Risk Recovery - Short Term
05/07/10 06:43
Risk Aversion - We Called It! Risk Recovery - Short
Term.
We have accurately anticipated the decline in risk that has taken place the past several weeks, as proven in previous issues of Forex Notes. We were far more specific in the accuracy of the price levels and turning points discussed in Pro Traders Club and had the opportunity to capitalize on the movements. We anticipate modest risk recovery before another round of selling in the coming weeks. On the institutional side, we saw short EUR holders get caught in a short squeeze during thin holiday trading. Another leg up on EUR is likely before buying eases off.
On April 1, the yen looked poised to weaken significantly. Policy rates in Japan and the rest of the G10 were beginning to diverge, led by an aggressive RBA tightening campaign which eventually saw the cash rate hiked six times in seven meetings. Furthermore, and more significantly, the market anticipated a wave of yen selling as Japanese life insurers looked set to begin their annual overseas investment program.
Yet since then, USDJPY has fallen steadily from 93.44 to close at 87.75 on Friday. The decline was interrupted only by a brief episode of political uncertainty surrounding the resignation of former Prime Minister Hatoyama. Market participants could legitimately wonder if life insurers have switched tactics this year, preferring instead to invest closer to home? No!
Japan's life insurance companies have been just as keen to invest overseas this year, and their foreign bond holdings have increased by approximately ¥1 trn during the months of April and May.
We have accurately anticipated the decline in risk that has taken place the past several weeks, as proven in previous issues of Forex Notes. We were far more specific in the accuracy of the price levels and turning points discussed in Pro Traders Club and had the opportunity to capitalize on the movements. We anticipate modest risk recovery before another round of selling in the coming weeks. On the institutional side, we saw short EUR holders get caught in a short squeeze during thin holiday trading. Another leg up on EUR is likely before buying eases off.
On April 1, the yen looked poised to weaken significantly. Policy rates in Japan and the rest of the G10 were beginning to diverge, led by an aggressive RBA tightening campaign which eventually saw the cash rate hiked six times in seven meetings. Furthermore, and more significantly, the market anticipated a wave of yen selling as Japanese life insurers looked set to begin their annual overseas investment program.
Yet since then, USDJPY has fallen steadily from 93.44 to close at 87.75 on Friday. The decline was interrupted only by a brief episode of political uncertainty surrounding the resignation of former Prime Minister Hatoyama. Market participants could legitimately wonder if life insurers have switched tactics this year, preferring instead to invest closer to home? No!
Japan's life insurance companies have been just as keen to invest overseas this year, and their foreign bond holdings have increased by approximately ¥1 trn during the months of April and May.
What then has acted to counteract these outflows? There has been a break down of institutional order flow over UBS books, and find that hedge funds have been determined sellers of USDJPY since early March, disposing of $6 bn worth. Assuming this pattern is representative of flows seen throughout the rest of the FX market, it seems approximately $40 bn have been sold into the market to buy yen over the past 4 months, easily overwhelming yen outflows due to the investment activities of life assurance companies.
More JPY strength is anticipated, but will be limited, in our view. The decline in risk appetite over recent weeks has shown little sign of abating, and the yen will likely continue to benefit as a safe haven destination. Also, US Treasury yields may have further to fall as the market continues to price out the possibility of Fed rate hikes until later in 2011. This will likely apply further tightening pressure to UST-JGB yield spreads, further reducing the incentives for Japanese asset managers to invest in dollar-denominated assets. The JPY safe haven status results in the yield advantage of JGB's over UST's.
Over the weekend, French Finance Minister Lagarde said that the results of stress tests on European banks will be released on or about July 23, and ECB President Trichet said that the results would be an "important element" in restoring market confidence. Trichet repeated his opposition to Europe-wide debt issuance and insisted that efforts to trim fiscal deficits would boost confidence and not choke growth. Meanwhile, ECB Executive Board Member Tumpel-Gugerell acknowledged that fiscal consolidation would have some short-term impact on growth but said that this would not be significant. Reuters is reporting that the European Financial Stability Fund may not be operational until late July or early August, citing unnamed sources.
For the Eurozone, the highlight of the week is expected to be ECB President Trichet's post-policy decision press conference on Thursday. UBS economists expect the refi rate to remain at 1.0%. As such, questions will likely focus on bank stress tests, and whether recently announced fiscal consolidation plans may influence ECB policy. Furthermore, the question of how government bonds purchased under the ECB's Securities Market Program can be sterilized in future is likely to arise, given the ECB's inability to attract sufficient bids at last week's auction of 1w deposits.
The RBA is due to announce its latest policy decision on Tuesday, and neither UBS's Australia economists nor the consensus expects any change in the cash rate. The minutes from the June meeting clearly indicate that the RBA has adopted a wait-and-see posture as the Board awaits "information on how the recent market uncertainty might affect the global economy". The next quarterly CPI estimate, not due for release until July 28, was also cited as a critical input to future rate decisions.
We are cautious on the near-term outlook for the AUD given that global risk appetite remains weak. Furthermore, appreciation pressure on the aussie due to expectations of further rate-hikes has also now subsided, and the market no longer sees any further tightening over the next 12 months.
Weakening Chinese economic data is also a cause for concern. Although China economist's do not expect a hard landing in overall economic growth, property construction accounts for about 40% of China's steel consumption. If the slowdown in construction and housing starts continues as expected, the aussie could suffer directly given Australia's dependence on China as an export market. Further downward pressure could also be applied through a consequent decline in global commodity prices. Should a major risk event follow through, we may see AUDUSD below .8000, at which point we will become aggressive buyers. We are short term buyers below .8500 with the goal of quick profit taking.
It will be a quiet week on the economic data front in New Zealand. The NZIER business sentiment index is due on Tuesday, followed by credit card spending on Friday. Although UBS New Zealand economist expects the RBNZ to hike the OCR by 25 bps at every opportunity this year, such a rapid pace of tightening is already largely priced in.
Source: UBS, Chris Lori, Bloomberg