FX sensitivity to yield

December 9, 2010 — Mitul Kotecha

It’s all about yield. The back up in US bond yields in reaction to the US tax compromise from the Obama administration has been particularly sharp. US 10 year bond yields jumped around 35bps this week prior to a small correction in yields overnight whilst 2s were up 21bps. US bond yields are now back where they were in June, a fact that makes a mockery out of the Fed’s attempts to drive bond yields lower via quantitative easing (QE). Yields elsewhere increased too but by a smaller degree whilst equity market sentiment has been dampened by the rise in global yields although US stocks still ended higher overnight.

There is plenty of commentary discussing the impact on currencies of the move in bond yields so it’s worth looking in more detail how sensitive FX markets have been to yield. The most sensitive currencies i.e. those with the highest 3-month correlations with relative bond yield differentials (2 year) are the AUD/USD, EUR/USD, and of course USD/JPY. However, there is less sensitivity to gyrations in 10 year yields with no currency pair registering a statistically significant correlation with 10-year bond yield differentials over the past 3-months.

Assuming that US bond yields continue to push higher into 2011, with much lager increases in both nominal and yields expected, this means that AUD, EUR and JPY will face the most pressure relative to the USD. Moreover, the stimulus measures agreed by the US administration will likely lead to many analysts penciling in higher growth forecasts over 2011 whilst reducing the prospects of QE3 from taking place, all of which is USD positive. I still retain a degree of caution in Q1 2011, especially with regard to a potential bounce in EUR, especially if the ECB becomes more aggressive in its bond buying, but even so, any EUR rally is likely to prove termporary.

The impact of higher US yields on the AUD may be more limited however, despite the high correlation with relative bond yields, as Australian bond yields are also likely to rise somewhat given the resilience of its economy. This was clearly demonstrated by Australian November employment data released overnight revealing yet another consensus beating outcome of +54.6k, with all the gains coming from full time employment. Against the background of a generally firm USD, the best way to play AUD resilience is via the NZD, with the currency pair likely break through resistance around 1.3220 (21 October high).

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Drastic Action Needed

December 1, 2010 — Mitul Kotecha

There has been no let up in pressure on eurozone markets and consequently risk aversion continues to increase. The failure of Ireland’s bailout package to stem the haemorrhaging in eurozone bond markets highlights the difficulties in finding in a lasting solution and worsening liquidity conditions in several eurozone bond markets highlights the urgency to act.

Indeed, if spreads continue to widen as they have since late October, by early to mid 2011, Portuguese, Spanish and Italian Euribor spreads would be higher than the EFSF loan spread. In the (admittedly extreme) case that sovereigns could not raise money in the market, peripherals would run out of money early in 2011. Policy makers will try to not let the situation get so out of hand but what can be done to stem the damage?

The European Central Bank (ECB) may be forced to delay its exit strategy by maintaining unlimited liquidity allotments to banks into next year and/or implement further liquidity support measures. The ECB meeting will be closely scrutinized for details, with ECB President Trichet having to adjust policy accordingly. A further option could be for the ECB to step up its bond buying programme which may provide some relief to peripheral eurozone bond markets and the EUR.

Whether this offers a lasting solution however, is debatable. The risk of action by the ECB tomorrow may fuel some caution in the market towards selling the EUR further in the short term and could even prompt some short EUR covering around the meeting which could see EUR/USD regain a sustainable hold above 1.3000 again but this may be temporary, offering better levels to sell.

Meanwhile, speculation of a break up of the eurozone into a core euro and a peripheral euro has intensified given the growing divergence in growth and competitiveness across the region. Such speculation looks far fetched. The eurozone project has been politically driven from the start and over the last 60 years or so internal economic strains have been papered over by politicians. The political will is likely to remain in place even if the divergence in fundamentals across Europe has continued to widen.

Bond market sentiment was not helped by the fact that S&P put Portugal’s ratings on creditwatch negative citing downward economic pressure and concerns over the government’s credit worthiness. Importantly S&P still expects Portugal to remain at investment grade if downgraded. Note that Portugal’s central bank highlighted that the country’s banking sector faced “intolerable” risk unless the government implements planned austerity measures.

In contrast the US story is looking increasingly positive, highlighting that the USD’s strength is not merely a reaction to EUR weakness but more likely inherent and broad improvement in USD sentiment. US consumer confidence, Chicago PMI and the Milwaukee PMI beat forecasts in November, continuing the trend of consensus beating data releases over recent weeks.
Although this does not change the outlook for quantitative easing (QE) as the Fed remains focused on core CPI and the unemployment rate, the data paints an encouraging picture of the economy.

Posted in central banks, Currencies, ECB, Economics, Economy, Europe, eurozone, Federal Reserve, Fiscal/Budget, FX, Germany, Greece, Interest rates, Ireland, Monetary Policy, Portugal, US. Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , . Leave a Comment »

Money Printing

October 6, 2010 — Mitul Kotecha

It was a day of surprises on Tuesday as the Bank of Japan (BoJ) not only created a JPY 5 trillion fund to buy domestic assets including JGBs but also cut interest rates to zero. Expect more measures to come in the fight against a stronger JPY and deflation. The Reserve Bank of Australia (RBA) also surprised markets by leaving its policy rate unchanged at 4.5% delaying another rate hike yet again despite expectations by many including ourselves of a 25bps rate hike.

The easier policy stance from the BoJ and RBA taken together with firmer service sector purchasing managers indices – including the September US ISM non-manufacturing survey, which came in at 53.2 from 51.5 – gave risk appetite a solid lift. Even the AUD which dropped sharply following the RBA decision, managed to recoup all of its losses and more overnight.

Japan’s decision could have set the ball rolling for a fresh round of quantitative easing (QE) from central banks as they combat sluggish growth prospects ahead and ongoing deflation risks. The US Fed as has been much speculated on and the Bank of England (BoE) are likely candidates for more QE. Whilst the European Central Bank (ECB) is unlikely to adopt such measures there are reports that board members are split over the timing of exit policy. The BoE decision on Thursday may provoke more interest than usual against this background although the Bank is unlikely to act so quickly. The Fed on the other hand appears to be gearing up for a November move.

Growing prospects of fresh QE looks likely to provide further impetus for risk trades. Notably commodity prices jumped higher, with the CRB commodities index at its highest level since the beginning of the year. Although there is plenty of attention on the gold price which yet a fresh record high above $1340 per troy ounce as well as tin which also hit new highs, the real stars were soft commodities including the likes of sugar, coffee and orange juice up sharply.

The main loser once again is the US dollar and this beleaguered currency appears to be finding no solace, with any rally continuing to be sold into, a pattern that is set to continue. Although arguably a lot is in the price in terms of QE expectations, clearly the fact that the USD continues to drop (alongside US bond yields) highlights that a lot does not mean that all is in the price.

The USD is set to remain under pressure against most currencies ahead of anticipated Fed QE. The fact that the USD has already dropped sharply suggests a less pronounced negative USD reaction once the Fed starts buying assets but the currency is still set to retain a weaker trajectory once the Fed USD printing press kicks into life again as a simple case of growing global USD supply will push the currency weaker.

USD weakness will only spur many central banks including across Asia to intervene more aggressively to prevent their respective currencies from strengthening. A “currency war” looms, a fact that could provoke some strong comments at this weekend’s IMF and World Bank meetings. In the meantime intervention by central banks will imply more reserves recycling, something that will continue to benefit currencies such as EUR and AUD.

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USD pressure, EUR resilience, GBP whipsawed

September 29, 2010 — Mitul Kotecha

Speculation the Fed will begin a new program of asset purchases or QE2 as soon as November is intensifying. The weaker than expected reading for US consumer confidence in September released on Tuesday has only added to this expectation as sentiment continues to be hit by job market concerns. Against this background the USD remains under strong downward pressure, with little sign of any turnaround.

The prospects of further USD debasing as well as intervention in many countries to prevent their currencies from strengthening against the USD continues to power gold prices which hit a new record high having breezed through the $1300 per troy ounce mark. In the current environment it is hard to see gold prices turning much lower although there may be some risk of profit taking in the weeks ahead.

The EUR remains a key beneficiary of USD weakness but this currency has problems of its own to contend with. Indeed, peripheral debt concerns, especially with regard to Ireland and to a lesser extent Portugal have increased, with borrowing costs rising as the yield on their debt widens against core eurozone debt. The stronger EUR will only make it harder for these countries to achieve any sort of recovery and could also damage the stronger exporting countries of Northern Europe led by Germany.

So far however, the EUR has managed to show some impressive resilience to renewed peripheral country sovereign debt concerns including comments by S&P about the high costs of rescuing an Irish Bank. Perhaps the knowledge that there is a still a huge bailout fund from the EU and IMF available if needed and also the prospect that the ECB will increase its buying of eurozone debt, has provided a buffer for the EUR.

At some point the ECB may be forced to join the battle in at least attempting to talk its currency lower but at this stage the central bank is showing no inclination to either talk down the currency or physically intervene to weaken the EUR. In the meantime, EUR/USD is likely to strengthen further despite the likely negative impact on European growth, with the currency likely to set its sights on an eventual break above 1.40.

One currency that may struggle in the wake of expectations of Fed QE2 is GBP. Uncertainty over whether the Bank of England will follow the Fed in implementing further quantitative easing could see GBP lag the gains in other currencies against the USD. Conflicting comments from MPC members Posen who noted that there may be a need for further QE in the UK to support the faltering economy were countered by Sentance who noted that there was no need for more QE. GBP/USD is likely be whipsawed as the debate continues and is set to lose further ground against the EUR.

Posted in Bond markets, central banks, Commodities, Currencies, Economics, Economy, Europe, eurozone, Federal Reserve, Fiscal/Budget, FX, Germany, IMF, Interest rates, Ireland, Monetary Policy, Portugal, UK, US. Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , . Leave a Comment »

What goes down must go up

September 2, 2010 — Mitul Kotecha

What goes down must go up! A day that began with a stronger than forecast increase in China’s purchasing managers index (PMI) and firm Australian Q2 GDP continued with a surprise jump in the August ISM manufacturing index. The ISM rose to 56.3 from 55.5 in July an outcome that contradicted most of the regional US manufacturing surveys. It was not all positive in terms of data, yesterday however, with a weaker UK manufacturing PMI and unexpected drop in the August US ADP employment report casting a shadow over markets.

Nonetheless, for a change the market decided to act on the good news, with risk assets surging. Despite the improvement in risk appetite it still feels as though the market is grasping for direction. The jump in equities is unlikely to prove durable in an environment characterized by various uncertainties about growth and policy, especially the US.

The next hurdle for markets is the US payrolls data tomorrow. Although the ADP jobs report revealed a surprise 10k decline the employment component of the ISM manufacturing survey strengthened to 60.4, suggesting an improvement in August manufacturing payrolls. Ahead of the payrolls release the US data slate today largely consists of second tier releases including July pending home sales, August chain store sales, weekly jobless claims, and factory orders. It is worth paying particular interest to jobless claims given that the four week moving average has been edging higher, suggesting renewed job market deterioration. The consensus is for a 475k increase in claims, which will still leave the 4-week average at an elevated level.

Given that one of the biggest debates raging through markets at present is whether the Fed will embark on further quantitative easing comments by Fed officials overnight were closely scrutinized for further clues. In the event, Fed Governor Kohn highlighted that the Fed’s reinvestment of the proceeds from mortgage-backed securities will not automatically lead to further QE, suggesting some hesitancy on his part. Meanwhile, Dallas Fed President Fisher noted his reluctance to expand the Fed’s balance sheet until fiscal and regulatory uncertainties are cleared up.

Both sets of comments highlight the difficulty in gaining a consensus within the FOMC for a further increase in QE, suggesting that the hurdle for further balance sheet expansion will be set quite high. Moreover, such comments put the onus on Congress to move quickly in clearing up fiscal policy uncertainties.

As markets flip from risk on to risk off almost on a daily basis the question for today is how sustainable the rally in risk trades will prove to be against the background of so much policy and growth uncertainty. Unfortunately today’s data will provide few clues and markets will turn their attention to tomorrow’s US non-farm payrolls report for further direction. To an extent this suggests that it may be a case of treading water until then. Nonetheless, I still maintain that risk trades remain a sell on rallies over coming weeks

Posted in Australia, central banks, China, Currencies, Economics, Economy, equity markets, Europe, eurozone, Federal Reserve, Fiscal/Budget, FX, Interest rates, Japan, Monetary Policy, UK, US, US administration. Tags: , , , , , , , , , , , , , , , , , , , , , . Leave a Comment »
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