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Crunch time for the Aussie?

13/05/13 @ 13:21 GMT by Simon Smith, Chief Economist

Even before Friday’s break of the parity level on AUDUSD, significant changes were underway on the Aussie which had lead it to be the weakest performer on the majors over the past month. Many have claimed that the Aussie has been fundamentally over-valued for years, but more than any other, it’s the FX markets where the old saying “markets can stay irrational longer than you can stay solvent” applies. So what’s changed now?

Firstly, the Aussie is no longer trading so strongly as a commodity currency. The Aussie used to move very closely with the fortunes of global commodity prices, together with the domestic mining sector. This is no longer the case. Indeed, so far this month we’ve seen a divergence, with factors that would have traditionally been supportive for the Aussie being met with a declining currency (against all majors apart for the yen). The breakdown in correlation is not new. Indeed, we can go back to the middle of last year to see the initial breakdown in some of the commodity currency correlations (see “The shifting sands of FX”). What is of notable is the severity of the move.

This brings us on to the second observation. For the past 6 months, markets have been moving away from (global) liquidity driven risk trades, focusing more on domestic developments. This can be seen in the greater sensitivity of currencies to data surprises (see “Proving the new FX regime”). This was also true for the Aussie in the first three months of the year, which accounted for much of the move down to the 1.02 area in early March and the subsequent recovery to the 1.06 area. But more recently we’ve seen this correlation break down, in part as a result of the latest rate cut from the RBA.

The above two observations combine with what we’ve seen from China of recently, both in the data and also beyond. China’s long-held ambition to move towards a more service sector orientated economy is slowly but surely starting to bear fruit. Early data for this year suggests that service sector output overtook that of the industrial sector for the first time. At the same time, growth itself is slowing, with a natural consequence being that Australia’s main export destination sectors are slowing faster than the economy as a whole.

The final point to note is that the premium the Aussie used to command from a sovereign risk perspective (good fiscal numbers compared to most peers) has also narrowed this year. Both the Aussie budget numbers have fallen short of expectations at the same time that the perceived riskiness of the Eurozone periphery has declined. Our series which tracks the weighted average of Eurozone peripheral bond spreads (over Germany) is just above the lows for the year, having halved over the past 9 months. Now this may be just a transitory move for the eurozone, masking the still perilous fiscal issues underneath, but for now the perception is holding. This could mean that investors who had viewed the Aussie as something of a safe haven from the sovereign storms elsewhere at a minimum don’t add to their positions, or they adjust Aussie allocations lower as a result.

Does this mean the Aussie is heading for the sort of re-adjustment seen by the yen over the past 6 months? Most likely not, given that it still retains a decent advantage on both rates and global growth differentials. But the moves over the past month are part of a wider re-alignment that has been underway for nearly a year now in terms of what is driving the currency. For this reason, when combined with the better dollar tone, we have now likely entered into a new sub-parity trading range.

Tags: aud USD

The impending ECB curveball

02/05/13 @ 14:16 GMT by Simon Smith, Chief Economist

For markets, an ECB press conference is a minefield. Rather than release all the pertinent information in a statement at the time of the decision (as other major central banks do), the ECB gives the bare minimum then throws in the curveballs in the press conference opening statement and quite often, in the question and answer session.

The price action on the euro reflects this once again today. A cut in the main refinancing rate was expected and delivered. The initial rally came on the fact that the deposit rate was kept at zero (there were fears that it could be pushed into negative territory). The reversal came as the ECB promised to offer full allotment at its refinancing operations (giving banks all the liquidity which they ask for) to the middle of next year. The curve ball was the revelation that Draghi has an “open mind” on a negative deposit rate. Two month ago, he described this as “unchartered waters” and noted that “the unintended consequences of a measure like that can be serious”.

But would it be such a serious thing? In some ways not as much as before, which is why Draghi may be softening his stance. During the depths of the financial crisis, banks were parking billions at the ECB on a daily basis rather than lending it out to other banks or elsewhere. This year, overnight deposits have fallen by half and excess liquidity in the Eurozone (as measured by the excess of current account balances beyond requirements and net lending back to the ECB) has also fallen by half, to EUR 383bln. At the same time, banks have repaid (ahead of time) more than EUR 400bln in 3 year loans.

In summary, there’s less money sloshing around, so less of it being deposited back at the ECB which means fewer banks will be impacted by a negative deposit rate. By waiting until later this year to implement such a measure, the ECB could well be thinking of having it as a stick, rather than a carrot, so that banks don’t find themselves in the situation of having to deposit huge amounts back to the ECB again.

For FX, the effects have been apparent today. The fact that such a measure has not been introduced elsewhere would make the Eurozone stand out from the crowd. It could encourage well capitalised banks to park money beyond the Eurozone, hence the negative currency reaction. But if current trends continue, the negative consequences of such a move diminish, which is why we could well see it soon.

Tags: ecb eur USD

Growth and FX

23/04/13 @ 14:06 GMT by Simon Smith, Chief Economist

The latest indications on output from both China and the Eurozone paint a disappointing picture for near-term growth prospects, but maybe not a wholly surprising one. There is a striking pattern to the way data is turning out in the developed economies over the previous two years. If we’re on a path to further disappointment, what could this mean for currency markets in the rest of the second quarter?

First let’s deal with the facts. Using the Citigroup data on economic surprises (index showing whether data is above/below expectations), we’ve seen a distinct pattern in 2011 and 2012 of data modestly disappointing expectations in the first quarter (so series falling) and more markedly so during the second quarter. There was a very tight mid-year correlation between 2011 and 2012 before the end of the 3rd and a final quarter showing data surpassing expectations. Of course, this can be down to (lagged) adjustment of expectations, as “the street” becomes to expect weak output numbers after the previous disappointment.

Perhaps what is different now is the synchronicity between developed and emerging markets (a distinction which is admittedly becoming less relevant). In 2011, emerging markets were largely immune to a mid-year slowdown, in 2012 less so but recovered well. This year, it’s a lot more synchronous. This is also evident in the actual output numbers. Last year was the slowest for growth in the major emerging markets (BRIC) since 2008. Back then, they were able to act as a significant counter-weight to the weakness seen in developed markets. Real GDP in the BRIC markets expanded by 20% between 2008 and 2010 whilst developed market growth was flat (from World Bank ‘high income’ countries series).

There is every reason to expect that we are not going to repeat that divergence this year or next. Slower growth in China is anticipated, warranted and positive for the global economy (in that it’s more sustainable). So whilst at the top level, cycles are becoming more synchronised, for FX it’s the opposite. Volatility has increased from the multi-year low reached at the end of last year, commodity currencies have become less correlated with commodities and FX in general has become less correlated with ‘risk assets’, both on a cross asset basis and between individual currency pairs.

Related has been the dollar’s stronger correlation with data surprises, so firmer activity leader to a higher dollar as expectations of the Fed withdrawing QE increase, rather than this leading to a ‘risk-on’ move into higher yielding currencies. The dollar’s relationship with data surprises has moved from deeply negative to deeply positive in the space of 6 months, but is now moving lower again, largely owing to the disappointing data been seen beyond the US.

At the top level, there are 3 implications for FX which I’ll explore more deeply in coming blogs. Firstly, despite recent moves, we will remain in a less correlated world. The effectiveness of QE programs is diminishing and becoming less influential on asset markets (see “Proving the new FX regime” from earlier this year for more thorough grounding on this), so even if there are rate cuts (Eurozone) or more QE (UK), the currency impact will be transitory. Secondly, the dollar will continue to benefit, less because the US is doing well, but more because elsewhere is doing not so well. Finally, commodity currencies will continue to defy gravity, particularly the Aussie, even if this means they weaken less than established correlations to commodities suggest. The fiscal numbers and cyclical position will continue to offer support.

Tags: forex fx g10 growth

Golden Rules Gone

15/04/13 @ 13:24 GMT by Simon Smith, Chief Economist

Even before the tumble in the price at the end of last week, things were not looking good for Gold. Before this year, the multi-year bull market (rising in dollar terms every year from 2001 to 2012) defied the credit crisis and the subsequent period of patchy global recovery and central bank quantitative easing. This increased the perception that gold could survive anything and the good times would continue. But it also created a false sense of security for gold bulls and that’s now increased, because the old rules have broken down and as yet, there’s nothing new to replace them.

Of course, unlike stocks or bonds, gold gives no income flow (coupon or dividend) and has limited use, so traditional approaches to security valuation (estimating and discounting these flows) can’t be applied. As such, many theories and views (some tame, some very crazy) fill this intellectual void to justify (mostly higher) valuations.

There have been many justifications of the rising gold price in recent years during the 2001 to 2012 period. During the early part, gold was painted as a dollar story, the rising gold price (in US dollars) the opposite side of the falling dollar story. During this time, gold’s correlation with the dollar was -0.55. On the same basis (rolling 3-month, measured weekly) it’s now in positive territory.

There’s been a similar change in gold’s relationship with global real interest rates (global bond yields minus inflation). The relationship is a simple representation of the opportunity cost of the real return forgone by holding a non-yielding asset. If inflation adjusted returns are high in general, then it’s a bigger hurdle for investors to give up to invest in gold, with a larger capital appreciation needed to overcome the real rate lost. This held quite strongly in the credit crisis period (2008-12), an inverse correlation of 0.50. Currently it’s strongly positive at 0.65.

Even the advocates of money debasement via the expansion of central bank balance sheets are having a hard time of late. Over the past 6 months, global G4 central bank balance sheets have expanded by more than 12% (weighted change in assets), whilst the gold price has fallen by 16%.

The upshot is that the golden rules for gold, as much as there can be rules for such an asset, have floundered. For now, nothing has emerged to take their place. As such, expect the bulls to push a return to the old world order. Whilst the global gold price peaked 19 months ago, global holdings of gold in ETFs peak just 4 months ago. From this perspective, the lack of a rule-book could mean that there is more liquidation to come before any recovery can take place.

Tags: Gold USD

Delivering in Japan

04/04/13 @ 10:18 GMT by Simon Smith, Chief Economist

There’s no doubting that the Bank of Japan delivered over and above what was expected. But the two questions to explore are will the policy announcements be enough to deliver 2% inflation on their imposed 2 year horizon and what will be the impact on the currency?

On the inflation ambition, it’s a tall order and there are two elements to the answer. The first is the transmission mechanism, the second is the reaction of the different sectors of the economy (firms, households, government). On the transmission mechanism, Japan has spent much of the past near twenty years pushing on a string with regards to monetary policy. Japan was the early ‘modern’ example of a balance sheet recession, one concentrated in the corporate sector (vs. the household sector of the US in the run-up to 2008). So as much as the Bank of Japan was cutting rates and pushing money (the monetary base increased 50% 2001-03), the corporate sector was choosing to pay-down debt.

From a balance sheet perspective, the omens are better this time around, although this must be set against the backdrop of all central banks suffering from a weakened transmission mechanism at the zero lower bound. It’s all relative and far harder vs. a positive nominal rate regime. This is where we fall into the reaction side. Deflation has a crippling impact on all 3 sectors of the economy. Households don’t purchase today what they believe they can buy tomorrow at a lower price. Firms are discouraged from investing (and increasing wages) and governments see an ever rising real debt burden.

There have been signs of change in the corporate sector after a period in which contractual cash wages have fallen 7% over the past 10 years. Some firms have been increasing wages, although many of the bigger ones have increased bonuses, rather than increase their cost base via wage increases. Indeed, over the past 4 years, the bonus element of earnings has risen 13.5%, reflecting this caution.

But it could well be fiscal policy and the actions of the government that determine whether the inflation target is achieved. Japan has been beset by periods where recovery has been choked-off by premature fiscal tightening. Such a move could well end up reversing any positive signs that emerge in the first year so the new administration needs to avoid the temptation of choking off any signs of a much-awaited sea change in the economy.

So for now, it’s a tall order to expect the 2% inflation target to be achieved. The best hope is that we see signs of an end to the deflationary mind-set that has gripped the economy. For the yen, we’re likely to see further weakness, but the pace of depreciation is unlikely to match that of recent months. The 100 level on USDJPY may well have to wait until later in the year.

Tags: JPY USD

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