Addicted to the medicine

September 7, 2009 — Mitul Kotecha

It comes as a relief to markets that G20 officials have agreed it is too early to begin withdrawing massive fiscal, monetary and financial support.   However, it is hardly surprising that officials are not formulating an early exit from emergency measures especially given the ongoing uncertainty about the pace and shape of global economic recovery.  

The latest US jobs report did not help clarify the outlook for markets as a smaller than forecast drop in employment in August (-216k) weighed against a surprise jump in the unemployment rate to a 26-year high of 9.7% and downward revisions to past months employment data.

There is a growing possibility that the Fed’s expectation the unemployment rate will breach 10% by the end of the year looks may be hit even earlier.  Fears about a “jobless recovery” will likely increase as a lack of hiring is set to persist for some time yet. 

The absence of any near term reversal of stimulus measures reduces the risk of a “double dip” recession but at some point there has to be a reckoning. Fiscal positions have blown out for many countries and will eventually require spending cuts, higher taxes and/or privatisation in addition to likely increases in the retirement ages for workers, to rectify them. It is questionable how sustainable recovery will be once such measures begin to be implemented.

In the meantime, it is not even evident that policy is working efficiently. Arguably yields on bonds and corporate debt are lower than they would otherwise have been had it not been for central bank actions but lenders are still not passing the additional liquidity to consumers and households against the background of fears about a rising tide of bad loans and delinquencies.

I would compare this to a patient who came close to death and has finally come off life support as the worst passed but has relied on support in the form of various strong medicines to keep him (or her) going.  The risk that the patient has become overly dependent on the drugs has grown but it is highly unclear how he will fare once he is weaned off.  

Fears about the ability of the patient to stand on his own two feet will increase.  The risk that the patient will relapse is intensifying but his ability to pay for more medicine is already diminishing and his options are running out quickly.

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

Speculative dollar sentiment worsens

September 2, 2009 — Mitul Kotecha

Data releases continue to fail to inspire markets despite the continuing run of better than expected numbers. In the US the Chicago PMI reached the critical boom/bust level of 50.0 in August whilst the less closely followed Milwaukee PMI surged into expansion territory at 56.0.  This revealed some upside risk to the ISM manufacturing index which duly beat consensus coming at 52.9 in August.  The fact that positive data is failing to lift markets is a sign of fatigue and stock markets appear to be running out of fuel.

From an FX perspective these developments will not be sufficient to provoke a break out of well worn ranges. Risk trades remain in favour but the momentum is limited. The prognosis does not look as positive for the dollar as the generally improving environment for risk will play negatively. Speculative sentiment (CFTC Commitment of Traders IMM data) has indeed worsened for the dollar; IMM data revealed net dollar short positions increasing sharply in the latest week, with market positioning worse than the 3-month average.

Much will depend on the US jobs report on Friday but until then the dollar is likely to cling to the weaker end of ranges. I believe that the dollar index will avoid dropping below its August 5th low of 77.428. The main exception to dollar weakness appears to be sterling where sentiment has become more bearish recently. This was reflected in the IMM report in which aside from the dollar, the pound has also been a loser and the only other currency for which speculative appetite worsened.

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An unusual dollar reaction

August 8, 2009 — Mitul Kotecha

Although many market participants are on summer holidays this has not prevented some interesting market moves in the wake of yet more improvement in economic data and earnings.  The most noteworthy release was the July US jobs report which revealed a better than forecast 247,000 job losses and a surprise decline in the unemployment rate to 9.4%.  Moreover, past revisions added 43,000 to the tally.

Although it is difficult to get too optimistic given that job losses since December 2007 have totalled 6.7 million, the biggest drop since WW2, the direction is clearly one of improvement.  Nonetheless, markets were given a dose of reality by the drop in US consumer credit in June, which gives further reason to doubt the ability of the US consumer to contribute significantly to recovery.

The data spurred a further rally in stocks and a sell of in Treasuries.   Such a reaction was unsurprising but the more intriguing move was seen in the US dollar, which after some initial slippage managed a broad based appreciation in contrast to the usual sell off in the wake of better data and improved risk appetite.

It is too early to draw conclusions but the dollar reaction suggests that yield considerations are perhaps beginning to show renewed signs of influencing currencies following a long period where the FX/interest rate relationship was practically non-existent.  Indeed, the strengthening in the dollar corresponded with a hawkish move in interest rate futures as the market probability of a rate hike by the beginning of next year increased.

Since the crisis began the biggest driver of currencies has been risk aversion, a factor that relegated most other influences including the historically strong driver, interest rate differentials, to the background.  More specifically, much of the strengthening in the dollar during the crisis was driven by US investor repatriation from foreign asset markets as deleveraging intensified.   This repatriation far outweighed foreign selling of US assets and in turn boosted the dollar.

Over the past few months this reversed as risk appetite improved and the pace of deleveraging lessened.  Ultra easy US monetary policy also put the dollar in the unfamiliar position of becoming a funding currencies for higher yielding assets and currencies though admittedly this was all relative as yields globally dropped.   The dollar also suffered from concerns about its role as a reserve currency but failed to weaken dramatically as much of the concern expressed by central banks was mere rhetoric.

Where does this leave the dollar now?  Risk will remain a key driver of the dollar but already its influence is waning as reflected in the fact that the dollar has remained range bound over recent weeks despite an improvement in risk appetite.   As for interest rates their influence is set to grow as markets price in rate hikes and as in the past, more aggressive expectations of relative interest rate hikes will play the most positive for the respective currency.

It is still premature for interest rates to overtake risk as the principal FX driver.   Even if rates increase in importance I still believe interest rate markets are overly hawkish in the timing of rate hikes. A reversal in tightening expectations could yet push the dollar lower.  This is highly possible given the benign inflationary environment and massive excess capacity in the US economy.

Eventually the dollar will benefit from the shift in interest rate expectations as markets look for the Fed to be more aggressive than other central banks in reversing policy but this could take some time. Until then the dollar is a long way from a real recovery and will remain vulnerable for several months to come as risk appetite improves further.

Posted in central banks, Currencies, Economics, Economy, Financial crisis, Interest rates, Monetary Policy, US. Tags: , , , , , , , , , , , , , , , , , , , , , , . 1 Comment »

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 »
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