Are currency market dynamics shifting?

June 8, 2009 — Mitul Kotecha

There has been a major shift in market pricing for US interest rates following the US jobs report and comments from Fed officials including Atlanta Fed president Lockhart, suggesting that the Fed should not wait too long before tightening monetary policy.  As a result the implied yield on the December 09 3-month eurodollar futures contract has spiked by around 50bps since the middle of last week and markets have now moved to pricing in a US rate hike by year.  This looks wildly premature given the likely absence of inflation pressures for many months to come. 

The most interesting reaction to the shift in interest rate expectations was exhibited by the dollar which has managed to register solid gains over the last couple of days indicative of the past relationship between the dollar and interest rate expectations.  The odd thing about the strengthening in the dollar is that it has come at a time when risk appetite has continued to improve, suggesting that the strong risk appetite/dollar relationship that has been in place for much of the past year could be diminishing in strength.  For instance, the correlation between various dollar crosses and the VIX volatility index has been higher over the last few months than it has been in previous years.   

Admittedly its early days and the bounce in the dollar may just have reflected a market that was positioned very short dollars.  There was already signs of some short covering prior to the release of the US May jobs report as reflected in the CFTC IMM commitment of traders’ report which showed that net aggregate dollar speculative positioning (vs. EUR, JPY, GBP, AUD, NZD, CAD and CHF) improved for the first time in five weeks.  It is not inconceivable that investors have continued to cover short positions over the last few days.  

Nonetheless, it is difficult to ignore the possibility that currency market dynamics may be shifting back towards interest rate differentials as a key FX driver.  Over recent months the interest rate / FX relationship had all but broken down as reflected in very low and insignificant correlations between interest rate differentials and various currency pairs.  This could be changing and as interest rate markets begin to price in higher rates the relationship with currency markets may once again be strengthening.  

The risk for the dollar is that this tightening in US interest rate expectations looks premature.   It seems highly unlikely that the Fed will raise rates this year which points to the risk of a turnaround in rate expectations at some point over coming weeks and months.  In turn this suggests that the dollar could come under renewed pressure in the event of a dovish shift in US interest rate markets.  Even so, this is a factor to consider further out.  Over the next few days such a shift is unlikely and the dollar is likely to hold onto and even extend its gains as markets continue to ponder the probability that the Fed tightens policy sooner rather than later.

Posted in central banks, Currencies, Economics, Economy, Financial crisis, Interest rates, US. Tags: , , , , , , , , , , , , , , , . Leave a Comment »

Are foreign investors really turning away from US debt?

May 29, 2009 — Mitul Kotecha

The press has been full of stories about the dangers to US credit ratings and growing concerns by foreign official investors about the value of their holdings of US Treasury bonds.   A combination of concerns about the rising US fiscal deficit, Fed quantitative easing and potential monetization of US debt, have accumulated to fuel such fears. Given the symbiotic relationship between China and the US it is perhaps unsurprising that China has been one of the most vocal critics. I have highlighted this in past posts, especially related to the risks to the US dollar. Please refer to US dolllar beaten by the bears and US dolllar under pressure. However, my concerns that foreign investors have been shunning US Treasuries recently may have proved somewhat premature.

Should China or other large reserves holders pull out of US asset markets, it would imply a sharp rise in US bond yields and a much weaker dollar.  However, it is not easy for China or any other central bank to act on such concerns.  China is faced with a “dollar trap” in that any decline in their buying of US Treasuries would undoubtedly reduce the value of their existing Treasury holdings as well as drive up the value of the Chinese yuan as the dollar weakens.  Such a self defeating policy would clearly be unwelcome. 

One solution that China has proposed to reduce the global reliance on the dollar and in turn US assets was to make greater use of Special Drawing Rights (SDRs) which I discussed in a previous post, but in reality this would be fraught with technical difficulties and would in any case take years to achieve.  Nor will it be quick or easy for China to persuade other countries to make more use of the yuan in the place of the dollar.  The first problem in doing so is that fact that the yuan is not a convertible currency and therefore foreign holders would have difficulties in doing much with the currency.  

Foreign official concerns are understandable but whether this translates into a major drop in buying of US Treasuries is another issue all together.  Foreign countries have been gradually reducing their share of dollars in foreign exchange reserves over a period of years.  This is supported by IMF data which shows that dollar holdings in the composition of foreign exchange reserves have fallen from over 70% in 1999 to around 64% at the end of last year.

In contrast the share of euro in global foreign exchange reserves has increased to 27% from 18% over the same period.  This process of diversification likely reflects the growing importance of other major currencies in terms of trade and capital flows, especially the euro, but the pace of diversification can hardly be labeled as rapid. 

Importantly, there is no sign that there has been an acceleration of diversification over recent weeks or months.  Fed custody holdings for foreign official investors have held up well.  In fact, these holdings have actually increased over recent weeks.  Moreover, the share of indirect bids (foreign official participation) in US Treasury auctions have been strong over recent weeks.  Taken together it provides yet more evidence that foreign official investors haven’t shifted away from US bonds despite all the rhetoric. 

Posted in Asia, Bond markets, central banks, China, Currencies, Economics, Economy, Europe, US, US administration. Tags: , , , , , , , , , , , , , , , , , , , , . 5 Comments »

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 »

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 »

US jobs report not so clear cut

May 11, 2009 — Mitul Kotecha

The US jobs report released last week was also not as clear cut as the headline figure suggested. The 539k drop in April payrolls was the smallest decline since October last year. Markets reacted well to the data, with equities continuing to rally as it was taken as yet another sign that the worst is over and compared favourably with the average Q1 monthly payrolls decline of 707k. The US has now lost 5.7 million jobs in a period of 16-months with the bulk of these in the past few months alone.

Nonetheless, the headline drop in payrolls masked the fact that there was a large temporary 72k boost from government hiring due to the upcoming 2010 US census which was a one off boost to hiring before real census hiring begins in the spring next year. Negative revisions to the data subtracted 66k from past payrolls, meaning that past months jobs losses were worse than initially reported. Moreover, the unemployment rate pushed higher, reaching 8.9%, the highest rate since late 1983 and is likely to reach at least 9.5% over coming months if not double digits.

As noted in a previous post “No `green shoots’ in the jobs market”, it will take a long time before the jobs picture turns around. Even the US administration admits that positive employment is unlikely until 2010. Moreover they admitted that growth will have to pick up to around 2.5% before unemployment will fall and this is highly unlikely before some months.

Posted in Economics, equity markets, Financial crisis, US, US administration. Tags: , , , , , , , , . 1 Comment »
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