US equities rallied sharply into the close, the catalyst being reports from the EU finance ministers meeting in Luxembourg that they were working on a coordinated plan to recapitalise European banks. It’s one thing to recognise that there is a problen, it’s quite another to come up with a workable solution. Back in 2008, bank recapitalisations were very much domestic affairs, resulting from country/institution-specific issues and exposure. This time around, there is a far more common theme (sovereign exposure) which has significiantly increased the risks of contagion and also introduced the need for a more coordinated approach. The positive vibes from these headlines though have been partially unwound by the downgrade of Italian debt by Moody’s, down three notches to A2. This comes on the back of the recent S&P downgrade, so the political establishment took this one more in its stride. Nevertheless, it will serve to make it that much harder for Italian banks to access capital markets and possibly lead to a further marginalisation of Italian debt in the eurozone bond market.
Sino-US currency war escalation. Fed Chairman Bernanke last night weighed in on the increased tensions being seen between the US and China regarding the yuan. Bernanke was quite pointed in his remarks, stating that “Chinese currency policy is blocking what might be a more normal recovery process in the global economy”. This comes after China expressed its displeasure in very strong terms over a bill currently being debated in the Senate that would impose import tariffs on countries with undervalued currencies. Beijing’s response has been exhortative, claiming that the measure violates WTO rules and that an appreciating yuan at this time would only further weaken an already fragile global economy. In expressing its “adamant opposition” to the bill, China suggested that it had the potential to trigger a trade war between the two superpowers, and that forcing it to revalue would not resolve America’s large trade deficit nor its high unemployment rate. Recently, the yuan has actually appreciated against the dollar, at a time when the greenback has made significant gains against virtually every other major currency. As a result, the yuan has appreciated markedly against many of its Asian competitors. It is likely that this issue will get more air-time over the next year, but at the same time it is doubtful that it will really impact on how China manages its exchange rate. America may be impatient, but China holds the aces, and moreover, absolutely understands that it needs to move towards a more market-determined exchange rate.
More moving EU targets. Just as the debate has moved on from securing agreement for the EFSF increase to EUR 440bln, the July agreement on Greece’s 2nd bail-out is also seeing attempts to re-negotiate the extent of private sector involvement in the deal. At the time, in an arrangement of debt swaps and maturity extensions, the EU embarked on a campaign of persuading private sector creditors to take a 21% write-down on their debt-holdings. However, the slippage on the deficit reduction plan announced by the Greek government over the weekend now means that these numbers are looking dated. These comments emanated from the chair of the Eurogroup, Luxembourg PM Juncker, but not surprisingly there isn’t unanimity around this proposal (France and Spain having voiced their concerns). The issue is that, whilst the political process is moving slower than events and financial markets, securing an agreement on voluntary restructuring is moving even more slowly. We’re now in a situation where the hair-cut being offered is insufficient, but there’s not enough interest from EU leaders in recognising this and adjusting the process accordingly. The danger is that the private sector involvement element continues to remain elusive, which will increase the risk that this eventually becomes a disorderly and involuntary involvement.
Carry carried out. The sharp correction witnessed in the Aussie over the first half of this week highlights the deterioration we’ve seen in carry currencies in the past 2-3 weeks, enhancing the underlying trend seen since April. AUD/JPY best reflects this, with the key carry cross yesterday threatening to break below the 72.20 low marked out in 2010. Taking a wider look at the carry trade, it’s notable just how badly it is now performing, even though we are living in a world with zero interest rates in several major currencies and plenty of carry opportunities beyond those shores. For anyone invested in a simple basket of Aussie, Kiwi, Turkish lira and Brazilian real, funded via the yen, the latest moves in these currencies would have wiped out the profit made over the past twenty-eight months, with the move in these currencies since April resulting in a 20% loss. Furthermore, the way things are panning out we are entering a phase when the dynamics of the carry trade could well be changing on a more permanent basis. Traditionally, carry trades have been characterised by long periods of gains, followed by short period of losses. In the period from 2000 to October 2007, a simple carry basket yielded gains in 66% of the months. From November 2008 to now, that figure falls to 49%. In other words, the dynamics of the carry trade have undergone a major readjustment, which could well call into question its longer-term use in currency trading strategies.
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