Action Shifting To Currencies as Rates Volatility Eases

US stocks barely closed higher at the end of last week and flirted with bear market territory. US consumer and retail stocks remain under pressure alongside industrials as recession fears intensify.  Indeed while inflation concern remain elevated, recession fears are increasing. US Treasury yields are finally coming off the boil amid such fears, with May seeing a significant pull back in yields; the biggest decline has been in the 3-10 year part of the yield curve over recent weeks.  This has been met with a decline in interest rate volatility unlike equity and implied currency volatility measures, which have pushed higher.   For instance, major currency implied volatility measures have reached their highest since around March 2020. Emerging markets volatility breached its March 2020 high in March 2022 and after a brief fall is moving back higher.  

Action is shifting to currencies and the drop in the US dollar from its highs, with the currency increasingly undermined by lower US yields.  In Asia, the 3 most sensitive currencies to yield differentials (US 10 year yield minus 10 year local currency bond yields) are the Thai baht, Indonesian rupiah and Korean won.  As such, Korean won is likely to rally the most in Asia should US yields fall further.   The Chinese yuan has strengthened amid US dollar weakness though underperformance of the Chinese currency is likely versus its peers as the authorities likely aim to weaken it on a trade weighted (CFETS) basis. 

In China, the surprisingly large 15 basis point cut in 5-year loan prime rate last week will be seen as a boon for China’s property market.  However, while support for the property market has increased there does not seem to be much more stimulus ready to be unleashed despite various pledges.  China’s April data slate was weak highlighting the risks of a contraction in GDP this quarter and providing evidence that the “around 5.5%” official growth target looks increasingly out of reach.  COVID restrictions across the country are easing gradually pointing to some pick up in activity though consumption and the service sector are likely to remain under pressure for months to come as mass testing, quarantines and border controls continue to restrict mobility.  

There was relief for China’s markets today as President Biden highlighted the potential for a reduction/removal of tariffs implemented by President Trump, stating that he will discuss tariffs with Treasury Secretary Yellen when he returns from his Asia trip.  Removing tariffs is by no means a done deal given there will be plenty of pressure to maintain some level of US tariffs on China. A reduction in tariffs would be beneficial for the US in that it would help reduce imported inflation pressures while it would also help to support Chinese exports at a time when they are slowing down and adding pressure on China’s current account position.  However, some of this impact would likely be mitigated by a relatively stronger yuan, which would undoubtedly benefit as tariffs were cut.  

Key data and events highlight this week include monetary policy decisions in Indonesia (Tue), New Zealand (Wed), South Korea and Turkey (both Thu).  Federal Reserve FOMC meeting minutes will also be released (Wed). Although not expected by the consensus there is a good chance that Indonesia hikes policy rates by 25 basis points. In New Zealand a 50bp hike is likely while a 25bp hike in South Korea is expected.  In contrast despite pressure on the Turkish lira and very elevated inflation no change in monetary policy is expected in Turkey this week.  Meanwhile the Federal Reserve FOMC minutes will provide further detail on how quickly the Fed wants to get to neutral rates and beyond and on its quantitative tightening policy. 

Nervousness Creeping Back – US dollar firmer

Last week ended on a sour note as concerns over second round virus cases intensified; Apple’s decision to close some US stores in states where cases are escalating added to such concerns. This overshadowed earlier news that China would maintain its commitment to buying US agricultural goods.  Although on the whole, equity markets had a positive week there is no doubt that nervousness is creeping back into the market psyche.  Indeed it is notable that the VIX equity volatility “fear gauge” ticked back up and is still at levels higher than seen over most of May.

Economic recovery is continuing, as reflected in less negative data globally, but hopes of a “V” shape recovery continue to look unrealistic.  In this respect the battle between fundamentals and liquidity continues to rage.  Economic data has clearly turned around, but the pace of improvement is proving gradual.  For example, last week’s US jobless claims data continued to trend lower, but at a slower pace than hoped for.  A second round of virus cases in several US states including Florida, Arizona and the Carolinas also suggest that while renewed lockdowns are unlikely, a return to normality will be a very slow process, with social distancing measures likely to remain in place.  Geopolitical tensions add another layer of tension for markets.  Whether its tensions between US/China, North/South Korea, India/China or the many other hot spots globally, geopolitical risks to markets are rising.

The USD has benefitted from increased market nervousness, and from US data outperformance, with US data surprises (according to the Citi economic surprise index) at around the highest on record.  JPY has bucked the trend amid higher risk aversion as it has regained some of its safe haven status. GBP was badly beaten last week selling off from technically overbought levels, amid fresh economic concerns and a dawning reality that a Brexit trade deal with the EU may be unreachable by year end.  EUR looks as though it is increasingly joining the club on its way down. Asian currencies with the highest sensitivities to USD gyrations such as KRW are most vulnerable to further USD upside in Asia.

Data highlights this week include the May US PCE Report (Fri) which is likely to reveal a bounce in personal spending, Eurozone flash June purchasing managers indices (PMIs) (Tue) which are likely to record broad increases, European Central Bank meeting minutes (Thu), which are likely to reflect a dovish stance, and several central bank decisions including Hungary (Tue), Turkey (Thu), New Zealand (Wed),  Thailand (Wed), Philippines (Thu).   The room for central banks to ease policy is reducing but Turkey, Philippines and Mexico are likely to cut policy rates this week.

 

 

JPY and Asian FX outlook

JPY is facing a double whammy of upward pressure related to both rising risk aversion and a narrowing US yield advantage over Japan. The latter influence has been significant, with 10 year US Treasury yields dropping by around 70bps since the end of last year, versus 10 year Japanese JGB yields. The net result is that the currency pair has fallen sharply over recent weeks and will remain constrained until US yields resume their ascent.

In the near term the escalation of tensions in the Ukraine will fuel increased safe haven demand for JPY potentially leading to a test of a test of technical support around USD/JPY 100.62 (11 September 13 high). However, strong demand around the 101.20-30 level suggests that it may require another leg lower for US yields to fuel a further sharp drop in USD/JPY.

Asian currencies are set to continue to show some relative resilience to events in Ukraine although a weaker bias is expected. Most currencies remain relatively insensitive to gyrations in risk appetite except KRW which registers the biggest correlation with our risk barometer.

Overall, lower US yields will help provide some support to Asian currencies and investors will continue to differentiate based on domestic factors rather than shifts in risk appetite. Additionally some relative stability in the CNY / CNH may also help to limit pressure on Asian currencies.

Australian dollar rallies, Korean won bounces back

On the currency front, the best performers so far this year have been an odd combination of JPY, NZD and AUD versus USD. JPY has benefitted from both compressed yield differentials with the US and risk aversion but its gains are likely to reverse over the coming weeks as these factors reverse.

I have been generally more constructive on AUD and NZD than the consensus and remain so. Both AUD and NZD look oversold and will gradually appreciate further, especially as both the RBA and RBNZ have now likely ended their easing cycles, with the latter set to raise policy rates by the end of this quarter. AUD/USD breached 0.90 this morning helped by a strong business confidence reading for January.

Most Asian currencies have rebounded so far this month, with some of the biggest losers over January recording gains. The KRW has been the best performer in February recording gains despite continued outflows of equity capital. Korea has recorded $1.26 billion in equity outflows so far this month, the highest among Asian countries.

In contrast bond inflows into Korea have been relatively solid over January and this continued into February, helping to provide some support to KRW despite equity outflows. Helping the KRW is the fact that is much less sensitive to US bond yields than many other Asian currencies helping it to avoid any fallout from higher US yields in February. USD/KRW is on path for a break below support around 1070.

Asian currencies under pressure

The close to 1% drop in the USD index over recent days is misleading in terms of the USD’s performance against emerging market currencies where it has registered strong gains. For example the ADXY (Asian USD index) has dropped to its lowest level since early September 2013 and looks set to decline further as Asian currencies face more pressure. The best performers in this environment are traditional safe havens, especially JPY and CHF while the EUR and Scandinavian currencies have also capitalised on the weaker USD.

The drop in the USD against many major currencies reflects the fact that positioning had reached extreme levels prior to the sharp moves at the end of last week. For instance, net long USD speculative positions (according to the CFTC IMM data) had risen to the highest level since June 2013 while in contrast EUR positioning had dropped to its lowest since July 2013. The subsequent position adjustment will have proved to be a healthy correction that will set the USD up for an eventual rebound and the EUR for a sell off.

The sharp drop in US Treasury yields will undermine the USD further in the near term, however, and the mixed slate of US data releases will offer the currency little assistance. Nonetheless, the USD is expected to stay firm against Asian currencies. Notably capital flows from Asian equity markets have increased over recent weeks, with Philippines, South Korea, and Thailand on track to register outflows for the first month of the year. Against this background it is unsurprising that both the KRW and PHP are the two worst performing Asian currencies so far this year. While I expect a reversal in both, the near term outlook is for further pressure.

%d bloggers like this: