite was improving it is exhibiting an asymmetric reaction to risk by strengthening when risk appetite is declining.  Its positive reaction to higher risk aversion should come as no surprise as it has been the most sensitive and positively correlated currency with risk aversion since the crisis began. 

Nonetheless, the Japanese authorities will likely step up their rhetoric attempting to direct the yen lower before it inflicts too much damage on recovery prospects.   The urgency to do so was made clear from another drop in domestic machinery orders last week as well as the poor performance of Japanese equities.  

The US dollar is also benefitting from higher risk aversion and is likely to continue to grind higher in the current environment.  Risk currencies such as the Canadian, Australian and New Zealand dollars, will be most vulnerable to a further sell off but will probably lose most ground against the yen over the coming days.   These currencies are facing a double whammy of pressure from both higher risk aversion and a sharp drop in commodity prices.    Sterling and the euro look less vulnerable but will remain under pressure too.   

There are some data releases that could provide direction this week in the US such as retail sales, housing starts, Empire and Philly Fed manufacturing surveys.  In addition there is an interest rate decision in Japan, and inflation data in various countries. The main direction for currencies will come from equity markets and Q2 earnings reports, however.  

So far the rise in risk aversion has not prompted big breaks out of recent ranges in FX markets.  However, unless earnings reports and perhaps more importantly guidance for the months ahead are very upbeat, there is likely to be more downside for risk currencies against the dollar but in particular against yen crosses where most of the FX action is set to take place.

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.

Show me the money

The long awaited results of the US administration’s stress tests for US bank will be announced on May 7th. There have been various rumours and speculation about the details in terms of the extent that banks will require further capital injections and indeed which banks will need such injections. Ahead of the announcement I thought it would be an interesting exercise to look at the potential equity needed in the global financial sector.

Some light on this was shed by the IMF’s recent release of the Global Financial Stability Report in which the fund increased its total estimates of global writedowns to over $4 trillion. The most recent estimates of financial sector writdowns suggest that institutions are only about one-third of the way there.

In other words there is still a considerable amount of writedowns on toxic debt left to be undertaken. The IMF estimated further writedowns in the US in 2009 and 2010 at $550 billion, $750 billion in the eurozone and $200 billion in the UK.

Moreover, they estimate that financial institutions will require $500 billion of additional capital in the US, $725 billion in the eurozone and $250 billion in the UK just to raise the ratio of common equity to total assets (a measure of leverage) to 6%. Even these estimates may prove conservative. After all, the IMF has raised its estimates of total writedowns several times already and will likely do so again. These figures do not even include the need for other financing which when added amounts to around 60% of Bank’s total assets.

The bottom line is that even with all the money that is being provided to financial institutions at present it will be highly unlikely that they will be able to raise sufficient capital if the IMF’s estimates are anything to go by. Consequently balance sheets will contract sharply and deleveraging will continue.  Governments will be forced to provide support for a long time to come and the end result will be either outright nationalisation or alternatively bankruptcy for some institutions that are deemed not too big to fail.  Worryingly the risks are skewed on the downside, especially if the economic recovery is a weak one which I believe is highly likely to be the case.

No “green shoots” in the jobs market


Over recent weeks various officials have highlighted signs of stabilisation in economic conditions.  Indeed, economic data have been coming in less bad than feared. Nonetheless, one indicator is likely to take a considerably longer time than others to turnaround.  The jobs market is set to continue to deteriorate globally for many months after other economic indicators stabilise.  In the US the pace of lay offs has been dramatic, with 5.1 million jobs lost since December 2007 and 2/3 of these registered in the last five months alone.

The US unemployment rate currently at 8.5% is set to move to potentially as high as 10%, with the change in the rate from its cycle low already greater than any time since WW2.  The contraction in the economy points to much further job losses in the months ahead.  The good news is that a smaller pace of economic contraction ought to result in smaller declines in payrolls over the coming quarters and this implies a decline from the Q1 monthly average of 685,000 job losses.  Nonetheless, this doesn’t mean there will be a quick improvement either. 


There are several other implications of rising unemployment.  If the unemployment rate does reach 10% it would match the worst case scenario visualized in the Fed’s stress tests for US banks.  Rising unemployment would imply not only less consumer spending, but more loan defaults, more writedowns and more pressure on bank balance sheets.  Just look at the massive provisions that some US banks have built into their forecasts for the months ahead.  The likely slower pace of economic recovery compared to past recessions suggests that any improvement in the labour market will also be more gradual. 


Another dimension to the deterioration in the jobs market underway at present is the growing number of temporary and/or contract workers that are being layed off.  A broad US government definition estimates that such workers account for around 31% of the labour market.   If the losses in these jobs are accounted for the unemployment rate could be as high as 15.6% according to the US Bureau of Labour Statistics.   This suggests that the economic impact of rising job losses may be much more severe than predicted.


And finally the effect of rising unemployment on wage pressures should not be ignored.   Many employers are not only shedding staff but also cutting wages.  Moreover, a looser labour market in general plays negatively for wages as the demand for labour decreases.   Easing wage pressures is good for dampening inflation pressures but in the current environment it could fuel further fears about deflation, which in turn could be extremely negative for the economy. In the worst case scenario it could even end up as a 1990s Japanese scenario of a downward deflationary spiral which ultimately crippled the economy for a whole decade.   Let’s hope not.

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