G-10 Currencies In Q3 - One Ugly Horse Race
Saxo Bank | Jun 28 11 07:50 GMT
G-10 Currencies In Q3 - One Ugly Horse Race
The outlook for the major economies for the next couple of quarters is like some grotesque horse race in which the horses have all been maimed or sickened and picking the winner is a choice between which horse looks the least likely to collapse before the finish line. The U.S. economy headed south while the Federal Reserve must honour its QE2 exit deadline at the quarter end; Europe's periphery is still a festering sore in need of fresh bailouts, Japan's economy has been desperately disrupted by a natural disaster, and China is headed for a landing of one kind or another as it faces inflationary overheating and a property bubble. Forecasting in any environment is a hazardous affair – but this quarter, the pitfalls are even greater because the potential energy the market might unleash at any time, given the magnitude of the challenges that face all of the major economies, is perhaps as great as ever.
USD – end of QE2, yes, but is main focus already on QE3?
The overriding concern for the USD as we write these words some weeks before the end of the Fed's QE2 programme is how the market will deal with the Fed no longer propping up the bond market, both in terms of what it will mean for interest rates, but also for risk assets. After all, the perception has been that the Fed's presence in the bond market has encouraged the steady rise in asset prices practically from the day QE2 was hinted at late last August until the market began anticipating the end of QE2 in May of this year. Ahead of QE2's actual end, the greenback has rallied more modestly than one might expect given the sell-off in risk appetite, but that is likely due to the market's enthusiasm for imagining the shape of QE's to come. But is there a chance for the greenback to make a medium-term comeback within its overall secular decline?
Going forward, one possible brake to further USD declines is a relative underperformance of economies around the world relative to the already weak US and relative to past expectations. This is part of the general ugly horse race idea, i.e., that the pro-cyclical currencies like AUD and SEK and others will tend to do worse when the situation globally is turning south because there is far more to take out of their actual policy rates and forward expectations, while the U.S. expectations/yields are already virtually nil.
Another potential source of USD strength would be a second round of the Homeland Investment Act (HIA), the original version of which allowed U.S. companies to repatriate profits tax free back in 2005. If the Obama administration decides to go this route, (And why wouldn't it? After all, it certainly appears that Mr. Obama could use every possible boost to the economy to improve his chances in the election next November) estimates of the amounts that might be repatriated this time around are far higher than the original HIA and lie somewhere in the hundreds of billions of US dollars in potential inflows. Most likely, an HIA 2 would not be launched until Q4 and aimed at heaviest impact in 2012, but hints may be on the way in Q3.
But most importantly, considering how 'successful' the Fed has been in manipulating markets over the last couple of years, we will have to watch the progression of thinking within the Fed for signs of what it wants to do next if the U.S. economy continues its recent slide and asset markets find themselves in a funk. For at least a short while, perhaps the entirety of Q3, it will do nothing, but it may still hint at possible solutions to the next crisis, should it arise, in speeches, white papers, and perhaps even at the Jackson Hole conference sponsored by the Kansas City Fed later this summer. Judging from the widespread dissatisfaction with the straight up bond buying of QE2 and its ineffectiveness by many measures (plenty of complaints from within the Fed as well), any hints at a QE3 will likely involve a different policy approach. Perhaps the most intriguing is the idea of an 'Operation Twist', which we discuss in our general outlook. This approach would see a rise in interest rates at the forward end of the U.S. yield curve and the lowering of rates farther out the curve. How would this affect the USD? Very hard to tell, but at first blush it might be USD supportive as it would at least knock the stuffing out of the passive carry trade that tends to focus on interest rate spreads at the short end of the yield curve.
Europe – not a question of the Grecian formula
One luxury that Europe has had over the last 18 months of its various sovereign debt crises at the Eurozone periphery is that the bloc's economic centre of gravity, Germany, has been experiencing nearly unparalleled boom times. As China reins in its economy and higher commodity prices seem to be pressuring growth everywhere, however, it appears that Germany's star may have peaked as the strength of its export markets are thrown into doubt for the coming few quarters. And still, the sovereign debt problems at the periphery fester on, with the ever present challenges to the awkward bailout mechanism framework that will be up for major review at the late June summit. Meanwhile, the ECB's Trichet continues to put on a hawkish face and has started hiking rates to fight higher inflation. Quite the policy mix!
Of the major currencies, the outlook for the Eurozone is perhaps the most uncertain in the near term. The EU and ECB are at logger-heads over how to approach version 2.0 of the Greece bailout, particularly in terms of whether bond-holders should be forced to have their bond maturities restructured. There's no space to go into the particulars here, but our base assumption is that the powers at the top do manage to stand together and ram through some kind of 'solution' to the problem in late June or early July. The question further down the road is how palatable the receivers of the said bailout find it. For the bailed out countries, it might feel like being saved from a shipwreck only to be thrown in jail. Greece is already clearly socially destabilised, and Spain is also showing unrest with its high youth unemployment and sit-ins. Could we see something akin to the 'Arab spring' revolutions? Most worrying for the Eurozone, however, is whether the sovereign debt challenges jump to one of the bigger countries like Spain or Italy, where the current mechanisms simply don't address the magnitude of the potential problem and would require a whole new scale to the approach – likely explicit money printing, assuming the consensus at the centre holds in favour of a bailout solution. Italy is a particularly interesting case, as it has received little mention during all of the turmoil even though, as a study by Edward Altman of Risk Magazine estimates, the country is saddled with around $2 trillion in debt and pays more on its sovereign debt as a percentage of GDP (5 percent) than does Portugal (4.2 percent), which is already insolvent and was forced to ask for a bailout earlier this year. The road for the Eurozone is likely to be a rocky one for the rest of this year – the market Is already pricing in a lot of risk for the Euro, so the currency could perform very well against the pro-risk trades and even against the Swiss franc if the Euro is able to muddle through, which is still the highest odds scenario. If not….we'd be interested in the DEM – it's looking very cheap.
Japan - the cost of rebuilding
After the initial shock of the earthquake/tsunami in mid-March, the JPY carry trade was suddenly re-engaged as the market felt comfortable selling the JPY against higher yielding currencies in an environment of higher interest rates globally while the Bank of Japan was engaged in frantic new easing measures. But then we saw a return echo of the initial 'repatriation' trade that powered the JPY stronger, on the idea that funds would return to Japan to pay for damages. Even more importantly, bond markets around the world rallied strongly and the short end of the US yield curve collapsed, which saw a drastic tightening in rate spreads in the yen's favour, where rate expectations were already as low as they could go. What is the outlook going forward? Clearly, the JPY will need a continued fall in bond yields to remain attractive, since any backup in yields would eventually trigger the doomsday fears of what awaits Japan and its world beating debt load if the Japanese public ever loses faith in its government's credit ratings and/or rates creep high enough. Assuming a lid stays on Japanese yields (which we assume for the near to medium term), if commodity prices remain fairly elevated and Japan begins the task of importing vast material to rebuild the vast damage from the earthquake/tsunami, this could weigh on the JPY, as could softer export markets, somewhat countering any gains from a further drop in interest rate yields. How and if the Fed decides to attack the U.S. yield curve in possible new versions of QE is perhaps the most important factor.
Chart: Saxo Bank Carry Trade Index vs. sample USD and JPY carry trades. The recent turmoil in risk markets is quite evident in the significant drop in the Saxo Bank Carry Trade Index to below the 0 level, which suggests an outright contraction in risk appetite. While the yen has responded quickly to this development, appreciating against our sample basket of higher yielders, the USD (the upper circle) has failed to rally convincingly – either a worrying sign that its ability to thrive even as a safe haven in times of turmoil is in doubt, or that the market is trying to gauge the shape, size and timing of QE3
The Antipodeans: overdone?
AUD and NZD – they seem to know nothing but upside lately. What gives? Their strength has far outstretched traditional measures that determine their trajectory, like interest rate spreads, risk appetite and commodities. One answer is that investors may be buying these currencies as proxies for the supposedly inevitable Chinese Yuan revaluation, as China is seen as far more willing to move on its currency as a part of its effort to fight inflation domestically and it is a huge importer of goods from Australia and New Zealand. China and Chinese investors may also be buying these currencies as an alternative investment and for reserve diversification. There is some real evidence of this, as Chinese sources have admitted to an interest in buying NZD 6 billion in New Zealand assets recently, an announcement that quickly sent NZDUSD to a new all-time (post-float) high.
On the interest rate front, it is clear that the Reserve Bank of Australia is letting the currency strength do some of the heavy lifting on inflation fighting rather than going for further interest rate hikes, as that would have aggravated the currency's strength even farther and perhaps worked against the country's increasingly fragile domestic non-resource extraction economic sectors. Besides, Australia's 4.75 percent cash rate far and away offers the most attractive carry among the G-10 currencies.
The Aussie's formidable strength began to come slightly unravelled in Q2, at least in part due to a pause in the commodity rally and nervous equity markets. Going forward, the market may discover that the currency remains vastly overvalued if we see a continued downshift in global growth expectations. Already in the first half of this year, Australia's fundamentals are showing worrying signs of deterioration – overall growth was outright negative in Q1, mining company stocks have come under pressure and the country's housing bubble seems to have gone beyond the tipping point now.
Chinese resource demand and the world's assessment of the Yuan will remain key factors for the Aussie in the second half of this year, and the market perhaps underestimates the risk to the country's financial sector (and headline RBA rates) stemming from a housing bubble unwind if liquidity in the housing market dries up and price drops become widespread. In New Zealand, the Kiwi is overvalued and its extreme levels are probably partly due to poor liquidity. If risk aversion is sustained in Q3, that same thin liquidity could mean a heavy reversal at some point once (and if) capital inflows slow or even reverse.
Chart: AUD vs. the rest of G-10. The Aussie has enjoyed record strength and has traded at record levels versus the USD and on a trade weighted basis. The currency has rallied over 40% vs. an evenly weighted basket of the remainder of its G-10 peers as shown in the chart above. The currency may prove overvalued in coming quarters on the least hiccup in Chinese demand for Australia's commodities, as the Australia mining sector is an economic one-trick pony for the nation's economy. Another potential source of weakness is the domestic financial sector, which could face challenges from the unwinding of Australia's housing bubble, which now appears to be getting under way.
G-10: The bottom line
USD: If risk appetite is wobbly at best in Q3, we assume this will help keep a floor under the USD as QE2 is allowed to expire and the shape of QE3 is not immediately evident. A Homeland Investment Act II remains an important wildcard, though this becomes more likely close to 2012. Credibility on attacking the structural U.S. budget deficit is another key factor.
EUR: Very up in the air – EU and ECB are not on the same page. It is likely that a serious new bailout framework attempt may stabilise things for a while. But will Spain or Italy destabilise the single currency once again?
JPY: The government bond rally has been an important support and it must continue for the yen to maintain altitude. Continued high energy/food prices and possibly weaker export markets could keep yen rallies modest further out.
GBP: Will trade much like the USD as the BoE is dragging its heels in getting out of the easing game, considering the risks to growth from the government's austerity programmes. There are also special risks to the U.K. from its banks' holdings of Irish and other PIIGS debt.
CHF: The Swiss franc is a release valve for the Eurozone, thriving in an environment of very low rates and from the turmoil in the Eurozone bloc. It could be vulnerable at some point in Q3 if the Eurozone framework is pushed through for a time as it is getting overvalued.
AUD: The demand for and price of coal and iron ore and other commodities from China and the status of the domestic housing market are critical. The latter could have the most influence on the RBA's policy trajectory. AUD is vulnerable in our base assumption of nervous markets in Q3.
CAD: Has been unloved due to its exposure to the U.S. economy and could yet remain vulnerable as the pro-cyclical economies often slow the most rapidly when global growth hits the ropes, but remains unjustifiably weak against the Antipodeans. Crude oil's trajectory will remain important.
NZD: The recent exaggerated rally feels more like demand from reserve diversification and the like rather than a celebration of the country's strengths. Could see considerable two-way volatility once the overvalued currency tops out.
SEK: A classically pro-cyclical currency that has remained the most consistent in performing according to risk measures. Its upside is limited given its tremendous rally in previous quarters and the risk to its all important export markets if global growth decelerates. Then there's the housing bubble!
NOK: A relative safe haven within Europe, one would think, given its peerless balance sheet, but tends nonetheless to trade more like a pro-cyclical currency or even petro currency. Would be interesting to see what it does if risk is off and crude is up.
Saxo Bank | Jun 28 11 07:50 GMT
G-10 Currencies In Q3 - One Ugly Horse Race
The outlook for the major economies for the next couple of quarters is like some grotesque horse race in which the horses have all been maimed or sickened and picking the winner is a choice between which horse looks the least likely to collapse before the finish line. The U.S. economy headed south while the Federal Reserve must honour its QE2 exit deadline at the quarter end; Europe's periphery is still a festering sore in need of fresh bailouts, Japan's economy has been desperately disrupted by a natural disaster, and China is headed for a landing of one kind or another as it faces inflationary overheating and a property bubble. Forecasting in any environment is a hazardous affair – but this quarter, the pitfalls are even greater because the potential energy the market might unleash at any time, given the magnitude of the challenges that face all of the major economies, is perhaps as great as ever.
USD – end of QE2, yes, but is main focus already on QE3?
The overriding concern for the USD as we write these words some weeks before the end of the Fed's QE2 programme is how the market will deal with the Fed no longer propping up the bond market, both in terms of what it will mean for interest rates, but also for risk assets. After all, the perception has been that the Fed's presence in the bond market has encouraged the steady rise in asset prices practically from the day QE2 was hinted at late last August until the market began anticipating the end of QE2 in May of this year. Ahead of QE2's actual end, the greenback has rallied more modestly than one might expect given the sell-off in risk appetite, but that is likely due to the market's enthusiasm for imagining the shape of QE's to come. But is there a chance for the greenback to make a medium-term comeback within its overall secular decline?
Going forward, one possible brake to further USD declines is a relative underperformance of economies around the world relative to the already weak US and relative to past expectations. This is part of the general ugly horse race idea, i.e., that the pro-cyclical currencies like AUD and SEK and others will tend to do worse when the situation globally is turning south because there is far more to take out of their actual policy rates and forward expectations, while the U.S. expectations/yields are already virtually nil.
Another potential source of USD strength would be a second round of the Homeland Investment Act (HIA), the original version of which allowed U.S. companies to repatriate profits tax free back in 2005. If the Obama administration decides to go this route, (And why wouldn't it? After all, it certainly appears that Mr. Obama could use every possible boost to the economy to improve his chances in the election next November) estimates of the amounts that might be repatriated this time around are far higher than the original HIA and lie somewhere in the hundreds of billions of US dollars in potential inflows. Most likely, an HIA 2 would not be launched until Q4 and aimed at heaviest impact in 2012, but hints may be on the way in Q3.
But most importantly, considering how 'successful' the Fed has been in manipulating markets over the last couple of years, we will have to watch the progression of thinking within the Fed for signs of what it wants to do next if the U.S. economy continues its recent slide and asset markets find themselves in a funk. For at least a short while, perhaps the entirety of Q3, it will do nothing, but it may still hint at possible solutions to the next crisis, should it arise, in speeches, white papers, and perhaps even at the Jackson Hole conference sponsored by the Kansas City Fed later this summer. Judging from the widespread dissatisfaction with the straight up bond buying of QE2 and its ineffectiveness by many measures (plenty of complaints from within the Fed as well), any hints at a QE3 will likely involve a different policy approach. Perhaps the most intriguing is the idea of an 'Operation Twist', which we discuss in our general outlook. This approach would see a rise in interest rates at the forward end of the U.S. yield curve and the lowering of rates farther out the curve. How would this affect the USD? Very hard to tell, but at first blush it might be USD supportive as it would at least knock the stuffing out of the passive carry trade that tends to focus on interest rate spreads at the short end of the yield curve.
Europe – not a question of the Grecian formula
One luxury that Europe has had over the last 18 months of its various sovereign debt crises at the Eurozone periphery is that the bloc's economic centre of gravity, Germany, has been experiencing nearly unparalleled boom times. As China reins in its economy and higher commodity prices seem to be pressuring growth everywhere, however, it appears that Germany's star may have peaked as the strength of its export markets are thrown into doubt for the coming few quarters. And still, the sovereign debt problems at the periphery fester on, with the ever present challenges to the awkward bailout mechanism framework that will be up for major review at the late June summit. Meanwhile, the ECB's Trichet continues to put on a hawkish face and has started hiking rates to fight higher inflation. Quite the policy mix!
Of the major currencies, the outlook for the Eurozone is perhaps the most uncertain in the near term. The EU and ECB are at logger-heads over how to approach version 2.0 of the Greece bailout, particularly in terms of whether bond-holders should be forced to have their bond maturities restructured. There's no space to go into the particulars here, but our base assumption is that the powers at the top do manage to stand together and ram through some kind of 'solution' to the problem in late June or early July. The question further down the road is how palatable the receivers of the said bailout find it. For the bailed out countries, it might feel like being saved from a shipwreck only to be thrown in jail. Greece is already clearly socially destabilised, and Spain is also showing unrest with its high youth unemployment and sit-ins. Could we see something akin to the 'Arab spring' revolutions? Most worrying for the Eurozone, however, is whether the sovereign debt challenges jump to one of the bigger countries like Spain or Italy, where the current mechanisms simply don't address the magnitude of the potential problem and would require a whole new scale to the approach – likely explicit money printing, assuming the consensus at the centre holds in favour of a bailout solution. Italy is a particularly interesting case, as it has received little mention during all of the turmoil even though, as a study by Edward Altman of Risk Magazine estimates, the country is saddled with around $2 trillion in debt and pays more on its sovereign debt as a percentage of GDP (5 percent) than does Portugal (4.2 percent), which is already insolvent and was forced to ask for a bailout earlier this year. The road for the Eurozone is likely to be a rocky one for the rest of this year – the market Is already pricing in a lot of risk for the Euro, so the currency could perform very well against the pro-risk trades and even against the Swiss franc if the Euro is able to muddle through, which is still the highest odds scenario. If not….we'd be interested in the DEM – it's looking very cheap.
Japan - the cost of rebuilding
After the initial shock of the earthquake/tsunami in mid-March, the JPY carry trade was suddenly re-engaged as the market felt comfortable selling the JPY against higher yielding currencies in an environment of higher interest rates globally while the Bank of Japan was engaged in frantic new easing measures. But then we saw a return echo of the initial 'repatriation' trade that powered the JPY stronger, on the idea that funds would return to Japan to pay for damages. Even more importantly, bond markets around the world rallied strongly and the short end of the US yield curve collapsed, which saw a drastic tightening in rate spreads in the yen's favour, where rate expectations were already as low as they could go. What is the outlook going forward? Clearly, the JPY will need a continued fall in bond yields to remain attractive, since any backup in yields would eventually trigger the doomsday fears of what awaits Japan and its world beating debt load if the Japanese public ever loses faith in its government's credit ratings and/or rates creep high enough. Assuming a lid stays on Japanese yields (which we assume for the near to medium term), if commodity prices remain fairly elevated and Japan begins the task of importing vast material to rebuild the vast damage from the earthquake/tsunami, this could weigh on the JPY, as could softer export markets, somewhat countering any gains from a further drop in interest rate yields. How and if the Fed decides to attack the U.S. yield curve in possible new versions of QE is perhaps the most important factor.
Chart: Saxo Bank Carry Trade Index vs. sample USD and JPY carry trades. The recent turmoil in risk markets is quite evident in the significant drop in the Saxo Bank Carry Trade Index to below the 0 level, which suggests an outright contraction in risk appetite. While the yen has responded quickly to this development, appreciating against our sample basket of higher yielders, the USD (the upper circle) has failed to rally convincingly – either a worrying sign that its ability to thrive even as a safe haven in times of turmoil is in doubt, or that the market is trying to gauge the shape, size and timing of QE3
The Antipodeans: overdone?
AUD and NZD – they seem to know nothing but upside lately. What gives? Their strength has far outstretched traditional measures that determine their trajectory, like interest rate spreads, risk appetite and commodities. One answer is that investors may be buying these currencies as proxies for the supposedly inevitable Chinese Yuan revaluation, as China is seen as far more willing to move on its currency as a part of its effort to fight inflation domestically and it is a huge importer of goods from Australia and New Zealand. China and Chinese investors may also be buying these currencies as an alternative investment and for reserve diversification. There is some real evidence of this, as Chinese sources have admitted to an interest in buying NZD 6 billion in New Zealand assets recently, an announcement that quickly sent NZDUSD to a new all-time (post-float) high.
On the interest rate front, it is clear that the Reserve Bank of Australia is letting the currency strength do some of the heavy lifting on inflation fighting rather than going for further interest rate hikes, as that would have aggravated the currency's strength even farther and perhaps worked against the country's increasingly fragile domestic non-resource extraction economic sectors. Besides, Australia's 4.75 percent cash rate far and away offers the most attractive carry among the G-10 currencies.
The Aussie's formidable strength began to come slightly unravelled in Q2, at least in part due to a pause in the commodity rally and nervous equity markets. Going forward, the market may discover that the currency remains vastly overvalued if we see a continued downshift in global growth expectations. Already in the first half of this year, Australia's fundamentals are showing worrying signs of deterioration – overall growth was outright negative in Q1, mining company stocks have come under pressure and the country's housing bubble seems to have gone beyond the tipping point now.
Chinese resource demand and the world's assessment of the Yuan will remain key factors for the Aussie in the second half of this year, and the market perhaps underestimates the risk to the country's financial sector (and headline RBA rates) stemming from a housing bubble unwind if liquidity in the housing market dries up and price drops become widespread. In New Zealand, the Kiwi is overvalued and its extreme levels are probably partly due to poor liquidity. If risk aversion is sustained in Q3, that same thin liquidity could mean a heavy reversal at some point once (and if) capital inflows slow or even reverse.
Chart: AUD vs. the rest of G-10. The Aussie has enjoyed record strength and has traded at record levels versus the USD and on a trade weighted basis. The currency has rallied over 40% vs. an evenly weighted basket of the remainder of its G-10 peers as shown in the chart above. The currency may prove overvalued in coming quarters on the least hiccup in Chinese demand for Australia's commodities, as the Australia mining sector is an economic one-trick pony for the nation's economy. Another potential source of weakness is the domestic financial sector, which could face challenges from the unwinding of Australia's housing bubble, which now appears to be getting under way.
G-10: The bottom line
USD: If risk appetite is wobbly at best in Q3, we assume this will help keep a floor under the USD as QE2 is allowed to expire and the shape of QE3 is not immediately evident. A Homeland Investment Act II remains an important wildcard, though this becomes more likely close to 2012. Credibility on attacking the structural U.S. budget deficit is another key factor.
EUR: Very up in the air – EU and ECB are not on the same page. It is likely that a serious new bailout framework attempt may stabilise things for a while. But will Spain or Italy destabilise the single currency once again?
JPY: The government bond rally has been an important support and it must continue for the yen to maintain altitude. Continued high energy/food prices and possibly weaker export markets could keep yen rallies modest further out.
GBP: Will trade much like the USD as the BoE is dragging its heels in getting out of the easing game, considering the risks to growth from the government's austerity programmes. There are also special risks to the U.K. from its banks' holdings of Irish and other PIIGS debt.
CHF: The Swiss franc is a release valve for the Eurozone, thriving in an environment of very low rates and from the turmoil in the Eurozone bloc. It could be vulnerable at some point in Q3 if the Eurozone framework is pushed through for a time as it is getting overvalued.
AUD: The demand for and price of coal and iron ore and other commodities from China and the status of the domestic housing market are critical. The latter could have the most influence on the RBA's policy trajectory. AUD is vulnerable in our base assumption of nervous markets in Q3.
CAD: Has been unloved due to its exposure to the U.S. economy and could yet remain vulnerable as the pro-cyclical economies often slow the most rapidly when global growth hits the ropes, but remains unjustifiably weak against the Antipodeans. Crude oil's trajectory will remain important.
NZD: The recent exaggerated rally feels more like demand from reserve diversification and the like rather than a celebration of the country's strengths. Could see considerable two-way volatility once the overvalued currency tops out.
SEK: A classically pro-cyclical currency that has remained the most consistent in performing according to risk measures. Its upside is limited given its tremendous rally in previous quarters and the risk to its all important export markets if global growth decelerates. Then there's the housing bubble!
NOK: A relative safe haven within Europe, one would think, given its peerless balance sheet, but tends nonetheless to trade more like a pro-cyclical currency or even petro currency. Would be interesting to see what it does if risk is off and crude is up.
