US dollar weakness providing relief

The US dollar index has weakened since mid-August 2018 although weakness in the broad trade weighted USD has become more apparent since the beginning of this month.  Despite a further increase in US yields, 10 year treasury yields have risen in recent weeks to close to 3.1%, the USD has surprisingly not benefited.  It is not clear what is driving USD weakness but improving risk appetite is likely to be a factor. Markets have been increasingly long USDs and this positioning overhang has also acted as a restraint on the USD.

Most G10 currencies have benefitted in September, with The Swedish krona (SEK), Norwegian Krone (NOK) and British pound (GBP) gaining most.  The Japanese yen (JPY) on the other hand has been the only G10 currency to weaken this month as an improvement in risk appetite has led to reduced safe haven demand for the currency.

In Asia most currencies are still weaker versus the dollar over September, with the Indian rupee leading the declines.  Once again Asia’s current account deficit countries (India, Indonesia, and Philippines) have underperformed most others though the authorities in all three countries have become more aggressive in terms of trying to defend their currencies.  Indeed, The Philippines and Indonesia are likely to raise policy interest rates tomorrow while the chance of a rate hike from India’s central bank next week has risen.

As the USD weakens it will increasingly help many emerging market currencies.   The likes of the Argentinian peso, Turkish lira and Brazilian real have been particularly badly beaten up, dropping 51.3%, 38.5% and 18.8%, respectively this year.  Although much of the reason for their declines have been idiosyncratic in nature, USD weakness would provide a major source of relief.  It’s too early to suggest that this drop in the USD is anything more than a correction especially given the proximity to the Fed FOMC decision later, but early signs are positive.

 

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Emerging market currencies under pressure

One of the key factors that have provoked the current bout higher risk aversion was the sub-50 Chinese manufacturing confidence gauge (PMI) which has intensified concerns about slowing growth . Additionally reports regulators in China have issued warnings about credit to the coal industry has reinforced debt fears in the country.

Domestic fundamental and political pressures in other currencies have contributed to the malaise in emerging markets, with a major drop in the Argentine peso and pressure on many other high beta emerging market currencies (including the usual suspects Turkish lira, South African rand and Indian rupee).

A deteriorating outlook for many emerging markets currencies based on concerns about the impact of Fed tapering and slowing emerging markets growth appears to be increasingly intensifying. Competition for capital as the Fed tapers will make things worse. The pressure is unlikely to ease quickly leaving many EM currencies vulnerable to a further sell off.

Beware of yield sensitive currencies

Markets are becoming increasingly accustomed to the idea of an imminent Fed tapering as reflected in ongoing gains in risk assets. Indeed, these gains have taken place even in the face of comments by Fed officials overnight including Bullard and Fisher which on balance supported the view of beginning tapering sooner rather than later.

The fact that US bond yields continue to decline despite the release of a slate of firmer US and global data also suggests that a lot in terms of tapering expectations are priced in. Nonetheless, year end position adjustment may also account for some of the moves, particularly with the USD coming under near term pressure against most currencies except JPY as US yields slip.

I remain constructive on the USD given that US growth will outperform, with an attendant rise in US yields. Not only am I constructive on the USD against many major currencies, I expect the USD to strengthen versus many emerging market currencies too.

Those currencies most sensitive to US yields (10 year US Treasuries) will be among the biggest underperformers in 2014. This list includes the INR, TRY, MYR, and BRL. The rationale for weakness in these currencies is that Fed tapering and higher US yields will further increase capital outflows or at least reduce inflows to many countries.

Conversely some of the currencies least effected by tapering / higher US yields are in the top half of the likely outperformers next year including KRW and TWD.

Bracing for a world without steroids

The sell off of risk assets in the wake of the Fed’s surprisingly direct FOMC communication continues unabated. Hopes that Fed chief Bernanke would attempt to assuage market concerns about tapering have been blown apart and instead the reality of forthcoming tapering continues to bite leading to higher US yields, weaker stocks and commodities and a firmer USD. In fact the USD appears to have finally re-established its positive relationship with yields and risk aversion.

The situation hasn’t been helped by the fact that data out of China has disappointed while local money market rates had risen sharply this week. Separately Japan’s reform momentum appears to have stalled ahead of Upper House elections as Prime Minister Abe’s third arrow missed target.

In combination these factors mean that markets are bracing for the day that they no longer have steroid injections to keep them going. Instead fundamentals will become important to sustain gains in risk assets. Why should anyone be surprised? US growth is recovering and at some point tapering has to occur. Unfortunately risk assets were just not ready for this revelation.

Ongoing volatility and uncertainty is likely to persist over the coming weeks as markets transition to an environment of Fed tapering, but this will give way to a renewed improvement in risk appetite and lower volatility later in the year.

The USD index continued to rise overnight having corrected around a third of its losses since 22 May. Gains remain broad based with gains registered against major and emerging market currencies. US Treasury yield differentials with other countries continue to widen across the board leaving the USD in strong form (10 year Treasury yield has risen by close to 80 basis points since early May).

Going forward firmer US data, taken together with higher US yields, will continue to drive the USD higher against major currencies, while some improvement in risk appetite as investors become accustomed to the prospects of Fed tapering will allow emerging market currencies to recover some, but not all lost ground against the USD.

Many currencies have become highly sensitive to US yields, with the TRY, NZD and INR the most sensitive over the past three months although notably most Asian currencies are near the top in terms of sensitivities.

Against this background unsurprisingly Asia continues to register capital outflows. All Asian countries have registered capital outflows this month, with total equity outflows of $10.2 billion registered, led by South Korea and Taiwan. Obviously the bigger concern is for deficit countries including India and Indonesia, with their currencies remaining particularly vulnerable to capital outflows.

Recent market volatility has meant that the prospects of Japanese investors stepping up their outflows have diminished over the near term. The latest data released yesterday showed that Japanese investors repatriated capital for a fifth straight week.

It is only a matter of time before outflows pick up as risk appetite improves as US yields move higher. The US 10Y Treasury yield advantage has widened versus Japanese JGBs to around 153bp and I expect this to widen further to around 185bp by the end of 2013. This will be consistent with a renewed slide in the JPY versus USD.

Fed does the Twist, markets do the Shake

Although it was widely expected the Federal Reserve’s decision to implement a fresh version of Operation Twist together with a downbeat assessment of the economy came as a disappointment to equities and risk assets in general. The only surprise was the larger size of the operation at $400 billion.

Moody’s downgrade of three US banks added to the malaise as US equities dropped sharply, commodities slid, longer term Treasuries rallied whilst shorter term bonds dropped. The USD registered broad gains both on the back of the fact that no more quantitative easing was announced and due to a shift away from risk assets. At least there was no more negative news out of the eurozone as talks between the Troika (ECB, IMF, EC) and Greek officials continue on the next tranche of the bailout.

Markets will continue to digest the Fed’s outcome today and the negative tone will likely filter through markets today. There is little on the data front to result in a shift in this tone. In the US data includes weekly jobless claims while in Europe attention will be on manufacturing and service sector confidence measures.

While the potential for a positive outcome to talks in Greece may provide a short term boost to sentiment the overwhelming tone is likely to remain negative especially as Operation Twist is unlikely to change the dynamic of a weak growth trajectory for the US and developed economies over the coming months. Against this background, selling risk assets on rallies remains the preferred option.

The USD will continue to look firmest against high beta emerging market currencies in the current environment. Currencies in this group are those that have the highest correlations with risk (as m measured by my in house risk barometer) over the past 3 months including CAD, ZAR, TRY, INR, MXN, ARS & RUB. In contrast currencies that also have high correlations but actually strengthen as risk aversion increases are CNY and JPY.

US Dollar On The Rise

There are plenty of US releases on tap this week but perhaps the most important for the USD will be the minutes of the April 26-27 Fed FOMC meeting. Taken together with speeches by Fed officials including Bernanke, FX markets will attempt to gauge clues to Fed policy post the end of QE2. The Fed’s stance at this point will be the major determinant of whether the USD can sustain its rally over the medium term. The lack of back up in US bond yields suggests that USD momentum could slow, with markets likely to move into wide ranges over coming weeks.

It is worth considering which currencies will suffer more in the event that the USD extends its gains. The correlation between the USD index and EUR/USD is extremely strong (even accounting for the fact that the EUR is a large part of the USD index) suggesting that the USDs gains are largely a result of the EUR’s woes. Aside from the EUR, GBP, AUD and CAD are the most sensitive major currencies to USD strength whilst many emerging market currencies including ZAR, TRY, SGD, KRW, THB, IDR, BRL and MXN, are all highly susceptible to the impact of a stronger USD.

Robust Q1 GDP growth readings in both Germany and France helped to spur gains in the EUR but this proved short-lived. Sentiment for the currency has soured and as reflected in the CFTC IMM data long positions are being scaled back. Nonetheless, there is still plenty of scope for more EUR selling given ongoing worries about the eurozone periphery, which are finally taking their toll on the EUR. A break below EUR/USD 1.4021 would open the door for a test of 1.3980.

The eurogroup and ecofin meetings will be of interest to markets this week but any additional support for Greece is unlikely to be announced at this time. However, likely approval of Portugal’s bailout may alleviate some pressure on the EUR but any positive impetus will be limited. Even on the data front, markets will not be impressed with the German ZEW index of investor confidence likely to register a further decline in May.

Japanese officials have been shying away from further FX intervention by blaming the drop in USD/JPY over recent weeks on general USD weakness despite the move towards 80. However, this view is not really backed up by correlation analysis which shows that there is only a very low sensitivity of USD/JPY to general USD moves over recent months. One explanation for the strength of the JPY is strong flows of portfolio capital into Japan, with both bond and equity markets registering net inflows over the past four straight weeks.

This is not the only explanation, however. One of the main JPY drivers has been a narrowing in yield differentials. This is unlikely to persist with yield differentials set to widen sharply over coming months resulting in a sharply higher USD/JPY. As usual data releases are unlikely to have a big impact on the JPY this week but if anything, a further decline in consumer confidence, and a negative reading for Q1 GDP, will maintain the pressure for a weaker JPY and more aggressive Bank of Japan (BoJ) action although the BoJ is unlikely to shift policy this week.

Respite for the dollar

Markets are increasingly discounting stronger than expected Q3 earnings.  Further gains in equities and risk appetite may be harder to achieve even if profits continue to be beat expectations, which so far around 80% of Q3 earnings have managed to do. Measures of risk such as the VIX “fear gauge” have highlighted an increasingly risk averse environment into this week.  The negative market tone could continue in the short term.

The USD has found some tentative relief, helped by the drop in equities and profit taking on risk trades.  The fact that the market had become increasingly short USDs as reflected in the latest CFTC Commitment of Traders’ (IMM) report in which aggregate short USD positions increased in the latest week (short USD positions numbered roughly twice the number of long positions), has given plenty of scope for some short covering this week.

The USD has even managed quite convincingly to shake off yet another article on the diversification of USD reserves in China.  The USD index looks set to consolidate its gains over the short term against the background of an up tick in risk aversion.  The USD index will likely remain supported ahead of the main US release this week, Q3 GDP on Thursday, but any rally in the USD is unlikely to be sustainable and will only provide better levels to short the currency.

Given the broad based nature of the reversal in risk sentiment with not only equities dropping but commodities sliding too, it suggests that high beta currencies, those with the highest sensitivity to risk will suffer in the short term.  These include in order of correlation with the VIX index over the past month, from the most to the least sensitive, MXN, AUD, MYR, SGD, NOK, EUR, CAD, INR, ZAR, BRL, TRY and NZD. The main beneficiary according to recent correlation is the USD.

EUR sentiment in particular appears to be weakening at least on the margin as reflected in the latest IMM report which revealed that net long EUR speculative positions have fallen to their lowest level in 6-weeks.  Whether this is due to profit taking as EUR/USD hit 1.50 or realisation that the currency appeared to have gone too far too quickly, the EUR stands on shakier ground this week.  EUR/USD may pull back to near term technical support around 1.4840 and then 1.4725 before long positions are re-established.

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