Asian currencies vulnerable to equity outflows

Asian currencies are set to continue to trade cautiously. One big headwind to further appreciation is the fact that there has been a substantial outlook of equity capital over recent weeks. Over the last month to date Asian equity markets have registered an outflow of $3.3 billion in outflows. However, whilst Taiwan, South Korea, Thailand and India have seen outflows Indonesia, Philippines, and Vietnam have registered inflows.

The net result is that equity capital inflows to Asia so far this year are almost flat, a stark contrast from 2009 and 2010 when inflows were much higher at the same point in the year. The odds for further strong inflows do not look good, especially as the Fed ends QE2 by the end of June. While a sharp reversal in capital flows is unlikely, it also seems unlikely that Asia will register anywhere near as strong inflows as the last couple of years.

This will have a significant impact on Asian currencies, whose performance mirrors capital flows into the region. Almost all Asian currencies have dropped against the USD so far this month and could remain vulnerable if outflows continue. Given the relative stability of the USD over recent weeks and imminent end to QE2, the better way to play long Asia FX is very much against the increasingly vulnerable EUR.

The THB has been the worst performing currency this month but its weakness has been attributable to upcoming elections on July 3, which has kept foreign investor sentiment cautious. Thailand has seen an outflow of $812mn from its equity market this month. Polls show the PM Abhisit’s party trailing the opposition and nervousness is likely to persist up to the elections at least. THB weakness is not likely to persist over coming months, with USD/THB forecast at 29.2 by year end.

USD/KRW has been whipsawed over the past week but made up ground despite a continued outflow of equity capital over recent days. KRW has been particularly resilient despite a firmer USD environment and a drop in consumer sentiment in June. Next week the KRW will likely continue to trade positively, helped by a likely firm reading for May industrial production on Thursday. USD/KRW is set to trade in a 1070-1090 range, with direction likely to come from Greece’s parliament vote on its austerity measures.

TWD has traded weaker in June, having been one of the worst performing currencies over the month. USD/TWD does not have a particularly strongly correlation with movements in the USD or risk aversion at present but the currency has suffered from a very sharp outflow of equity capital over recent weeks (biggest outflow out of all Asian countries so far this month). Next week’s interest rate decision on Thursday by the central bank (CBC) will give some direction to the TWD but a 12.5bps increase in policy rates should not come as a big surprise. TWD is likely to trade with a weaker bias but its losses are likely to be capped around the 29.00 level versus USD.

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Equity Flow Reversal Supports Asian FX

Asian currencies have rebounded smartly from their post Japan earthquake lows on March 16. The ADXY (Bloomberg-JP Morgan Asia Currency index) is now at its highest level since September 1997 reflecting a sharp rebound in capital inflows to the region. The performance of Asian currencies continues to correspond closely with the movement in capital flows.

Although almost all Asian equity markets have registered outflows so far this year (total equity outflows -$6.2bn), the trend is reversing. Over the past month there has been a major slowing in capital outflows for most countries in Asia whilst India, Thailand and the Philippines have actually registered sizeable inflows. South Korea is notable in that there has been a sharp increase in equity capital inflows over the past week.

Although there has been much focus on a rotation of capital flows out of Asia and into developed economies this year, it is worth noting that the pattern of equity flows in Q1 2011 has not been too different from that witnessed in the past couple of years. In both 2009 and 2010 equity outflows were recorded over the two (2010) or three (2009) months of the year before a reversal took place. This pattern looks like it is repeating itself.

Clearly the environment for Asian equity markets is not as supportive as it was last year given the belated tightening in monetary policies being undertaken by many central banks and prospects of an end to QE2 in the US. Whilst this will result in some reduction in capital flows to the region compared to last year, the overall outlook is positive. Easing risk aversion (our risk aversion barometer has already reversed all of its post Japan earthquake spike and is trending lower), positive growth outlook and maintenance of low US rates point to more inflows.

One currency in particular that will benefit is KRW, with a further drop in USD/KRW likely over coming weeks. KRW has already strengthened by around by around 2.7% since its post Japan earthquake low making it the best performing currency since then. Further gains are likely; a test of USD/KRW 1100 is on the cards in the short-term, with the year end target standing at 1050.

Why buy KRW? 1) Korea has registered the biggest improvement in equity capital flows recently, 2) KRW has been the most sensitive Asian currency to risk over the past month and therefore benefits the most as risk appetite improves, 3) Estimated Price/Earnings ratio for Korean equities looks cheap compared to its historical z-score according to our estimates. As a result our quantitative model on USD/KRW based on commodity prices, risk aversion and equity performance highlights the potential for significantly more KRW strength.

Follow The Oracle

Many investors are probably wishing they had the psychic abilities of Paul the octopus. The mollusc once again gave the correct prediction, by picking Spain to beat the Netherlands to become the winner of the World Cup. This ability would have been particularly useful for currency forecasters, many of which have been wrong footed by the move higher in EUR/USD over recent weeks.

Confidence appeared to return to markets over the past week helped by a string of rate hikes in Asia from India, South Korea and Malaysia, and firm data including yet another consensus beating jobs report in Australia. An upward revision to global growth forecasts by the International Monetary Fund (IMF) also helped, with the net result being an easing in double-dip growth concerns.

The good news culminated in a much stronger than forecast June trade surplus in China. However, China’s trade numbers will likely keep the pressure on for further CNY appreciation, and notably US Senators are still pushing ahead with legislation on China’s FX policy despite the US Treasury decision not to name China as a currency manipulator.

Political uncertainty on the rise again in Japan following the loss of control of the upper house of parliament by the ruling DPJ party. The JPY has taken a softer tone following the election and will likely remain under pressure. CFTC IMM speculative JPY positioning has increased but this has been met with significant selling interest by Japanese margin accounts who hold their biggest net long USD/JPY position since October 2009 according to Tokyo Financial Exchange (TFX) data.

In the absence of the prodigious abilities of an “oracle octopus” data and events this week will continue to show slowing momentum in G3 country growth indicators but not enough to warrant renewed double-dip concerns. Direction will be largely driven by US Q2 earnings. S&P 500 company earnings are expected to have increased 27% from a year ago according to Thomson Reuters.

There are several data releases of interest in the US this week but the main release is the retail sales report for June which is likely to record another drop over the month. Data and events in Europe include the Eurogroup finance ministers meeting, with markets looking for further insight into bank stress tests across the region. Early indications are positive but the scope of the tests remains the main concern. The July German ZEW survey will garner some interest and is likely to show a further slight decline in economic sentiment.

EUR/USD gains looked increasingly stretched towards the end of last week, as it slipped back from a high of around 1.2722. Technical resistance around 1.2740 will prove to be tough level to crack over coming days, with a pullback to support around 1.2479 more likely. CFTC IMM data reveals that short covering in EUR has been particularly sharp in the last week, with net short positions cut by over half, highlighting that the scope for further short covering is becoming more limited.

Conversely aggregate net USD long positions have fallen by over half in the last week as USD sentiment has soured, with longs at close to a three-month low. The scope for a further reduction in USD positioning is less significant, suggesting that selling pressure may abate.

Risk trade rally fizzles out

The risk trade rally spurred by China’s decision to de-peg the CNY fizzled out. The realization that China will only move very gradually on the CNY brought a dose of reality back to markets after the initial euphoria. The fact that unlike in July 2005 China ruled out a one off revaluation adds support to the view that China will move cautiously ahead with CNY reform. In addition, renewed economic worries have crept back in, with particular attention on a potential double dip in the US housing market following a surprise 2% drop in existing home sales in May.

European banking sector woes have not disappeared either with S&P raising the estimate of writedowns on Spanish bank losses, whilst Fitch ratings agency noted that there is an increased chance of the eurozone suffering a double-dip recession. The net impact of all of these factors is to dampen risk appetite and the EUR in particular.

The UK’s announcement of strong belt tightening measures in its emergency budget did not fall far outside of market expectations. The budget outlined a 5-year plan of deficit reduction, from 11% of GDP in 2009-10 to 2.1% of GDP in 2014-15. The main imponderable was the response of ratings agency and so far it appears to have been sufficient not to warrant a downgrade of the UK’s credit ratings. Fitch noted that the “ambitious” plan ensured that the UK would keep its AAA credit rating. The emergency budget and reaction to it has been mildly positive for GBP, which has shown some resilience despite the pull back in risk currencies.

The recent rally in Asian currencies is looking somewhat overdone but direction will come from gyrations in risk appetite and the CNY rather than domestic data or events. Encouragingly equity capital flows into Asia have picked up again over recent weeks, with most countries with the exception of the Philippines registering capital inflows so far this month, led by India and South Korea.

China’s CNY move may attract more capital inflows into the region, suggesting that equity capital flows will continue to strengthen unless there is a relapse in terms of sovereign debt/fiscal concerns in Europe. Nonetheless, central banks in the region will continue to resist strong FX gains via FX interventions, preventing a rapid strengthening in local currencies.

Although India and Korea have registered the most equity inflows this month, both the INR and KRW have had a low correlation with local equity market performance over recent weeks. In fact the most highly sensitive currencies to their respective equity market performance have been the MYR and IDR both of which have reversed some of their gains from yesterday. USD/MYR will likely struggle to break below its 26th April low around 3.1825 whilst USD/IDR will find a break below 9000 a tough nut to crack.

Wait And See

It’s difficult to be too conclusive in my blog post today given that markets are in waiting mode for a number of events to pass. First and foremost is the US May jobs report. The consensus forecast is for a gain of 536k in nonfarm payrolls and a slight drop in the unemployment rate to 9.8%. Payrolls estimates range from a high of 750k to a low of 220k, the wide margin likely reflecting the uncertainty of the amount of census hiring.

On the face of it a 500k+ gain in payrolls looks strong, but the bulk of this, probably about three-quarters, will made up of census hiring which by its nature is transitory. Therefore, only about 100k in payrolls will be due to private sector jobs growth, which is still not bad. Most of the clues leading up to the jobs data are consistent with the consensus, including the 55k increase in the May ADP.

The second event is the change in Prime Minister in Japan. Naoto Kan, the previous Finance Minister is set to take over the helm. His job is going to tough, with all eyes on how and when the government begins to get to grips with Japan’s burgeoning debt burden which is approaching 200% of GDP. Most of this, around 96% is held by domestic investors, so Japan is less exposed to foreign investor sentiment.

Nonetheless, even domestic investors including many large life insurance companies are increasing their overseas investments at the expense of Japanese debt. Kan is also a supporter of weaker JPY so at the least the rhetoric from Japanese officials to weaken the JPY will step up, especially given the very painful move in EUR/JPY over recent months.

Finally, the G20 meeting beginning today in South Korea will garner attention. Topics will include bank regulation and capital requirements, the European debt crisis, and policy tools such as the recent suggestion by South Korea to make permanent the currency swap agreements between central banks. Aside from a commitment to keep policy supportive, and likely talking up the efforts to combat the crisis in Europe, it is difficult to see anything particularly market moving emerge from the meeting.

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