US dollar beaten by the bears

May 22, 2009 — Mitul Kotecha

Since I wrote my last post on the US dollar a week ago, US dollar under pressure, the slide in the dollar has accelerated against most currencies. Rather than being driven by an improvement in risk appetite however, it appears that the dollar is being hit by a major shift in sentiment. Indeed currency market dynamics appear be changing rapidly.

In particular, there has been a major breakdown in the relationship between the dollar and equity markets, suggesting that the influence of risk on FX markets is waning. For example, rather than rallying on the back of weaker equity markets over recent days, dollar weakness has actually intensified.

More likely this is becoming a pure and clear slide in sentiment for the dollar. There was some indication of this from the latest CFTC IMM Commitment of traders’ report which is a good gauge to speculative market positioning, showing that net dollar positioning has become negative for the first time in several months.

More evidence of this is the fact that the dollar / yen exchange rate has fallen even as risk appetite has improved. This is at odds with the usual relationship between the Japanese yen and risk appetite. The yen benefited the most from higher risk aversion since the crisis began, strengthening sharply against many currencies. As risk appetite improves and equity markets rally the yen would be expected to weaken the most as risk appetite improves.

I had looked for dollar weakness to accelerate into the second half of 2009 but against some currencies the drop in the dollar has come earlier than anticipated. I also thought that the dollar may stand a chance at a bit of a recovery in the near term if equity markets slipped and risk aversion increased. I was wrong about this. Despite the drop in equities over recent days the USD has also lost ground. Nor has the USD benefited from higher bond yields in the US.

The evidence is clear; USD bearishness is becoming more entrenched and the likelihood of a risk related rebound is becoming more remote even as risk aversion picks up once again. There appears to be a general shift away from US assets in general particularly Treasuries and most likely by foreign official investors who appear to be accelerating their diversification away from the dollar over recent weeks.

The importance of foreign buying of US Treasuries should not be underestimated in terms of its influence on the USD. Foreign purchases of US Treasuries made up 77% of total foreign buying of US securities in 2008. If there is a growing chance of a downgrade to the US’s AAA credit rating in the wake of a budget deficit that will be around $1.85 trillion this year and a rising debt/GDP ratio, the drop in the dollar seen so far may prove to be small compared to downside risks in the months ahead.

Posted in Bond markets, central banks, Currencies, Economics, Economy, equity markets, Financial crisis, US. Tags: , , , , , , , , , , , , , , , , , , . 1 Comment »

US dollar under pressure

May 15, 2009 — Mitul Kotecha

The US dollar has come under major pressure, with the US dollar index (a composite of the dollar against various currencies) falling to 4-month lows.   The weakness of the US dollar has been broad based and even the Japanese yen which normally weakens as risk appetite improves, has strengthened against the USD.  The euro has also taken advantage of dollar weakness despite ongoing concerns about the European economy. The main source of pressure on the dollar is the improvement in market appetite for risk.  

As I noted in a previous post, “What drives currencies?” risk appetite has been one of the biggest drivers of currencies in the past year.   This has pushed other drivers such as interest rate differentials into the background.   In the post I also stated that we would all have to watch equity markets to determine where currencies will move, with stronger equities implying a weaker dollar.

The dollar looks particularly sickly at present and it is difficult to go against the trend.  It will need a major reversal in equity markets or risk appetite to see a renewed strengthening in the dollar.   Although I still think it will require some positive news as opposed to less negative news to keep the momentum in equity markets going (see previous post) the prospects for a stronger dollar remain limited.   

Over the coming months the dollar is set to weaken further and those currencies that have suffered most at the hands of a strong dollar will benefit the most as risk appetite improves.  It is no coincidence that the UK pound has strengthened sharply over recent days, and this is likely to continue given its past undervaluation.  Other currencies which were badly beaten such as the Australian dollar and Canadian dollar will also continue to make up ground, helped too by a rebound in commodity prices.   

Aside from improving risk appetite the dollar may also come under growing pressure from the Fed’s quantitative easing policy, especially if inflation expectations in the US rise relative to other countries as a consequence of this policy.  It will be crucial that the Fed removes QE in a timely manner and many dollar investors will be watching the Fed’s exit strategy closely.  

Although the US trade deficit is showing improvement another concern for dollar investors is the burgeoning fiscal deficit.   The US administration revised up its estimate for the FY 2009 deficit to $1.84 trillion or about 12.9% of GDP, highlighting the dramatic deterioration in the US fiscal position.  Concerns about this were highlighted in an FT article warning about the risk to US credit ratings.

The deterioration in dollar sentiment has also been reflected in speculative market positioning, which has seen speculative appetite for the dollar drop to its lowest level in several months. The bottom line is that any recovery in the dollar over the coming weeks is likely to be limited offering investors to take fresh short positions as investors continue to move away from holding the dollar.

Posted in central banks, Commodities, Currencies, Economics, equity markets, Europe, Financial crisis, US, US administration. Tags: , , , , , , , , , , , , , , , , . 6 Comments »

How compelling are equity valuations?

May 12, 2009 — Mitul Kotecha

Relief over the results of the US bank stress tests, better than expected US jobs data, generally less negative economic data in general, as well as better than expected Q1 earnings provided markets with plenty of fuel over recent days and weeks. This has helped to spur an improvement in risk appetite and a resultant strengthening in equity markets. Meanwhile, government bonds have sold off, commodity prices have risen and the USD has weakened.

At the time of writing the S&P 500 has recouped all its losses for the year, having climbed around 34% from its low on 9th March. To many this has sent a bullish signal about the path of the economy ahead given the historical lag of around 5 to 6-months between equity gains and economic recovery but to others include myself this is sending a false signal. Even if the economy stabilizes any recovery is likely to be slow.

As stocks have risen, cautiousness about the current rally has intensified, with many now calling for equities to correct lower. This could partly reflect sour grapes from those investors who have missed the move in equities (I like to think that I am not in this camp even if I did miss the move) but there is also an element of truth in terms of equity market valuations, which have risen sharply over recent weeks. Although arguing whether stocks are cheap or expensive depends on what measures are used there is even some caution coming from equity bulls.

Bloomberg estimates one measure of equity valuation, the Price / Earnings ratio of the S&P 500 at 14.78, which is still below the estimated P/E ratio of 15.96 but much higher than the P/E ratio of around 10 at the beginning of March. Other estimates also suggest that the current P/E ratio on the S&P 500 is approaching a long run average, which suggests that further upside for equities may be more difficult in the weeks ahead.

What now? So far markets have reacted to the fact that economic conditions are the past the worst and the reaction has reflected less negative economic data releases, with many data releases coming in ahead of expectations. Going forward, it will require actual positive news as opposed to less negative news to keep the momentum going. If positive news is lacking the improvement in risk appetite and equity market rally will falter, especially as valuations are arguably far less compelling now.

I would be interested in your view about whether you think the rally will continue. Please tick the the relevant circle in poll on the sidebar to give your view and also view what others are thinking.

Posted in bank rescue, Bond markets, Commodities, Currencies, Economics, equity markets, Financial crisis, US, US administration. Tags: , , , , , , , , , , , , . 5 Comments »

Anxiety over Swine flu

April 29, 2009 — Mitul Kotecha

Although I have been writing about various factors that could derail the rally in equity markets and improvement in risk appetite over recent weeks I did not envisage that a virus such as Swine flu would be one of the factors to consider. However, it is and the stress and anxiety about its effects on the economy and of course health are rising rapidly.

In Hong Kong where I have been based for the last 8 months the concerns are particularly acute. Exposed from a high proportion of tourism as a percent of GDP, high population density and its importance as an air travel hub, Hong Kong is somewhat more sensitive than many other countries. Moreover, the memories of SARS and its devastating impact on the economy still linger for many people. A local paper revealed such tensions in its headline, “its creeping closer”

Nonetheless, there is little in terms of concrete evidence to go on and outside of Mexico the health impact of the virus has not been as severe. Even in Mexico there have been conflicting reports about the actual amount of deaths, with some putting it at a much smaller number. Until there is some clarity markets will continue to react to the uncertainty. The rapid spread of the flu has sparked fears of a global pandemic but it has yet to be categorized as such.

Risk indicators have not yet reacted sharply even if equity markets have been hit over recent days, suggesting that at the least there is not a panic in markets. Even the usual FX beneficiaries of higher risk aversion such as the US dollar and Japanese yen have not strengthened and remain in a broad range. It is difficult to predict the damage from the flu and much depends on its severity and how much it spreads but the relative calm in the market is at least encouraging for now.

Posted in Asia, Currencies, Economics, equity markets. Tags: , , , , , , . Leave a Comment »

What drives currencies?

April 7, 2009 — Mitul Kotecha

Currency forecasting is never an easy thing to do. The drivers of currencies appear to change over time making it quite tough to develop forecasting tools with great accuracy. This is not an excuse from someone who has been trying to analyse currencies for a number of years but just a statement of reality. Over the past year or so one of the biggest drivers of currencies has been risk appetite. As equity markets sank in 2008 the main winners were the dollar and yen both of which appreciated due to strong repatriation flows and safe haven demand. This influence of risk in determining currency movements saw historical influences such as interest rate differentials pushed into the background.

Where does it leave FX now? Well, if the rally in equity markets continues it implies that both the dollar and yen will fall further whilst long suffering currencies such as the pound will strengthen further. In the pound’s case it has a lot of room to recover given that is massively undervalued by many measures. For instance during my time in Hong Kong the pound against the dollar has dropped by around 30% making things look far more expensive than when I first came. However, to a foreigner UK assets now look quite well priced and London is no longer such an expensive city. Add in the steep drop in house prices and the UK looks even more competitive. This will no doubt benefit the economy in time.

So if the current risk/FX relationship holds it means that we should all be watching equity markets to see where currencies are going to move over coming months. If equity markets fail to sustain their rally it could put the dollar back on the front foot which will see the pound back under pressure. Eventually the dollar will weaken as risk appetite improves and when that happens the pound may be one of the main beneficiaries.

Ps. I hope this works as I am posting this article on holiday. It also means that my contributions may be a bit more sporadic over the next couple of weeks.

Posted in Currencies, Economics, equity markets, Financial crisis. Tags: , , , , , , . 4 Comments »
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