FX Views : Currencies in the Crossfire of Politics

NZPA

Friday 12th August 2011

Competitive Devaluations?

After the immediate shock of the credit crisis in early April 2009, G20 leaders pledged to "refrain from competitive devaluation of our currencies." At the time, other policy tools were still available, in particular fiscal easing, which contributed substantially to the earlier stages of the recovery.

Now, two years later, the global economy is slowing again. But the scope to use fiscal policy has been exhausted. Markets and rating agencies force fiscal consolidation on both sides of the Atlantic.

Monetary policy rates remain very low in most countries. Suddenly, currencies look like an obvious tool again to engineer easier financial conditions. Last year's debate about the "wall of money" and "currency wars" was the beginning of an increasing debate about FX policy. Japan's and Switzerland's interventions to prevent excessive strengthening of their currencies are two recent examples.

A number of Asian authorities have joined the trend with increased use of "macro prudential" tools and complaints about excess liquidity. Brazil continues to tighten capital controls to limit inflows. However, the most significant development that leads to policy-induced currency weakness may be the new Fed commitment to keep rates at exceptionally low levels until at least mid-2013 and to probably engage in QE3. We expect a lot more debate about competitive devaluations in the months to come.

Competitive Devaluations Force Additional Monetary Easing. One interesting aspect of the rising pressure to devalue currencies in many countries is that taking such a step typically requires additional monetary policy easing. Unsterilised interventions to weaken the exchange rate are also a non-traditional policy tool to ease.

On a global scale, a race to "competitively devalue " all currencies if delivered in this way would likely see a propagation of easier monetary policies - which might be exactly what the slowing global economy currently needs.

Underlying Dollar Weakness to Remain the Main FX Trend. Though we have been in a bearish Dollar camp for some time now, it is still surprising to see just how weak the USD is, even in the face of the broader risk aversion seen in recent weeks. Compared with the post-Lehman period in 2008, the steep fall in risky assets should have caused the broad trade weighted Dollar to strengthen by about 8%-9% instead of the 2% observed in reality. This increasingly suggests that the USD is losing its safe haven status.

We continue to believe that structural US imbalances are the main reason: These lead to weak capital inflows and a continued large current account deficit, as highlighted again today by a widening trade deficit. Furthermore, structural weaknesses combined with the dual Fed mandate lead to easier monetary policy than elsewhere, as the FOMC made clear this week. It will take a while before these structural factors change and the Dollar downtrend slows. This weak Dollar theme also remains dominant across our tactical and Top Trade recommendations for currency markets. We remain exposed to the weak Dollar theme across our tactical and Top Trade recommendations, and have just added a new tactical short USD basket (versus NZD, RUB, SEK, KRW, MYR, and CLP). Structural US imbalances and the impact on neighbouring countries have also helped us reach a 4.3% return target on our short MXN/CLP recommendation closed this week.

CNY on the Move.

There are many reasons why it makes sense for the Chinese Authorities to take the foot off the Reserve Accumulation Accelerator. First, the continued broad Dollar weakness has led to trade weighted depreciation of the CNY in recent months. Second, inflation pressures remain material while at the same time export performance remains strong as the latest batch of macro data has indicated. Third, accumulating ever-more US and European bonds when the governments in these regions struggle with fiscal policy consolidation may not be a popular use of what constitutes a big chunk of China's national savings. The arguments are not new but they have become a lot more convincing in recent times, and $/CNY has dropped by 0.6% in the last two sessions. We remain short $/CNY as one of our Top Trade Ideas for the year.

Watch the TWI for JPY Intervention.

Given the experience of the Japanese authorities with exceptionally fast and large reserve accumulation in 2003-2004, a repeat of this strategy is probably unlikely. The intervention last week started at about 77, while the joint G7 action after the earthquake started at a level of 79.50. The difference is about 3%, quite similar to the decline in the trade weighted Dollar over the same period. Moreover, both interventions took place at levels very close to multi-year highs in the trade weighted JPY. And interestingly, in both cases, there was evidence from our GS Sentiment Index that speculative JPY positioning was getting long.

Bottom line, it appears the Japanese authorities will not intervene to block the strong underlying Dollar downtrend - a notion that is also partly reflected in capital flows into Japan as discussed by Fiona Lake last week. Consequently, we have revised our JPY forecasts against the USD stronger. However, the Authorities will likely intervene when there are signs that the JPY appreciates more versus the USD than other currencies - in particular when associated with speculative long JPY risk.

Any Natural Sellers of CHF?

We have asked this question before in our research and still haven't found any. The situation remains very difficult with option markets being the main driving force. Unwinding of legacy carry trades remains a factor, as do worries about sovereign tensions in Europe. The fact that the USD downtrend undermines its status as a reserve currency makes the CHF even more attractive as a safe haven. And with fixed income markets pricing rate cuts in virtually every country recently, the already-small interest rate differentials are becoming even less CHF negative. The new feature of the continued CHF rally in recent weeks has been the rapid rise in very short-dated implied volatility, which suggests that speculative CHF longs have been growing as well.

In this environment of self-fuelling price action, intervention by the SNB clearly makes a lot of sense. Ideally a policy similar to a managed float should be implemented. Small daily ranges and gradual CHF weakening may be necessary to act as a circuit breaker for disrupted volatility markets. At about 45% overvaluation and stronger signs of slowing export demand, the SNB now also has strong fundamental reasons to act decisively. We think the concerns about valuation losses on FX reserves should be ignored, as central banks are the only institutions that can recapitalise themselves by printing money. Given that the SNB clearly needs to ease monetary conditions anyway, this policy would be consistent.

How much more TRY weakness?

We do not think the Turkish Lira depreciation is over yet, but we are impressed by the way the Turkish authorities have managed the depreciation so far. Despite a cumulative depreciation of nearly 30% since the policy change late last year, implied volatility has remained very well contained - even during the disruptive price action across global markets in recent weeks. However, doing a good job of managing the volatility of the decline should not be read as a sign that the TRY is about to strengthen. Quite the contrary. The continued dovish stance of the CBRT, the still very large current account deficit, and slowing activity suggest that the TRY will approach clearly undervalued levels, where it would make more sense for policymakers to firmly state a preference for a stronger currency.

Some Final Thoughts about the EUR.

The developments in recent weeks suggest that European policy makers finally realised that they were looking down the abyss again and had to act. The July summit was a significant step toward deeper political integration and a shift towards more support for pro-growth policies in program countries. But Europe being Europe, it now all depends on implementation at the country level. Understandably, markets fear a lack of follow-through, and a sense of urgency regarding the implementation would help. Here is the ideal scenario that would lead to a decline in the Fiscal risk premium:

1) Italy and Spain adopt growth-boosting structural reforms during the holiday period combined with some additional fiscal consolidation to underpin credibility.

2) The ECB signals strong commitment to Italian and Spanish bond purchases until markets become comfortable with the improved policies.

3) Parliamentarians in Germany, Finland, and the Netherlands vote as soon as possible in favour of the July summit resolutions and the still-missing guarantee increases to get the EFSF to the full EUR 440bn lending capacity.

4) Private sector participation in the second Greek package is substantial enough to appease voters in these fiscally strong countries. All of this could be delivered by mid-September and, relative to the very low expectations that prevail, we think there is potential to surprise markets on the upside. Our base case remains that the fiscal risk premium in the Euro will ultimately decline.

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